Let's Talk About Momentum Trading

by: Matthew Allbee

Summary

Momentum investing has proven to be a surprisingly successful form of investing for more than 80 years now.

Despite this, you may find yourself on the wrong side of many so-called "momentum" trades.

In this article, I explain what may be going wrong and how you can put together a market-beating portfolio for years to come.

Momentum investing is a technique that almost everyone has utilized at some time. It seems obvious: buy winners and short losers. Many have found success with this method, but countless others have also been duped into costly mistakes. In this article, I will take a look at what does and doesn't work in momentum trading.

It turns out that momentum investing seems to be an excellent strategy in the medium term, but this relationship breaks down over different time periods. Securities that performed well 7-12 months ago continue to outperform both the broader market and securities that have done well in the more recent past. Going further than 12 months, momentum quickly becomes useless in determining price moves.

This is the outcome of research summarized in the academic study "Is Momentum Really Momentum?" The researchers found that momentum was mostly not due to short-term "autocorrelation" - future price movements correlating with past price movements. Instead, momentum seems to be an extension of medium-term strength.

This may be why some seem to have extraordinary success, while others flounder (at least that's how it seems to me). Momentum is a much better predictor of market movements over the medium term than over the short term. So, those with short-term or long-term strategies are just using the wrong time frame.

Even better, this momentum strategy performed well not just for U.S. stocks. It also predicts international stock, commodity and currency returns in the medium term. In other words, definitely something to keep an eye on.

Another paper, "Momentum has its Moments," goes into more detail on how you can best optimize your strategy according to the risk-adjusted metric known as the Sharpe ratio. Momentum outperforms the overall market by 1.49% per month, or as much as 1.75% when controlling for the three "Fama-French Factors" of small-cap and value stocks which traditionally perform better than the overall market.

Unfortunately, there is a cost to this outperformance. During sustained market crashes, such as in 1932 and 2007, momentum securities are obliterated, losing an average of about 80% of their value. While these sustained crashes are exceedingly rare, having only happened rarely in the last 80-something years, they can easily wipe out decades of gains. Still, momentum strategies did outperform the market over the period 1932-2010 with an average yearly return of about 10%.

Luckily, the researchers found a way to significantly curtail this "crash risk." While the maximum 1-month loss for an unmanaged momentum portfolio was an astounding -96.69%, they managed to achieve a maximum 1-month loss of a much more manageable, but still gut-wrenching, 45.2%. This was not significantly affected by increased transaction costs in the managed portfolio.

The exact strategy is fairly complex and would take up much more room than a single article, but it revolves around a fairly simple concept: crash risk is highest after a recent bear market. Looking back about 12 months, you should be long low-beta securities and short high-beta ones if the market was down, and vice versa. The concentration of long and shorts in your portfolio is determined by the severity of the move, with strong declines leading to a high concentration in low-beta securities, and strong moves upwards leading to a high concentration in high-beta securities. For instance, if the market moved down by a relatively small amount in the past 12 months, such as is currently the case, you would want to be long low-beta securities and short high-beta securities, with low-beta securities being slightly overweight in your portfolio.

Both studies find that the best results are found from looking back around a year into the past, and trading according to the results at that time. Basically, momentum investing is for the medium term, and is determined by the market of the past year. Putting this all together, you should be able to create a diversified, risk-adjusted portfolio that, when adjusted as necessary, should beat average market performance for years to come.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.