Momentum investing is ideal for stock traders because it has a clear short (and medium) term aim. That is to buy winners and avoid losers. It sounds brute and over-simplistic. But it has proved effective.
Practically, momentum trading means buying stocks with proven performance history and dumping stocks that are not performing at the ‘moment’. This is a strategy that has real range, criss-crossing easily also across a range of commodities and currencies as well as stocks.
The usual caveats apply, of course: this strategy does not claim to work all the time. But it is a strategy that has proved robust and consistent. Simply, a history of previous past returns means likely future high returns.
Let the trend be your friend – four key points
- Momentum trading and investing means a stock trader places a position on any asset that’s showing a steady upward path. This is a rational move. Unless there’s negative news to the contrary that upwards journey will continue. (Keeping responses rational is excellent trading discipline.)
- Momentum trading and investing completely ignores fundamental pricing issues such as P/E ratios or debt levels. In other words, momentum investors invest in trends
- Momentum is about the speed of price change. Once this slows, so does momentum. Stocks that bob around sideways must be ruled out as they have no underlying direction or strength
- Momentum day trading can last a few minutes using highly targeted entry and exit points. Or it can last for several days, even months. The point is you buy, you hope, in the early stage of ‘momentum’, and you sell when it flags. It’s also equally fine to buy high and sell higher
Keep the ‘mo-mo’ going
The icing on the cake is that when momentum gets behind a stock, the quicker it climbs in value. That’s not just good news for stock traders because your trade is rising in value. It’s good news for your costs because rising asset values squash fees faster.
As far as longer term stocks and shares go, bear in mind momentum investing is relatively risk averse because you’re only investing for certain time periods. You review and make changes regularly.
However, momentum investing is still contrary or counter-intuitive because it often flies in the face of traditional stock-picking metrics and laborious time-intensive research, such as return-on-equity, cash flow or price-to-earnings.
“Momentum investing,” says Jon Horton of financial advisers Chamberlain de Broe, “can be great with a rising tide but beware of the turn of the tide. Tesco is a classic example. For years under Terry Leahy [Tesco boss until March 2011] if you wanted retail exposure you had to have Tesco.”
But then Tesco issued a shock profits warning, followed by a string of other warnings. Its share price, several years later in 2017, is still struggling, currently -12.5% year-to-date.
Identifying momentum stocks
Momentum stocks might be in the news or have strong consumer brand names. There is often strong volume movement attached to them. Momentum stocks can be more sensitive to regulatory, environmental or political news because of that – the price of being a ‘name’ (you’re warned).
- Momentum opportunities exist both at the large cap and small cap sector end and everything in between
- Watch for institutional backing. When big investment houses get behind stocks, that can really light a fire under a share price
- A record of consistently beating earnings updates is also a good indicator of ongoing momentum
Having said that, there is nothing wrong buying in the middle or even later stage – as long as momentum is maintained.
Tools for the job
For the stock trader these include technical aids such as momentum indicators. These measure the average price of an asset; their inputs are based on closing and opening prices and give a sense of averages over the short, medium and long term.
When the value of an asset accelerates past its moving average that is often a buy signal. Volume oscillators can suggest when a security is over-bought. You can also set up alerts to allow you to take action at certain points – to buy more, buy less or to sell.
These are the building blocks of buy-and-sell signals – basic supply and demand evidence. You have to build up your own experience and sector knowledge. Momentum trading is not something you can jump into right away.
Chase performance but stick to a strategy
Many stock traders opting for a momentum investing strategy will want clear entry and exit points. It keeps their strategy systematic and rules-based. Your research needs to be read in the context of other factors. It can be complicated and nuanced – and sometimes entirely straightforward and obvious (with some basic market nous).
Financial adviser Brian Dennehy from Dennehy Weller & Co says you need a clear and proven process to select outstanding performers and the discipline to apply it. “The underlying process must be clear and understandable. It must be repeatable. There must be long term evidence of it generating extra growth.”
The case against momentum investing
You may not be trading or investing in good quality management, or even good quality products or brands. There are no ethical concerns because you are only looking at current performance. That hard-edged approach can give momentum investing a bad name.
Critics say it does nothing for the long-term value of an asset. Buying momentum stocks because they’re on a roll, some add, encourages mispricing and market inefficiencies. Momentum investing can also mean loading up, if you’re not careful, on assets from the same sector, meaning more diversification risk.
It is a thoroughly politically incorrect investing style, in other words. And when a lot of people do it, it’s a serious headache for a fund manager: too many abrupt entry and exits for comfort, often at the wrong time.
A stock trader's 'no-go' area?
Momentum trading picked up traction from the 2008 financial crisis when old-fashioned value stocks suffered badly and many financial 'experts' failed to predict the blow-up. From pronounced market lows the only way was up (and up again).
It has also picked up some credence from major fund managers. For example, Fidelity has its own Momentum Factor ETF fund, up 12.2% YTD against the Dow Jones, up 11.4% YTD (early August 2017).
Momentum investing, then, has a momentum of its own.