Momentum investing is based on the premise that past price performance is a good indicator of future price performance. Stocks with the highest relative strength over the past 3-12 months often remain among the best price performers over the next 3-12 months. The central idea behind this investment approach is to find an already existing price trend and a proper point of entry.
The stock market is a forward looking mechanism that constantly tries to discount collective expectations about the near-term future. Prices change when expectations change. Expectations change under the pressure of external factors, which I call catalysts. Catalysts represent new information that alters perceptions of value and boosts risk appetite, which have the potential to start a process of major re-pricing (new trend).
At the foundation of every major price trend there is either an improvement in fundamentals or (as it is in most cases) rising expectations for future improvement in fundamentals. From a bird’s eye view major changes in expectations for fundamentals are based on new social trends, business cycle, economic cycle or new regulations – all of them are sustainable sources of change and don’t just disappear overnight. This is what makes the existence of trends possible.
At the beginning of a new trend many market participants adjust slowly to new reality due to:
– Naturally ingrained conservatism. Many don’t change their mind when new facts start to appear and wait for additional confirmation before they act. Some wait for price confirmation as an evidence that other market participants have interpreted the new information in a similar way. Others wait for volume confirmation as prove of institutional involvement. The logic behind such thinking is that when institutions buy, they leave traces and if they don’t get involved, a new trend cannot be sustainable;
– Market participants are using different sources of information, take different time to analyze it and might come to totally opposing conclusions based on dissimilar investing/trading styles and time frames of operation;
– Disposition effect. Many market participants are looking for instant reward and feel fear against realizing losses. They are quick to sell winners and reluctant to sell losers, which essentially leads to slow reaction and under-discounting of new information.
The sustainability of surprises makes the existence of trends possible. In any given year, the best performing stocks are the ones that manage to surprise the most and most often. Every genuine surprise is a catalyst that changes perceptions of value and boosts prices. Several consecutive surprises in a row are needed to convince enough market participants that the underlying dynamics of the new trend are not going away any time soon. At this point the stock becomes an institutional darling and discounting becomes pro-active.
The common denominator between price and the underlying fundamentals is that they are both cyclical. The difference is that when institutions get involved, price volatility increases much faster than fundamentals’ volatility as the market tries to take into account any potential future surprises. The best case scenario, all the potential good news is getting discounted proactively. Investors like to discount both extremes. From overly conservative at the beginning of a new trend, they gradually become overly optimistic and overreact. Overreaction could be explained by dissecting the following three concepts:
– Herd mentality. Institutions have an incentive to buy the best performing stocks over the past quarter or two in order to sugarcoat statements to current and prospective investors. The real growth names are rare and everyone would like to claim in their prospects that they own them. This is what makes the stocks with the highest 3-9 months RS even stronger.
– Blind obedience to perceived authority results in a false sense of security. Investors often outsource their due diligence to people who are considered experts in their areas. While it is true that experts are more knowledgeable, have more experience and probably access to better sources of information, their incentives are not entirely clear. For example, analysts’ statements have huge impact on the market despite the fact that many of them have been proven to be lagging indicators. Their price projections are often based on: 1) the assumption that the existing earnings trend will continue infinitely and 2) simplified models that assume normal distribution of market moves in a complicated world full with outliers and fat tails. This often leads to projecting and discounting of an unsustainable scenario of growth.
– Bandwagon effect. Short-term traders may use the recent performance as a signal to buy or sell. Longer-term investors look at recent performance to confirm their convictions. The interactions between those participants might create price run-ups or –downs that can persist for many months until an eventual correction. Everyone is watching what the others are doing assuming that they know more (something). Price is considered as the ultimate sign that fundamentals are improving and will improve in the near future.
Finding a great trend is not difficult (at least in hindsight). Riding it and having a proper exit plan in place is the hard part. It is said that the difference between a great momentum investor and a good momentum investor is that the former knows how to time his exit properly.
What are some of the leads that might hint a potential danger to a great price trend:
– When the consensus opinion says that the only thing a stock can do is go higher, be careful. If everyone owns it, there are not many buyers left. There are always plenty of sellers as market participants, who operate on shorter time frames, are quick to sell their winning positions and lock in profits. Tops are formed when a stock runs out of buyers;
– Eventually the Wall Street printing press catches up with market’s demand by 1) issuing more shares of existing companies that are currently growing in an impressive pace and 2) underwriting IPOs of companies in currently popular industries. Don’t forget that investment banks are in the business of printing and marketing securities that are currently in demand;
– The appearance of negative earnings surprise or not positive enough one. When expectations are high and a stock is priced for perfection (another expression for projecting unsustainable growth), even the slightest disappointment leads to a sell off;
– Risk appetite vaporizes due to a macro event;