In the heart of all momentum strategies lies relative strength in some form. It could be related to price, earnings and sales growth, margin expansion or a combination of all of them. There are different nuances in the time frame to which RS is applied. Those of us, who use it in our market approaches believe that the relative outperformance of all momentum strategies is based on a structural edge – something that cannot be erased by the fact that everyone knows about it, at least until stock markets are dominated by human emotions.
We tend to learn fastest by association, like things that are similar to something we already know and base our choices on relative comparison.
It makes the perfect sense to take a look at the best performing stocks in any given year and ask yourself, what was the common denominator that would had helped you to catch part of the trend? The answer is simpler than it seems. Relative strength begets more relative strength. All the stocks that appreciate 300% in a year, are up only a 100% at one point in their price cycle. I don’t imply that all stocks that reach a 100% return in let say a few months, will continue to outperform. No. Many of them will go back where they came from, but among the herd of parabolic junkies, we can find the true market leaders. How to distinguish them? They have a clear catalyst behind them. Actually a number of consecutive catalysts, as one is not enough to sustain a prolonged price up-trend. Catalysts are always based on expectations for profit. After all, everyone opens a position with the expectation to have a positive return on it. Now those expectations might be based on hundreds of different factors. Some buy solely based on price action, assuming that breakouts to new highs beget higher prices. Sounds crazy, isn’t it. But it has worked enough times in the past to turn many people into believers. When enough people act on their expectations, their beliefs turn into a self-fulfilling prophecy.
Relative strength is universal. It works in all areas of life. In the video above, Dan Ariely says that everything in the human world is judged on the basis of relativity. I remember a research, which claimed that if you go to a bar with a similar, but slightly uglier version of you, you will be perceived as much better looking that you actually are. I leave the conclusions to you.
There is so much more that could be said about the underlying logic behind buying relative strength, but who likes to read long rants. I don’t want to be that guy who will say:”I am sorry this post is so long, I didn’t have time to make it shorter.”
Risk appetite is a function of recent portfolio’s performance. Exited by the acquisition of $ISLN which has been a sizable position in my holdings for a while, I went to chase setups where I don’t really have an edge. I decided to open a small pilot position in a stock that was declining towards its rising 20-day MA and a previous zone of support. It was a make or break moment for the stock. The logic was that I risk 10 cents with the potential to make at least 30-40 cents.
The loss was tiny, but this is not the point. Even if the trade was profitable, the process was wrong. This is a flashing warning light for me. Such type of behavior leads to the building of bad habits. I should stick to setups, which underlying psychology I understand well and I have been consistently profitable trading them.
The best performing stocks in any given year are usually the ones that surprise the most frequently and by the highest margin. Powerful price trends are sustained by a sequence of catalysts. Under the surface, all catalysts are earnings related.
In the previous post, I pointed out that a big number of the best performing stocks are neglected price-wise and volume-wise in the beginning of their trend. Most market participants miss the first stage of the move by focusing only on highly liquid stocks, without understanding that liquidity often follows price when there is a catalyst involved.
There are different type of buyers at the various stages in the price cycle of one stock. Earnings related catalysts (earnings reports, new contract, move in the underlying commodity…) have the potential to change perceptions of value and to start a process of major repricing – the beginning of a new trend or the acceleration of an already existing one. The first buyers believe that their expectations for strong earnings growth will one day materialize into strong price growth. This is why they are not afraid to buy low liquid stocks.
After the initial run, a typical stock will consolidate and form what many call a bullish flag or wedge. This is the stage when this stock will be caught by the scans of technical traders and they will get involved, further exacerbating the liquidity. Technical traders assume that someone knows something about the company and this is why the underlying stock is accumulated. They might not be right, but when enough market participants act on their beliefs, their expectations turn into a self-fulfilling prophecy and the stock breaks out from the bullish pattern, further attracting fresh capital. At some point, the enthusiasm of the buyers will fade out. This is the make or break moment for the stock. If another fundamental catalyst does not appear, the trend is short-lived and the price turns south. This is why in the beginning of this post, I highlighted that strong price trends are sustained by a sequence of catalysts.
In the middle of their price trend, most of the future best performing stocks look overextended. Most market participants will ignore such stocks because they are up “too much, too fast”. In capital markets, what feels irrational is often the right thing to do.
Let’s take a look at the weekly charts of another five stocks that shined during the year: