Why Momentum Investing Is A Contrarian Approach

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  • on April 26th, 2011

It is said that the four most dangerous words in the financial markets are “This time is different”. History rarely repeats, but it often rhymes. The truth to the matter is that it is always different and it is never different. The hot investing themes and stocks change every few years, but the investors psychology and the price charts of the best performers always look the same.

Recently I stumbled upon a paper titled “Predicting the Improbable“. The line that made me the biggest impression as I was able to relate it to the stock market goes as follows:

People tend to adjust their expectations of future events based on only small pockets of recent experience. In lotteries they tend to under-select recently drawn numbers, only to get for them in a big way if the number is drawn repeatedly.

This is essentially how trend following works. At the beginning of a new trend, there is usually an abnormal range and volume expansion. At this stage most market participants are reluctant to buy because the stock looks extended. The sudden change of the supply/demand dynamics often causes a “freeze” reaction = doing nothing. No one is willing to chase at this point, despite the fact that breakouts of long bases often precede much higher prices over time. The expectation of mean reversion is natural as it would restore the “balance”. Most traders are waiting for some form of consolidation for two reasons:

1) clear level to place a stop
2) prove of institutional support

The first major breakout is always considered an outlier and most market participants intuitively will desire to short it or simply will stay on the sidelines. At the beginning of a new major trend, people tend to under-react. As the breakout is followed by higher prices and more breakouts, more and more people become believers in the validity of the new trend and gradually the fear of missing out become stronger than the fear of losing. That fear of missing out has a particular name. It is called greed among independent investors and career risk among institutional managers. This is the time when the market start to proactively discount and the dreams of future potential trump the reality.

What happens when a stock doesn’t form a base after a 20% breakout, but continues to rise? The more a stock extends above its base and major moving averages, the less natural it looks to the human eye. It seems counter-intuitive that the move can keep going. For those who already own the stock, psychologically it feels harder and harder to stay and continue to ride the trend. For those on the sidelines, shorting becomes more and more enticing. This is the time, when the perspective becomes increasingly important. If you look at a monthly chart of the best performing stocks for the past year or for any other year, you are likely to notice nice green candles, one after another. At the monthly chart, most of the great performers will constantly look extended from their base. The more you decrease your horizon and move into weekly, daily and hourly charts, the more evidence of consolidation you will find and therefore places to put your stop.

Very few are able to ride the majority of a trend. The common scenario is that there are different owners at the different stages of a trend and what is buy signal for one might be a sell signal for another.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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