Momentum indicators are commonly used to find winners. Winners are stocks with comparatively higher price returns. In normal market conditions, momentum indicators work well on an aggregate basis. Momentum indicators can lose their usefulness in turbulent market conditions, in the initial rebound period following a bear market or during slowing economic conditions.
I’ve noticed the “crashing” of momentum indicators as I backtest elements of the new stock strategy I’ve been working on. As some of you might recall, I’m developing a new strategy that combines value and momentum. The process has been going slower than expected, but I recently backtested components of the strategy through the financial crisis of 2008 and the spring of 2009. The data revealed periods where momentum indicators either didn’t work or did more harm than good.
There are different momentum indicators, but I’ll start with one that the anomaly called WML (winners minus losers) is most associated with: relative price strength. Relative price strength compares a stock’s returns over a given period of time (e.g., 26 or 52 weeks) to all other stocks. The more a stock has appreciated relative to a broad market index or all stock universe, the higher its relative price strength is. Price performance is considered an anomaly, because if the market were efficient (meaning excess return cannot be realized through the analysis of individual securities), an investor should not be able to create a portfolio out of the stocks with the best relative price strength and realize a market-beating return. Yet there is research showing that stocks that have performed well in the past will continue to perform well over the next one to two years. Academic research also shows that a profit can be made by buying “winners” and shorting “losers,” hence the WML acronym.
More on AAII.com
- Why Momentum Strategies Can Crash – A study showed that fund momentum strategies particularly fail when the two-year market return is negative.
- Money from Momentum: Positive Feedback Can Drive Returns – The reasons why momentum works, as well as the anomaly’s limitations.
- Do You Adjust Your Momentum Strategies in Down Markets? – See how members responded on the AAII.com Discussion Boards.
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