Momentum Investing

Momentum investors look for stocks that recently outperformed the market hoping that they will continue to do so for some time.

In addition to stock price's outperformance, momentum investors back their stock picks with either an Earning Growth Acceleration, an Upward Earnings Revision or a Positive Earnings Surprise.

Note: some momentum investors, notably Stan Weinstein, do not require any fundamental justification and will simply buy based on price action (Technical analysis).

Let's build Momentum stock picking strategies following the theme approach outlined in Stock Screening.

Investing Universe Go back to Top

Small Cap and Liquidity

Momentum strategies are best with Smaller Capitalizations. Information diffusion is slower with small cap because of lower coverage by analysts, therefore price adjustment to news and earnings upgrade should take longer time: you'll have time to jump in before the trend ends. With larger cap, any news should be quickly reflected in the stock's price.

An interesting observation about how Momentum affects various Market Caps is to contrast James O'Shaughnessy's findings in What Works On Wall Street with Charles B Carlson's findings in Winning with the Dow Losers.

O'Shaughnessy finds that investing in stocks with worse 52 weeks performance is a losing strategy. On the other hand, Carlson finds that investing in the Dow Jones Industrial Average stocks with worse 52 weeks performance is a winning strategy (although marginally better than the Dow Jones Index itself). This suggests that you should get into a Dow stock before it starts to outperform - not after because it may be too late - confirming the quicker price adjustment for Larger Cap.

A liquidity test is always used with smaller cap to reduce the Bid-Ask spread and make sure you don't lose out any advantage to high trading costs: it may be a minimum price threshold, a minimum daily transaction volume...

Stock Ratings

Zacks Research finds that upward EPS (Earnings Per Share) estimates revision is a significant factor impacting a stock's price. The reason is that a stock’s fair value is linked to its EPS so an upward revision in EPS should be followed by an upward revision in the stock’s price.

Stocks with upward Earnings revision are often those likely to post positive earnings surprise as well: 2 fundamental justifications that Momentum investors look for.

Zacks publishes the Zacks Rank that ranks Stocks based on upward EPS estimates revision. Investing in stocks with a Zacks rank #1 (200 stocks) earned 33% vs S&P500 gain of 12% from 1988-2005 using Monthly Rebalancing.

An alternative to the Zacks rank is Value Line that ranks 1700 companies based on a mix of EPS growth acceleration, EPS growth revision and Price Momentum. Investing in stocks with a Value Line Timeliness Rank #1 (100 stocks) earned 14.1% vs S&P500 gain of 6.7% from 1965-2005 using Annual Rebalancing.

If you think it is impossible to buy 100-200 stocks every month, then check Stock Basket Account. For less than 200$/year and no other trading costs, you can exactly do that.

Due to their track records and underlying factors, Zacks rank #1 or Value Line Timeliness #1 are excellent Investing Universes in a Growth/Momentum mechanical strategy. Because they already include so much in their rating, they often just require an extra Ranking function but no or little additional screening to reach a final portfolio.

Primary Theme Go back to Top

Relative Strength Rank

Relative Strength Rank, or simply Relative Strength, is a measure of a stock’s price performance relative to the entire market over a set period (e.g. 1 month, 3 months, 1 year…). A Relative Strength of 70 means that a stock has outperformed 70% of all other stocks during the period under consideration. Momentum Investors look for stocks with high Relative Strength, typically >80.

Similarly to the use of Moving Averages in Technical Analysis, the shorter your holding period the shorter the Relative Strength’s period you should use. An investor with a monthly or quarterly rebalancing period should use Relative Strength over a shorter period (1 to 3 months Relative Strength) compared to a Value Investor adding a Relative Strength to its screen a la O’Shaughnessy (1 year Relative Strength).

Most Momentum investors do not include any valuation criterion in their screening. According to work from David Dreman in Contrarian Investment Strategies, expensive stocks with high valuation fall more than value stocks in case of Profit Warning.

Momentum Investing can then be extremely volatile with possible sharp drops.

In this regard, not all Relative Strengths are equal.

Pitbull Investor StockTables

Earning per Share Rank

In How to make money in Stocks, William O'Neil shows that most momentum stocks had Earning Growth Acceleration before their most impressive price increase.

The Earning Per Share Rank (EPS Rank) measures a company's EPS Growth relative to the entire market. An EPS Rank of 80 means that a company has an EPS growth better than 80% of all other companies. The ranking usually takes into account growth over the last 5 years and last few quarters with higher weights assigned to recent data.

Because of higher weights assigned to recent growth, this parameter is a prime criterion for screening for Earning Growth Acceleration which is often required by Momentum investors.

If your screener does not offer the EPS Rank, you may build a series of tests if it offers good 5 years historical data.

Secondary Theme Go back to Top

Momentum Investors can use some Technical Analysis indicators.

Moving Averages crossover: in Online Investing, John Markman recommends to buy a stock passing a screen when its 15 days Moving Average crosses up the 50 days Moving Average and Sell when its 15 days Moving Average crosses down the 50 days Moving Average. A positive Moving Averages crossover usually confirms that a stock is on an uptrend.

A more practical alternative that he recommends is to run your mechanical momentum screens when the overall market crosses its Moving Average up. Sell everything when the market crosses its moving average down and wait for the next up crossover to re-run the screen to buy new stocks.

Momentum investing works best in Bulls Market so such strategy makes sense. It is Mechanical Stock Picking with Market Timing. Market Timing reduces volatility because you're in the market mainly during favorable periods.

Increased Volume: it shows that some interest has been generated in a stock. Biggest players in the market are institutional investors. Increased volume signals that some big players are interested in the stock. Only them can make a stock price move significantly.

Accumulation/Distribution: volume is one thing but is it selling or buying pressure ? Accumulation/Distribution tries to answer this question. The accumulation/distribution is useful when a stock is going sideway but the Accumulation/Distribution is going up: it shows that the stock is under accumulation - usually by smart people - and is likely ready for an up move.

It can be an effective way to get in early, before a big move. It is also well suited to investors with a contrarian nature or those fearing investing in high Relative Strength Stocks because they think they missed the boat. In this case, Relative Strength may be omitted from the screening.

Avoiding over-extended stocks
To limit exposure to stocks that may have run too far, William O'Neil (Mr CANSLIM) suggests buying high Relative Strength Stocks only if they are not over-extended. His method can be quite subjective as you have to recognize a special chart pattern (called a cup with handle) in the stock's chart.

A more quantitative approach would be to screen for stocks that are less than X% above the stock's price few months ago or check the recent price against the 52 weeks high.

Others
Momentum Investors often seek stocks with high EPS Growth: typically in excess of 25%. Such growth rates are unsustainable in the long term and failure to maintain such rates will send any stock to hell, Momentum is adapted to short holding period and then:

does not (necessarily) require any Value criterion
does not require any Quality criterion
best used when the market is Bullish
best used with Trailing Stop Loss (see below)

Ranking Go back to Top

The logical ranking for Momentum investing is the Relative Strength.

Zacks Research suggests that Value Investors should not be shy using its Zacks rank despite its Growth/Momentum appeal. Price/Earning PE or Price/Earning/Growth PEG can therefore be used as well if you use Zacks or Value Line as Investing Universe.

In fact, in Contrarian Investment Strategies, David Dreman shows that value stocks react positively to positive earnings surprise while overvalued stocks do not. Therefore PE or PEG can be a good companion to Zacks, Value Line or any Momentum strategy (especially with holding period of 1 year).

Holding Period

Over long periods of time, stock's performances mean revert. Momentum does not add value when holding period exceeds 1 year.
Momentum Investing should be used with short holding period ≤1 year.

Stop Loss Go back to Top

Because of higher volatility, many momentum investors recommend using Trailing Stop Loss - an unemotional, mechanical way to get out of a stock -

However, if you suffer loss aversion, it may be difficult for you to use Stop Loss.

You can get rid of Stop Loss if you:

Use short Rebalancing frequency (e.g. 1 month). In this case, since holding period is very short, a stock has a lower chance to dive before it is replaced,
Have many stocks in your Momentum Portfolio: if 1 or 2 stocks fall hard from a 25 stocks portfolio, it won’t represent too much of your portfolio’s value,

Number of Stocks in Portfolio Go back to Top

The shorter your Holding period, the fewer stocks you may own: 10 stocks with monthly rebalancing is 120 stocks in 1 year.

1 month holding period : you may hold as low as 10 stocks.
1 month < Holding period ≤ 1 year: increase your number of holdings. At least 25 with annual rebalancing unless you like volatility.