Momentum Says Buy Tech and Financials, Avoid Health Care and Energy

Momentum is an ideal strategy for the individual investor. But it’s often overlooked because it can seem complex to implement.

And fair enough, but with a little background, some research and help from stock analysts, anyone can learn to trade options using momentum. Let’s get started at the beginning shall we…

Defining Momentum: Academic researchers call momentum an anomaly to the efficient market hypothesis (EMH). The EMH basically says that the current stock price is the correct price because the market price reflects all the information that can be known about the stock.

No one individual has all the information about the company. Collectively, buyers, sellers and investors choosing not to trade the stock interact, using the limited information they have, to generate the correct price.

As investors and analysts obtain new information, their actions result in price changes. This causes the price of the stock to move up and down. But the market price is always the correct price under the strongest forms of the theory.

The EMH leads to the conclusion that it’s not possible to beat the market. Since the market price is correct, there is no point doing additional research because the market already reflects the information.

Theory and real life are not always well correlated.

While that’s the theory, in practice, there are some investors who beat the market. Researchers have searched for factors that contribute to beating the market. They have found several factors that are classified as anomalies to the EMH.

In finance, an anomaly is defined as “cross-sectional and time series patterns in security returns that are not predicted by a central paradigm or theory.” [1] Researchers have identified anomalies that include value, momentum and the quality of earnings.

Strategies relying on momentum are detailed in many papers, including a 2001 Journal of Finance article by Jegadeesh, Narasimhan and Sheridan Titman, “Profitability of Momentum Strategies: An Evaluation of Alternative Explanations.” [2]

Jegadeesh and Titman showed that these strategies could deliver an average excess return of about 1% per month. That means an investor could outperform the broad market by 12% a year.

 

Finding Momentum

Momentum is the academic term for what investors call relative strength. With an RS strategy, an investor buys stocks that have delivered the best performance in the recent past. Calculations over the past 3 months, 6 months and 12 months are commonly used.

In simple terms, RS strategies relies on the idea that the trend is your friend. That means if the stock has outperformed the stock market over the past year, it is likely to be a winner over the next year. This idea is supported by many academic studies. [3]

Academic papers often use a calculation referred to as 12-1 momentum which subtracts the most recent (1-month) performance from the 12-month performance. This avoids buying after a large rally when the stock is likely to decline.

The papers also show results for large portfolios, often portfolios of several hundred stocks. This is impractical for an individual but is important to reduce risk. An alternative for the individual is to use exchange traded funds, or ETFs.

The table below applies that calculation to a group of sector ETFs.

 

Source: Optuma [4]

 

The results are similar for a simple calculation using the just the most recent 12-month performance.

 

Source: Optuma

Trading Momentum

Either momentum strategy can deliver market-beating results. A simple implementation is to sort by one-year performance and rebalance the portfolio every 12 months. This would require one trade a year to follow a momentum strategy.

It’s also possible to use a 6-month calculation or a 3-month. Papers confirm that momentum strategies are robust with almost time frame from 3 months to 12 months. Subtracting recent performance helps improve the strategy but isn’t necessary.

To trade ETFs, investors could buy the top or three. If possible, shorting the bottom performers could improve performance. Because shorting increases risk, put options could be used. In the example above, a put option on SPDR Select Energy ETF expiring in January 2021 could be bought.

Completing this process and rebalancing the portfolio once a year, or more often, could be all an investor needs to beat the market.

Regards,

Michael Carr, CMT, CFTe

Editor, Peak Velocity Trader

 

Sources:

[1]: Wharton Finance – Financial Market Anomalies

[2]: National Bureau of Economic Research – Jegadeesh, Narasimhan and Sheridan Titman. “Profitability Of Momentum Strategies: An Evaluation Of Alternative Explanations,” Journal of Finance, 2001, v56(2,Apr), 699-720.

[3]: Research Foundation Literature Reviews – Technical Analysis: Modern Perspectives by Gordon Scott, CMT; Michael Carr, CMT; and Mark Cremonie CMT, CFA

[4]: Optuma