Momentum trading

- Melville, Jessup, Weaver, Consulting Actuaries


The basis is that markets are slow to price in new information about a stock. So the stock will continue to rise for some period after the initial movement upward. This may be due to transactional issues where all those wishing to buy the stock on the new information cannot do so immediately or may be due to the nature of assimilation of knowledge which, even in the current age, takes some time to be understood by all interested parties.

Working against momentum trading is the evidence that suggests human beings tend to overreact. One school of thought runs that market participants will tend to overweight new information compared with prior knowledge.

Thus, the contrarian strategy advocates the opposite of momentum trading; buying into past losers and selling out of stocks that have performed well.

Evidence for momentum trading can be found in Jegadeesh and Titman’s “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency” (1993) while the contrarian argument is discussed in De Bondt and Thaler’s “Does the Stock Market Overreact?” (1985) – both published in the Journal of Finance.

Implications for efficiency

The efficient markets hypothesis gives 3 levels of efficiency in markets.
•    Weak Prices incorporate all information from previous price movements.
•    Semi-strong Prices incorporate all publicly available information.
•    Strong Prices incorporate all current information, whether public or not.

Each of these definitions has implications for profitable trading strategies. If weak form efficiency holds, all information from previous price movements is known by everyone. Technical analysis will not provide abnormal returns.

Moving up the continuum, if semi-strong form efficiency holds, prices fully reflect all information about the underlying asset and its likely future cashflows. In this case, fundamental analysis will not yield an extra advantage. Fundamental analysis is examination of the financial statements of the company and includes measures such as earnings per share, price-to-book ratio, etc.

If strong form efficiency holds stock prices reflect information yet to be released to the public. In this case, insider trading would have no benefit as the stock price would already reflect the implications from announcements not yet made public.

So, what form of efficiency, if any, holds? There is much debate on this that usually surfaces in times of acute market stress. How can the market be considered anything but irrational through September 2008?

However, we can make several observations;

• The existence of laws prohibiting insider trading would suggest that there is at least a perception that markets are not strong form efficient.
• There is a plethora of managers who actively manage portfolios, making the case that semi-strong form efficiency does not always hold.
• Passive management continues to have its supporters. Especially in large diverse markets where many believe it is hard to continually outperform benchmark in excess to active management fees. This would support semi-strong form efficiency.
• Technical strategies exist and some have good track records.
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For momentum trading to be successful, markets cannot be even weak form efficient. Here, behavioural finance studies step in suggesting that investors do not always behave rationally and price movements do indeed exhibit patterns. See again any of the work by Richard Thaler, one of the founders of modern behavioural finance theory.

A brief discussion on growth investing

Growth investors favour stocks that they expect will have higher earnings growth. These investors often buy into stocks that have high prices. Is this momentum investing?

No. The key difference is in the information used to make stock selection decisions. A growth manager will rely on fundamental analysis and their expectations for earnings potential. Technical analysis does not typically feature and these managers will most probably believe that markets are weak-form efficient. (Or at least that they do not have the ability to exploit these inefficiencies.)

However, the analogy between momentum investing and growth investing is clear as both will tend to favour stocks that have recently performed well, although their justification for holding them would differ. The diagram below, shows how four schools of thought on investing fit together.



Momentum investors are diametrically opposite to value investors and are likely to hold quite different portfolios of stocks.

A sure thing?

It is easy to be generally suspicious about an investment strategy that can be simplified into a set of rules regarding stock prices, especially when there exists a contrarian strategy that dictates the exact opposite philosophy and can also show examples of superior performance. (Our understanding is the relative success of each strategy is largely dependent on the length of the holding period of stocks.)

Conviction in this strategy comes down to one’s belief in the rationality of the market. No rational market would allow such a strategy to exist over the long term. In his 2001 paper “Rational Markets: Yes or No? The Affirmative Case”, Mark Rubinstein, professor of Applied Investment Analysis at the University of California, remarked; Profitable trading strategies self-destruct. In practice, their profitability is limited by their tendency to move prices against themselves as they are exploited; eventually, the strategies are discovered by other investors, and the profitability is eliminated through overuse.

That is, if momentum trading was a sure thing, all rational investors would partake in it, bidding away any price advantage.

Another way of looking at it would be to ask what the fees are paying for. Can the manager identify an inflection point better than any competent analyst given the same set of rules? Possibly, given their technical expertise and access to market data, but once these set-up costs are looked past, there may be little additional added value.

In fundamental analysis, there is more of a degree of comfort. Not everyone has the skill-set to calculate earnings-per-share and even if they did, the degree of time spent collecting the data and doing the analysis lends a more concrete feel. The fees one is paying can be looked at as a wage for performing the analysis.

MJW view

When building a strategy we look to avoid any style biases. For example, we may combine a growth manager with a value manager. This ensures underperformance due to a particular strategy moving temporarily out of favour is less likely. The graph below shows how the MSCI has gone through phases of favouring Growth or Value stocks.



So in that sense there is the argument for including a technical analysis strategy for diversification.
However, we still require a degree of faith in the strategy being employed. Our view in relation to most investment markets is that weak form efficiency holds for at least most of the time. We believe any opportunities that present themselves from a technical analysis sense would not last long enough to be exploited after taking into account trading costs.

While we agree with technical analysts in that markets will move in cycles, we do not believe you can predict a change in the cycle based purely on the trends to date. We believe underlying fundamentals will drive long-term performance.

Human beings love finding patterns in the natural world. Take star constellations for example. We have to be careful not to transfer this temptation to recognise patterns to the investment world.