It's a strategy that even the professionals pursue. Fund managers may be loathe to admit it but most employ some sort of momentum element to their investing strategies because it works. In a paper published in the Journal of Finance in 1993 entitled 'Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency', Narasimhan Jegadeesh and Sheridan Titman, of the University of Austin in Texas, demonstrated through exhaustive number crunching that investors buying shares showing strong upward momentum would have beaten the wider US market between 1965 and 1993.
Their theory was pretty straightforward. Stocks that had relatively high returns over the past three to 12 months should return to investors above-average returns over the next three to 12 months. But they also found that momentum can be used to understand the right time to sell a share since their findings suggest that stocks with relatively poor returns over the past three to 12 months should return to investors below-average returns over the next three to 12 months.
The study by professors Jegadeesh and Titman was based on Wall Street, but momentum is not unique to the US. An equally interesting, and more recent study (December 2003) by J Spencer Martin, Assistant Professor of Finance at Arizona State University, showed that by buying the 20 best-performing UK shares of the previous six months, and short-selling the 20 worst performers, investors would have beaten the All-Share index by 1 per cent a month between 1999 and 2000.
Our own research shows a similarly attractive pattern. We've been tracking a momentum portfolio based on the quarterly performance of the 10 best- and worst-performing blue chips of the previous three months, starting off when the market peaked in June 2007, four years ago. As we reported last month ("' 22 June 2010), while the system is certainly not perfect, there's enough evidence to suggest it works well, delivering nine quarters of outperformance and a paper profit of 33.4 per cent since inception, compared with the FTSE 100’s 22.5 per cent decline over the same period. The results are particularly impressive for long positions, too, with the most recent number crunching showing our picks beating the wider market in six of the last seven quarters, and producing a return of 104 per cent since the market’s nadir in March 2009.
Bulls and bears
Uptrends emerge when bullish views among investors are stronger than bearish ones, and subsequent share buying forces prices up. If bears manage to push prices down, bulls return in force, break the decline, and force prices up again. Obviously, the flip-side to this is prolonged downtrends triggered by bears exerting greater influence over the stock market than the optimists, with their selling pushing markets lower. When a flurry of buying lifts prices, bears sell short into that rally, stop it, and send prices back into decline. Traditional investors, used to buying shares and holding for a while, obviously prefer a rising market. However, much better access to short-selling products, such as contracts for difference (CFDs) and spread-betting, means momentum investors can these days milk good returns whichever direction the market heads.
Momentum investing works best when there are established market trends, either up or down. What can trip the momentum investor up are sharp changes in market direction, as has been clear during the past two to three months, with the FTSE 100 lurching in spectacular fashion from one day to the next.
And, as we have shown earlier, a momentum strategy has done pretty well since the stock market's bottom in March 2009 following the subsequent surge.
Mechanical stock-picking
Selecting which individual shares to go for can be done mechanically with a decent stock-picking tool, but timing when to close a position is the real trick. Investors generally have to be ready to buy and sell shares over a relatively short space of time since clinging on long term will only increase your chances of bumping into one of those 'outside forces' we talked about earlier. In truth, there is no guarantee that a one-off selection of momentum picks will outperform the market but the statistics say that slavishly following a momentum system year in, year out should have investors singing from the rooftops, no matter whether you're a blue-chip buyer, mid-cap investor or prefer to target Aim hopefuls.
, the FTSE 100, Mid 250, Small Cap and Aim, ranked by the biggest margin of market outperformance. We're not suggesting you buy all 25 stocks, rather that these lists can be used to tailor make your own momentum portfolio. So, if you prefer only bigger companies, you might select from the FTSE 100 and Mid 250 lists; love market minnows for their exponential growth potential? The Small Cap and Aim will be for you, or if you're looking for a mixed bag to spread risk, you can do that too.
Or there's another way. Hunting for shares that are already moving confidently higher is one thing, but we can also search out possible momentum stocks of tomorrow. We can seek shares that have underperformed over the past year, but have started to beat the market more recently, showing positive relative strength over both three- and one-month periods.
The lowdown on relative strength
Relative strength compares the percentage gain in the price of an asset to the percentage gain of a chosen index over the same period.
For example, if you were looking at the relative strength of Vodafone you could compare its performance with:
■ FTSE 100 (the index of the largest 100 companies on the London market by market value).
■ FTSE All-Share index (representing the whole London market), or
■ The mobile telecommunications sector index (representing only its business peer group).
If a company's share price rises in any period by more than the comparative index, it is said to have positive relative strength. If it falls by more than the index falls, it has negative relative strength. It can, however, get a bit more complicated than that.
For example, a company's shares would still show negative relative strength against the comparative index if they rise at a lower percentage. The same is true in reverse also – the shares would show positive relative strength should they fall at a lower rate than the comparable index. Even so, relative strength can still be used as a pretty accurate measure of how a share price, or other asset, is performing against a comparable peer group.
Momentum in a bear market
Momentum investing works best in a rising market. If you are worried that further periods of economic slowdown and a prolonged bear market lie around the corner, you could still take momentum positions, and at the same time short sell the market as insurance. Simon Thompson has outlined how to do this in previous columns.
