Although one-day share price movements get a lot of attention, there is a “better measure of price strength that investors should be paying attention to—price momentum over time.” This according to a recent Forbes article by contributor John Reese, CEO and founder of Validea.com.
Drivers of Momentum
“It seems counterintuitive to many investors to buy stocks that have gone up the most, but this sits at the heart of momentum investing,” Reese writes. He divides momentum investing into the following categories:
- Overreaction, fueled by the notion that stock prices can “drift away from their intrinsic values,” leading to herding behavior and performance-chasing.
- Underreaction, which emerges from the idea that prices can “drift towards their intrinsic values,” leading investors to hold losers and/or avoid admitting mistakes while “quickly selling winners to show success.”
- Reflexivity: “A company’s stock goes up for one reason or another, which allows it to buy other companies, raise additional capital or hire the best employees and talent with attractive stock-based compensation programs,” all of which contribute to an improved business and continually improving stock price.
“As if often the case in investing,” Reese notes, “it can be difficult to pinpoint the exact reason a stock is outperforming.”
Reese outlines the momentum statistics used in Validea’s stock selection models:
- Intermediate-term momentum, which uses the 12-month return but excludes the most recent month.
- Relative strength, which “takes the returns of all stocks over the past year and ranks them using a score from 1 to 100. The higher the relative strength, the better the stock looks from a momentum standpoint.”
Downsides of Momentum
Reese notes that momentum investing, like many other investing strategies, has risks: “First and foremost, momentum can be subject to crashes and struggle during market regime changes when the leadership in the market flips suddenly.” These strategies can also suffer from high turnover and trading costs. Finally, Reese notes, investors who are unclear about how the strategy works can be less likely to stick with it over time and during down periods.