It has been over two decades since academics started focusing on what we today call the “momentum effect” in stock markets. Momentum is basically the tendency of winning stocks (i.e. stocks that have outperformed the market in recent times) to keep winning and losing stocks to keep losing.
It is based on the idea that once a stock establishes a trend, it is more likely to continue in that direction instead of moving against the drift. Unlike the hugely-followed Value or Growth styles, this strategy has barely anything to do with the fundamentals of a company, and instead works with the human penchant to extrapolate current trends into the future.
At the core, momentum investing calls for investors to “Buy High, Sell Higher.”
Why Does Momentum Strategy Work?
There is a simple reason behind this. It works because we are humans!
There’s a whole laundry list of behavioral biases that most investors exhibit, and these emotional responses and mistakes are the very reason that momentum strategy works. For instance, we all know of investors who are afraid to book losses, and hence hold onto losing stocks for too long, hoping that they will spring back to their original prices. On the other hand, investors sell their winners way too early.
Furthermore, investors initially tend to under-react to news, events or data releases. However, once things gain clarity, they tend to go with the flow and overreact, causing dramatic price reactions.
These behavioral problems extend trends, and thus open up huge opportunities for momentum players. So basically, it’s a way to profit from the general human tendency to extrapolate current trends into the future.
Momentum investing is based on that gap in time that exists before the mean reversion occurs, i.e. before prices become rational again.
Momentum versus Other Styles
It is worth reflecting on how the momentum strategy compares to the other styles of investing over time. Recent research indicates that the size premium for small-cap stocks has shrunk dramatically since the 1980s and value premium has also declined radically since the 1990s. Academics are of the opinion that once research on factor premiums (like size and value) becomes known to public, the investment world catches on and the premium gradually erodes.
However, unlike other investment styles, momentum premium has stood the test of time, remaining remarkably robust ever since it was identified by financial academics in the 1990s.
Chase the Alpha
Momentum strategies have been known to be alpha-generative over long periods of time and across markets. So obviously, this strategy is quite tricky to implement, as detecting these trends is no child’s play.
Here, we have created a strategy that will help investors get in on these fast movers and make handsome gains. Our screen will help you take advantage of both long-term price momentum and a short-term pullback in price, which indicates some profit-taking in the stock.
- Percentage Change Price (52 Weeks) = Top #50: This item selects the top 50 stocks with the best percentage price change over the last 52 weeks. This parameter ensures we get stocks that have appreciated the maximum over the past one year.
- Percentage Change in Price (1 Week) = Bottom #10: From the 50 stocks, we choose those that are also among the 10 worst performers over a short one-week period.
- Zacks Rank #1: No matter what the market conditions are, stocks with a Zacks Rank #1 (Strong Buy) have a proven history of outperformance. You can see the complete list of today’s Zacks #1 Rank stocks here.
- Momentum Style Score of B or better: A top Momentum Style Score cuts short the screening process as it takes into account several factors including volume change and performance relative to its peers. It indicates when the timing is best to grab a stock and take advantage of its momentum with the highest probability of success. Stocks with a Momentum Style Score of ‘A’ or ‘B,’ when combined with a Zacks Rank #1 or 2 (Buy) handily outperform other stocks.
- Current Price greater than 5: The stocks must all be trading at a minimum of $5.
- Market Capitalization = Top #3000: We have chosen stocks that are among the top 3000 in terms of market value to ensurestrong liquidity.
- Average 20-Day Volume greater than 100,000: A substantial trading volume shows that these stocks are easily tradable.
Here are four of the eight stocks that made it through this screen:
Western Digital Corp (WDC), which develops, manufactures, and sells data storage devices and solutions worldwide, rallied nearly 95% in the past one year. The company carries a Momentum Style Score of ‘A’.
Yelp Inc (YELP), which operates a platform that connects people with local businesses primarily in the United States, gained over 172% over the past one year. The company carries a Momentum Style Score of ‘B’.
MKS Instruments, Inc. (MKSI) provides instruments, subsystems, and process control solutions that measure, control, power, monitor, and analyze critical parameters of manufacturing processes in the United States and internationally. The stock appreciated over 107% in the past one year and has a Momentum Style Score of ‘A’.
Union Bankshares Corp (UBSH) operates as the bank holding company for Union Bank & Trust that provides banking and related financial services to consumers and businesses. The stock rallied roughly 71% over the past one year and has a Momentum Style Score of ‘B’.
You can get the rest of the stocks on this list by signing up now for your 2-week free trial to the Research Wizard and start using this screen in your own trading. Further, you can also create your own strategies and test them first before taking the investment plunge.
The Research Wizard is a great place to begin. It’s easy to use. Everything is in plain language. And it’s very intuitive. Start your Research Wizard trial today. And the next time you read an economic report, open up the Research Wizard, plug your finds in, and see what gems come out.
Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.
Disclosure: Performance information for Zacks’ portfolios and strategies are available at: https://www.zacks.com/performance.
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