Education & Insights: What is momentum?

For many investors, Momentum feels like a strategy best left to traders. It’s full of charts and words like ‘breakout’ or ‘volume’ which seem pretty technical. As a fully-committed member of the ‘Fundamental Analysis is Best’ investment club, I was previously unaware of the power of momentum in the markets - until I was asked as part of my application for my current role at Stockopedia to write an article on the momentum factor.

It was in this article that I really dug into why momentum works and the whole concept became much clearer to me. Here is a snippet:

“It is hard to rationalise intense dislike for a stock. There is no reason, for example, why every announcement from international textbook company Pearson irritates me to the point that I dismiss it. And yet, despite mounting evidence that the Pearson’s management are getting their ducks in a row, I continue to stick to my belief that the company will never amount to anything good.

It’s an example of a dangerous bias in investing: under-reaction. Investors tend to hold onto their opinion that a stock is a dud in the face of mounting new evidence to the contrary. It is also one of the reason’s that momentum investing works – as investors don’t immediately respond to good news, share prices can continue rising for many weeks or months after a positive announcement as the news sinks in.”

A year and a half later, Pearson has become an example of a stock which has benefited from strong and enduring share price momentum. With each positive announcement from the company, investors have been gradually ditching their concerns. The stock was one of the top performers in the FTSE last year.

You can read more about the behavioural biases which have contributed to my Pearson mis-step, here: Pearson - three lessons in behavioural finance

But the momentum factor doesn’t always work. In some markets the best performing stocks just stop being the best performing and that is most likely to happen at the end of a bear market. Once again, Pearson provides an interesting case study.

The company has been a relative outperformer during a difficult period. Why? Because it had the benefit of very poor comparatives. After years of bad decision making and underinvestment, management has finally pulled the company together and investors are gradually ditching their views that this is a no-hoper. Its share price has risen ahead of the market and it has become a ‘momentum stock’. But when (if) the markets rebound, it will be the most sold-off stocks from the bear period which are the most attractive, not those which have benefited from enduring momentum.

But while the momentum strategy in general doesn’t appear to be working right now, there are some markets which could be on the precipice of a ‘breakout’. In his article this week, Ed has explained why markets can suddenly surge fro lows and how to spot ones that might. He’s also run a poll on Twitter to assess how his followers feel about a market which is a great barometer of private investor sentiment: The AIM All Share.

Now, the results are inconclusive (about a third of the respondents are buying AIM shares right now, but the same percentage have said that they are waiting for the breakout and the final third think the market is going lower). But looking at the chart, London’s junior market is exhibiting some of the signs of a potential surge. At what stage will investors ditch their hangups about AIM? And who among you is ruthless enough to take advantage?

Momentum investing is a bold strategy, but not necessarily one that fundamentalists should dismiss out of habit.

Read more: Breakout Momentum - the stock market strategy for the ruthless