Finding Winners That Keep On Winning

31st Jan by Mark Simpson

9 comments 4373 reads

Momentum is one of the most robust findings in academic finance. It is clear that, under certain conditions, winning stocks keep on winning and losing stocks keep on losing, but as always, the details matter. A recent comment on one of my articles made me think this would be a great topic to explore further.

What is Momentum?

Not Momentum

There appears to be a recent phenomenon in small cap markets where a beaten-up stock attracts a few buyers, who attract further buyers, leading to some significant short-term gains, only for those to be given back on a profits warning. Perhaps the best recent example is SDI (LON:SDI) :

The share price had been weak following results in August 2023, which showed flat adjusted profits and the company taking write-downs on several recent acquisitions. Weak general markets meant the share price bottomed in October at around 80p before gaining around 50% on no further news. A profits warning in December, followed by the CEO leaving in January, means that the shares have subsequently halved. Because Momentum is a common everyday phrase, it is tempting to call the types of share price rise that occurred in October price momentum. However, this wouldn’t be technically correct. These types of short-term effects may be tradable by some. Still, they are certainly not “Momentum” as defined by academic finance (and hence have a robust and repeatable tendency to lead to outperformance.)

Real Momentum

In academia and amongst practitioners, “Momentum” has a precise definition. It is based on the “serial auto-correlation” of stock prices. That sounds complex, but it really isn’t. “serial” means that the correlation is time-based, and “auto” means that stock prices are correlated to themselves and not to some third factor. If the serial autocorrelation is positive, positive share price moves are likely to be followed by positive moves and negative by negative. If the serial autocorrelation is negative, then stock prices are likely to experience what is known as mean reversion and move in the opposite direction.

It was already known by the late 1980s, from the work of Thaler and DeBondt, that stock prices tended to mean revert over very short periods, up to a month. Given the transaction costs, this anomaly is unlikely to be consistently tradable. The same authors also showed mean-reversion over much longer periods, three…

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donald pond

31st Jan

Interesting post, as ever. But surely if you want to explore momentum stocks, the UK market is the last place you would look. It has been rangebound for 20 years, has high dealing costs, high spreads and low liquidity. Surely it is better to look at the US?

And if I look at some of the biggest winners of all, like NVIDIA (NSQ:NVDA) or even Alphabet (NSQ:GOOG) the simple principle of buying or selling when it moves through the 50 WMA would have captured almost all the upside with very little of the down. NVDA is a better example of course, and I'm sure the Advanced Micro Devices (NSQ:AMD) chart would be near identical. For NVDA, you would have had 4 signals in the last 7 years, 2 buys and 2 sells.

The stocks with most momentum can make big moves without ever testing the MAs. The trick is to identify them and ride them. And, as you highlight, do it in markets where trading costs aren't material.

WarrantStar

Mark, Thank you for a really good piece of work.! This evidence based approach is the kind of thing that I really take notice of. My share selection process relies on momentum to quite a large extent. I will go through this article in detail so that I can introduce further improvements to my my process.

Hi Mark. Based on the above, I am looking at using Stockopedia's Auto Correlation as a screen factor. But I have no idea what time periods this screening factor is comparing. Please can you tell me what time periods it is comparing so that I can decide whether or not it would be beneficial for me to include Auto Correlation in a screen?

littledavesab

Hi for US market indices as a whole driven by the Mag 7 very true. NASDAQ growth over time also stunning. But UK does have its bright spots amongst the gloom and of course it is not all gloom!

Harry Hindsight

Looks good Hill & Smith (LON:HILS) but after Supreme (LON:SUP) my faith in UK has evaporated. Crypto looks good, and gold - ffs.

Silverback01

1st Feb

Mark, your exploration of the Momentum anomaly strikes a good balance I think between theory and practice, particularly highlighting the importance of understanding true Momentum versus short-term gains. The challenges of rebalancing costs and 'stale Momentum' provide critical insights for anyone considering this strategy. I appreciate the innovative solutions proposed, like Dual Momentum and Industry ETFs, to navigate these challenges. It does spark my curiosity though about incorporating ESG factors into Momentum strategies to align financial returns with broader values. In summary, I think that successful Momentum investing very much demands a nuanced and informed approach.

Mark Simpson

I think I'd agree that certain types of markets are better for momentum investing, hence why I say in the article, "Only investing when the general market has a clear trend or cutting the strategy holdings early if they underperform may well improve returns to Momentum investing."

But the key word there is may. My research certainly doesn't have the full rigour of an academic analysis. One of the reasons momentum is considered so robust is that the findings are widely replicated across geographies and asset classes. So there is nothing per se wrong with a momentum strategy investing in the UK. And it is worth remembering the research into multi-baggers. It may seem like the US would be the best place to look, but when Alta Fox Capital studied it, the UK was actually over-represented for multi-baggers and the US under-represented.

The big benefit the US appears to have for implementing a momentum strategy is higher liquidity and lower costs, which may make the strategy more profitable. But then, that doesn't explain why US momentum funds have been lacklustre compared to what their theoretical returns should have been. And the logical conclusion of the highest liquidity/lowest cost argument for investing in the US is to espouse stock-picking all together and follow something like Dual Momentum or a sector ETF momentum strategy.

I'm afraid I'm struggling with this one myself. In the explanation, the key info seems to be missing, which is what time period is being looked at. I also don't think this is a useful measure for an individual stock, apart from it may show when a trend is reversing for a stock. Given the uncertainty, I wouldn't include it in a momentum strategy, personally.

Thank you Mark. I was tending to arrive at the same conclusion myself. But my conclusion was based on the the fact that, when I was screening for positive values of auto correlation, and not including any other screening factors, over 99% of the values I found were below 0.5. And I don't consider that to be of much use in terms of predicting the future share price trends of individual companies.

Finding winners that keep on winning

What is Momentum?

Not Momentum

Real Momentum

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Mark Simpson

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