Momentum Strategy (strong sectors/stocks)
The momentum factor is based on the price change of a stock over a specified period relative to all other stocks. It is considered to be an anomaly or a risk factor in the analysis of stock returns because...
The chart above, taken from the paper entitled “Value and Momentum Everywhere” (Clifford Asness, Tobias Moskowitz, and Lasse Pedersen), compares cumulative returns and annualized Sharpe ratios (SR) for a value strategy, a momentum strategy and a 50-50 value-momentum strategy (rebalanced monthly) as applied to an equal-weighted combination of stock selections from the US, UK, Japan and continental Europe. The benefit of combining the two negatively correlated (-0.62) value and momentum strategies is evident. The Sharpe ratio for a 50-50 value-momentum strategy limited to US stocks is 1.13, compared to 1.88 as diversified across the four equity markets. Further info can be found under following link: https://www.cxoadvisory.com
...stocks with high relative levels of momentum tend to continue to outperform while stocks with low relative levels of momentum tend to continue underperforming. Momentum can have higher levels of turnover and, like other anomaly-based strategies, have periods of underperformance.
In the following article, Charles Rotblut ( http://www.aaii.com/authors/charles-rotblut ) discusses the research on momentum and its long-term record of performance. Included in this discussion is why momentum is not merely for those who rely on technical analysis and why, as well as when, momentum strategies can crash. He then explains why it makes sense to pair momentum with valuation in a strategy. (I shortened the full article, but the complete article can be found under the link given at the end)
While some of the discussion may come across as being academic in nature, it will help you to have a better understanding of what momentum is, how researchers look at it and the role it can play in a portfolio. It will also help you better assess whether or not you want to incorporate momentum into your own stock investing strategy.
Relative Price Strength/Why Does Momentum Work?
Though the concept of momentum is accepted in academic and practitioner circles, there is not an agreement as to why momentum works. Some research has linked it to earnings news. Jegadeesh and Titman estimated that the periods around earnings announcements accounted for about 25% of portfolio returns over their holding period. Such an influence could occur if a company issues better- or worse-than-expected results. Investors anchor their opinions to past expectations and are often slow to adjust their opinions to the new evidence. This lag is evident in strategies incorporating earnings estimate revisions. As analysts adjust their profit forecasts, stock prices will rise or fall. The reaction can last several quarters.
Scott Bennett, the director of equity strategy and research at Russell Investments, theorized that momentum reflects herding behavior on his company's blog ("Momentum Strategies: Knowing When to Leave the Party," October 2015). He said investors with limited information will favor what’s popular and what’s outperformed recently. This fits within the theory of investors preferring winners over losers, as well as behavioral tendencies such as recency bias, which is the tendency to think current trends will continue into the future.
Cliff Asness, Andrea Frazzini, Ronen Israel and Tobias Moskowitz had a different take, saying "the jury is still out on whether momentum is a behavioral or risk-based factor" ("Fact, Fiction, and Momentum Investing," Journal of Portfolio Management, Special 40th Anniversary Issue, 2014). They argue that both theories provide good reasons why the premiums should exist.
Behavior would be a reason if there was an underreaction, a delayed overreaction or both to new information. Mr. Rosenblut adds that risk would be a reason if investors believed momentum stocks face greater cash flow risk or incur a higher cost of capital. Risk would also arguably be a reason if the higher valuations and/or price momentum increased expectations for good future results, creating a greater opportunity for the company to disappoint.
Source: Kenneth French Data Library
The chart above shows the performance of portfolios tracking both small and large companies. The portfolios are formed monthly based on the relative performance for stocks over the period of 12 months prior through two months prior. The Up portfolios contain stocks whose relative price performance ranks in the top 30% based on NYSE percentiles, and the Down portfolios contain stocks whose relative price performance ranks in the bottom 30%. The monthly size breakpoint is the median NYSE market equity.
The chart shows, there is significant differential in returns. Small Company Up returned 19.8% on an annualized basis versus 9.4% for Small Company Down. Large Company Up returned 15.1% on an annualized basis versus 4.6% for Large Company Down. The use of “up” and “down” comes from academic research, which often calculates the return differential from momentum as up minus down, or simply UMD. (It is also common to see winners minus losers as WML for momentum, small minus big as SMB for company size, and high minus low as HML for valuation. HML uses book value to market value, which is the inverse of the price-to-book ratio, so a low HML number implies a lower valuation.)
In "What Works on Wall Street" (McGraw-Hill, 2011), James O’Shaughnessy calculated returns without incorporating a lag. His findings show a performance advantage to using both six-month and 12-month relative strength. In both cases, stocks whose relative strength rank was in the top 50% outperformed the all-stock universe. Stocks with relative strength in the top 30% or higher had annualized returns of approximately 12% or higher versus 10.5% for his all-stock universe. O’Shaughnessy’s data is for the period of 1927 through 2009.
Carhart argued that his four-factor model explained most of the difference in returns among mutual funds. He specifically found that the capitalization of the companies and the one-year price momentum of the stocks invested in by a fund could mostly explain its performance. Twelve-month momentum alone accounted for nearly half of the difference in monthly returns between the best-performing 10% of mutual funds and the worst-performing 10% of mutual funds.
While chartists may have previously long looked at momentum, the work of Jegadeesh and Titman and, later, Carhart confirmed its existence in academic circles. The implication of their research is that momentum is as important a characteristic to seek in a stock as value, size or volatility are. In other words, momentum is not merely for short-term traders and those who rely on technical analysis, but also for those who focus on fundamental analysis.
In summary, a portfolio that combines value and momentum strategies across global equity markets and other asset classes may offer investors relatively high returns with low volatility.
aaii-journal-article (May 2016): http://www.aaii.com/journal/article/momentums-role-as-a-driver-of-stock-prices?