Editor’s Note: This story was originally published in October 2021. Momentum is Adam O’Dell’s favorite factor within his proprietary Stock Power Rating system, and you’ll see why in the research below.
Markets are picking up steam again.
After a 5% drawdown in September that had some investors worried, action ramped up throughout October. Now major indexes are floating around all-time highs again.
Activity’s really picking up. I’m seeing trading volumes pick up. I’m seeing a lot of order flow going into stocks.
This is the kind of market momentum we like to see!
And with the large influx of new retail investors who entered the market throughout the COVID-19 lockdown, we could be in for a fall and winter season unlike any we’ve witnessed before. An estimated $1 trillion will flow into the stock market in the coming months.
To make the most of this perfect trading environment that’s taking shape, you need to understand how powerful momentum is. It’s one of six factors we use every day in my proprietary Green Zone Ratings system, and it’s at the core of my investing philosophy.
Here’s why…
How Momentum Gained Traction as a Strategy
Nobel-prize-winning economist Eugene Fama wrote his doctorate thesis on the Efficient Market Hypothesis (EMH) in 1962. In essence, the theory claimed that all stocks always trade at their “fair value,” and, thus, it is impossible to “beat the market.”
That theory was accepted as truth and dominated all thinking on investing for the following 30 years. Anyone who claimed otherwise was laughed out of the conversation — especially momentum traders. Their strategy, which involved “buying because it’s going up,” seemed not only simpleton but downright foolish.
Though by the early 1990s, even Eugene Fama himself began to crack open the door to the possibility that an investor could earn market-beating returns with the same or less risk.
In what’s called the “three-factor model,” Fama admitted that one could beat the market by systematically buying stocks with cheaper valuations and by buying stocks of small companies. These are called the “value” and “size” factors, which we use in the Green Zone Ratings model every day.
Still, in 1993, Fama refused to acknowledge momentum as a means of beating the market.
But later that year, the seminal paper on momentum was published: “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency” by Jegadeesh and Titman.
I love the title of this paper…
It smacks of both obvious logic and an ironic irreverence for all the complex theories and models that the academic investment community held out as gospel at the time. That includes the gold-standard Efficient Market Hypothesis.
Even after that, it took Fama three years to come around to admitting that momentum works.
He wrote “Multifactor Explanations of Asset Pricing Anomalies” in 1996. It was an attempt to disprove momentum. And when he couldn’t, he finally admitted defeat … further saying that momentum is the “main embarrassment” of his three-factor model.
What You Need to Know About Momentum
OK, enough beating on Fama for now!
If you’re like me, you want to know two things about the momentum strategy, or any strategy for that matter…
- If it really works and can be expected to continue working in the future.
- Why it works.
For those of us who gain confidence in a strategy after seeing results in a wide range of unrelated markets over time … these two papers are essential:
These will show you that the momentum (aka trend-following) strategy has worked for, well, centuries!
What’s more, not only did Jegadeesh and Titman prove that momentum works on individual U.S. stocks, the momentum strategy has since been proven to work on:
- Country stock market indices (1997).
- Portfolios of mutual funds (1997).
- Foreign stocks (1998).
- Foreign currencies (1999).
- Industry groups (1999).
- Emerging-market stocks (1999).
- Commodity futures (2006).
- Commodity spot prices (2008).
- Bonds (2012).
I hope this is enough to answer that first question: “Does it really work?”
Now, let’s see why the momentum strategy works. Admittedly, this is a conversation that could drag on for days!
But I’ll keep it short and sweet…
Most of the prevailing explanations for why momentum works are “behavioral.” Meaning they’re related to specific behaviors that investors are known to exhibit.
These include:
- “Herding,” where individual investors tend to jump on the bandwagon when they see a larger group of other investors do the same thing.
- “Confirmation bias,” where individuals tend to believe information that confirms their pre-existing belief, more so than information that’s contrary to it.
- “Anchoring bias,” where investors place too much emphasis on one piece of information that is now outdated.
- “Disposition effect,” where investors feel an urge to sell winning positions quickly to feel the thrill of locking in a win and hold on to losing positions for too long to feel the hope of a potential turnaround, thus avoiding the feeling of taking a loss.
We can discuss each of these behavioral biases over time — they’re quite interesting! For now, it’s sufficient for you to know that these biases, or “mental glitches,” as I like to call them, are baked into the human psyche…
We all suffer from these glitches … we have suffered them for all of human history, and we always will.
Most importantly, they systematically create the mispricing of stocks, whereby they are either underpriced or overpriced for some period of time. And it’s the mispricing of stocks that momentum investors take advantage of to earn market-beating returns!
To good profits,
Adam O’Dell
Chief Investment Strategist