Everyone loves a winner and that applies to stocks as well. While the popular finance theory “Random walk” states that the past movement of the price of a stock cannot be used to predict its future movement, history shows that recent past performance can be a pretty good predictor of short-term future performance. (Read: 3 Biotech ETFs Crushing the Market in 2015)
Momentum Effect Documented in Academic Studies
It has been more than two decades since the academic discovery of “momentum effect” in stocks; Jegadeesh and Titman documented in 1993 that strategies which buy stocks that have performed well in the past and sell stocks that have performed poorly in the past generate significant positive returns over 3- to 12-month holding periods. The study further found that the profitability of these strategies is not due to their systematic risk or to delayed stock price reactions to common factors.
The momentum effect was seen in almost all the markets studied and in time periods going back to more than 200 years. A study by AQR Capital Management, found that best momentum US stocks outperformed worst momentum ones by more than 10% a year between 1927 and 2010. Reasons for this outperformance are not difficult to understand. Enthusiastic investors love pouring money into high fliers, even ignoring fundamentals at times. (Read: 3 ETFs Surging at the Start of 2015)
Price Momentum Driven by Earnings Momentum?
Although momentum investing involves price action as the determinant of momentum, stock prices are mostly driven by earnings growth—actual as well as expected. At Zacks, we strongly believe that earnings momentum drives stock prices. So, momentum stocks are usually stocks of companies that have been doing the right things and showing strong growth potential.
Momentum as a Complement to Value
On the face of it, value investing strategy looks virtually opposite of momentum since it involves purchase of healthy companies with solid fundamentals that have been ignored by investors. In fact, value and momentum strategies exhibit negative correlation and while momentum strategies work in shorter time periods, value strategies deliver returns over longer term. (Read: Bet on These Top Ranked Tech ETFs for Outperformance)
A simple combination of these two strategies can be very effective in boosting portfolio returns while hedging risk (learn more about this strategy in my forthcoming article on the topic).
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