Momentum Investing

What Is Momentum Investing?

Momentum investing is a strategy that aims to capitalize on the continuance of an existing market trend.

Understanding Momentum Investing

Momentum investing involves going long stocks, futures, market exchange traded funds (ETFs), or any financial instrument showing upward-trending prices and short the respective assets with downward-trending prices.

Momentum investing holds that trends can persist for some time and that it’s possible to profit by staying with a trend until its conclusion, no matter how long that may be. For example, momentum investors that entered the U.S. stock market in 2009 generally enjoyed an uptrend until December 2018.

Although he wasn't the first to use the strategy, fund manager and businessman Richard Driehaus is often credited as being the father of momentum investing.

Momentum Investing Methods

Momentum investing usually involves abiding by a strict set of rules based on technical indicators that dictate market entry and exit points for particular securities.

Momentum investors sometimes use two longer-term moving averages (MAs), one a bit shorter than the other, for trading signals. Some use 50-day and 200-day MAs, for example. In this case, the 50-day crossing above the 200-day creates a buy signal, while a 50-day crossing back below the 200-day creates a sell signal. A few momentum investors prefer to use even longer-term MAs for signaling purposes.

Another type of momentum investing strategy involves following price-based signals to go long sector ETFs with the strongest momentum, while shorting the sector ETFs with the weakest momentum, then rotating in and out of the sectors accordingly.

Other momentum strategies involve cross-asset analysis. For example, some equity traders closely watch the Treasury yield curve and use it as a momentum signal for equity entries and exits. A 10-year Treasury yield above the two-year yield generally is a buy signal, whereas a two-year yield trading above the 10-year yield is a sell signal. Notably, the two-year versus 10-year Treasury yields tend to be a strong predictor of recessions, and also has implications for stock markets.

If you intend to practice momentum investing, make sure you choose the proper securities and consider their liquidity and trading volume.

In addition, some strategies involve both momentum factors and some fundamental factors. One such system is CAN SLIM, made famous by William O’Neill, founder of Investor’s Business Daily. Since it emphasizes quarterly and annual earnings per share (EPS), some may argue it’s not a momentum strategy, per se. However, the system generally seeks stocks with both earnings and sales momentum and tends to point to stocks with price momentum, as well.

Like other momentum systems, CAN SLIM also includes rules for when to enter and exit stocks, based mainly on technical analysis.

The Debate Over Momentum Investing

Few professional investment managers make use of momentum investing, believing that individual stock picking based on an analysis of discounted cash flows (DCFs) and other fundamental factors tends to produce more predictable results, and is a better means of beating index performance over the long term. "As an investment strategy, it’s a thumb in the eye of the efficient market hypothesis (EMH), one of the central tenets of modern finance," to quote a UCLA Anderson Review article, "Momentum Investing: It Works, But Why?" published Oct. 31, 2018.

However, momentum investing has its advocates. A 1993 study published in the Journal of Finance documented how strategies of buying recent stock winners and selling recent losers generated significantly higher near-term returns than the U.S. market overall from 1965 to 1989.

More recently, the American Association of Individual Investors (AAII) found that, in October 2017, CAN SLIM beat the S&P 500 in the trailing five-year and 10-year periods, and has beaten it soundly over an even longer time frame.