Today we want to discuss momentum investing as a strategy. In this first article will be discussing how we apply our proprietary trend following models to remain in the trade for the greatest appreciation. The following articles that we will be discussing will be specific stock ideas utilizing our models.
For those new to momentum based investing, momentum is the basic mechanics for trend following. Keep in mind, trend following like any type of technical analysis cannot forecast future price series returns. Technicals can only look at all known information that is built into the price at this moment of time to determine price strength. Trend following is purely a strategy of letting portfolio winners keep running and sell the losers. The issue with applying basic technical indicators with a trend following approach is they are full of momentum noise. This momentum noise generates too many false signals and doesn’t allow investors to get the biggest portion of a trades gains. We will discuss why this happens at the end of this article.
There are many ways to deploy a momentum based strategy on an investor's specific time frame. The most common momentum factor is using relative strength, typically over a look back period of 6 to 12 months over a specific benchmark. The idea would be to allocate to the strongest relative strength names within an index and rebalance the portfolio on a predefined time frame (monthly quarterly, etc.) and sell the weakest names. Longer look back periods like 12 months will provide the greatest momentum, however; they will also be subject to larger drawdowns during momentum crashes and corrections. In theory, these momentum crashes occur during periods of fundamental repricing. Additionally, during a garden variety correction, investors will sell the best performing names first, thus causing a momentum crash.
Relative Strength can also be calculated by using a weighted approach over specific moving averages. For example, you can use a 50 and 200 day moving average and calculate the percentage above and below the blend between these two time periods for a score. You can blend the weight, say 30% to the 50 day and 70% to the 200 day moving average.
While, relative strength is a very solid momentum factor and a lot of empirical data to back up its historical returns as a strategy. It cannot provide an edge as every investor is basically using the same factor tilt. Especially, today you have almost $600 billion allocated to Smart beta ETFs which are using relative strength for their momentum tilt. This would be a case to argue that momentum via relative strength can cause more crowded trades thus causing momentum crashes.
The biggest issue with momentum is it generates a lot of noise and volatility. This often results to investors not being able to capture the greatest portfolio of returns as the wave of momentum comes crashing down. What ChartLabPro attempts to do is diversity away from commonly followed indicators that are not robust and generate to much momentum volatility. These models create robust confirmation of trend strength and trend exhaustion. Finding a way to measure trend exhaustion is vital to mitigate downside volatility to capture profits. Identify trend exhaustion is a much more superior way of trading then using stop loses. Stop losses typically will only whip you out of the market much too soon.
Example of Reduction in Momentum Volatility
An example of this would be the recent move in the Walt Disney Co (NYSE: DIS) and Apple Inc. (NASDAQ: AAPL) seen below. Below is a chart of DIS – Disney. You can also see a video on how to apply our rating and counter trend for DIS here.
The first line is the price series of the stock. The two lines below the price is our rating value model (measuring trend strength) and our counter trend model (measuring trend exhaustion). You will notice how robust the models are in their ability to remove daily price volatility… they are smooth and steady. This helps investors to maximize their return on capital and gain a greater level of conviction to remain in the trade or investment. Once the rating value reaches its maximum trend strength, investors will want to focus on the counter trend. The counter trend will help investors to determine when the trend is fully exhausted and to reduce exposure and look for greater potential opportunities. The counter trend helps mitigate downside volatility and momentum crashes that are commonly associated with momentum based strategies. This is an important element of our risk management for trades ranging from 60 to 300 days.
Commonly Followed Indicators = No Edge
In the same example of Disney below, we have two commonly followed indicators: RSI and MACD. As you can see, both of these are full of price noise and volatility. These indicators do not paint a clear direction for investors in terms of price strength or price exhaustion. These commonly followed technical indicators cause many false signals (as you can see below represented in the red circles). These false signals create that whipsaw in-and-out behavior that doesn’t allow technical traders to experience full appreciation.