Avoiding momentum crashes

In this week's Stockopedia Strategy Map article, Ed introduced the concept of Momentum. Momentum is the tendency for medium-term winners to keep doing well. A typical Momentum strategy looks at the share price performance from 12 months to one month ago. (In the very short term, share prices tend to mean revert rather than trend, so the last month is ignored.) A market-neutral strategy buys the top performers and shorts the worst performers, but a Momentum strategy can be implemented successfully on the long side only. Momentum is pervasive and has been shown to work across multiple time periods, geographies and asset classes.

It is generally accepted that Momentum generates excess returns because investors under-react to fundamental changes in company performance. This may be due to a psychological bias where investors dislike buying something they could have bought more cheaply earlier. I certainly suffer from this bias. However, the momentum effect may also be due to the under-reaction of company management to positive changes in their business performance.

These effects are relatively short-lived. As this chart from a study called Factors from Scratch

shows, high momentum stocks tend to exhibit higher than average EPS growth over the next year: