Momentum Riding Stocks — It Beats the Average

A secret traders have known and used has always been hushed away by the mainstream. The simple process of picking stocks that are breaking out of 52-week highs that show strong momentum is a time proven winning strategy. Reading any investing section of a newspaper, or a book by a so called ‘investing expert’, market players should be instead investing in the opposite; stocks that are hitting their lows, as they represent good ‘value’. In my yet unfinished essay (coming soon, I promise!), I argue that timeframes are the reasons why buying bottoms is a bad strategy. Keep an eye out for it. For now, I’ll just post some research performed by CrossingWallStreet. Moneyquote:

I know that stocks with favorable valuation characteristics do better than the rest of the market. For example, stock in the lowest decile (or 10%) of price/earnings ratio have historically beaten the market. The same is true for stocks with higher dividend yields or low price/book ratios. Also, small-caps do better than large-caps (although I’m not particularly impressed by the small-cap premium). These phenomena are very well-known and have been documented countless times.

But simply put—high momentum creams them all.

At the data library, French has ten portfolios listed by momentum (see “10 Portfolios Formed on Momentum”). He gets his data from the Center for Research in Security Prices at the University of Chicago. I looked at the long-term returns of stocks with the greatest momentum.

From the beginning of 1927 through August of 2007, the overall market has returned an average of 10.10% a year. The highest momentum stocks returned an average of 17.76% a year.

The graph they present speaks for itself:

It’s official — buying stocks that show strong momentum blows away the market average. The ‘why’ is simple. Stocks showing new highs on a big upsurge are rarely going to have sellers. Who sells when the stock they bought is now starting to pay off? A void of sellers means any buyers have to pay a premium, bidding up the price. Soon, the stock suffers from an exponential incline until either the initial buyers wish to sell out, or the guys who started to pile on think all the profits have dried up. This investing phenomenon is powerful and has made many great fortunes on Wall Street. The Friday Five I post on this blog are stock picks with the intention of exploiting large momentum plays.