Momentum: Force or speed of movement. Impetus of a process, such as an idea, or course of events.
That’s how the dictionary defines the word “momentum.”
We’ve all seen what can happen when an index, sector, or stock catches momentum – either to the upside or downside. However, momentum waves don’t move uniformly. They can bounce up and down in an upward trend, gradually making new highs and higher lows, or they can fall into a downward trend.
While the momentum concept is nothing new, the introduction of the online momentum day-trader in 1996 has kicked it up several notches and helped create unprecedented volatility in the markets.
And being able to nail down stable, predictable, repeated price patterns gave birth to a wave of momentum-based traders. Individuals could suddenly thrash Wall Street, with some “Joe the Plumber” day-traders becoming millionaires by raking in 458% on Qualcomm (Nasdaq: QCOM), or 608% in Yahoo! (Nasdaq: YHOO) in just six months in 1999.
Of course, the consistent returns of momentum investors baffled “efficiency theory” economists and stuffy Nobel Laureates who claimed that the markets move randomly like bacteria in a Petri dish, not that stocks in upward momentum price patterns are more likely than other stocks to keep rising.
But they’re wrong. The key is to find a momentum model that works. And here it is…
Beat the Market With Momentum
In short, momentum investing is holding a fast-rising stock for a few days, weeks, or months.
It’s a strategy where an investor tries to capitalize on a stock’s trend (be it on the long or short side) in hopes of riding the move further. And it’s less risky than momentum day-trading, where you’re “in-at-dawn” and “out-in-the-afternoon,” as long as you follow the rules below.
Momentum trading is most powerful when cash on the sidelines starts to pour into the market once it’s fully recovered from a crash. For instance, it was particularly profitable from 1996 through 2000 – nine years after the 1987 crash. And the recovery from the 2000 crash was much faster, as momentum investors racked up startling returns from 2003 to 2007, using the guidelines that I’m about to explain…
Five Common Characteristics of the Perfect “Momentum” Stock
The beauty of momentum stocks is that there are very simple ways to find them…
~ Momentum Alert Factor #1: Rising Trend
One of the key traits of a good momentum stock is a rising stock price for a few weeks.
The Momentum Alert solution: Target stocks in a recently rapid rising up-trend.
~ Momentum Alert Factor #2: Institutional Ownership
The real forces behind stock market momentum are the big institutional players, mutual funds and hedge funds that trade in and out of stocks slowly, compared to the momentum players.
Take Columbia-trained New York University adjunct professor, Max Holmes, who gobbled up one-fifth of Playboy Enterprises Inc. (NYSE: PLA) total outstanding shares over the summer through his Plainfield Asset Management hedge fund.
The Momentum Alert solution: When large investment houses buy and hold huge blocks of shares, it exerts heavy upward pressure. So look for strong institutional ownership that has been recently increasing.
~ Momentum Alert Factor #3: Earnings Surprises
Academic studies of a phenomenon called the “post-earnings announcement drift” have shown that you should search out companies that have beaten analysts’ earnings expectations. This is because these stocks are the most likely candidates for stellar momentum-based returns over the course of a few weeks or months.
A great example is Intuitive Surgical (Nasdaq: ISRG). Its recent earnings climbed by 12% on a 19% increase in revenue, with annual sales about to surpass $1 billion. We expect future earnings surprises because Japan, the world’s second-largest economy, is closer to giving the go-ahead to sell the company’s surgical robots there.
The Momentum Alert solution: Look for companies that are surpassing analysts’ earnings expectations.
~ Momentum Alert Factor #4: Brace for Price Reversals (Know When to Fold)
The same studies I mentioned above also show that momentum stocks can unexpectedly reverse into a downtrend. For this reason, you should never buy and hold a momentum stock.
Instead, use a moving-average as an exit signal (I recommend five days for the fast moving-average and 20 days for the slow one). If you see the fast moving-average drop below the slow moving-average, get out immediately.
Learn the lesson from ITT Educational (NYSE: ESI) here, which reported a 50% jump in third-quarter profits on a 33% increase in sales. But when the fast moving-average closed below the slow line shortly thereafter, it was a sign to get out of the stock before it took a dive.
The Momentum Alert solution: Watch for a crossover where the fast moving-average crosses below a slow moving-average.
~ Momentum Alert Factor #5: Use Trailing-Stops
A big problem with momentum stocks is that they often drop like a rock after reversing. For that reason, you should always place a trailing-stop 25% below your entry price. This doesn’t mean you’ll necessarily exit there; you’ll most likely sell on the moving average exit signal.
The Momentum Alert solution: Stops protect you from heavy losses and take the emotion out of the sell decision.
The Single Best Way to Invest in Momentum
You can spot likely momentum suspects by visiting the Wall Street Journal’s NYSE Biggest Percentage Gainers list.
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