On Stock Market, Trend is NOT always your friend!
Highlights & Takeaways
- Price Momentum in the Stock Market
Price momentum, a phenomenon in the stock market, is well-documented and widely recognized by traders, investment professionals, and retailers — the old tone says: “Trend is always your friend”.
Our research under the SP 500, Russell 1000, and Russell 2000 validates this effect, but to some extent.
- Good vs. Bad Momentum Stocks
Under the SP 500, we observed that stocks with strong momentum outperform weaker momentum ones. The outperformance can be reflected from both return and risk metrics, and especially the beta-hedged returns. For example, during past two decades, stocks with good momentum deliver an annualized beta-hedged return of 4%, versus bad momentum counterparts deliver an beta-hedged annualized return of -4%, creating an attractive 8% long-short beta neutral opportunity for investors.
- Caution: The Momentum Crash Effect
However, blindly following price momentum strategies won’t be ideal. We would like to emphasize the “momentum crash” effect, which exists particularly when the stock market recovers from a big crisis. During such periods, stocks with good momentum underperform significantly compared to those with bad momentum. This effect occurs because the higher beta nature of the worst momentum stocks, leading to a substantial rally in prices.
To summarize, while price momentum is a well-known and frequently used technique in the stock market, investors should be aware of the potential risks posed by the momentum crash effect.
Introduction & Intuition
To calculate the 6-month price momentum, you would typically take the current price of the security and divide it by the price from six months ago.
The 6-month price momentum is often used in technical analysis and trend-following strategies. It helps traders identify stocks or other assets that have shown consistent price strength or weakness in recent months, potentially indicating continued upward or downward trends.
In this section, we will examine the above argument from a quantitative perspective.
Factor Study Framework
We will analyze the performance of stocks with higher price momentum (6 month) compared to those with lower price momentum (6 month) during the period of January 2000 to March 2023, using the following framework to determine which group delivers better returns.
Price Momentum (6 Month) Factor in SP 500
The following results (Jan 2000 — Mar 2023) are displayed.
- Quintile Annualized Returns (both total return and alpha return).
- Quintile Long-Short Cumulative Returns, where the best quintile (Q1) is long and the worst quintile (Q5) is short.
1. Quintile Annualized Returns
Just as a reminder, we use two types of return measures in our analysis. Total return measures the overall return from the stock, which includes both the market return and the stock selection return. On the other hand, alpha return focuses solely on the stock selection return by removing the market return component from the stock return. This distinction will allow us to evaluate the effectiveness of the price momentum (6 month) factor more precisely.
Details on two return components can be found:
Quintile Analytics
Observations:
- The above results indicate that trend following can be an attractive strategy within the SP 500 universe for identifying stocks with favorable risk-return profiles. Stocks exhibiting higher recent 6-month price momentum demonstrate a tendency to deliver superior returns in the subsequent month when compared to stocks with the poorest 6-month price momentum.
- Notably, the risk associated with stocks displaying the best momentum is significantly lower than that of stocks with the worst momentum. These findings highlight the potential benefits of incorporating momentum-based strategies in investment decision-making processes.
2. Quintile Long-Short Cumulative Returns
Long-Short (Q1 — Q5) Return Analytics (Monthly)
Observations:
- From the cumulative performance chart, it’s obvious that good momentum stocks consistently outperform their bad momentum peers. However, it’s crucial to highlight the presence of the “momentum crash” effect.
- Over the past two decades, the long-short total return strategy for the momentum factor has been running into difficulties. This trend can be primarily attributed to the fact that stocks with the worst price momentum are associated with higher stock beta. As a result, the long-short momentum factor inherently faces headwinds due to the beta component, which negatively impacts the performance.
Price Momentum (6 Month) Factor in Russell 1000 and Russell 2000
It is worth noting that the S&P 500 index consists of the 500 largest and most actively traded companies in the US, where stocks are generally priced more efficiently than in other stock universes.
To determine whether our conclusions hold true in different stock universes, we extended our study to include the Russell 1000 and Russell 2000 universes. This expansion allowed us to compare the performance of stocks with higher price momentum (6 month) to those with lower price momentum (6 month) under different market conditions and environments.
- Quintile Annualized Returns
2. Quintile Long-Short Cumulative Returns
Observations:
- The behavior of the momentum factor remains consistent under the Russell 1000 and Russell 2000 universe, where the “momentum crash” phenomenon is observed during recovery periods as well, such as post 2008 Great Financial Crisis and the 2020 post-COVID period.
- Given that stocks with the worst 6-month price momentum have higher stock beta components, it is recommended to harvest alpha return rather than the beta return when trying to utilize the price momentum factor, in order to avoid the risk of losses due to the prolonged market uptrends over the long term.
Notes:
- All data in the analysis are sourced from Yahoo Finance & Financial Modeling Prep.
- Past performance is no guarantee for future investment results.
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