Riding the Wave: Profiting from Momentum in the Stock Market

Riding the Wave: Profiting from Momentum in the Stock Market

What is Momentum Investing?

Momentum investing is a strategy that aims to capitalize on the continuance of existing trends in the market. It involves buying stocks that have performed well in the recent past and selling those that have performed poorly, based on the idea that those trends will persist in the near-term future. Momentum investors believe that stocks which have outperformed recently will continue to do so, while those that have underperformed will continue lagging.

Why Does Momentum Investing Work?

The core premise behind momentum investing is that markets are slow to react to new information. When good news about a company emerges, it tends to be absorbed gradually by the market, leading to sustained upward pressure on the stock price as more investors buy in. Similarly, when bad news comes out, the stock tends to steadily decline as more investors exit their positions. These slow, steady moves create momentum that can be profitably harnessed.

Behavioral factors also contribute to momentum. Investors often underreact to new information initially then overreact down the line, heightening the momentum effect. Herding behavior, where investors follow the crowd into and out of stocks, and the disposition effect, where investors sell winners too early and hold losers too long, also fuel momentum.

Measuring Momentum – Academic Research

Several academic studies have validated momentum as a market anomaly that can be profitably exploited. In their seminal 1993 paper “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency,” professors Sheridan Titman and Narasimhan Jagadeesh documented that stocks that have performed well over the past 3-12 months continue outperforming, while recent losers continue underperforming.

Other studies have shown that momentum exists across asset classes and geographies.

Quantitative Momentum by Wesley Gray

On Validea, one of our key momentum models is the Quantitative Momentum Investor approach based on the work of Wesley Gray. Gray’s research has shown that momentum works best when focused on the 3-12 month time frame, excluding the most recent month. He also found that the most effective momentum metrics are those that also consider the consistency of a stock’s outperformance.

Gray’s model homes in on stocks with the highest quality momentum by starting with the top 10% of performers over the past 2-12 months, excluding the last month. From there, he selects the stocks with the most consistent momentum as gauged by metrics like hit rate and volatility. This added layer of rigor helps filter out “flash in the pan” momentum stocks in favor of more reliable performers.

Twin Momentum by Dashan Huang

Validea also utilizes the Twin Momentum Investor model based on research by finance professor Dashan Huang. Huang’s approach combines traditional price momentum with fundamental momentum, measured through metrics like earnings growth and return on equity.

By requiring both strong price performance and robust underlying fundamentals, the Twin Momentum model answers the criticism that traditional momentum just chases “hot stocks” with no grounding in company quality. Huang has shown that this dual momentum approach significantly enhances returns compared to pure price momentum alone.

5 Stocks with Strong Momentum Now

Using the above Validea models, here are 5 stocks that earn top marks for momentum currently:

Super Micro Computer (SMCI) – This IT infrastructure company earns a perfect 100% score from both the Twin Momentum Investor and Quantitative Momentum Investor models. SMCI has delivered torrid price momentum, rising over 700% in the past year, excluding the most recent month. It pairs that with stellar fundamental momentum in earnings, ROE and profit margins.

Abercrombie & Fitch (ANF) – This well-known apparel retailer also notches 100% scores for Twin Momentum and Quantitative Momentum. ANF has surged over 260% in the past year on the back of accelerating sales and earnings growth. The stock’s recent momentum has been extremely consistent with limited volatility.

NVIDIA Corporation (NVDA) – Chip giant NVIDIA is another Twin Momentum favorite with a 100% score. The firm’s revolutionary AI chips have made it one of the market’s top momentum names, nearly tripling over the past year. NVDA combines that price strength with explosive earnings growth in excess of 100%.

Apollo Global Management (APO) – This alternative asset manager is a top pick of the Quantitative Momentum model with a 100% score. APO’s stock has more than doubled over the past year with steadily rising 12-1 month momentum. Notably, APO’s momentum has come with low volatility, a key feature the Quantitative Momentum model screens for.

General Electric (GE) – Iconic industrial conglomerate GE may seem an unlikely momentum play, but it currently earns a 100% score from the Quantitative Momentum model. GE has quietly posted strong price momentum over the past year while maintaining a smooth volatility profile that meets the Quantitative Momentum model’s strict consistency requirements.

While often associated with more speculative areas of the market, momentum investing – when grounded in rigorous academic research like that underpinning the Validea models – offers a compelling, fundamentally-sound pathway to market outperformance. By carefully measuring momentum and combining it with quality screens, investors can harness the momentum anomaly while sidestepping riskier “hot stocks” and positioning for sustained long-term gains.

Further Research:

High Momentum Stocks

Quantitative Momentum Portfolio

Twin Momentum Portfolio