Momentum: The Fifth Factor
Beyond fundamentals, price momentum can influence investment outcomes. Let's understand this controversial but important factor.
What Is Momentum?
Momentum = The tendency for rising stocks to keep rising and falling stocks to keep falling.
It's based on a simple observation: trends tend to persist, at least in the short to medium term.
The Rolling Ball
A ball rolling downhill tends to keep rolling. A ball rolling uphill tends to slow and reverse.
Stock prices show similar behavior. Stocks going up tend to keep going up (for a while). Stocks going down tend to keep going down.
This isn't magic—it reflects how information and sentiment spread through markets.
Why Momentum Works
1. Information Diffusion
Not everyone learns news at the same time. As more investors learn, they buy, pushing prices higher.
2. Behavioral Factors
- Winners attract attention
- Success breeds confidence
- FOMO (Fear of Missing Out) kicks in
3. Institutional Flows
Large investors buy gradually, creating sustained buying pressure.
4. Fundamental Confirmation
Rising prices often reflect improving fundamentals that continue improving.
Measuring Momentum
Common momentum metrics:
| Metric | What It Measures |
|---|---|
| 1-Month Return | Very short-term trend |
| 3-Month Return | Short-term trend |
| 6-Month Return | Medium-term trend |
| 12-Month Return | Longer-term trend |
| 52-Week High % | Distance from peak |
| Moving Averages | Trend direction |
Key Takeaways
- Momentum = tendency for trends to persist
- Rising stocks tend to keep rising (short-term)
- Falling stocks tend to keep falling (short-term)
- Momentum is one factor, not the only factor
Momentum in ShareValue.ai
We incorporate momentum as a secondary factor:
Positive Momentum
- Stock outperforming market/sector
- Price above key moving averages
- Recent trend is upward
Effect: May boost signal strength for fundamentally sound stocks.
Negative Momentum 📉
- Stock underperforming market/sector
- Price below key moving averages
- Recent trend is downward
Effect: May add caution even for fundamentally attractive stocks.
The Momentum Debate
Pro-Momentum View
- "The trend is your friend"
- Momentum has worked historically
- Combines well with value
Anti-Momentum View
- "What goes up must come down"
- Momentum can reverse sharply
- Buying high feels wrong
Our View
Momentum is one input among many. We don't chase momentum blindly, but we acknowledge its influence.
Value + Momentum
Research shows that combining value (buying cheap) with momentum (buying what's rising) can improve returns.
The logic: Cheap stocks with positive momentum may be starting to be recognized by the market.
Momentum Risks
1. Reversal Risk
Momentum can reverse suddenly, especially at extremes.
2. Crowding
When everyone chases the same momentum stocks, corrections can be severe.
3. Ignoring Fundamentals
Pure momentum ignores whether a stock is actually worth buying.
4. Timing Difficulty
Knowing when momentum will end is nearly impossible.
How to Use Momentum
✅ Good Uses:
- Confirmation: Fundamentally attractive + positive momentum = stronger case
- Timing: Wait for momentum to turn before buying beaten-down stocks
- Risk management: Be cautious with strong negative momentum
❌ Bad Uses:
- Chasing: Buying just because something went up
- Ignoring fundamentals: Momentum without value is speculation
- Fighting trends: Catching falling knives
Momentum Traps
- Buying at the top of a momentum run
- Assuming momentum will continue forever
- Ignoring negative momentum on "cheap" stocks
- Using momentum as your only criterion
Momentum + Fundamentals
The best approach combines both:
| Fundamentals | Momentum | Strategy |
|---|---|---|
| Strong | Positive | 🟢 Best opportunity |
| Strong | Negative | 🟡 Wait for turn, or buy gradually |
| Weak | Positive | Be cautious—momentum can fade |
| Weak | Negative | 🔴 Avoid |
Next up: Risk assessment—understanding the warnings.