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Money From Momentum: Positive Feedback Can Drive Returns

by Shelly X. Liang

Positive feedback trading takes into account trends in the stock market. It posits an alternative to theories that advocate buying the market or tracking corporate performance.

According to advocates of technical analysis, it is possible to discern trends and cycles in securities prices that can be traded profitably. The simplest form of this is momentum trading—buying securities with prices that are rising and selling those with prices that are falling. Recent studies find that this can work.

Increasingly, financial economists are uncovering evidence of price trends in various markets. Many markets that appear random are not. Rather, they are complex and hard to predict. The contradictions between experience and accepted theory have led researchers to look for an explanation.

Reacting to Momentum Is Rational

The positive feedback trading hypothesis (PFTH) is gaining increasing support among researchers as an explanation for momentum in securities markets. The idea is that at times traders may buy a security simply because it is going up in price. If a large number of traders buy the security, their combined buying pressure drives the price even higher, inducing even more traders to buy.

The buying frenzy is rational because people buy securities to make money, and with rising prices they are making money. Eventually this rational bubble bursts, and prices collapse precipitously. People begin to sell because the prices are falling, and prices fall because people are selling. Momentum up, momentum down.

Positive feedback traders also include traders who use stop-loss orders to sell a security when the price reaches a certain level and portfolio insurers who hedge a portfolio against market risk by short-selling stock index futures.

At times, traders buy securities simply because prices are going up. Their buying pressure can drive prices even higher.

The positive feedback trading hypothesis is of particular interest to equity-market traders because the theory allows for market prices to diverge from any normal valuation of the securities. This is the key: Our traditional notions of valuation led us to believe that momentum profits in excess of normal returns were not possible.

Random Prices and Divergence From Fundamental Factors

Securities are intangible assets. The conventional view is that rational traders value assets based upon all available information regarding returns that can reasonably be expected. Their valuation is based on information regarding “the fundamentals”—profit margins, market share, sales force performance, and so on.

But information arrives randomly, so that the market valuation based on fundamentals is constantly shifting. Because investors and traders have a lot at stake, they are constantly re-valuing the securities in their portfolios based on news about fundamentals. The implication is that securities prices are also random, meaning that there are no trends in the prices to be exploited. This is the basis of the efficient markets hypothesis (EMH).

If stock prices are random, then picking stocks based on predicted prices will not generate higher profits than holding a randomized, diversified portfolio. This is the realization that has led to modern portfolio theory—a strategy for managing risk and return in diversified portfolios.

The high price volatility and the price bubbles experienced in the past few decades, in which market prices deviated far from fundamental values, provide real-world counter-evidence to the efficient markets hypothesis and random walk pricing. That’s where the positive feedback trading hypothesis comes in.

A study published in the Journal of Finance (DeLong et el., 1990) showed in a theoretical framework that the presence of positive feedback trading can cause prices to diverge from fundamental levels even if all other trading is rational. Divergence from fundamentals leaves the door open for excess returns. Traders who take advantage of this divergence are called feedback traders, or momentum traders. They are also called noise traders because they are basing decisions on factors other than corporate fundamentals.

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The positive feedback trading of noise traders imposes risk for rational traders.

Suppose a rational trader predicts a price will fall and short-sells an asset, while positive feedback traders have driven up its price. The price may continue to be driven up by the noise traders within the time when the rational trader has to cover the short. To avoid this risk, rational investors tend to disregard their own information and follow the prevailing price movements. The resulting market prices will diverge from the levels determined by the fundamentals, giving rise to momentum profits.

Are Profits From Price Momentum Possible?

Using a comprehensive data set of U.S. stocks from 1980 to 2009, two researchers and I empirically examined the extent of positive feedback activities and momentum profits in the U.S. stock market and its implications. We eliminated stocks with prices lower than $5 per share and those smaller than the bottom 10% in the New York Stock Exchange. This ensured that our results were not driven by small and illiquid stocks.

Figure 1 shows the percentage of stocks that exhibited day-to-day positive feedback trading activity during any six-month period. The intensity of the positive feedback trading activities varied frequently over time, spiking during periods of market turmoil—for example, during the 1987, 1991, and 2008–2009 economic downturns. On average, around 9.4% of the stocks in our sample experienced day-to-day positive feedback trading over the entire sample period.

The figure also shows that for most of the time, loser portfolios (the bottom 10% of stocks with the lowest cumulative return) displayed stronger positive feedback trading than winner portfolios (the top 10% stocks with the highest cumulative return).

In order to determine whether day-to-day positive feedback trading could predict future momentum profits, we divided stocks into those that displayed positive feedback trading during the past six-month period (PF stocks) and those that did not (non–positive feedback stocks, or NPF stocks). We then formed momentum portfolios by buying the top 10% of stocks with the highest cumulative returns and short-selling the bottom 10% of stocks with the lowest cumulative returns.

Figure 2 shows the cumulative returns of PF and NPF momentum portfolios with the holding period varying from one to 60 months. For the first year, cumulative returns increased for both PF and NPF stocks, with PF stocks producing higher returns. After the first year, cumulative returns declined, and the decline was faster for PF portfolios. After year three, the cumulative returns of PF portfolios started to go below those of NPF portfolios.

Our study also showed that a higher level of information uncertainty will strengthen the positive feedback trading activities and lead to higher momentum profits. Theoretically, information uncertainty tends to add more noise and induce uninformed traders to carry out more feedback trading. As a result, prices further diverge from the fundamental values, leading to a higher level of positive feedback trading and return momentum.

We found that stocks of firms with a higher degree of information uncertainty (firms that are small or exhibit lower trading volume, younger age, higher return volatility, or higher cash flow volatility) were more likely to evidence positive feedback trading activities. The discrepancy between the momentum returns of the PF and NPF stocks also widened with a higher degree of information uncertainty.

Limitations of Momentum Strategies

Our research and that of others show that it is possible to outperform the market using the momentum strategy. But there are serious limitations.

One comes from the divergence from fundamental values. Eventually the market will reach a point where many traders will start to sell. Then the positive feedback mechanism works again, but in a reversed direction. In addition, for ordinary investors, it is not easy to predict the price movement of a specific stock, especially the point where the cumulative return of momentum portfolios starts to decline.

Another drawback stems from the higher level of information uncertainty that creates the potential for momentum profits. Uncertainty, by definition, means higher risk. Besides, momentum is most evident among small-cap stocks, which are associated with a higher degree of information uncertainty. With small caps, the high investment-related costs make a momentum strategy less profitable.

Finally, any predictable and profitable pattern may lose its effect soon after it receives publicity. People learn quickly and exploit the predictable pattern to the extent that it becomes no longer profitable. No positive feedback patterns would be sufficiently stable to guarantee consistently superior results.

Faced with tempting profits and discouraging risk and costs, investors have to decide the extent to which they want to employ momentum trading strategies.

Instead of actively seeking positive effects from momentum, some mutual fund managers try to avoid the negative effects of momentum while maintaining their conventional strategy. When the price of a stock rises out of a range and signals a sell according to their traditional strategy, they may delay selling the stock to allow the opportunity of profits from an upward momentum. Similarly, when the price of a stock falls and indicates a buy, they may postpone buying it to avoid possible losses from further price drops.

This wait-and-see approach, according to the reports of some mutual funds, has enhanced the performance of their portfolios. It seems that a “diversification” of the different strategies may be a productive solution.

As an individual investor, implementation of this approach is more difficult than you might think. So far, researchers have not established an easy-to-follow formula for momentum trading that ordinary investors can systematically exploit. Investors interested in momentum strategy would do well to proceed cautiously. The best course might be to find a mid-point between momentum strategy and traditional portfolio management based on the efficient market hypothesis and modern portfolio theory.

This article was republished with the permission of AIER.

Shelly X. Liang is a research fellow at the American Institute for Economic Research (AIER).


Discussion

M from FL posted over 2 years ago:

Momentum Trading and/or Momentum Investing is not a late comer into the Art of common stock Price forecasting. in 1968 while in my last year of MBA studies I became aware of it and since then I have been actively using it as an Intermediate Term Momentum tool, for which I have to thank Mr. Robert A. Levy, Ph.D. who authored "THe Relative Strength Concept of Common Stock Price Forecasting" publ. by Investors Intelligence, 1968. After that I studied the technique of the great Master, the late A.E.R. Coppock and his letter "TRENDEX".
For modern times, it is a must read Professor Grant Henning's book" THE VALUE AND MOMMENBTUM TRADER" pub.by John Wiley & Sons. 2009. It has been amply discussed in Computerized Investing by Wayne Thorp.


M from FL posted over 2 years ago:

Momentum Trading and/or Momentum Investing is not a late comer into the Art of common stock Price forecasting. in 1968 while in my last year of MBA studies I became aware of it and since then I have been actively using it as an Intermediate Term Momentum tool, for which I have to thank Mr. Robert A. Levy, Ph.D. who authored "THe Relative Strength Concept of Common Stock Price Forecasting" publ. by Investors Intelligence, 1968. After that I studied the technique of the great Master, the late A.E.R. Coppock and his letter "TRENDEX".
For modern times, it is a must read Professor Grant Henning's book" THE VALUE AND MOMMENBTUM TRADER" pub.by John Wiley & Sons. 2009. It has been amply discussed in Computerized Investing by Wayne Thorp.


A from MI posted over 2 years ago:

From an Old Investor.
I believe Momentum trading works, but nothing works perfectly all the time. Started trading in 1957 with about $2,000. Trading was hit and miss until about 1968, when with a slide rules started to work out my own technical momentum system to overcome my trading weaknesses. Studied by correspondance under a professional trader in New England, and visited him when he moved to California for a few years in 1969-and early 1970's to learn chart reading, usinf fundamentals and how to trade. In the late 1970's moved my hand system to computers. Was one of the early members of the NY Traders Society, and tried many of their systems, but kept refining and trying to improve my 1970 system, which I now use in a somewhat revised customized fashion at Stock Charts.com. It sure is faster than the slide rule. However, I still do alot of pencil work, because I find just looking at computer outputs, doesn't give one the feel for change that on gets from recording certain data with a pencil or pen in hand.
I've found sign posts in the system that says when to sell and move on, or buy and get in. But, still find that it's hard to do what the system says, like sell a nice winner, or buy an investment early, that has been a loser. Experience in and a feel for the market is very important and should be developed over the years. IBD can help. One needs to determine why one isn't winning in the market and refine a momentum system that helps one to become a winner. Even then systems need refining as the market changes, and that is a constant battle.
Currently handle over 100 investments regularly totaling in the mid eight figures amounts and about 200 trades a year. Consider myself an intermediate trader trying to be a long term investor. Got out of most all equities in 2007 and while my toe got dipped in the water a few times; I didn't really go back into the market with size until March 2009. High volitility bounced my system and me in and out of the market in 2009, 2010, and 2011, but basically have been a buyer since last August 2011, and am trying to hold on, altho a few sales have occured recently. Many bonds and other nice yielding investments have always been held. They keep ones portfolio growing when one is light or out of the market. If momentum is used, one must be persistent, because of the failures that will occur. It only can help ones batting average and no one bats 1,000. Take it from an old ball player-want-a-be and Investor!


Richard from GA posted over 2 years ago:

I HAVE USED MOMENTUM INVESTING FOR 50 YEARS. I WAS LUCKY IN THAT ONE OF THE FIRST BOOKS I READ CAUTIONED TO GET COMPLETELY OUT OF STOCKS WHEN THE PPI GETS ABOVE 5%. I ADDED GETTING OUT WHEN THE CURRENT PRICE VS THE 39WMA OF THE SP-500 IS NEGATIVE BASED ON DICK FABIAN'S WORK. THIS IS REALLY A KEY. I GOT OUT OR WENT SHORT SEVERAL TIMES IN THE 60S AND 70S AND BEFORE OCT. 87 AND 2001 AND 2008. ONCE I DETERMINE I NEED TO BE IN THE MARKET I PICK STRONG FUNDEMENTAL STOCKS WITH STRONG EPS AND SALES GROWTH AND CAPITALIZATION BETWEEN $80MM AND $1500MM. THEY MUST ALSO HAVE HIGHER VOLATILITY THAN THE SP-500 AND LEAD IN EITHER THE MARK-UP OR MARKDOWN, AS DESCRIBED BY RICHARD WYCKOFF. I SELL WHEN THE MARK-UP OR MARKDOWN BREAKS THE TREND LINE AND THEN STAY OUT UNTIL THE NEXT BREAKOUT OR BREAKDOWN. I MUST ADMIT THAT I HAVE BEEN MORE SUCCESSFUL BUYING LONG AS OPPOSED TO SHORT.


Alyce from NC posted over 2 years ago:

Any comments from those that are using Vector-Vest's techniques?


David from IA posted over 2 years ago:

It would be nice if AAII had a stock strategy backtester. Then discussions could focus around verifiable examples.
AAII could offer the backtester as an add-on to SIPro for an additional cost.
But to the point, my comment is based on backtested data:
Momentum screens backtested, based on various criteria, but having selected stocks sorted on ratios of volume averages, say of 10 day versus 3 month, show promise. Price change is secondary to the volume change supporting it.
The other aspect of selecting by sorting is that the number is not very "deep" per screen. That is, the best results
are of a handful of screens. The backtested returns and the variation to return ratio are impressive. Picking a smaller set of stocks per screen when selecting by momentum makes sense because only the top few would be showing sufficient momentum.
For a backtester, the problem is that the "exit criteria" is the fixed time period selected. Because of this, the more impressive results are of a time period less
than the AAII Strategies (i.e., < 1 month).


Charles from NM posted over 2 years ago:

At the time I started investing in mutual funds in 1990, it was said that all one needed to do was place your money in Fidelity Magellan and come back when you were ready to retire. Then came the transition in fund managers and the new manager promptly made a large bet that went awry. Disgusted with the significant loss, I decided that I needed to make decisions about where to invest, but didn't know any good books to read, so I experimented. I didn't want to do all the background work suggested by most folks about valuing a stock. That seemed way too much work to invest in a mutual fund. Very quickly I fell into momentum investing on my own, but did not know for nearly ten years that it was called momentum investing. Did I bat a thousand? Of course not! It is always possible to buy a fund the day before it begins to fall in price and that eventually teaches one about discerning when to sell. But the system worked well for the next 15 years and my meager investments grew significantly from a few thousand dollars to a high six figure number. Then came 2008 and by that time the mutual fund providers had extended the holding periods for mutual fund selling without incurring a penalty. The combination of volatility and extended holding periods made it impossible to sell mutual funds at the necessary times and the result was a string of losses. I finally got the message that I needed to move on to investing in stocks and ETFs, so that I could sell when needed without being penalized. That change has introduced a new learning curve for me, but I am finally getting a handle on applying my momentum investing experience to the stocks and ETFs. I am optimistic that it can work for me in this new realm of investing.


M from FL posted over 2 years ago:

Ms. S.X.Liang:
Today I have re read your fascinating essay.and want to comment on the Limitations of Momentum Strategies as you see them. Basically 3: Divergence from Fundamental Values, Increased uncertainty (Risk), and strategies lossing effectiveness on becoming too publicized.

In spite of my academic training in economics,management, finance and statistics, I admit to being a Technical Trend Trader prefering Price Momentum equities and have learned more from practical experience through many years, yet some fundamental values are included in my analysis,which does neutralize some of your stated Limitations, but statistics introduces its own limitations: when we extrapolate into the future with assumed expectations we end up working in a virtual reality due to a % coeficient of error. This is how I handle the limitations.

I no longer Day Trade, do not trade Short and do not leverage. My trade period is 3 weeks to 12 months. Portfolio has no more than 20 equities of equal $ amountss, diversified into several momentum industries. Essential before aBuy order is placed there has to be an exit strategy for each position, as trends don't last forever and may change overnight.

My basic exit is via a Mental Trailing Stop. It is not placed as a Stop Loss Order to avoid the Market Maker from profitting therefrom. At purchase time it is set at 10% below the Price, as Current Price(CP) rises higher than Purchase Price(PP) the Stop Loss is raised thus:

If CP rises 10% over the PP, don't give back to the market >66% of the profit(CP-PP)

If CP rises 20% over the PP, don't give back to the market >50% of the profit(CP-PP)

If CP rises 50% over the PP, don't give back to the market >30% of the profit(CP-PP)

This way you protect your profit without selling too soon nor too late; and the limitations mentioned earlier become irrelevant.If you back test this methodology
you may find that Momentum Strategy is, indeed, profitable.


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