Research confirms that momentum is as important a characteristic to seek in a stock as value, size or volatility. Momentum is not merely for short-term traders and those who rely on technical analysis, but also for those who focus on fundamental analysis.

Price momentum is normally measured by comparing the price change of a stock over a specified period relative to a benchmark, such as the S&P 500 index, or against a segment of stocks; the resulting number is called relative strength. If shares of Apple Inc. (AAPL) appreciate by 51.3% and shares of Fitbit Inc. (FIT) rise by 8.9% over the same period, Apple will have better relative strength. Its stock performed better than Fitbit’s stock did.

Relative strength has grown in popularity as a characteristic used in stock selection. A number of research studies and successful investors have highlighted the benefit of seeking out stocks with high relative strength, especially when combined with other fundamental selection characteristics, such as size and value.

Price momentum is often used as a signal that the market has recognized that the stock price is reacting to the investing concept. Investors look for stock price performance better than that of other stocks with the belief that the rising price will attract other investors, who will drive up the price even more. Relative strength’s utility is built on the belief that relative strength persists over time. Momentum is considered to be an anomaly because if the market was pricing in all known information then a stock’s future returns shouldn’t be influenced by past returns.

In “What Works on Wall Street” (McGraw-Hill, 2011), James O’Shaughnessy’s findings show a performance advantage to using both six- and 12-month relative strength. In both cases, stocks with relative strength in the top 30% or higher had annualized returns of approximately 12% or higher versus 10.5% for his all-stock universe. O’Shaughnessy’s data is for the period 1927 through 2009. Other studies show a performance advantage to using 13-week relative strength as well as the aforementioned time periods.

Viewing a Firm’s Momentum Factor on AAII.com

There are several ways to measure the price performance of a stock, typically on either an absolute or a relative basis. Price change over a specified time period is an example of absolute performance, while relative performance communicates how well a stock has performed compared to some benchmark, usually a market or industry index. The most basic means of calculating relative strength is by dividing the percentage price change of a stock over some time period by the percentage change of a market index over the same period.

Members can see the latest 52-week price change for a given company’s stock and see how it compares to its sector median. These price changes are examples of absolute performance and are provided on the snapshot tab of the stock quote page on AAII.com. As an example, Figure 1 highlights the 52-week price change for Quantum Corp. (QMCO) and the median return for the computer hardware industry as of March 13, 2020. Quantum’s price increased by 28.6% over the period while the industry median rose 58%.

Members can also see a stock’s relative performance compared to the stock’s overall performance. This price change illustrates how well a stock has performed compared to all stocks in the S&P 500. The rank figure of 92% means that Quantum Corp. ranked in the 92nd percentile for relative strength among all stocks in AAII’s Stock Investor Pro database as of March 13, 2020. This means that, over the last 52 weeks, Quantum’s relative strength is better than 92% of all stocks during the period. The stocks with the lowest relative strength will have a rank of 0% and those with the highest relative strength will be assigned a rank of 100%.

Momentum’s Weaknesses

The concept of momentum is accepted in academic and practitioner circles with some researchers theorizing that momentum reflects herding behavior. Investors with limited information will favor what’s popular and what has outperformed recently. This fits within the theory of investors preferring winners over losers, as well as behavioral tendencies such as recency bias, which is the tendency to think current trends will continue into the future.

Though momentum has been shown to lead to good returns, it’s not appropriate for every strategy. Its downsides can give investors reason for pause. Momentum does not have staying power on an aggregate basis. While some stocks can retain high levels of relative strength for an extended period of time, relative outperformance is fleeting for others. Research found momentum’s advantage to wane after a period of one year for the average stock. Due to the lack of staying power, portfolio turnover can be higher than it is with other factors.

A far bigger concern with momentum is the potential for the factor to backfire or “crash.” This occurs when stocks with the worst past relative performance (e.g., over the past 12 months) outperform those with the best relative performance. Returns are adversely affected by buying winners and selling or avoiding losers. Momentum crashes are caused by a shift in sentiment. The past losers rise at a faster pace than the past winners do. This results in underperformance for past winners and negative returns for a portfolio that has a long position in past winners and a short position in past losers.

One way to mitigate the downsides of momentum is to combine it with value. Research shows that from a quantitative standpoint, momentum and value are negatively correlated. Due to this lack of correlation, combining momentum with value results in diversification benefits. It not only helps to offset momentum crashes, but it can also reduce both volatility and turnover.

Screening for Momentum Using Relative Strength

AAII tracks a number of screens that incorporate the momentum factor based on relative price strength as the indicator; you can access these screens online as part of membership in the Stocks area of AAII.com. Notable screens include:

• O’Shaughnessy Tiny Titans Screen: Seeks attractively priced micro-cap companies with low price-to-sales ratios and strong relative price strength.
• O’Neil’s CAN SLIM Screen: Seeks companies with accelerating earnings and sales growth showing strong relative price strength and ownership from leading institutional investors.
• Stock Market Winners Screen: Seeks stocks showing recent price strength with strong earnings growth and low price-to-book ratios.
• Value on the Move—PEG With Estimated Growth Screen: Seeks profitable growth stocks trading at a reasonable price using relative strength and low price-earnings relative to earnings growth (PEG ratio).

Grading Momentum With Relative Strength

As part of our new A+ Investor service, subscribers can view Stocks Grades based on the momentum factor for a given company. The Momentum Grade uses the weighted four-quarter relative strength price change for each of the past four quarters to rank companies. The most recent quarterly price change is given a weight of 40% and each of the three previous quarters are given a weighting of 20% (Figure 2). The weighted four-quarter relative strength price score for Quantum Corp. is 91. Quantum’s price performance was 8.0% greater than that of the S&P 500 over the same period, while the technology sector median was 8.0% lower than the benchmark.

Company performance that is equal to that of the S&P 500 is represented by a relative strength index score of 0%; companies outperforming the S&P 500 have positive relative strength figures while those underperforming the S&P 500 have negative relative strength values.

Closing Thoughts

When interpreting relative strength, it is important to note that even a stock that is rapidly rising in price may have weak relative strength if the market is rising faster than the stock. Likewise, a stock that is falling in price will show positive relative strength if it is declining more slowly than the overall market.

The concept of momentum using relative strength can be a revealing and useful investment analysis tool to consider as you look for stock ideas and manage your holdings. Momentum has been associated with higher returns over the long term. ▪

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