What Is A Momentum Crash And Why Does It Happen ?

30th Oct '12 by Edward Croft

8 comments 17834 reads

It's quite a daft premise really but, in general, constructing a portfolio full of stocks that have risen the most over the previous year or so gives you the highest probability of making a profit in the coming months. Between the end of WWII and 2008 a strategy that went long recent winners and short recent losers (i.e. top and bottom 10% of stocks ranked by 1 year price performance) returned an annualised 16.5% with remarkably low volatility. So strong is the return to these long-short momentum strategies and so universally is it witnessed across sectors and asset classes that billions are allocated to it by fund management groups globally.

Victor Niederhoffer, the famous quantitative trader, once poetically described statistical trading strategies such as this as 'like collecting nickels and dimes in front of a steamroller'. Indeed, hidden within the smooth and strong profit line of this momentum strategy lurks a black swan with a nasty bite. It displays what is known as 'negative skewness' - every once in a blue moon profits from the strategy completely and utterly collapse, wiping out careless traders in the process.

What happens in a momentum crash

In April 2011 Kent Daniel published the research paper '*Momentum Crashes' to investigate this phenomenon. A long-short momentum portfolio is created by going long the 10% of stocks with the strongest previous 12 month performance (winners) and short the 10% of stocks with the weakest (losers). He discovered that since 1926 there have been several periods during which the profits from this 'winner minus loser' strategy dramatically crashed, most notably March to December 2009 and the period from 1932 through to the end of World War II.

In normal times the winner portfolio outperforms the loser, but during such a momentum crash the loser portfolio massively outperforms the winners. Daniel illustrated this with the fact that over the 3 months between March and May 2009 the winner portfolio rose by only 6.5% but the loser portfolio (or the stocks that had collapsed the hardest in the financial crisis) rose by 156% ! Anyone short the losers clearly had a miserable time and probably went bust in the process.

Essentially, what is happening in a momentum crash is that the worst performing stocks in the market, the losers, rebound dramatically more quickly than the winners.

Thus to the extent that the…

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emptyend

30th Oct '12

On the topic of momentum stocks, I'll be interested to see what happens in Apple shares when trading resumes, in view of the pull-back from the $700+ highs and the unexpected departure yesterday of two top execs.

Apple was IMO a key momentum stock behind the recent NASDAQ performance.....the consequences of a sharp sentiment change there could be interesting....

8th Nov '12

I'll be interested to see what happens in Apple shares when trading resumes, in view of the pull-back from the $700+ highs and the unexpected departure yesterday of two top execs.

Apple was IMO a key momentum stock behind the recent NASDAQ performance.....the consequences of a sharp sentiment change there could be interesting....

....now $537 - and looking pretty weak in the near term.....

loglorry

9th Nov '12

Apple like most MoMo stocks is interesting but how do you make money from them unless you got in early. If you are long then how do you know when to sell as they always look expensive but still keep climbing. If you look at them at $700 and think they are really very expensive and try to short them you may well get burned betting against the momentum. I don't think there is an easy answer here with stocks like Apple and Google etc. The herd can drive them a lot higher or lower and it is hard to invest rationally when the herd is not rational.

Log

True, re the herd.

In Apple's case I certainly thought they looked too expensive at $700 (can't recall where I said that - debate with Isaac somewhere I think) ....but then I don't short anything. Ideally of course one would get in long early on - but I guess the point with all momentum stocks is that they tend to keep going longer in the same direction than their peer group does. VERY much longer in some cases. Accordingly perhaps one needs more of a private equity mindset with them?

I think there are several very good reasons for thinking Apple might get derated by the market, most of which relate to the very source of their stunning success in recent years........the basic question being can they maintain a pipeline of innovative desirable products that can be sold at a fat premium over competitors - or will their competitors make more of a fist in fighting back? I know where I stand on that - but doubt I'll be putting a trade on.

tiswas

Apple: What’s the Case for Its ‘Bear Market’ Status?

http://finance.yahoo.com/blogs/the-exchange/apple-case-bear-market-status-203033820.html

Edward Croft

I ordered an iPhone 5 and was told it would be with me in 3 days. A week later I called to hassle them. I was then told 3 weeks. I have now just called 3 weeks later and asked where it is... I've now been told up to 12 weeks.

Seems like Apple is struggling to keep up with demand. Clearly the demand is off the scale of even their own projections.

davjo

Seems like Apple is struggling to keep up with demand. Clearly the demand is off the scale of even their own projections.

Either that or the latest consignment aboard the MS Apple has sunk in the South China Sea ;-)

Fangorn

10th Nov '12

You'd be better off getting a Samsung Galaxy S3 in my view. Far superior and distinctly better service if your mobile develops a problem. Apple stores are disgraceful, particularly if your child's phone develops a repeat problem(They try to fob you off several times, and when you put your foot down you still have to book an appointment with an in house engineer - getting a same day appointment is unheard of - and the inconvenience of having to return at a later date only to be told that your child's phone has the same "repeat problem" is infuriating)

Won't buy Apple going forward ever again.

What is a momentum crash and why does it happen ?

What happens in a momentum crash

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Edward Croft

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