Five Guidelines for Supercharging Your Portfolio with Momentum Stocks
by Dr. Scott Brown, Education Director
Monday, November 23, 2009: Issue #1143
Momentum: Force or speed of movement. Impetus of a process, such as an idea, or course of events… That’s how the dictionary defines the word “momentum.”
We’ve all seen what can happen when an index, sector, or stock catches momentum – either to the upside or downside. However, momentum waves don’t move uniformly. They can bounce up and down in an upward trend, gradually making new highs and higher lows, or they can fall into a downward trend.
While the momentum trading concept is nothing new, the introduction of the online momentum day-trader in 1996 has kicked it up several notches and helped create unprecedented volatility in the markets.
And being able to nail down stable, predictable, repeated price patterns gave birth to a wave of momentum-based traders. Individuals could suddenly thrash Wall Street, with some “Joe the Plumber” day-traders becoming millionaires by raking in 458% on Qualcomm (Nasdaq: QCOM), or 608% on Yahoo! (Nasdaq: YHOO) in just six months in 1999.
Of course, the consistent returns of momentum investors baffled “efficiency theory” economists and stuffy Nobel Laureates who claimed that the markets move randomly like bacteria in a Petri dish, not that stocks in upward momentum price patterns are more likely than other stocks to keep rising.
But they’re wrong.The key is to find a momentum model that works. And here it is…
Beat the Market With Momentum Investing
In short, momentum trading is holding a fast-rising stock for a few days, weeks, or months.
It’s a strategy where an investor tries to capitalize on a stock’s trend (be it on the long or short side) in hopes of riding the move further. And it’s less risky than momentum day-trading, where you’re “in-at-dawn” and “out-in-the-afternoon,” as long as you follow the rules below.
Momentum trading is most powerful when cash on the sidelines starts to pour into the market once it’s fully recovered from a crash. For instance, it was particularly profitable from 1996 through 2000 – nine years after the 1987 crash. And the recovery from the 2000 crash was much faster, as momentum investors racked up startling returns from 2003 to 2007, using the guidelines that I’m about to explain…
Five Common Characteristics of the Perfect “Momentum” Stock
The beauty of momentum stocks is that there are very simple ways to find them…
- Momentum Stock Factor #1: Rising Trend
One of the key traits of a good momentum stock is a rising stock price for a few weeks.
Take Mednax (NYSE: MD), for instance. The company has pediatric practices in 33 states and its share price has remained in a strong uptrend since we recommended it on November 2.
Solution: Target stocks in a recently rapid rising up-trend.
- Momentum Stock Factor #2: Institutional Ownership
The real forces behind stock market momentum are the big institutional players, mutual funds and hedge funds that trade in and out of stocks slowly, compared to the momentum players.
Take Columbia-trained New York University adjunct professor, Max Holmes, who gobbled up one-fifth of Playboy Enterprises Inc. (NYSE: PLA) total outstanding shares over the summer through his Plainfield Asset Management hedge fund.
Solution: When large investment houses buy and hold huge blocks of shares, it exerts heavy upward pressure. So look for strong institutional ownership that has been recently increasing.
- Momentum Stock Factor #3: Earnings Surprises
Academic studies of a phenomenon called the “post-earnings announcement drift” have shown that you should search out companies that have beaten analysts’ earnings expectations. This is because these stocks are the most likely candidates for stellar momentum-based returns over the course of a few weeks or months.
A great example is Intuitive Surgical (Nasdaq: ISRG). Its recent earnings climbed by 12% on a 19% increase in revenue, with annual sales about to surpass $1 billion. We expect future earnings surprises because Japan, the world’s second-largest economy, is closer to giving the go-ahead to sell the company’s surgical robots there.
The Momentum Alert Solution: Look for companies that are surpassing analysts’ earnings expectations.
- Momentum Stock Factor #4: Brace for Price Reversals (Know When to Fold)
The same studies I mentioned above also show that momentum stocks can unexpectedly reverse into a downtrend. For this reason, you should never buy and hold a momentum stock.
Instead, use a moving-average as an exit signal (I recommend five days for the fast moving-average and 20 days for the slow one). If you see the fast moving-average drop below the slow moving-average, get out immediately.
Learn the lesson from ITT Educational (NYSE: ESI) here, which reported a 50% jump in third-quarter profits on a 33% increase in sales. But when the fast moving-average closed below the slow line shortly thereafter, it was a sign to get out of the stock before it took a dive.
Solution: Watch for a crossover where the fast moving-average crosses below a slow moving-average.
- Momentum Alert Factor #5: Use Trailing-Stops
A big problem with momentum stocks is that they often drop like a rock after reversing. For that reason, you should always place a trailing stop 25% below your entry price. This doesn’t mean you’ll necessarily exit there; you’ll most likely sell on the moving average exit signal.
Solution: Stops protect you from heavy losses and take the emotion out of the sell decision.
You can spot likely momentum trading suspects by visiting the Wall Street Journal’s NYSE Biggest Percentage Gainers list.
It all starts with education,
Dr. Scott Brown
Any investment contains risk. Please see our disclaimer.
One Response to “Five Guidelines for Supercharging Your Portfolio with Momentum Stocks”
Comments
By submitting your comment you agree to adhere to our Comment Policy and Privacy Policy.
Check out our selection of daily investment research:
 |
 |
Dr. Brown specializes in teaching stock investing because as he emphasizes "the stock market is where individuals and families have the best shot at succeeding financially!"
I’ve seen a common tendency in the Alert Services to make stock recommendations very late in their trend cycles. As an example I’m not sure why MD wasn’t recommended as a buy in either April or July rather than November (and on declining average volume). I’ve watched a lot of these stocks make their biggest moves weeks or months before you recommend them – presumably because of some criteria of yours that hasn’t been met. Would prefer an alert service that identifies stocks much earlier in their trends. If you’re applying Alert Factors #1, #4 & #5 I don’t see the problem.
Reply