Sir Isaac Newton wasn’t much of an investor.
Despite being one of the most brilliant and influential minds in history, he famously lost a fortune when England’s South Sea Bubble burst in 1720. Once the stock crashed and Newton realized the scale of his losses, he allegedly said he could “calculate the motions of the heavenly bodies, but not the madness of people.”
It’s OK. We can’t all be experts in everything. As a trader, I know all about the madness of people … but I don’t know an iota of what Newton understood about physics!
Ironically though, some of Newton’s insights on the natural world provide fantastic insight into the stock market. Newton’s first law of motion tells that that an object in motion stays in motion unless something stops it.
Well, that’s the essence of momentum investing and trend following. And as you likely know, these are major foundations of my investment philosophy and the trading systems I develop.
Why Momentum Works
We know that momentum investing works. It’s proven in study after study. Even Nobel Prize winner Eugene Fama, perhaps the biggest high-profile skeptic of momentum investing, threw in the towel and accepted that it works over 20 years ago.
But why does it work?
That’s a longer story, but it mostly comes down to behavioral effects. Investors have a recency bias. They see what’s been working recently and want to jump on board. This is closely related to “herding” behavior in which investors copy each other and chase the same stocks. So, a popular stock becomes more popular, and buying begets more buying in a virtuous cycle.
Furthermore, momentum can be something of a self-fulfilling prophecy. A rising share price might attract attention to a company, which acts as advertising for its products. It also gives the company access to cheap capital.
As a recent example: GameStop Corp. (NYSE: GME) took advantage of the crazy short squeeze earlier this year, which sent its shares up hundreds and hundreds of percent in a matter of weeks, to issue new shares, completely pay off all debts and replenish its cash coffers. The momentum in the stock literally transformed it into a more investable company.
The Problem With Momentum Investing
Momentum investing works. But at some point, the music stops. The company can bomb an earnings release, or a major investor could decide to bail. Or traders can simply get bored with the narrative and move on to the next stock. There are infinite reasons why a momentum stock can lose momentum.
This is why, as much as l love momentum, I try to marry it to other critical factors.
In my Green Zone Ratings system, momentum is one of six factors I use to build a composite score. The other five are value, growth, quality, size and volatility.
I’ve written about each of these individually, which you can find in our archives. For now, let’s just focus on growth and value.
Growth pairs nicely with momentum because it’s the growth of the underlying business that ultimately gives fuel to the price momentum.
Think of it like this. Imagine a stock is shooting higher by 100% per year. That might sound ridiculous and excessive. But let’s say that sales and earnings are growing at a 150% or 200% clip. At that point, the stock price action looks almost conservative. The price is simply following the business fundamentals higher.
Now, let’s look at value. I’m not a “value investor,” per se. But all else equal, I’d prefer to buy a cheap stock than an expensive stock. If a high-momentum stock is screaming higher, but the shares remain cheap by my value factor, I have a lot more faith in the sustainability of that momentum.
In an ideal world, I’d like to buy high-momentum stocks with high earnings and sales growth trading at a cheap or at least reasonable price. And I’d be a lot more cautious with a stock showing strong momentum but with lousy growth numbers and expensive pricing.
It’s my job to sort through these scenarios, which is what I do in my research service Green Zone Fortunes. I target stocks that my readers can “buy high … sell higher.” That’s what the Momentum Principle is all about. Click here for the details on my Millionaire Master Class, including how we use this investing strategy to go after winning stocks.
To good profits,
Chief investment strategist, Money & Markets
P.S. Live on September 23, I will reveal a simple way to make 10 years’ worth of gains in a single 48-hour trading window. You don’t want to miss this. Reserve your spot at my live event here.