Momentum Mechanism

• Posted by DynamicHedge
• on May 26th, 2015

 

I want to touch on a couple reasons why momentum works and why I see it as one of the few durable edges in the market. With markets becoming more efficient every year, and edges coming and going faster than ever it’s important to understand principles. Momentum is a principle that can be used as a pillar of strategy development for trend following or swing trading.

Markets trend. End of story. When news comes out on a stock, prices do not instantly reset to a new equilibrium price. Sometimes stocks gap on the news release but they often undershoot and continue to trend toward what eventually becomes a new fair value. Overshooting the equilibrium price also happens but is far more common in the most mature large market cap stocks and news after a prolonged run. There are a million variations, models and theories we can debate.

When price trends to the upside it can take a long time to develop and continue for long periods of time. Sometimes trends turn into manias and markets overshoot on the upside. There is a good reason for this.  On the downside, prices can be quick to reset but are equally slow and often stubborn to trend lower and then often cascade once momentum is achieved to the downside.

Point number one: Upside momentum is usually slower and appears more methodical. Upside parabolic moves are the exception, not the rule.

Point number two: Downside momentum happens equally slowly but resets happen faster. Cascading downside moves are the norm, and orderly declines are anomalies.

Why does this happen?

1. Investors as a whole tend to underreact to news.
2. Investors are risk-averse to upside moves and loss-averse to downside moves.

Investors underreact in part because they anchor themselves in past events that are already well understood. Once an idea has taken hold in the mind of an investor or analyst, it’s tough to detach the old view and fully appreciate the new view. Since we have such a hard time digesting new data, trending markets can partly be seen as the digestion of information.

There is also an asymmetric risk-utility at work. Investors are risk-averse with their winners. They value gains and losses equally but prefer certainty over uncertainty. If there’s an opportunity to make certain gains as opposed to uncertain ones, the investor takes the certain gains every time. When a market is trending higher, investors have certain gains, and continually realize these gains as the market moves up. At the same time, other rational participants identify the same opportunity and buy, only to sell shortly after. This continual realization of small gains applies steady selling pressure to a market that might naturally move higher faster, thus prolonging the trend. Risk averse behavior partially explains why we see long uptrends riding the wall of worry on their way to higher prices.

When it comes to losing trades, investors are loss averse — nobody likes taking a loss. Perversely, not liking to take a loss means investors actually value losses higher than gains. Not a typo, let me explain. When a market is moving against them, investors prefer to take more risks in hopes they can make up for the loss by waiting it out. At a certain point, the risks to total wealth overwhelm the preference to not realize the loss and the investment is sold. The key here is that the losing investment is sold much lower than a corresponding winning trade. Investors don’t let their winners run the same way they let their losers run. Loss averse behavior can account for the cascading effect we see in down trending stocks. At a certain point, stocks cross an imaginary line, sentiment changes, and everyone wants to get out.

The process:

Some event or news motivates investors to buy a stock. Many others are also motivated but are underreacting to the news and either take no action or less action then they rationally should. Price moves higher, validating the risk-averse investors who took action or already own the stock and will soon sell for certain gains. The underreacting investors now become motivated to buy because prices have confirmed their thesis, and they don’t want to be left behind. Once these new buyers have a small certain gain, they sell. This process is ongoing and inches the stock up the chart. Ironically, as stocks rise, many investors interpret rising prices with increased risk. The truth is that while upside price discovery is actively occurring there is an embedded momentum mechanism to support it. In addition, if the price moves up too fast, the chase instinct engages, higher prices stop looking expensive as fear of missing gains overcomes fear of loss and you can get a parabolic move. Let me be clear, stocks can and do get too expensive over various holding periods, but active upside price discovery supports further active upside price discovery.

Think about the same process on the downside. Something happens to decrease the price of the stock. Some sell right away, and others underreact to the information and wait longer than they rationally should. The price initially moves down quickly in reaction, then slowly moves lower. Fewer investors are selling because they are loss averse and do not wish to realize the loss. As the price continues lower, selling cascades as it breaches the utility point of holding the loss for each investor. Loss realization coupled with lower liquidity sends price overshooting to the downside. As prices decrease, investors believe that there is less risk in the stock because “news must be priced in by now” and are constantly baffled by how unreasonably low prices are getting. As downside price discovery is actively occurring, support is only definable by the available liquidity. Selling will not stop until the most loss-averse investors realize their losses and move on or buyers with a different time frame intervene. Stocks that are objectively cheap can and do get cheaper.

Hopefully, the mechanics of momentum make more sense. This article represents a simplified illustration and I purposefully left out variables around short sellers and the vagueries of understanding the motivations behind different classes of investors (retail vs institutional, momentum traders vs value investors).

blog comments powered by Disqus