Achieving Alpha Through Momentum Stocks
- Achieving alpha is our mission every day.
- This is the time to “buy high, sell higher.”
- Trading momentum with ease.
- Also recommended: What the…?
There are a million different ways to tackle stock investing.
But however you go about picking stocks, your goal should always be to generate alpha.
Put simply, alpha is the return on an investment in excess of a benchmark, such as the S&P 500 or Dow Jones industrial average.
The relentless pursuit of alpha is our mission every day here at Wall Street Daily.
And the shorter the time horizon to realizing those returns, the better.
Today, senior analyst Jonathan Rodriguez breaks down one of our favorite market-beating strategies to do just that.
Ahead of the tape,
Chief Investment Strategist, Wall Street Daily
Why It Pays to Swim With the Current
Most investors approach the market with a simple game plan: Buy low and sell high.
Not a bad way to make your bones at all.
In fact, the “value” investment strategy — buying undervalued stocks relative to a company’s industry or the broad market — is based on this idea.
But thanks to record-low interest rates and weak economic growth over much of the last decade, value stocks have underperformed the market.
At the same time, growth stocks — the issues priced at a premium to the market — have soared.
In fact, as valuations climb, many financial talking heads are telling investors to stay out of the market and wait for a crash to buy up stocks.
That’s a perfectly good way to miss out on a rally in stocks — one that could last a lot longer than people think.
There’s better way to play the action: Flip the script.
Make Friends With the Trend
Believe it or not, the stock market behaves very much like the real, “physical” world.
For instance, Sir Isaac Newton’s first law of physics most certainly applies to stocks: An object at rest will remain at rest unless acted on by an unbalanced force.
Let me explain…
Stocks have a tendency to continue moving in the direction they have been travelling. This is especially true over one-year periods. And the “gravitational” phenomenon applies to both stocks in uptrends and downtrends.
And as stocks approach new highs and lows, this phenomenon becomes even more pronounced.
What’s behind the gravity of market trends?
It’s simple, really…
Human investors are emotional beings and have difficulty in objectively valuing stocks at highs or lows, both on near-term and long-term bases.
New information about a stock at either level is slow to be digested by the market, and that delay causes its price to dislocate from its underlying fundamentals.
Simple enough, right?
Well, here’s how you could trade the action…
Instead of buying “low” and selling “high,” an investor would buy the market’s strongest stocks and sell “higher.” And on the downside, investors short underperformers.
This trading strategy is called momentum investing.
And according to Mark Hulbert, citing data from famed economists Eugene Fama and Kenneth French, the top decile momentum portfolio has beaten the total return of the S&P 500 by 6.6 percentage points from 1927 to March 2017, before transaction costs.
That kind of outperformance is nothing to scoff at.
How the Average Joe Scores Above-Average Returns
Senior analyst Martin Hutchinson covered the basics of momentum investing on Monday. But let’s take a deeper dive today…
There are several different ways to trade momentum.
But for the average investor, the easiest way to implement this strategy is to simply follow the stocks making new 52-week highs and lows.
From there, investors should take a look at a stock’s sector and industry to confirm outperformance or underperformance against their peers, too.
If the performance is well defined and the stock is backed by your own fundamental analysis, simply go long the strength and/or short the weakness.
This strategy works on stocks in all sectors of the market and on stocks of all sizes.
Of course, there is a marked difference between trading a stock’s momentum and simply chasing expensive stocks (on the long side of the strategy).
The most successful momentum investors buy high-quality names and sell low-quality names.
And while the emotional decisions of investors drive the engine of this strategy, a stock’s fundamentals are the basis of its price movement and should never be ignored.
If sales and earnings are rising, its price will almost assuredly follow. And the converse is most certainly true.
Bottom line: Any way you tackle it, momentum investing is one of the best, easiest ways for the average investor to achieve alpha. And if done right, an investor can handily outperform the broad market with this strategy.
On the hunt,
Senior Analyst, Wall Street Daily