Momentum Investing

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Causes
Richard Morin explains momentum investing in this video.  Such momentum can be explained by the tendency of investors to hold onto losers (hoping to return to profitability) and to readily sell winners (and take profits).   Momentum can also be created by investors' over reaction to events affecting the stock market and by herding tendencies, particularly those of fund managers not wanting to risk missing the next big move.

Performance
Of course, the old efficient market theory espoused by most economists says a stock can never be mispriced, yet strategies like this exist to take advantage of just such occurrences.  In this case, he is claiming an annual average performance which is five percent better than the returns of the TSX index.  That is a significant performance improvement!

Momentum, Eh?
Mr. Morin says that price momentum works particularly well in the Canadian market.  I would assume it is because of the cyclical nature of resource companies, but don't know of any research that would back up my statement.  If anyone knows the reason, I would appreciate it if they could provide the information in a comment to this post.

Liquidity
When asked about costs, he stated the use of highly liquid stocks (lots of shares traded) is important in keeping costs low.  Larger companies, especially those included in indexes and funds make good candidates.

So much for not being able to time the market!

My Recent Trade



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Context
This post attempts to answer the question, can the technical indicators be used to time the market?  The Elliott Wave Theory tells us what the overall fractal patterns followed by the markets look like.  The fact that it is some sort of fractal means we can verify where in the pattern we are, by looking at it in the context of the shorter time frame and the longer time frame.  We can view the indicators in that context. One dip, or one rise in the market does not a trend make.  When we see a series of higher highs and higher lows, we have an uptrend.  When we see a series of lower highs and lower lows, we have a downtrend.  That means we can't know the top until, at least, we see another lower high, and we can't know the bottom until we see another higher low.  Rather than try to explain what I mean, let's look at the trade I made at the end of July.

Going Down
First, the RSI indicator at the top of the chart peaked out at the beginning of July as evidenced by the lower high two weeks later.  So did the price candles, the MACD in the section below that and the stochastics in the section below that.  I should have bought (the inverse fund) when the price crossed the green dotted line which represents the midpoint of the Keltner Channel from above.  Instead, I waited for the price to drop below the blue line which represents the 40-day moving average (circled in orange).  By this time any conceivable uptrend had been clearly broken.  Even without any knowledge of the Elliott waves, it would be clear to most people the market was headed lower.

How Far?
At that point in time I had no target price.  I knew fair value based on the historical average annual earnings was  850.  The Point and Figure chart (also found on StockCharts.com) indicated a bottom at 1140.  The Fibonacci ratios associated with the Elliott Wave would suggest a bottom around 1190.  There is nothing in the indicators, initially,  that suggest how much down-side to expect.  On August 9 we had a big bounce, then another drop  on August 10.  I was happy with my gains at that point and exited my position.

Too Early
Had I played the downturn at the beginning of July, I would have been on the right track, but the lower high near the end of July would likely have been sufficient to cause me to start to lose money, even though the longer trend was still down.  I make it a policy to exit such a position when I start losing money.  If the trend resumes in my favour, there is nothing to say I can't take the position again, perhaps even at a better price!

Momentum
The reason I believe we can rely on these indicators is because this "toing" and "froing" in the market is caused by momentum.  The momentum is caused, not by events that happen, but by people's perception of the events that happen.  These optimistic and pessimistic moods take a while to develop and then, to run their course.  Generally, it is not the value of the indicators themselves which I rely on, but the trend in the indicators.  The indicators have since taken a positive shorter trend, but I don't trust it as long as the moving averages are inverted with the 40-day beneath the 200-day and prices lower still.

Comments?