<FOOLISH WORKSHOP>
Respecting Momentum
by David Forrest ([email protected])
Loon Mountain, NH (March 19, 1999) -- Well, I'm up here trying to get in one last bit of skiing before the season's over. Upper Flying Fox is a great trail for the intermediate skier out there -- long, wide, and fast! On my last run down, I was thinking about the amazing success the IBD Relative Strength screen has had so far this year, racking up about 36% versus the Standard & Poor's 500 Index's 7% and the Nasdaq's 12%. This screen had all of the following stocks on it in the beginning of the year:
America Online <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: AOL)") else Response.Write("(NYSE: AOL)") end if %>
Yahoo! <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: YHOO)") else Response.Write("(Nasdaq: YHOO)") end if %>
VISX, Inc. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: VISX)") else Response.Write("(Nasdaq: VISX)") end if %>
Charles Schwab <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: SCH)") else Response.Write("(NYSE: SCH)") end if %>
EMC Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: EMC)") else Response.Write("(NYSE: EMC)") end if %>
All of these stocks had high relative strength ratings, and all of them were also listed as Timeliness # 1 stocks in Value Line's electronic database at the beginning of the year. For those of you unfamiliar with relative strength (RS), it's a quantitative measurement of how well any given stock is doing relative to the rest of the stocks out in the investment universe. Investor's Business Daily (IBD) publishes these rankings each weekday, and we've come to use them in our screens.
Stocks with high relative strength ratings (99 is the highest) have outperformed most other stocks recently. The general theory here is that if a stock's price movement has been "strong," it will continue to be strong until something gets in its way. This is the old "an object in motion tends to stay in motion until acted upon by another force of equal or greater magnitude." It's also called momentum.
Those who follow momentum screens have pretty much accepted that their portfolios will be volatile. If you're thinking about following some measure of momentum to pick your stocks, you need to understand why high RS stocks can be so wild.
1. High risk, high return. Most of the stocks that receive high rankings (90-95) have already appreciated greatly. Usually, when a stock does better than most others in the investment universe, it's because people are looking to the future and seeing good things. Any negative surprise will tend to have a dramatic and negative effect on the stock price. The risk is greater with these stocks because they have already run up so much in anticipation of future good news. When that good news doesn't materialize, the stock falls that much harder.
2. Riding the train. Quite simply, there are a lot of people out there (Workshop followers included) that will buy a high RS stock simply because it's a high RS stock. They don't necessarily care what the company does. They might not believe in the business for the long term. They are only trying to "ride that train." But when the RS ranking drops or there is any bad news, these investors are the first to bail out. They'd rather take a nasty loss and move into a better-performing stock than sit around and hope that the train wreck comes back to life. So you have to be careful of herd mentality, too.
Recent examples of high RS stocks that got taken out and shot include Network Associates <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: NETA)") else Response.Write("(Nasdaq: NETA)") end if %>, which dropped from $65 in December all the way to $32 today. Bad news in a momentum stock = horrible results. Another example is Willams Sonoma <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: WSM)") else Response.Write("(NYSE: WSM)") end if %>, which fell from $40 on the last day of 1998 to $28 today. Ugly.
So, while I tempted you with impressive returns in the first paragraph of this article, I leave you with the sobering thoughts of recent train wrecks. I do this to both excite you and to make realize that there's a flip side to the story. If you decide to get involved with momentum trading using screens like IBD-Relative Strength, then please just realize that while there may be greater rewards possible, there are equally greater downside risks.
Take care.
Bogey