A Primer On Quick-Pick Momentum

Accelerators
Mar. 9, 2017 2:16 AM ET
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JD Henning

Value & Momentum Breakouts

Revealing the best financial models with consistent double digit success

(10,227 followers)
Summary

Evidence shows that certain technical, fundamental and behavioral criteria can accurately classify
stock momentum into distinct categories of price performance behavior (Henning, 2016).

The price momentum anomaly has not been arbitraged away despite decades of research and a large
number of informed traders (Schulmerich, Leporcher, & Eu, 2015).

The momentum return premium is evident in 212 years of equity data across 40 countries and more
than a dozen other asset classes (Asness, Frazzini, & Moskowitz, 2014).

With consideration for measurement error, idiosyncratic risk and limited time periods, research
shows that stocks sustain returns within each category consistent with momentum theory.

Financial researchers contend that among many hundreds of market anomalies analyzed over
several decades, two irregularities in particular rise above all the rest (Chordia & Shivakumar,
2006). These two unique market anomalies relate to forms of momentum that have been well
documented in generating excess risk-adjusted returns even to this day. They are most simply
described as the earnings momentum anomaly and the price momentum anomaly - they both defy a
consensus rational explanation to this day. This short primer on momentum accelerators is intended
(1) to briefly answer some questions I receive regularly, (2) to provide some links and research for
further investigation, and (3) to broadly illustrate the methods and research behind the trading
approach I developed, and continue to refine, that may also be of tangible economic value to other
market traders like me.

PEAD

The earnings momentum irregularity is commonly referred to as PEAD (post-earnings

announcement drift) and is credited to the research of Ball and Brown (1968). A great deal of
research on PEAD is available examining decades of behavioral reactions to earnings
announcements and the search for rational explanations for the subsequent overreaction,
underreaction, information uncertainty and mispricing effects that generate anomalous stock price
performance (i.e. alpha). Consensus still eludes academics and practitioners though the persistence
of excess returns (i.e. profits) from the post-earnings announcement drift remains well-documented.

The variety of published explanations for the source of the PEAD is enormous and in many studies
overlaps potential drivers of the price momentum anomaly as well. A sample of attributions include,
unsophisticated investors (Bartov, Radhakrishnan, & Krinsky, 2000); arbitrage risk (Mendenhall,
2004); the inflation illusion hypothesis (Modigliani & Cohn, 1979); erroneous stochastic beliefs,
and excessive optimism or pessimism (De Long et al., 1990; Lee et al., 1991; Kumar & Lee, 2006);
short sale constraints block market balancing (Ofek et al., 2004; Chang et al., 2007); external
sentiment drivers create overpricing distortions (Lamont & Thaler, 2003; Ofek & Richardson,
2003); timing of company news (Barberis et al., 1998; Daniel et al., 1998; Hong & Stein 1999) and
many other potential drivers possibly contributing to the excess returns of PEAD.

Price Momentum

The second key market irregularity is the price momentum anomaly. This is the anomaly principally
behind my research to identify momentum accelerators (among other segments of momentum) for
active trading. The price momentum anomaly is credited to the research of Jegadeesh and Titman
(1993) and has subsequently been validated by many others including Nobel laureate Eugene Fama
and Kenneth French (2008) as the "premier market anomaly." The price momentum differs from the
earnings momentum in that it is not confined to the drift-periods following earnings
announcements, but is continually impacted by the introduction of new information. Price
momentum is based on the observed phenomenon, "where stocks with low returns over the last year
tend to have low returns for the next few months and stocks with high past returns tend to have high
future returns" (Fama & French, 2008, p. 1653).

You may consider that the price momentum anomaly allows for broader attribution of excess
returns than the earnings momentum (PEAD) that ties returns more closely to earnings
announcements. So again the variety of potential explanations ranges the full spectrum of financial
theory across behavioral, technical, sentiment, rational and fundamental theories, even including
idiosyncratic theories of astrology, air pollution levels in NY city, sporting events, and down to the
smallest details of partisanship trends of Senate banking committee appointments. How all these
variables may drive or explain the price momentum anomaly I will leave to their authors, but the
point is that the price momentum anomaly continues to generate measurable excess returns that
have not been arbitraged away after all these years (Schulmerich, Leporcher, & Eu, 2015).

The Concept

So here is the logic to the approach I took toward my dissertation research titled, "Multiple
Discriminant Analysis of the Price Momentum Anomaly and Reversal Event Signals" (2016). There
are hundreds if not thousands of documented stock anomalies from which traders can seek to
generate profits. Many other anomalies still hold my interest and I occasionally dabble with them on
the side. However, if prominent researchers have already substantially pared the list of anomalies
down to PEAD and price momentum, why not start there?

Second, if PEAD is essentially a discrete quarterly drift analysis, why not go with a more
continuous anomaly like price momentum that is not quite so limited by specific events or time and
seems to resemble market forces more realistically?
(My methodology using multiple discriminant analysis could be just as easily applied to earnings
announcement drifts as it has to price momentum and may reveal additional useful insight in a
subsequent study)

Third, if I'm going to analyze a continuous price momentum anomaly that varies from extreme
positive gains to extreme negative losses and all returns in between, why not use a sinusoidal curve
to approximate the entire momentum cycle?

Fourth, if I'm going to divide up a sinusoidal curve into different momentum conditions for testing,
why not include tests of positive and negative reversal event theories as well? Wouldn't it also be
helpful to observe what signals may be present prior to a correction or sudden upswing in price?
What would a sample of thousands of stocks look like classified across each of these momentum
conditions?
Fifth, if Altman (1968) and Taffler (1984) could use multiple discriminant analysis (MDA) from
biological and behavior sciences to successfully predict corporate bankruptcies using multiple
variables, why not use similar MDA statistical tools to differentiate between each of the segments
using even more test variables, say like 24 variables for starters?

Sixth, then I got to thinking that if this study could be conducted every month for a year with more
than 39,000 data points, why not also run the MDA tests on each of the eight largest market sectors
to see if different variables are statistically better at predicting different conditions of momentum in
each different market sector? Why not test (1) Basic Materials, (2) Consumer Goods, (3) Financial,
(4) Healthcare, (5) Industrial Goods, (6) Services, (7) Technology, and (8) Utilities?

Seventh, if the multiple discriminant tests could generate functional equations that organize into
statistically distinct groupings each of the stocks in each of the sectors according to seven different
conditions of momentum for predictive purposes using the variables I tested, what would a plot of
this look like, say for example in the basic materials sector?

Eighth, if my MDA testing can classify stocks into different momentum conditions based solely on
behavioral, technical and fundamental characteristics of individual stocks AND the theory of
momentum holds that stocks in positive and negative momentum conditions tend to sustain that
momentum for some period, does that indicate a predictive probability of a stock's future
performance based on its current characteristics?

So what I found was quite surprising. There are strong discriminant variables that can correctly
classify any given stock into a particular momentum condition at probabilities that exceed five
times the level of pure chance. These results are stronger and more precise using the discriminant
function equations of each particular sector than they are for using the more general function
equation for the whole stock market. This is intuitively as we might suspect when considering how
differently the characteristics between biotechs and utility stocks, for example, tend to appear.

The variables can change from month to month. Sometimes the changes in the equations are very
small and sometimes significant. For example, the coefficients (strengths) of the variables also
change over time. What I found is the more current the MDA results to the investment period the
more accurate the predictive applications. So what I found to be most significant for trading
purposes was that stocks that were classified as a certain category (e.g. Positive Acceleration) and
yet were not performing, as that particular momentum category often had a breakout or
subsequently behaved as previously classified by the equations in the short term. This was most
interesting to me as the discriminant variables used in combination to categorize momentum were
technical, behavioral and fundamental variables not directly linked to price. It showed that after
taking into consideration error and idiosyncratic risks (e.g. bankruptcy, SEC investigation, lawsuits,
unexpected earnings announcements, loss of corporate officers and other corporate catastrophes)
there is still a significant probability of accurately classifying a stock into a particular momentum
category for current and future momentum returns.

The applications are numerous. Not only is it helpful in identifying supporting evidence with
individual stock selections, but the usefulness for sector and broad market decisions is meaningful
too. As entire sectors move through the momentum cycle just like individual stocks, this can lend
excellent applications to ETF selections and entry/exit decision-making. Furthermore, as fewer
positive/negative momentum stocks emerge on the daily, weekly and monthly screens, this often
precedes as a signal to a negative/positive reversal event in the short term. The application for
indexing and creating broader sector and market sentiment type indicators is excellent also. For
example, the table below illustrates momentum group changes from month to month this time last
year (Henning, 2016)

Wh
at I concluded in my dissertation and I leave you with here is that these research findings support
the early findings of Altman (1968) that the multidimensional variable approach of MDA, using an
entire variable profile simultaneously in combination, removes possible ambiguities and
misclassifications found in standard regression and sequential variable tests more traditionally
applied in finance (Henning, 2016). This primer on an exciting field of financial anomaly research
provides a brief overview of the methodology from which my quick pick of momentum acceleration
stocks is drawn.

I hope you are able to benefit both from this research overview and the stock selections I post from
time to time. We are always learning, your comments and questions are welcome and give us all the
more to think about.