Do Stocks Have Momentum

Does that stock have momentum?

Here's how to find out

How to understand stock price momentum

rying to predict a stock’s momentum is sometimes compared to fortune telling, and not always favorably. But many investors do incorporate momentum into their decision-making process — sometimes in concert with their fundamental analysis.

This approach is based on the premise that when trying to predict where prices are going, it is helpful to know where they have been. By looking at a chart tracking the stock price over a period of time, whether a week, a month, or a year, we can see at a glance not only what the price of the stock is but how quickly it got there. This helps us assess the most important part of a stock’s life — its trend. Is the stock moving higher or lower over time?

Why momentum matters

The price alone won’t tell you whether a stock is underpriced; to understand that, you have to know what the trend is. A stock can trade at the same price in a rising trend one month and in a falling trend the next. For example, say a share is priced at $65. Was it $60 last month, or $70? That is vital information, and in most cases all we have to do is glance at a stock chart to glean it. It is far better to buy a stock when its price is on the upswing than the other way around. As Will Rogers wrote nearly a century ago, “Buy stocks that go up; if they don’t go up, don’t buy them.” Little did he know that he nailed the most important part of investing and one of the most quoted mantras of today, namely, “The trend is your friend.” Knowing if a market is moving up or down — and how quickly it’s moving — helps investors buy only those shares that have the odds stacked in their favor.

Spotting a good value stock

How do we know when a stock might cease its ascent? We can never know in advance, and therefore selling at the very highest price is a rare feat. We can only know that a bullish trend turned bearish well after the fact. But there are technical tools measuring momentum, volume, and other factors that can help us make a decision to sell in a timely manner. Momentum indicators are related to price changes much the same way that in physics, acceleration is related to speed. As a car decelerates, an observer on the side of the road does not know if the car’s engine has died or a red light is just up ahead. In the stock market, a chart watcher does not know if the company’s fundamentals have changed or if the market is simply reacting to some outside factor, such as interest rates or politics. But for our purposes, it does not matter as much why the stock is decelerating. If it’s slowing down, it may be time to sell. When the momentum of a stock slows or changes direction, that is a warning sign for investors. So is the change in cumulative volume, an indicator that measures trading volume on up days minus trading volume on down days. Rising cumulative volume tells us the bulls are winning. The strategy works for weak stocks, too. Coal stocks were under pressure in 2015, and the trend in one of the sector’s larger stocks, Peabody Energy (BTU), was clearly in decline. It was tempting to think that the coal industry was quite cheap and that the need for coal was not going away anytime soon.

There was a brief awakening in the stock in March 2016, but the big trend never wavered. Just as quickly as Peabody rallied, it fell back, and the next month the company declared bankruptcy. A low price is not necessarily cheap, and the trend can help us know the difference.

There are countless other tools that measure the madness of crowds (sentiment), the best months or years to buy (cycles), price structures (triangles and other price patterns), and even if the stock market’s soldier stocks are following the leaders (breadth). However, none of those things measure our success as investors. Only price — the difference between purchase and sale — goes into the bank at the end of the day.

Glossary term

[Click on the term below to open a related article for more details]

Technical analysis: A method of studying past trends and patterns in share price movements and trading volume to predict future returns.

Source: Barron's | This infographic was created by Avalaunch Media

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