Mr. Market at the Psychologist, Part 7: Don’t Get Carried Away by Momentum

February 16  

This is part six of a series on market psychology, specifically on how to use momentum. Click here for part one on decoding market psychology. Click here for part two on investor sentiment and fundamentals. Click here for part three on emotional investing. Click here for part four on the herd mentality. Click here for part five on the buy low, sell high philosophy. Click here for part six on investor sentiment and central bank commentary.

Investor psychology also drives momentum in the market as asset prices sometimes rise simply because they were already increasing. The existence of momentum in asset prices defies logic because they should only rise based on fundamentals or changes in supply and demand. However, sometimes investors simply get carried away, and momentum rallies result.

Momentum as psychology

One reason asset prices have a tendency to keep rising because they have already been rising is irrational exuberance. Former Federal Reserve Chairman Alan Greenspan coined the term in a speech he gave at the American Enterprise Institute in the late 1990s during the dotcom bubble. It basically just means that the stock market is overvalued because investors just keep pushing prices higher and higher with no basis for reality. Investors keep buying an asset or assets because they assume everyone else can’t be wrong, and they want a piece of the action.

In many cases, momentum rallies begin because something happened to trigger a multiple expansion or increase. For example, a company may post a big earnings surprise, resulting in expansion. The stock price rises because the company is worth more with higher earnings, but then investors become overly excited and keep pushing the price higher and higher. Before too long, the stock price has become divorced from fundamentals, carried along by simple momentum, and investors are buying it simply because everyone else has already bought it.

Negative momentum rallies are possible too. Typically, something happens within the market to convince investors to sell an asset. Often that may be some sort of macroeconomic event affecting a particular sector or a change in fundamentals like a disappointing earnings report. Sometimes when one company posts disappointing earnings results, the negative momentum spreads to other companies in the same sector as investors start to worry that their competitors will have the same problems.

How chart technicians use momentum as a guide

Because momentum is irrational, it might seem like an unhelpful guide when it comes to predicting where an asset will move next. However, chart technicians become adept at gauging investor sentiment and using it to inform their predictions about what’s next for a particular asset. Simply knowing that investor psychology can drive an increase or decrease in asset prices opens up another way to invest.

Professional traders and financial analysts often use a simple equation to measure market momentum. Momentum equals the most recent price minus the closing price a set number of days ago. This enables chart technicians to draw a trendline using different periods in their calculation.

For example, gold prices are currently in a momentum rally as more and more investors are buying into the expectation of a coming bull market for the yellow metal. In late June, gold topped $1,400 an ounce, and it has since climbed even higher. Bloomberg reported that more than 1 million ounces of gold traded in only five minutes on June 24. That volume was the highest in nearly six years. The news outlet termed gold’s rise as a momentum rally, although there are reasons to expect it to rise. If and when the bull market finally ends, gold prices will likely rise, so investors who are diving in now are trying to get in early before gold prices really take off in the next bear market.

Momentum as a factor or style

Some companies now offer momentum indices to enable investors to track momentum within their indices. For example, MSCI offers a momentum index in its factor index series. The factor indices capture the returns of investing styles which have historically earned a premium in the long term. The index assigns a momentum score to gauge how much momentum the index has.

Traders and technicians use a number of different indicators to measure the momentum of individual assets. Moving averages are one of the most important indicators because they show a stock’s average price over a period of time. Some common indicators are the simple moving average, 50-day moving average and 200-day moving average. Traders use shorter moving averages if they are thinking with a short-term investing horizon in mind.

Another important indicator is the volume-weighted average price, which shows how a stock price is trending against the volume of shares that are being traded. By factoring in the number of shares that are being traded over a period of time, you begin to see whether investors are getting carried away in either direction. If a stock is trading in low volumes, then you know that momentum probably isn’t much of a factor because not many investors are trading it. Taking the volume-weighted average to another level, we have the positive and negative volume indexes. This indicator provides more data on how volumes are affecting the stock price.

Finally, investors tend to use the Relative Strength Index to gauge momentum as well. The indicator evaluates how prices are changing related to the speed and amount of change in a set timeframe. The Relative Strength Index is calculated by taking 100 minus 100 over 1 plus the relative strength. The relative strength is calculated by dividing the average up period gains in a set timeframe by the average loss from down periods over the same timeframe.

Price bubbles

Of course, the problem with using momentum to predict where an asset will go next is that it doesn’t always work. Eventually, any asset’s price will return to reality. Price bubbles develop because investors allow themselves to get carried away with a particular stock or other asset, but all bubbles eventually pop.

Momentum traders take advantage of everyone else’s irrational decisions, buying an asset on the assumption that it will keep trading higher and higher simply because investors are excited about it. However, the party will eventually be over, and reality will come crashing in—just like it has every other time there has been a bubble.

On the other hand, opportunities can be had by moving in the opposite direction of momentum. This means buying an asset because momentum carried it too low for fundamentals or selling it because others are happily gobbling it up like it will never go out of style.

About the Author

Trading and investing in markets is second nature to some, but a mystery to others. The goal is to provide a forum where everyday people aspiring to be part time or full time traders will learn how view markets differently and profit beyond their wildest dreams.

David Frost