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January 30, 2016

Technical Indicators in a Turbulent Market

Momentum indicators are commonly used to find winners. Winners are stocks with comparatively higher price returns. In normal market conditions, momentum indicators work well on an aggregate basis. Momentum indicators can lose their usefulness in turbulent market conditions, in the initial rebound period following a bear market or during slowing economic conditions.
I’ve noticed the “crashing” of momentum indicators as I backtest elements of the new stock strategy I’ve been working on. As some of you might recall, I’m developing a new strategy that combines value and momentum. The process has been going slower than expected, but I recently backtested components of the strategy through the financial crisis of 2008 and the spring of 2009. The data revealed periods where momentum indicators either didn’t work or did more harm than good.
There are different momentum indicators, but I’ll start with one that the anomaly called WML (winners minus losers) is most associated with: relative price strength. Relative price strength compares a stock’s returns over a given period of time (e.g., 26 or 52 weeks) to all other stocks. The more a stock has appreciated relative to a broad market index or all stock universe, the higher its relative price strength is. Price performance is considered an anomaly, because if the market were efficient (meaning excess return cannot be realized through the analysis of individual securities), an investor should not be able to create a portfolio out of the stocks with the best relative price strength and realize a market-beating return. Yet there is research showing that stocks that have performed well in the past will continue to perform well over the next one to two years. Academic research also shows that a profit can be made by buying “winners” and shorting “losers,” hence the WML acronym.
During and coming out of a bear market, relative strength can backfire. This is because sentiment shifts. The “losers” can suddenly be in favor as short sellers cover their positions and/or value-oriented investors attempt to buy stocks near what they foresee as the bottom of a turbulent market. Evidence of this occurring can be seen in the AAII stocks screens performance in December 2008. Two low relative-valuation-only screens handedly beat the returns of a momentum-only screen with returns of 9.7% and 11.3% versus 3.4%. (The all-stock universe rebounded strongly after being down significantly in November 2008.) The underperformance of momentum was also very evident in April 2009 (a month after the bear market ended), when the momentum screen trailed the two value screens by nearly 20 percentage points (a gain of 10.1% versus gains of 28.9% and 28.2%).
My momentum criteria combines both a 26-week relative price strength rank of at least 60% and no downward earnings estimate revisions. Relative price strength rank puts stocks into percentile rankings of 0 (worse) to 99 (best) based on their relative strength scores. Earnings estimate revisions are a momentum indicator because upwardly revised earnings forecasts often lead to higher future prices, while downwardly revised earnings estimate revisions often lead to lower future prices.
A challenge to using earnings estimate revisions during periods of economic weakness is the higher number of downward revisions. This isn’t surprising given that lousy economic conditions are not conducive to profit growth. From a screening perspective, attempting to require positive revisions or at least requiring no negative estimate revisions can lead to fewer companies passing even a relatively basic screen.
Mixing momentum and valuation in a stock screen during a bear market becomes even more troublesome when relative valuation indicators are used. Relative criteria generally identify approximately the same number of stocks in all market environments. As long as the universe stays relatively unchanged, the number of stocks with a price-to-sales ratio in the bottom 40% will stay relatively unchanged. What will change is the actual price-to-sales ratio defining the difference between the 40th lowest percentiles and any percentage ranking above it. A stock’s valuation has to be much lower to make it into the bottom 40% during a bear market than it does during a bull market (e.g., the median price-to-sales (P/S) ratio was 1.7 in September 2007, but just 0.7 in February 2009.) One way around this problem is to use absolute instead of relative valuation criteria during turbulent market conditions.
A similar type of problem was evidenced in our CAN SLIM screens. Between September 2008 and June 2009, few—and often no—stocks passed the screens. The culprit was a requirement for stocks to trade within 90% of their 52-week highs. Percentage of 52-week high is another “winners” criterion; it is used to identify only those stocks trading at or near their recent highs. Since bear markets drag down the prices for the overwhelming majority of stocks, the pool of stocks trading near their 52-week highs becomes limited during those turbulent market periods. Adding any additional criteria to a screen restricts the number of passing stocks even further and can cause a momentum-oriented stock screen to not identify any stocks.
None of this is a criticism of momentum. Rather it shows that momentum, like any other anomaly (low valuation, smaller company size, etc.), doesn’t work all the time.
The Week Ahead
The U.S. financial markets will be closed next Friday in observance of Independence Day. Our offices will be closed as well. Have a happy Fourth of July!
A handful of S&P 500 member companies will report quarterly results next week: ConAgra Foods (CAG) on Tuesday and Constellation Brands (STZ), General Mills (GM), McCormick & Co. (MKC) and Paychex (PAYX) on Wednesday.
The first economic report of note will be the National Association of Realtors’ May pending home sales index, released on Monday. Tuesday will feature the April S&P Case-Shiller home price index, the Conference Board’s June consumer confidence survey and the June Chicago PMI. The June ISM manufacturing index, June ADP employment report, June PMI manufacturing index and May construction spending will be released on Wednesday. Thursday will feature the Labor Department’s June employment report (released a day early because of the holiday) and May factory orders.
St. Louis Federal Reserve president James Bullard will speak on Tuesday.

About The Author - Charles Rotblut, CFA is the VP and Editor for American Association of Individual Investors (AAII). Charles is also the author of Better Good than Lucky. (EconMatters author archive here)
Stock & ETF Trading Signals

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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