Monday, January 10, 2011

Maybe You Can Predict the Stock Market After All

If you are an avid reader of this site, you know how I feel about attempts to predict the movements of the stock market.  Any known information about the movement of a particular stock already will be taken into account in the price of the stock.  However, this week's Economist provides a counterpoint to this view.  In the article Why Newton Was Wrong, the Economist discusses research which shows the effect of momentum on the stock market.

Momentum is a complicated word for a simple concept:  stocks that have gone up in the recent past will continue to go up.  The Economist describes research which shows that on average the price of the top performing stocks of the previous year will outperform the rest of the market over the next year.  This trend is observable not only in the U.S. stock market, but in stock markets from around the world.  This trend has also existed since at least the beginning of the 20th Century, so it's been around for some time.

The article points out that this defies conventional logic.  As I have pointed out, if a trend is observable, people will take advantage of the trend which effectively destroys this pattern from appearing in the future.  However, it seems as if the momentum trend defies this logic.  One must search beyond logic for an explanation of why this pattern persists.

The article talks about some of the explanations for this anomaly.  One possible explanation is a "bandwagon effect".  People see that a stock is going up so they feel the need to "jump on the bandwagon" lest they feel like they are missing out.  As a consequence of this, the stock price continues on its rising trend.  A perfect example of this is the dotcom bubble.  Back in the late 1990's, people heard about how others were becoming overnight millionaires from all of these tech company IPO's.  They didn't want to be left out of the excitement so people started throwing money at anything with a dot com in its name in the hopes of getting rich, too.  That lead to a period of euphoria where the price of tech stocks went through the roof.

This illustrates that as logical as people like me try to make investing out to be, humans are creatures of emotion.  As such, we get caught up in an irrational exuberance which can defy logic.  The role of emotion and psychology in markets is something which cannot be denied, as markets are made up of people, not automatons.

Of course, in the case of the dotcom bubble, it reached a point where logic finally did take over.  Cooler heads realized that the tech sector is completely overvalued, and the whole house of cards collapsed.  This illustrates another point that the Economist article makes:  momentum is a short term phenomenon.  At some point, rationality prevails as people realize that momentum can't last forever.  This often leads to a "whipsaw" effect where stock prices suddenly drop and return to a more logical level.  The trick for momentum investors is to figure out when the bandwagon is about the crash so they can jump off. 

Of course, predicting when your luck is going to run out is a tough business.  Human nature is such that we always want to hold out for just one more day in hopes that we'll be able to wring that last dollar from the stock.  Las Vegas was built on the backs of people who thought that their winning streak would keep going so they stayed behind for "just one more" roll of the dice.  It's tough to walk away from the table when you are ahead.  That's why we get burned over and over again by the whipsaw effect.

The moral of the story is that maybe there is a momentum effect that a savvy investor can exploit.  However, don't get too greedy because it may not last for long.

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