Momentum & Trend Screening of Relative Performance Charts

Peter Beuttell first recognised the importance of relative strength analysis as a portfolio manager in 1984, eventually proving that when combined with fundamental inputs it produced first quartile results.  When MTS was founded in 1989, the UK’s first pure relative strength services covering sectors and stocks were introduced to the London market.  James O’Shaughnessy in his 1997 book “What Works on Wall Street” confirmed the performance-enhancing ability of this technique.  Twenty years of experimentation and observation have identified the following aspects as important to monitor:

Does it Trend or Trade?:  Being aware of whether a relative produces longer-term trends, or whether it trades in a wide range is vital to interpreting the other clues.  Part of the function our services perform is to highlight potential risk and reward, and knowing where a relative lies within its overall trend or trading range is important.  The six charts below are good examples of stock charts from Europe, Japan and the UK, covering a range of different industry types.

Trend direction:  Whilst this is often obvious, we overlay two moving averages (50-day and 200-day for longer time horizons) for confirmation.  Shorter-term corrections usually hold near the 50-day, whilst intermediate retracements should hold around the 200-day, as long as the prevailing trend is intact.  When either of these are decisively broken it is often a signal of a trend change.  This may merely be from up to sideways, for example, but it is also a signal to re-evaluate.  By its very nature, using the 200-day m.a. for buy and sell signals will produce false signals at tops and bottoms, but momentum techniques help avoid these pitfalls.

Momentum:  We use momentum in its simplest form for this purpose - % change point to point, described as:

Short-term:                 13-day % change
Smoothed:                  21-day % change, smoothed over 13 days
Medium-term:             13-week % change.

These indicators are combined to support or question the message coming from other areas.  If the momentum trend is matching that of the relative, it is confirming the trend.  If the trend is making a new extreme (up or down) and momentum is not, then divergence is occurring (bearish or bullish, respectively) and is warning of the potential for a trend change.  We say “potential” because divergence can persist for some time whilst the trend continues.  The more extreme the momentum behind the trend initially, the longer any warning signal is likely to take to develop.

When a correction meets the rising or falling 200-day m.a. a buy or a sell signal is given.  If momentum is diverging at that point, the signal is said to be “confirmed”. 

Putting it together in real time - Unilever case study:  The signals shown in the table appeared in the respective UK RPM monthly publications, and were the only signals given during this period.

BFB	01/03/2000		TAKE PROFITS	09/01/2008
TAKE PROFITS	02/08/2001		BUY	04/03/2008
TAKE PROFITS	16/10/2002		Buy	02/04/2008
Sell	04/06/2003		Buy	07/05/2008
REDUCE	04/02/2004		BUY	03/06/2008
BFB	01/06/2005		BUY	09/07/2008
REDUCE	10/11/2005		BUY	06/08/2008
Buy	03/05/2007		Buy	10/09/2008
Buy	31/05/2007		Buy	21/10/2008
Buy	19/07/2007		TAKE PROFITS	26/11/2008
Buy	23/08/2007		BUY	02/04/2009
Buy	18/09/2007		BUY	06/05/2009
Buy	18/10/2007		Buy	09/06/2009
Buy	13/11/2007		REDUCE	12/08/2009
Buy	04/12/2007

The charts below illustrate a number of these dates, and show the indicator configurations at the time.  Substantial proportions of the two bull and intervening bear trends were captured, with some profit-taking along the way.  By no means every stock gives such strong and regular signals, but these techniques do  demonstrably add value.