Momentum is related to the first law of motion formulated by Isaac Newton: "Every body perseveres in the state of rest or uniform motion in a straight line in which it is, unless some force acts upon it, and compels it to change its state". This law explains why an object at rest tends to remain at rest, while an object in motion tends to remain in motion. Only an external force can change its state. This well-known law of physics also applies to investing. In the context of financial markets, stocks that have performed well recently will continue to perform well, and stocks that have performed poorly will continue to perform poorly, until a catalyst changes this dynamic. This is known as the momentum effect.

1. The beginnings of momentum

Discovered in the early 1990s - rather late in comparison with other more traditional investment styles such as growth or value - the momentum style was first put forward in earnest in a Journal of Finance research paper in 1993. This study explained how the strategies of buying recently winning stocks and selling recently losing stocks generated significantly higher short-term returns than the US market as a whole from 1965 to 1989.

This research was controversial at the time, as it called into question the foundations of Benjamin Graham's value investing approach, which consisted of stashing assets considered to be at a discount to their intrinsic value. And yet, the momentum approach makes sense: you're more likely to arrive in the middle of an already established trend (up or down) than at a market low or high. For a long time, this new investment style has been little appreciated by investors, despite a great deal of academic research, not least because of its lack of credibility and traditional fundamental explanatory power.

A "momentum" stock therefore fulfils criteria relating to its share's upward trend. The trend horizons used to qualify a momentum strategy are generally 6 and 12 months (those used, for example, for the MSCI World Momentum index, but only 12 months for the S&P 500 Momentum). According to some research, 3-month and 9-month periods are also interesting.

2. Does the momentum style really work?

In terms of performance, the momentum factor has historically outperformed the market over the long term. As the time horizon lengthens, the chances of outperforming with a momentum index increase. At least, that's what we've seen in the past for over 70 years.

In fact, index manufacturer MSCI has created factor indices based on these different criteria. We can see that the MSCI World Momentum index outperforms its benchmark: the MSCI World. Since 1999, the MSCI World Momentum index has generated an annualized outperformance of nearly 3% compared to the MSCI World.

Source : MSCI

This performance has not been achieved at the expense of risk (risk is measured here by volatility), since the MSCI World Momentum index generates a better annualized performance for an equivalent annualized standard deviation (14.96% p.a. vs. 14.98% for MSCI World over the last decade).

We observe similar results for the S&P 500 Momentum index compared to the S&P 500, with a steady net performance for comparable volatility.

Sources: Factset & S&P Global

Beyond the developed countries (MSCI World) and the US market (S&P 500), the momentum factor also works on most marketplaces. This is shown by MSCI data over the last decade (2014-2024) with price data. We're seeing better performance regardless of country or geographic zone.

The momentum factor works best when a trend is clearly established, such as a long bull market. This is when the momentum effect will deviate from the benchmark (the classic index) and perform best. On the other hand, the momentum effect and the indexes created around it have more difficulty in bear market phases, as well as in market reversals (from bullish to bearish and vice versa). As an example, the 50 US companies with the best relative strength (RS) - i.e. the best performance over the last 12 months according to James O'Shaughnessy's criteria (What works on Wall Street) - underperformed the US stock market as a whole over the 2000-2003 period (periods circled in red in the table), whereas they had generally outperformed in previous decades (periods circled in green in the table). 

Source : What works on Wall Street

James O'Shaughnessy has taken the time to divide the US equity universe into deciles based on relative strength. Over the entire 1951-2003 period, the higher the relative strength (performance over the last 12 months), the higher the performance over the next 12 months. Cumulative performance is also higher over the entire period observed (1951-2003).

Source : What works on Wall Street

What's more, this performance can also be observed in subsequent years, with outperformance over the following 5 years in 58% of cases, and over the following 10 years in 67% of cases.

Source : What works on Wall Street

3. Performance partly explained by psychology

This significant performance gap can be explained at least in part by investor behavior. Investors (and financial analysts for that matter) sometimes react belatedly, following a domino effect, to the release of macro or micro-economic information. Revisions to financial forecasts and price targets are made progressively and with a certain time lag, over several weeks, months and sometimes even years.

A change of regime or a disruptive situation in a sector or company therefore takes time to be incorporated into stock prices. This is what we saw recently in the artificial intelligence sector and in the European arms industry. The catalysts are there, but the scale of the estimates is difficult to estimate. Analysts and investors alike are rather conservative at the start of a new trend, and end up - as revisions are made and mindsets change - exaggerating their forecasts and ambitions. This is when they become greedy and overconfident.

The momentum style therefore benefits from this gradual increase in the power of financial forecasts, but also from the greed of investors, who sometimes think it's normal to pay too much. investors, who sometimes find it normal to pay 50 times earnings for a stock today when it was 10 times earnings 12 months ago. The story that investors tell themselves plays a vital role in a company's valuation. This exaggeration on the upside works in the same way on the downside for the lame ducks of the stock market. If momentum style doesn't reduce risk, it capitalizes on human bias.

4. So how do you integrate momentum logic into your selection and management approach ?

Check in quarterly (every 3 months), semi-annually (every 6 months) and annually (every 12 months) to see which stocks have risen and fallen the most. If you're looking to rebalance your portfolio, don't hesitate to lighten up on the worst-performing stocks and strengthen your best-performing ones. It's counter-intuitive, but it works. If you're hesitating between two stocks to hold, choose the one with the strongest momentum over these different time horizons.

However, momentum is not a sufficient risk management tool. It is possible to combine a momentum style with other investment factors such as quality, value, growth or low volatility. If applied correctly, these strategies can further enhance performance and reduce the associated risk.

Once again, the work of James O'Shaughnessy (What works on Wall Street) illustrates this case. By combining relative strength (the outperformance of the overall equity market over the last 12 months) with valuation criteria (low Price-to-earnings ratio, Price-to-sales ratio or Price-to-book value ratio) or profitability (high Return On Equity), for example, performance is further enhanced, as can be seen over the period 1951-2003:

Source : What works on Wall Street

At MarketScreener, we help you identify the stocks with the most favorable momentum. The Momentum investment style list, updated daily, lists the best momentum stocks by country.

Finally, we have a quarterly Momentum Picks selection based on a Quality-Momentum approach. This selection of US stocks has outperformed broad US indices such as the S&P 500 and Nasdaq-100 since its inception.