The idea behind relative strength is to find companies with the best-performing stock prices, the ones that have increased the most over a specific period.
In his book, ‘What works on Wall Street’, James O'Shaughnessy calculated relative strength by looking at the price increase of a stock over the past year. Looking at the change in stock prices over a year, he found that winners seemed to continue to win, and the losers kept on losing.
In this study, we first set out to also see if relative strength can separate winners from losers. Then with the multiple-factor portfolios, we will see if the combination of reasonably priced stocks with momentum can give you even higher excess returns. We have analysed two periods of short-term price momentum:
- Companies with the best 6-month price appreciation (stock price on the day the portfolio was compiled minus the stock price six months ago, which we called the 6-month price index, and
- Companies with the best 12-month price appreciation (stock price on the day the portfolio was compiled minus the stock price 12 months ago, which we called the 12-month price index.
6 Month Price Index
12 Month Price Index
As you can see the short-term price index (6-month price index) is a strong factor as we defined it. Results are linear, with Q1 beating Q5 for all size companies, and the factor outperformed the market just over 83% of the time for all three market-sized companies.
The 12-month price index is not strong as it is not linear for large-cap companies. It also outperformed the market only 58% of the time for mid-cap companies.
What is very clear is that companies with a low price index (Q5) for both the 6- and 12-month price index are to be avoided at all costs as for small companies as the 6-months was the worst, and 12-month price index the second worst single factor strategy we tested.
The results also show good or bad news about a company that may be quickly incorporated into the stock price. Still, clearly, with some delay, otherwise, the top quintiles would not outperform the bottom quintiles and the market. The factor is particularly strong for small and mid-cap companies. This may be, for example, if a company's order book is decreasing, the company’s employees or suppliers may notice this and start selling the shares, who then tell others who then sell shares before the news is public.
The increased number of selling sellers leads to supply exceeding demand, causing the stock price to decline. But there may also be other reasons, such as company insiders that may be buying.
Another reason why short-term momentum works is the so-called ‘inertia effect’. In his book, ‘The New Finance’, Robert Haugen said stock prices exhibit inertia in the short term and often have reversals in the long term. This is driven by the tendency of companies in competitive industries to revert to the mean. Yesterday's winners become losers or average performers, while yesterday's losers improve. The market is slow to recognise these reversals, and thus share price trends continue.