The momentum factor in asset pricing is widely recognized and respected, but there’s nothing close to consensus on the best definitions for what is arguably the most durable “anomaly” in the markets. A quick review of the voluminous literature on the subject reveals a variety of methodologies—absolute vs. relative momentum or price-based vs. return-based strategies, for instance. But the common theme that unites all definitions and strategies in this space is a focus on trending behavior for short- to medium-term horizons. Although minds will differ on the ideal for measuring and exploiting this phenomenon, a reasonable way to begin is by comparing an asset’s latest closing price to a variety of simple moving averages.
Why several moving averages? Because no single trailing period rises to the high standard of dispensing relevant insight for all assets under all macro and market conditions at all times. The good news is that at least one facet of the momentum game is enduring and universal in the all-important business of looking for turning points and/or confirming the current trend. When positive momentum is giving way to its negative counterpart, a recurring pattern unfolds: short-term moving averages break down, eventually leading to a progressive series of reversals in the longer-term measures. The same holds true in reverse when negative momentum is transitioning to positive momentum. Meanwhile, when the signals for a spectrum of moving averages are aligned, that’s a strong signal that tells us that the current state of momentum is strong.
These historical lessons inspire monitoring momentum via a series of moving averages for perspective on a market’s current state. But it’s best to show rather than tell. Here are three examples using ETFs for US stocks (SPY), foreign stocks in developed markets (EFA), and emerging-market equities (EEM) with closing prices as of yesterday (Nov. 17). Each graph shows the percentage difference between the closing price vs. five moving averages, ranging from a 10-day average up to a 200-day average. For additional perspective, the spreads are shown for each of the past five days, with the most recent data (yesterday’s close) shown by the red bars.
