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Reaction, Momentum and Reversion

| | Posted in: Momentum Investing, Technical Trading, Value Premium

A reader observed and asked: “There are two strategies, both of which appear to work, but which also seem contradictory to each other. Momentum says what goes up must go up further. Reversion says what goes up must come down. Both work? There must be something wrong here?!?

There is a stream of research that indicates three phases of price dynamics in equity markets, reaction – momentum – reversion, that operate over different horizons:

  1. The reaction phase is short-term (roughly a month or less), wherein price tends to reverse recent momentum. “Short-term Reversal by Industry” examines this phase in detail.
  2. The momentum phase is intermediate-term (roughly three months to a year), wherein price tends to continue its recent (multi-month) trend. Items in the Momentum Investing category cover this phase, and sometimes address the other two phases as well.
  3. The reversion phase is long-term (roughly two to five years), wherein price tends to reverse a longstanding trend. Items in the Value Premium category address concepts of this phase but seldom assign any time frame to the process.

It is possible to combine the specifications for phase dynamics within a single portfolio. For example, one can impose a skip-month in momentum portfolios to avoid adverse reaction moves. And, one can choose stocks for which momentum is moving prices toward fair values rather than away from fair values (as noted in “What Works Best?”).

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