Using Absolute Momentum to Identify Breakthrough Stocks in the Market

Investors are always on the lookout for strategies to spot stocks that could outperform the market. One such approach is absolute momentum, a simple yet powerful concept that focuses on a stock’s price trend over time. In this article, we’ll break down how absolute momentum works, how it shapes stock market movements, and how you can use it to make smarter investment decisions.

What Is Absolute Momentum? Absolute momentum is a trend-following strategy that evaluates a stock’s performance over a specific period, typically the past 12 months. If a stock’s price has risen during that time, it is considered to be in a positive trend and may be a candidate for investment. Conversely, if the price has fallen, the stock is avoided. The idea is to ride the wave of stocks that are already moving upward, capitalizing on momentum while sidestepping those in decline.

This strategy differs from relative momentum, which compares stocks to each other to identify the strongest performers. Absolute momentum, instead, focuses on a stock’s own performance, making it a straightforward tool for assessing trends.

Applying Absolute Momentum in Real Life Investors can use absolute momentum in several ways. For example, a 12-month rule might dictate that you only invest in stocks with positive returns over the past year. This approach helps capture stocks in strong upward trends while avoiding those in freefall. Some mutual funds and ETFs use similar rules to construct portfolios that adapt to market conditions.

To enhance this strategy, investors often combine absolute momentum with other factors, such as strong fundamentals (e.g., revenue growth, profit margins) or favorable valuations (e.g., low price-to-earnings ratios). This hybrid approach balances trend-following with value-based analysis, reducing the risk of chasing overhyped stocks.

A Real-World Case Study Consider Tesla (TSLA) in 2020. From April 2020 to April 2021, Tesla’s stock surged from around $50 to over $600—a staggering 1,100% increase. An investor using absolute momentum would have noticed Tesla’s 12-month upward trend and stayed invested, capturing further gains as the stock continued to rise. Conversely, a stock like GameStop (GME) in early 2021, which saw a short-term spike due to retail trading frenzy but then fell back below its previous levels, would have been avoided under this strategy, protecting investors from volatility.

Risks and Considerations Like any strategy, absolute momentum has limitations. It may miss stocks in short-term decline but with strong long-term potential. For instance, a company might face temporary challenges (e.g., supply chain issues) but have a solid business model. Additionally, in a sideways or highly volatile market, trends may be unclear, leading to false signals.

To mitigate these risks, investors should: 1. Use absolute momentum as part of a broader strategy that includes fundamental analysis and diversification. 2. Set stop-loss orders to limit losses if a stock’s trend reverses. 3. Regularly review and adjust their portfolio to stay aligned with market conditions.

Key Takeaways Absolute momentum is a valuable tool for identifying stocks with upward momentum, helping investors stay ahead of market trends. By focusing on a stock’s own performance over time, it simplifies decision-making and reduces exposure to declining assets. However, it works best when combined with other strategies and a disciplined approach to risk management. As with any investment technique, thorough research and adaptability are key to success.