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Conclusion

Momentum-based strategies appeal to investors because it seems intuitive that stocks that have gone up in the past will continue to go up in the future. There is evidence of price momentum in financial markets, but with a caveat. Stock prices that have gone up in the past—winner stocks—are likely to continue to go up in the near future. The momentum, however, reverses itself after a few months, and stock price reversals are more likely if you hold for longer time periods. With information announcements such as earnings reports and stock splits, the evidence is similarly ambiguous. When firms report good news, stock prices jump on the announcement and continue to go up after the announcement, but only for a few days. As with price momentum, there is a point at which price momentum seems to stall and prices reverse themselves. In both cases, the empirical evidence suggests that price momentum is more likely to be sustained if it is accompanied by an increase in trading volume.

There are two classes of momentum strategies that you can construct. In the first, you buy stocks with both price and volume momentum, that is, stocks that have gone up more than other stocks in the market over a previous period with an accompanying increase in trading volume. These stocks tend to be riskier than other stocks in the market, and your odds of success improve if you can screen these stocks to eliminate stocks overpriced because insiders are selling. In the second, you buy stocks after positive earnings surprises, hoping to gain as the stock prices increase. Here again, you can improve your odds of success if you can separate the firms that have sustainable earnings increases from the firms that do not.


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