Momentum and Risk Management

“Professor Russo, what stock should I buy?”

“Professor Russo, is Zoom going to keep running?”

Professor Russo, what do you think of Virgin Galactic?”

When I am teaching the technical analysis class to college seniors, I can count on getting some version of this question numerous times over the course of the semester. My answer is always the same: "I have no idea!” This is usually met with some form a deflated response from a student who was hoping to find the next big idea. But it’s the truth. I really have no idea, no one does. I have an analytical process that I think tells me if the odds favor an investment going higher but I am never 100% certain.

What I do know for certain is that investing or trading successfully over the long term requires a solid discipline when it come to risk management. This is something that you don’t hear discussed often. Likely because it is not all that fun to talk about. Having a risk management process means that you are admitting right from the start that you could be wrong. The best traders on earth are right somewhere around 55% of the time. That means the odds that they are correct on any single idea is a little better than a coin toss. Let that sink in. What they do is make sure that they lose a little when they are wrong and make a lot when they are right. Over time, they should come out way ahead. No one likes to admit when they are wrong but it is necessary to be a successful investor over an extended period of time.

I also know that momentum is a viable strategy to employ. Stocks and ETFs that have worked in the recent past (the last 3 - 12 months) usually continue to work. I manage a large portion of my assets in a momentum strategy. Every month I evaluate the investment options and I own what as been working. The risk management takes care of itself here because when something stops working, I sell it. You can read more about momentum investing here.

That brings me to the topic on everyone’s mind…GameStop (GME). Here are the returns for GME over various lookback periods:

For all intent and purposes, GME was a fundamentally broken company. They are mall-based retailer (strike one), selling physical video games (strike two), and has seen slowing sales growth since 2011 (strike three).

With this in mind, a lot of professional investors thought that they could make money by betting against the stock. Instead of buy low, sell high they wanted to flip the order…sell high and buy back lower. This is a risk because there is, in theory, no cap on how high the stock can go. This is exactly what one of the best performing hedge funds of the last 10 years did. This fund has averaged more than 30% returns annually since 2014. And they weren’t the only ones making this bet. Many others were on the same side of the trade. That is usually not a good thing.

Then news actually started to get better:

November 2020: GameStop Reports Third Quarter Results, A Positive Start to Fourth Quarter with November Comparable Store Sales Increasing 16.5% And Sustained Progress Toward Long-Term Strategic Objectives

January 2021: GameStop Corp. (NYSE: GME), today reported worldwide sales results for the nine-week holiday period ended January 2, 2021 reflecting a 4.8% increase in comparable store sales and a 309% increase in E-Commerce sales. 

Notice the e-commerce sales, GME is no longer strictly a mall-based retailer. The story changed. The company also made changes to the board of directors that was viewed favorably. At the same time, a group of retail traders on Reddit’s Wall Street Bets message board began to talk up the stock and the fact that a lot of hedge funds were betting against it. The theory is that if the stock begins to rise, the hedge funds will have to buy to limit their losses, driving the stock even higher…MOMENTUM! Once the train got rolling, the momentum fed on itself, it became the talk of the Street and we get the returns highlighted above. Lesson: Respect momentum. Here is what is looks like.

Unfortunately, the hedge funds stuck to their view and continued to bet against the stock. The highly successful fund has taken on big losses to start the year. They required a capital injection from outside investors and have now exited the trade. The question is, how could that loss get so big? It comes down to risk management and being able to admit you are wrong in an effort to keep the loss small.

Purely from a technical perspective, it was clear that something had changed when the stock crossed $7.50. But even if you really thought the company was broken, when the stock crossed $16 (green line), you had to question your views, right?. Finally, when the stock powered through $60 (red line) you had to close the bet, right. Yesterday, the stock traded at $380. This is why I always look for the technical trends to confirm the fundamental view. If they don’t, I defer to the trend. There is no room for dogma here.

So at the end of the day, while there are going to be many lessons and stories from this drama, for me it all boils down to momentum and risk management. That is why I spend so much time on both of these topics when I teach my class.

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Thank you for reading my thoughts. Please remember that nothing here should be considered investment advice.