Theory
The underlying premise is that investors exhibit certain types of behaviour that are reflected in patterns for both stock and Exchange Traded Fund (ETF) prices.
Stock prices are a function of two forces:
- Momentum – the tendency of a stock to continue on a trajectory, and
- Reversal – the tendency of a stock to return to a price within a range that is “normal” for the stock.
Empirical analysis of stock prices provides evidence of persistence or momentum, in which stock prices that are rising tend to continue to rise and for stock prices that are falling to continue to fall. Our research and analysis has determined that these price tendencies also apply to ETFs.
While there is established evidence of momentum of price, both up and down, it is a general tendency or pattern with many exceptions. Momentum does not persist indefinitely but rather the general pattern tends to persist or trend for several quarters. Investors seem to only partially adjust their assessments of a holding in response to changes in important factors that influence price. This trending pattern of influential factors and investors’ partial adjustment to those factors often result in price persistence and momentum, either up or down.
Most investors can cite many examples where price has been driven to an unsustainable extreme that was followed by a reversal of the price to some average or normal level. This pattern is usually referred to as reversal-to-mean. This pattern exists because investors often exhibit a tendency to become overly optimistic or pessimistic about a stocks or EFTs prospects, driving its price to an extreme. When a more rational assessment of the holding and its prospects begins to prevail, the tendency is for the price to revert to a more sustainable normal level. This tendency of extreme price to revert to a more normal level is evident over relatively short time periods of approximately three to four months or less.
Even investors who integrate these two important price patterns into their investment approach tend to consider them independently or even as opposing patterns or forces. We see momentum and reversal as two important interacting factors or patterns that influence stock and ETF prices. In fact, Channel Trend strongly believes that momentum and reversal-to-mean are important interacting forces that have significant influences on the behavior of price.
Channel Trend’s Price Projector Model was explicitly designed to simultaneously quantify price momentum and its potential for reversal-to-mean. The model measures rates of change in the trend of a stock’s or ETF’s price to project that trend into the future. This is a way to capture and quantify momentum or price persistence. The model also measure the current price of a stock or ETF within a price channel that is determined by the historical variability of the stock’s or ETF’s price momentum. The likelihood and magnitude for reversal of a stock’s or ETF’s price toward some normal level becomes greater when the stock or ETF trades at an extreme position in relation either to the top or bottom of its price channel.
Note that our channel work is quite different from, and much more complicated than, Bollinger Band analysis and similar methods of analysis.
We have ranked stocks since 1982. Beginning in 2010, we began applying our Price Projector to ETFs with considerable success.