Don't Catch The Falling Knife: Understanding Momentum Investing
Momentum investing is a strategy that has gained significant attention in financial markets. It capitalizes on the continuance of existing trends, with the basic premise that stocks or other investment instruments that have performed well in the recent past will continue to do so in the near future.
This article delves into the nuances of momentum investing, its historical performance, the psychological dynamics behind it, and the risks associated with this strategy. By understanding these elements, investors can make more informed decisions and potentially enhance their portfolio returns.
Momentum Investing: A Strategy That Capitalizes on Existing Trends
Momentum investing is based on the observation that securities that have performed well in the recent past tend to continue performing well, while those that have performed poorly tend to continue underperforming. This strategy leverages the psychological tendency of investors to follow the crowd, often driven by news and social proof.
When a stock or investment instrument performs well, it attracts more positive news and investor attention. This increased interest leads to more research and investment in the instrument, creating a self-reinforcing cycle of rising prices. Conversely, when a stock performs poorly, it attracts negative sentiment, leading to selling and further price declines.
The essence of momentum investing is simple: buy high, sell higher. Investors seek assets with significant upward trends, supported by positive news and increasing interest. Conversely, the strategy involves avoiding or shorting assets with downward momentum, capitalizing on the negative sentiment that accompanies poor performance.
Historical Performance and Evidence: Momentum Investing Has a Proven Track Record
There is an ongoing discussion about the historical performance of the momentum strategy relative to the performances of other investment strategies such as value or growth. The main reason for the debate is that these strategies are differently implemented, and not all momentum portfolios include the same instruments.
Research by Kenneth French, a renowned finance professor, has shown that momentum has been a dominant factor in generating high returns. Over the past two decades, his momentum portfolio consistently outperformed those based on other factors such as value or growth.
However, a comparison of the S&P 500 and Vanguard Momentum portfolio shows that momentum outperformed the market from September 2003 to September 2015, but it has been underperforming since.
Scholars and practitioners continue their research on the performance of momentum portfolios, and we are likely to see contradicting conclusions in the future as well.
One thing is clear, if implemented correctly, the momentum strategy is a valid one that can outperform the broader market.
The Vicious Cycle of Momentum: How Good Performance Attracts More Investors
The most attractive thing about momentum investing is the positive feedback loop it creates. When an investment performs well, it attracts more investors, leading to further gains. This cycle is driven by psychological factors, where positive performance leads to increased interest, more research, and additional investment. Conversely, poor performance attracts negative sentiment, leading to further declines as investors sell or avoid the investment.
This feedback loop is a key aspect of momentum investing. It can be illustrated through several stages:
Initial Performance: A stock or investment instrument begins to perform well due to positive earnings reports, new product launches, or other favorable news.
Increased Interest: As the stock performs well, it attracts more attention from analysts, media, and investors.
Rising Prices: The increased interest leads to more buying, which drives the stock price higher.
Reinforced Belief: As the stock continues to rise, more investors believe in its potential, leading to further buying.
Continued Momentum: This cycle continues until an external factor disrupts the trend, such as negative news or broader market changes.
This cycle is not without risks. Just as positive momentum can drive prices higher, negative momentum can lead to sharp declines, creating a vicious cycle of falling prices and negative sentiment.
Additionally, the positive feedback loop can easily be broken when the business shows weakness. As the company has attracted a lot of interest at that point, bad news may spread fast and lead to a significant decline in the stock price.
Beware of the Falling Knife
While the momentum strategy might help find stocks to buy, it becomes a risk item when it causes a negative feedback loop. Despite potential inexpensiveness, investing in a declining stock can lead to substantial losses.
Negative price performance may create a vicious cycle of declining prices and negative sentiment, further driving down the stock’s price. Although some people think it is irrational that a stock remains cheap for long, as Keynes said, “the market can stay irrational longer than you can stay solvent”.
That is why you should not try to catch the falling knife.
Additionally, momentum investing can be susceptible to market volatility and sudden changes in investor sentiment. For example, a sudden market correction or unexpected negative news can quickly reverse positive momentum, leading to sharp declines, as previously mentioned.
Current Market Examples: Industries and Stocks with Positive and Negative Momentum
Here are some stocks that benefit from positive momentum, and some that are under pressure because of the negative momentum.
Positive Momentum
One industry benefiting from the positive momentum has been the residential market. Players in this space including homebuilders and mortgage insurers have been thriving thanks to favorable supply-demand dynamics, and this is being recognized by the market. Some of these companies are NVR (NVR), Cavco Industries (CVCO), DR Horton (DHI) and NMI Holdings (NMIH). Stocks of these companies have been benefiting from the positive vicious cycle, attracting more demand as the stock prices increase.
Another example is what everybody has been talking about: AI and investments around it. We are building more data centers that have higher capacity, investing in power generation and storage, and other industries enabling these technologies such as cybersecurity and cloud.
Companies winning in these industries have been outperforming the broader index in the past year. However, this last week, the tech sell-off deepened and the positive feedback loop seems to be broken for the Magnificent 7. Therefore, it may be better to stay on the sidelines and wait until the momentum turns positive again.
The stock chart of the Magnificent 7 companies can be found below:
Negative Momentum
High rates and low demand have hurt certain industries, and we have seen stock prices of supposedly high-growth companies decline.
Similar to companies benefiting from positive momentum, back-to-back positive news can change the investor sentiment around these companies, creating a positive feedback loop. However, currently, these stocks continue to decline.
One industry that has been facing negative momentum is electric vehicles. High interest rates have caused demand to decline, and companies like Tesla (TSLA) have been releasing disappointing earnings.
That’s why investors are shying away from the stock.
Additionally, industries with high-growth potential such as renewable energy have lacked the growth their investors hoped to see. This was mostly due to high interest rates hurting innovation and demand. However, now, the anticipation of interest rate cuts is driving the stock prices higher. This is an example of negative sentiment turning positive.
Conclusion
Momentum investing is a compelling strategy that leverages market psychology and trends.
While it has shown strong historical performance, it is essential to balance momentum with fundamental analysis and be aware of the associated risks. Understanding the dynamics of momentum can help investors make more informed decisions and potentially enhance their portfolio returns.
By recognizing both the power and the pitfalls of momentum investing, investors can navigate the markets more effectively and avoid the dreaded falling knife. With careful analysis and risk management, momentum investing can be a valuable addition to an investor's strategy.
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