The Price of Momentum

Man on Tricycle with Rocket

Stock price momentum—how rapidly a stock's price is moving upward—is having a major influence on the markets. For the spring, it was one of the better performing factors out of the 135+ we track (and one of the top factors in May), meaning that the current winners are often winning because they have a lot of stock price momentum behind them.

Is this good or bad?

The punchline here is that price momentum can help improve buy/sell decisions in the right context—it plays a mild role in areas of our large cap strategy, for example—but it is not a meaningful long-term driver, in our view. And its dominance today is raising the risk for investors, both active and passive alike, who are not aware of its consequences.

To explain, let’s have a look at what our Fundametrics® Research System is revealing.

From our system, we see that:

  • Tech stocks represent a disproportionate 32% of the High Momentum leaders (45 out of 139 stocks), almost double the tech weighting of our investable universe. In fact, 21 of the 41 stocks up 15% or more since March are tech stocks. For comparison, the S&P 500 index was up about 3% during this period.
  • Of this group, about half of them are trading toward the higher end of their historical Price-to-Earnings ratio—meaning, that they are expensive relative to their own histories. This characteristic is often associated with future underperformance, by our research.

The implications?

Certain tech stocks clearly aren’t cheap—although they are not yet near “bubble” territory as a group. We suspect they have a low margin for error at this point, dependent on better revenue growth, low interest rates, and a mixed outlook for the economy, where growth is otherwise scarce.

More worrisome is that:

  • The S&P 500 is heavily skewed at this point to the tech winners. It’s well reported that the five FAANG stocks (Facebook, Apple, Amazon, Netflix, and Google) now account for over 12% of the S&P 500 total value. That’s five stocks out of 500 carrying a significantly disproportionate weight as performance drivers.
  • Four of those five have the higher risk profile of HIGH MOMENTUM and UNATTRACTIVE VALUATION defined by historical P/E. Exhibit below illustrates, including Tesla.
    • Most of these stocks—especially Tesla and Netflix—were unattractive by these metrics in December, prior to the latest rally.
    • Incidentally, CornerCap owned Apple and Alphabet over the past 18 months, selling them at various points this spring as they surged.

Exhibit: Dominant Tech Stocks of the S&P 500

Biggest Tech Stocks 

NOTE: “Worst” means a Relative P/E multiple in the worst 30% of all large stocks—i.e., the relative multiple was unattractively high relative to that company’s history. “High” means a Stock Price Momentum in the highest 30% of all large stocks—i.e., those stocks showing the fastest price appreciation over the past 12 months.

These are stocks of great companies doing great things. But they are priced for extreme optimism and future performance. We prefer a different (i.e., value) investment profile.

Our final point is that passive investors riding the current performance of the S&P 500 index are indeed making a very specific bet that price momentum in a special group of tech stocks will continue.

With an index fund that is “cap weighted” (i.e., where the bigger companies dominate performance, either good or bad), passive investors are necessarily following a price-driven strategy. Cap-weighted indices are always influenced by the biggest stocks—even if those stocks become overvalued or unsustainable from a fundamental perspective.

In fact, active and passive strategies tend to cycle around each other, for this reason. No one strategy dominates all the time. Momentum does have a price.

To read more on how active and passive cycle and our thoughts on index strategies, please see "Our Thoughts on Burton Malkiel's Article on Active vs. Passive Investing" from June 2013.

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