First, Facebook did a face plant. Then Twitter and Tesla. Next, the mightiest of the mighty FAANGs—Amazon and Netflix—buckled and saw sharp declines.

We can come up with individual reasons to justify the selloffs in each company’s shares. What we’re witnessing from a broader perspective, though, is an unwind in the so-called ‘momentum trade.’

Momentum is a quant jargon label for assets that have outperformed. Trailing 1-year price returns are one common way for measuring momentum.

A fundamental law from physics is: bodies in motion tend to stay in motion. Research shows this principle holds true in the stock market. Outperforming stocks tend to keep outperforming.

To illustrate, MSCI maintains an index that periodically rebalances to favor high momentum stocks. From March of 1998 through February of this year, MSCI’s momentum index returned 10.7% annually compared to 6.9% for the S&P 500, compounding into a cumulative result more than double the S&P 500 (chart below is rebased to 100).

Data source: Bloomberg

The above finding does not, however, mean the momentum factor is invincible to corrections. On several occasions in the past, momentum stocks deviated far north of the long-term trend line, then corrected sharply relative to the rest of the market.

Following epic outperformance in 2017 and early ’18, momentum stocks are now stretched and ripe for mean reversion.

Momentum investing has attractive features outside of a return premium. There are behavioral pluses. People feel comfortable traveling in packs, which makes us more naturally inclined to follow a momentum strategy compared to a value strategy. The momentum style also plays to our brain's recency bias. We can easily envision current winners continuing to prosper in the future.

Which begs the question: If momentum is an easy strategy to follow, why does it work?

After all, if an investing strategy is known to outperform and is easy to implement, everyone should theoretically be able to adopt it. But if everyone adopted a strategy, there would be no edge.

The reason momentum works is times like now. Corrections hurt. They're very sharp in this category, which whipsaws a lot of Johnny-come-latelies who pile into hot stocks at precisely the wrong time.

Before you buy the dip in Amazon, Nvidia, or any other stock that appears a secular winner, it is worth asking: Is this just a temporary soft patch for momentum stocks, or something more serious?

The physics principle mentioned earlier has another important nuance. That is: bodies in motion stay in motion until an external force intercedes.

A breakout in volatility may be the external force that matters for momentum. Momentum stocks typically falter around 45 days after a jump in the VIX volatility index, according to analysis by UBS Group.

The VIX surged in February. After stocks sold off, momentum led the market bounce. Now, consistent with the historical 45-day pattern, the momentum factor is faltering.

Perhaps this is the start of an intermediate-term rotation to value, quality, or defensive stocks?

Just in case, I recently took profit on a few winners, and increased portfolio exposure to the above factors.

***

If you're lamenting some of your favorite stocks being clobbered lately, the following anecdote may help you feel better.

Newton’s Principia Mathematica, published in 1687, was a major leap forward in our understanding of how momentum forces interact.

Yet even Sir Isaac, brilliant as he was, found it hard to apply the laws of momentum to market timing.  The following passage appears in Jason Zweig’s updated version of Ben Graham’s classic book, The Intelligent Investor:

Back in the spring of 1720, Sir Isaac Newton owned shares in the South Sea Company, the hottest stock in England. Sensing that the market was getting out of hand, the great physicist muttered that he 'could calculate the motions of the heavenly bodies, but not the madness of people.' Newton dumped his South Sea shares, pocketing a 100% profit totaling £7,000. But just months later, swept up in the wild enthusiasm of the market, Newton jumped back in at a much higher price — and lost £20,000 (or more than $3 million in [2002-2003's] money. For the rest of his life, he forbade anyone to speak the words 'South Sea' in his presence."

 

Originally published by Forbes. Reprinted with permission. 

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