Monday, April 7, 2014

Looking for Momentum

Looking for Momentum

During last night’s basketball game between Connecticut and Stamford, Doris Burke wondered if Breanna Stewart, the Huskies All-American forward, would get a bit of momentum by hitting a couple of free throws.  Unless you watch a sporting event with the sound turned off, you’ll hear the word momentum used throughout the broadcast.  A baseball pitcher retires several batters and suddenly he has momentum.  A running back rumbles for nine yards, and he’s anointed with momentum.  Momentum is also conferred by a couple of birdies, a break of serve, or a power play goal.  Of course, broadcasters also take away momentum.  Momentum shifts if a batter hits into a double play and fails to drive in any runners.  Momentum evaporates when there’s a fumble, turnover, double fault, or bogey.
Referee (2000)
The stock market goes through similar phases.  Instead of commentators creating ebb and flow in a sports event by invoking and rescinding momentum, some money managers make bets based on momentum.  Rather than relying solely on fundamentals, such as revenues and earnings, momentum investors depend on on price appreciation as a criterion for investing.  While momentum investors might spend a bit of time on a company’s prospects, the key determinant can be discerned by studying a price chart.  If a group of managers believe that a stock has momentum, this method of investing can work for a period of time as the believers bid the stock ever higher.

We’ve just been through this kind of investment period.[1]  In the last eighteen months, a group of technology and biopharmaceutical stocks have been bid upward by mutual fund and hedge fund managers.  What probably began as a fundamental investment in the future of some specific mobile application or customized medical treatment became inculcated with momentum.  While research analysts continue to write reports about these companies, their conclusions are next to useless.  When I became Director of Research at First Albany Corporation in the mid-1980s, my research mentor Ed Gibson told me that we should dispense with writing research reports at the point that stocks became infected with momentum.  Since the securities were no longer connected to financial reality, there was no way to give investors any advice based on reason.

While it lasts, momentum is wonderful.  It requires very little thinking and provides instant gratification.  You don’t really need to know much about a company other than that is blessed with momentum.  However when it ends, the experience is particularly painful.  Since the stock was only in a portfolio because it was appreciating, the same security becomes a pariah that must be sold.  As a result, a reversal of momentum usually results in merciless price depreciation.  Typically, the inflection point comes with little warning, so only a few lucky investors escape before the carnage ensues.

Can old-fashioned fundamental investors pick up bargains as momentum is replaced by panic?  For someone with the time and inclination to do serious research, there is an opportunity.  However, momentum tends to lift all sorts of companies into the stratosphere.  When the Internet bubble burst, most companies deserved to crash.  Nonetheless, a few companies were actually sound businesses and became solid investments. 

Momentum seems to satisfy a basic human need to see order and patterns where none really exist.  In sports, the rise and fall of momentum allows us to believe that there’s a story in every athletic contest when in fact there’s a lot of random stuff transpiring on the field or court.  In investing, momentum also creates the appearance of a pattern, which is comforting to those of us participating in the markets.  However, investing in momentum is a dangerous game because when it ends, we have nothing to fall back on.

You are probably sick of the word momentum in this post.  I used it twenty-five times.  However, you can expect to hear it many more times if you tune into tonight’s or tomorrow night’s men’s or women’s NCAA championship basketball games.

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