Momentum Investing Works Until it No Longer Works

Momentum investing was one of the major fads of the past decade, fueled by the red-hot performance of technology and dot-com stocks. The prices of these stocks seemed to rise for no good reason, despite lack of earnings -- or sometimes even the prospect of earnings. No historical valuation models could justify the prices achieved by many of these stocks. Unfortunately, momentum investing, like many other investment strategies, is basically a strategy that seems to work until it no longer does. In other words, the strategy may work for some period of time, but by its very nature, it contains the seeds of its own destruction. To understand why, let's take a look at the basic strategy.

Momentum investing involves trying to capture the benefits of a call option without the expense. A call option is the right -- but not the obligation -- to buy a stock during some future time period. For example, suppose ZZZ Corporation (symbol: ZZZ) currently trades at $50 per share. A call option with an exercise price of $50 allows the option holder to buy a share of ZZZ for $50 at any time during the next three months. If the price of ZZZ goes up, say to $70 after three months, the option holder makes a $20 profit. He can exercise his option, buying one share at $50, and selling it immediately on the open market at $70. If the price of ZZZ instead goes down, the holder will simply let the option expire, without exercising it. He has no obligation to buy at $50 if he does not want to. Thus the upside is theoretically unlimited, with very little downside.

This comes at a price. The option seller (who, in principle, holds one share of ZZZ and is willing to sell it to the option buyer for $50 at any time within the next three months) is giving up the potential for gains if ZZZ goes up in price. The seller will require compensation for that -- and the buyer will have to pay. The cost of the option, commonly known as the "option premium," is the cost of the strategy described above.

Momentum investors attempt to replicate the call option without paying the premium. They "borrow to buy stock as prices rise, capturing the upside of price movements, and sell stock as its price declines, limiting their downside." ( Bruce I. Jacobs, "Momentum Trading: The New Alchemy"; Journal of Investing, Winter 2000) To fully replicate a call option, the investor needs to catch a stock whose price is rising, and then sell at a price higher than the purchase price (mimicking the exercise of the option), or, at worst, sell when the stock falls back to the original purchase price (akin to allowing an option to expire unexercised).

As momentum investors see a rising trend, they all join in, driving prices even higher. It may seem like a winning strategy, with the promise of high upside and limited downside -- a bet one apparently cannot lose. But the risk of this strategy is that, while momentum investors can all pile in at the same time, they cannot all escape (sell) at the same time unless markets are both highly liquid (large blocks can be sold quickly and at the same price) and continuous (prices do not gap sharply downward with no opportunity to sell).

Unfortunately for momentum investors, there is no guarantee of either condition being true all the time. And, unfortunately, markets sometimes seem to become both illiquid and non-continuous at just the wrong time. The door shuts just as everyone is trying to escape. As increasing capital is attracted to the momentum strategy (including investments in many newly formed mutual funds and hedge funds) the market's volatility increases.

The result is that, whenever there is a whiff of bad news, numerous previous buyers scramble to get out before the barn door shuts. In this type of environment, stocks become highly illiquid and prices become discontinuous. When the upward momentum ceases, concentrated selling quickly accelerates, as momentum investors attempt to be among the first to get out. This not only drives prices lower but also leads to margin calls, and thus more selling.

Prices, particularly those with no fundamental underlying valuation, tend to fall at least as hard and as fast as they had risen and panic can ensue. (As an aside, this also happens on the way up. As many momentum investors jump in at the same time, the price tends to spike up very quickly and discontinuously. Momentum investors perceive this as a very fortunate turn of events, not realizing that the exact same thing will happen on the way down when they tend to try to sell the stock all at the same time.)

The bottom line is that momentum investors cannot escape downside risk without actually paying the call premium. By avoiding the premium, they do receive the upside potential, but the downside risk of the strategy cannot be known until the game is over. And the really bad news is that momentum investors who use leverage to increase the size of their bets (attempting to increase their returns) can often ill afford to be wrong even once; they can literally be wiped out by one bad choice.

A common human weakness is to have a short memory regarding past investment trends, particularly those that have failed. We would propose that momentum investing is just another form of the failed 1980s strategy that was known as portfolio insurance. Unfortunately, in that case, the term "insurance" was an oxymoron. Portfolio insurance was also an attempt to capture the upside without investing in options. The idea was to buy more as prices rose (increasing the investor's position) and to sell as prices fell (decreasing the position).

Again, this strategy relied on both liquid and continuous markets. With the crash of 1987, the fatal flaws in the portfolio insurance strategy were exposed. The strategy again seemed to work ... until it did not. In the collapse of October 1987, markets became both illiquid and discontinuous. Investors using portfolio insurance were forced to sell into highly illiquid markets and they absorbed huge losses.

Momentum investors in 2000 experienced similar pains as the technology and dot-com bubbles burst in March 2000. They discovered that markets can and do become simultaneously illiquid and discontinuous. Thus their assumption that they would be able to sell out at any time proved unfounded.

In general, we believe that strategies based on capturing excess returns without commensurate risk is highly likely to fail. Unfortunately too many investors cannot resist the siren call of such strategies. For a while, such strategies attract capital, and they seem to work in a virtuous circle. The more prices go up, the more capital the strategy attracts and the more prices continue to rise. But eventually, and usually with no warning, the virtuous circle becomes a vicious cycle. The allegedly failsafe mechanism fails.

We would propose that momentum investing and similar strategies are not really investing, they're speculating. Proponents of such approaches are speculating that they can predict the manner in which prices will move and that, when price movements change, they will be able to sell in a liquid and continuous market. The evidence suggests that those are two very poor assumptions. And if you are wrong about either, even once, you may not get to play another day.

RSM McGladrey Inc. and McGladrey & Pullen LLP have an alternative practice structure. Though separate and independent legal entities, the two firms work together to serve clients' business needs.