Momentum works to the downside too

Some of the momentum stocks that posted giant gains in recent months and remain big favorites for retail traders — think Palantir, SoundHound AI, Rocket Lab, Robinhood Markets, SoFi Technologies, and GE Vernova — are sliding again Tuesday morning as September trading gets underway.

With little fundamental news suggesting this disparate group’s sales and profitability are set to tumble over the coming year, the sell-off is a continuation of recent sputtering we’ve seen in the momentum trade.

For the record, the term “momentum,” essentially, is the qualitative-finance-speak shorthand used to describe stocks that have been going up for a good long while.

As a strategy, investing in momentum shares can make sense because basically, statistically speaking, stocks that have been going up for a while are a bit more likely than usual to keep going up compared to other stocks. (This is a pretty well-researched area of market behavior that’s found across a number of markets. For more, check out this paper.)

At any rate, betting on such stocks has been a big winner this year, especially since the market snapped back from its early April lows, when it was on the brink of bear territory.

But as you can see in the chart above, the outperformance of momentum stocks — they were beating the plain vanilla market by nearly 10 percentage points in early June — has ebbed away a bit in recent months. Now they’re up by only about 3 points.

Whether that’s enough of a return to compensate investors for the risks of investing in momentum at the moment is an open question.

Despite the statistical persistence of stocks that have been going up continuing to go up, no investment is risk-free.

Stocks that have been going up for a while sometimes start going down incredibly quickly. The top paper on such so-called “momentum crashes” says that “while past winners have generally outperformed past losers, there are relatively long periods over which momentum experiences severe losses or ‘crashes.’”