Don’t look now but after a harrowing few weeks earlier this year, US equity markets sit at (or above) all time highs depending on which index you are tracking. Market commentators are once again discussing the many reasons they “knew this was coming” (sidenote- they did not) and discussing why markets will march higher from here (sidenote #2- they cannot know this with certainty). One of the many cited reasons for the rally is the return of the momentum trade. A client asked me what exactly that refers to – let’s take a look

Momentum

Simply put, momentum trading is the belief/approach that things that have been working in the market will continue to keep working. It assumes a continuation of a trend – if a stock’s price has been rising, the momentum approach to investing suggests it’s more likely to continue rising in the short term. It has its roots in behavioral finance to a large degree as investors tend to like buying stocks that are going up (and avoid stocks that are declining/”on sale”).

Investors use many indicators to track this trend continuation – all of them tied to how stocks are trading (and not to the underlying traits of the businesses or their earnings/cash flows). These may include moving average prices and convergence/divergence to measure strength of price movements.

How to Invest in Momentum

Not to worry, there’s a product for that! There are countless investments (like ETFs) that allow investors to hop on the momentum train. These strategies compile momentum scores for various stocks and then screen for those with the highest rankings.

Potential Pitfalls

As of late, the momentum trade has been doing quite well ( as names that have risen continue to do so). However, as we observed in March/April, trend lines can (and will) move in both directions. Momentum strategies are the poster child of “past performance will lead to future performance.” Any wise investor knows that may be true… right up until the moment it isn’t. Momentum can turn – and that can leave strategies like momentum in a tough spot. As a result these strategies tend to be high risk/high reward.

Needless to say, investing in momentum products should be carefully evaluated in context of your specific financial goals. Proceed with caution – you just never know when the momentum will swing the other way.