Momentum is eating fundamentals
Momentum trading and computer-driven ETFs are reshaping markets, leaving fundamentals in the back seat and long-term investors feeling like they’re watching a casino from the sidelines.
You probably haven’t, but you might have heard the expression “mo mo”, which basically means momentum. Over the last year in particular, momentum trading has started to dominate markets.
The sense is that there are some very big hedge funds at work, with a speculating retail horde following behind, helped by the creation of ETFs. This lump of money is mostly being moved by algorithms – trades put on by computers. Imagine 50% of trades now being done by machines. Momentum trading is moving that lump of money from one place to another, often thematically rather than in individual stocks.
Thanks to ETFs you can now buy themes instead of single stocks, and the hedge funds are doing exactly that.
How momentum money jumps between themes
This became really obvious in the middle of last year when the Australian banks, led by CBA, suddenly topped out. Everyone was saying, “This is too expensive.” CBA on a PE of 30 – about double its long-term average.
Then the banks suddenly fell over. Nothing fundamental changed in the banks. The catalyst was talk about the Chinese stimulating their economy. Everybody suddenly wanted to buy resources. To find the money to put into resources, they had to sell the other big sector – so they sold the banks.
You get the idea. There’s a lump of money moving around the market and jumping from one theme to another. It’s almost like imagining every theme as a hydraulic piston, all connected to the same base. Push one piston down and another pops up. When that goes down, a different one rises. Those themes are being chosen by hedge funds.
The timing often comes from some trigger – China stimulus talk, Trump threatening Iran and everyone piling into oil, or some other headline that gives the algorithms something to chase.
How ETFs camouflage fundamentals
The interesting bit is that, especially using ETFs, nobody seems to care about fundamentals anymore. ETFs effectively camouflage the underlying fundamentals of the stocks inside them.
ETFs push stocks around because people are blindly buying into the ETF marketing message and, in the process, funnelling money into the underlying holdings. They are doing it on momentum and enthusiasm for the current theme rather than any sort of fundamental analysis.
That’s why we started doing ETF analysis. Very few people do it in Australia. Morningstar has some sort of rating system, but they are clearly not alerting people to what we are doing – which is looking at all the underlying stocks, assessing how cheap or expensive they are, aggregating the fundamentals and working out whether an ETF itself is cheap or expensive.
Momentum trading is pushing themes way beyond what is fundamentally reasonable. The FANG ETF’s average PE has been over 30 times. The S&P 500 averages around 18 times and has run closer to 22–25 times in the longer term. Yet themes are moving regardless of fundamentals.
Algorithms chase trends, not value
The theory behind this is that algorithms and computer trading are being triggered not by PEs, yields or value, but by chasing trends. It is self-fulfilling. If something starts to move higher, the algorithms join in and push it further. The more they push, the more algorithms get involved.
Then the retail speculative horde gets involved, and then the hedge funds and fund managers. Everyone else is getting left behind. Hence expressions like FOMO and “mo mo”. It is all about the weight of money moving around the market, and it is not doing it on fundamentals. The computers are doing it on price action.
A lot of algorithms are built on rules like “if the price goes up, buy more”, which is technically correct as a momentum strategy, but not if it ignores fundamentals.
What do you do about momentum trading?
So what do you do about momentum trading?
First, you have to be aware it is happening. If you want to beat the market, you have to know what the herd is doing. If the herd is now a bunch of computers pushing prices up simply because they have already gone up, you have to think about how those computers behave.
Interestingly, algorithms do not have human weaknesses programmed in – things like mean reversion, the assumption that if something has gone up a lot, it must come down. That is a human bias. No one bothers programming it into an algorithm. So prices can go as high as the code allows.
Things get overbought. Things get oversold. And that creates opportunity.
How to adapt without abandoning fundamentals
To really exploit this environment, you have to recognise what is going on. If you try to do everything purely on fundamentals right now, you risk getting obliterated. Talking about intrinsic value and fundamentals sounds very 1980s in a market dominated by momentum and algorithms.
One day fundamentals will come back. The next proper market crash will have everyone interested in value again because we will all have lost our heads to momentum and algorithms. But for the moment, it is momentum and algorithms in charge, so you have to think like a computer.
That means recognising that computers will respond to tops and bottoms and learning to spot those turning points. You also have to recognise when things are overvalued – but not sell just because they are expensive. You wait until they actually top out. And when they do, you do not sit there in denial saying, “Gold’s a really good story,” while the computers eat you alive.
More technical, more short term
A couple of practical implications:
You have to be more technical. Look at charts more. It may not sound like quality, long-term investing, but in a momentum-driven market you need to spot tops and bottoms.
You also have to be more short term. The money moves between themes far faster than it does across a traditional economic cycle, where fund managers slowly shift into different parts of the market as conditions change. That sort of slow-moving style is not going to work while this big body of money is confidently jumping between themes.
The moment that confidence is knocked out of it – for example, in a proper market crash – we will go back to worrying about PEs and fundamentals. But for now, you are playing against computers.
Try to think the way they do and, rather than simply copy them, look to exploit what they create. They are going to generate some very big highs and some very deep lows – and that is where your opportunity lies.