In skiing, there is this feeling that the better you get, the lower the risk is.
This is how some good skiers justify not wearing a helmet.
The logic behind this is sound – the better you, are the less you fall – but the conclusion is utterly false.
The better you are, the faster you will go. You might fall less, but you will fall faster.
Crashes at higher speeds are exponentially more threatening than toppling over at 3mph.
Momentum is everything. At high speeds, one you start to lose control, it is incredibly difficult to regain it.
The same is true in financial markets.
People see success as safety. Things which have gone up are seen as safer bets. This drags more and more people in over time (creating something of a self-fulfilling prophecy).
This is called the momentum effect.
I recently saw that some economist somewhere said, “there is no good reason” for the momentum strategy to work.
Which I found pretty baffling.
Show anyone two charts, one in a three-year downtrend and one in a three-year uptrend, and see which one they’d rather buy…
Anyone who has read any of Howard Marks’ books knows instantly why this is the case.
Success breeds interest, which begets further success.
Howard’s analogy is often of a pendulum, gathering pace, swinging past the midpoint and moving up towards the other side. But it cannot go on forever. The laws of gravity don’t allow it.
And in investing, human psychology has its limits too.
The momentum effect has been a successful investing strategy for a long time. You can see how it performed well from the start of 2020, all the way through until early February of this year.
Arguably, this could be because the rise of passive investing has added fuel to the circular motion of returns driving fund flows driving returns – the self-fulfilling prophecy all over again.
However, just recently, the momentum factor, like the racer on the slopes without a helmet, has caught an edge, lost control and is showing its first signs of a major crash.
To help explain this phenomenon, Charlie Morris of The Fleet Street Letter Wealth Builder has kindly allowed me to re-print some of his latest update to subscribers…
When the bear comes to an end, the economic recovery favours the losers, and they start to beat the winners for a period of time. Why? Because the winners are heavily overpriced and eventually succumb to the laws of gravity. In the meantime, the losers are dirt cheap, and no longer suffer from bad news. The economy recovers, and they brush themselves down, and lead the market higher.
In 2003, 2009, 2016 and now in 2021, we’ve seen saw major downturns in the momentum effect. The current downturn began last summer. This means the past winners, that are full of hope and praise, are dying in comparison to the unloved losers. People will soon wake up and realise the winners are now the losers and vice versa.
Since last summer, the leading tech stocks have ground to a halt, while the losers have delivered superior performance. This is because the economy and stock market crashed last March, courtesy of Covid-19. The nature of lockdown was music to the tech industry, while the old economy was shut. The end of lockdown would see this reverse, as we return to spending money in the real economy as opposed to online.
The harsh second lockdown over the winter delayed the full extent of the momentum crash, but it’s happening anyway, and it’s happening now. On 10 November, I published a piece reporting the largest single-day momentum crash of all time. Last week, the momentum crash entered its next phase. Not only did big tech get a beating by the market, but the price of oil and other commodities soared simultaneously.
This is a good time to mention the impact of inflation in destabilising existing trends… Most professional investors would have no clue about this relationship. The simple conclusion is that the more inflation rises, the more pressure on the established trends. Given the pickup in inflation since March last year, this is long overdue, and the end of lockdown will exacerbate it.
The losers, described earlier, are forgotten by most investors. They are barely owned by the institutional investment funds, and not only provide an opportunity, but also protection. An inflation hedge is much more effective at low prices, than at high prices. That means cheap companies, which are likely to survive, are more likely to protect you from inflation than highly priced companies. Cheap stocks have many advantages over pricey ones, and never more so than at major turning points.
Rumours of the death of the old economy have been greatly exaggerated. Some companies are unpopular due to current political thinking (energy, tobacco, defence, etc). Others are in real trouble (shopping centres, travel and leisure). I am on the hunt for cheap success stories. I have found one…
Subscribers can find out where Charlie goes next.
We will have to satisfy ourselves with the broad brush of Charlie’s analytical mind.
He also shared this chart (on a log scale) which I found terrifying to an extraordinary degree.
Source: Charlie Morris on Twitter
They say that the way to lose 90% on a stock is to lose 80% and then watch it halve again.
If the narrative of the tech bubble bursting is true (and US ten-year yields are back up above 1.6% as I write this, which suggest the trend has legs), then the decisions we take in the coming weeks and months could be decisive.
Charlie’s subscribers are lucky to have him guiding the ship away from troubled waters.
We would do well to pay attention to his views on this highly significant turning point in markets.
All the best,
Editor, UK Uncensored