Why Stock Investors Play the Risky 'Momentum' Game

Chasing the fastest-rising stocks, regardless of the fundamentals, was one way to rack up truly outsized gains in 2017, the Wall Street Journal reports. The MSCI USA Momentum Index advanced 37.82% in 2017, versus 21.90% for its parent, the MSCI USA Index, per MSCI Inc. Meanwhile, the S&P 500 Index was up by 19.42%.

While the S&P 500 contains just large-cap stocks, the MSCI USA Index also includes mid-cap equities. It is designed to reflect the performance of an equity momentum strategy by emphasizing stocks with high price momentum, while maintaining reasonably high trading liquidity, investment capacity and moderate index turnover, according to MSCI.

Yet, despite its success in 2017, continuing to play the momentum investing game in 2018 may prove hazardous to your wealth, the Journal warns. (For more, see also: Stocks Could Rise As Much As 27% in 2018.)

Signs of Froth

Pure momentum investing ignores fundamentals such as corporate earnings, the broader economy and stock valuations, picking stocks solely on the basis of which already have enjoyed significant gains in price. Inevitably, this follow-the-crowd strategy becomes a recipe for buying high and thus increasing the downside risks in one's portfolio. The Dotcom Bubble resulted from a similar pursuit of hot stocks and hot concepts even as prices shot upward.

To add more historical perspective, the Journal notes that the MSCI USA Momentum Index last posted such a large advantage over the broader market was in the 12 months ending in the summer of 2008. Soon thereafter, the collapse of Lehman Brothers set off a full-fledged financial crisis.

Another sign of froth in U.S. equities today is the 14-day relative strength index (RSI), a measure of short-term stock price momentum. The RSI is now at its highest level since 1996 for the S&P 500, the Journal adds, indicating a highly overbought market that is vulnerable to a reversal. (For more, see also: 5 Global Risks That Could Hammer Stocks in 2018.)

The Bullish View

Although the current bull market has lasted nearly nine years, optimists note that it has taken until now for the worldwide economic outlook to brighten considerably, and for widespread confidence in future corporate profit growth to take hold among investors, the Journal indicates. This, in the bulls' opinion, justifies further buying.

Meanwhile, compared to its parent MSCI USA Index, the MSCI USA Momentum Index did not present radically higher valuation metrics as of Dec. 29, per MSCI. On forward P/E, the comparison was 18.77 (USA) versus 19.47 (USA Momentum), on price to book ratio it was 3.29 versus 4.14, and on dividend yield, it was 1.86% versus 1.34%. On the other hand, bears will argue that valuations for the broader market are themselves excessive by historic standards.

More Momentum

The iShares Edge MSCI USA Momentum Factor ETF (MTUM), which is structured to track the index, advanced 37.49% in 2017. For 2018, through the Jan. 17 close, it has gained another 7.24%. Meanwhile, the S&P 500 is up 4.82% during the same period. How long momentum investing will continue to be a winning bet is anyone's guess.