MOMENTUM is one of the great puzzles of finance. It is the tendency for stocks that have previously risen to keep going up. Of course, it does not square with efficient market theory, which states that past price information tells you nothing about future price movements. And it also sits oddly with the so-called “value effect” which shows that stocks that have fallen in price tend to outperform.
Momentum and the value effect are distinguished by their time horizons. Momentum persists for 6-12 months; over long periods (five years or so) value kicks in. Logically this has to be so; if momentum persisted for long periods, then stocks would rise to a value of infinity.
Why might momentum work? The hedge fund AQR has just issued a paper on the subject. It suggests a number of explanations, such as that investors are slow to react to new information (such as higher-than-expected profits); or that bandwagon investors exist who assume that recent price rises are not random, but the sign of a good investment. Momentum is an obvious explanation for bubbles like dotcom mania.
– “The mo the merrier”, Buttonwood, July 23
The basic explanation for this is that, as Bernard Baruch said so many years ago, the stock market is people. People see the market going up and they chase performance, they fear missing out, they think it signals economic recovery, etc… People don’t evaluate everything independently. They follow the crowd, they pile on, they think other people know something they don’t. It’s that simple.