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Pushing Prices

Adam M. Grossman  |  December 2, 2018

WITH INCREASING frequency over the past month, I’ve been hearing the question, “Why does the stock market keep going down? I understand why the market dipped when the Fed raised interest rates, but why does it keep going down day after day?”

If you’ve been feeling unnerved by recent headlines, you aren’t alone. After gaining 10% in 2018 through late-September, the U.S. stock market reversed course and gave up that entire 10% over the course of just two months, before rallying modestly over the past week. And that’s just the average. Many individual stocks, including Apple and Netflix, have done far worse, down more than 20% in recent months. In short, it’s been an unpleasant year—and it isn’t over yet.

At times like this, in an effort to provide some explanation, investment advisors typically trot out a well-worn quote from Warren Buffett’s mentor, Benjamin Graham. In the short run, Graham said, the stock market is like a “voting machine,” but in the long run it’s a “weighing machine.” In other words, stock market investors are fickle. From time to time, they will push stock prices to irrational highs or lows. But over time, they act more rationally and, when they do, stock prices will fall back in line with reality. The message: Don’t worry, this too shall pass.

While I generally agree with this way of looking at the market, I believe there’s a third factor influencing stock prices today—one that wasn’t a significant factor in Graham’s time. That factor is momentum trading.

As the name suggests, momentum trading is based on the straightforward assumption that stock price movements don’t happen all at once. They tend to move in stretches—sometimes up and sometimes down. For example, when a company releases a quarterly earnings report that tops investors’ expectations, that company’s stock will tend to rise over a period of several days. The first day might see the biggest move, but a positive trend often continues well beyond that.

Why is this the case? Suppose a company issues an earnings press release on Tuesday at 5 pm. At that point, the news is out there. But it still takes time for investment analysts to write up their reports, and then more time for investors to read and digest this information, before deciding whether to trade the stock.

Moreover, investors don’t all react at the same time. Hedge funds, for example, might place their trades within seconds of receiving a press release, while mutual funds might trade a day or two later. And individual investors might not react until several days or weeks after that. This is what causes stock prices to exhibit ongoing momentum.

We’ve long seen this sort of momentum in stock prices. What’s changed? An increasing number of investment firms have launched funds to take advantage of this momentum effect. These momentum funds scour the market, looking for stocks that are displaying strong directional moves. When they find them, they effectively jump on the bandwagon, buying stocks that are going up and selling stocks that are going down. While it’s difficult to quantify, these momentum funds amplify the market’s ups and downs by bidding up stocks that are already going up and putting downward pressure on shares that are already headed lower.

Momentum strategies have been around since the early 1990s, but they are gaining in popularity. While they used to be the relatively obscure purview of professional investors, major fund companies are now promoting momentum strategies to individual investors. Of particular note, industry leader Vanguard Group launched a momentum fund earlier this year. Given Vanguard’s reach, I assume it’ll only be a matter of time before this fund accumulates significant assets, contributing further to the amplification effect I described above.

When the market is going down, it’s natural to worry. That is why I think it’s so important to understand—as much as possible—why the market is doing what it’s doing. My hope: You’ll sleep easier when you know what forces are at work pushing the prices of your investments up and down.

One final note: You may be wondering whether it would be worth allocating a portion of your portfolio to one of these momentum funds. In other words, if you can’t beat ’em, should you join ’em? My answer is “no.” Their performance is inconsistent and unconvincing to me. They’re also more volatile and more expensive than standard, broadly diversified funds.

Adam M. Grossman’s previous blogs include Counting DownDeadly Serious and Five Messy Steps. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.

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