Like Newton’s laws, the stock market often takes an external force to change the supply-demand dynamic, thereby altering the current momentum.
Written by Harshad Patwardhan:
“I can calculate the speed of heavenly bodies but not the madness of people.”
Isaac Newton is believed to have made these famous comments in 1720 after losing his fortune in a disaster following the bursting of the South Sea bubble. He must not have found the madness of people in the stock market so obscure. To know why, read on…
We all studied Newton’s laws of motion in school physics, but I bet most of you have forgotten about them. To refresh your memory, let me reproduce the broad concepts behind his first two laws of motion:
Newton’s first law
An object at rest remains at rest, and an object in motion continues in motion unless acted upon by an unbalanced external force.
Newton’s second law
The acceleration of an object is directly proportional to the applied force and inversely proportional to its mass.
While these laws are meant to understand, explain, and predict the behavior of physical objects, they can also be drawn on a conceptual level to understand the direction and movement of stock prices. The market price is set when excess demand is matched by increased supply. If, overall, buyers are more eager than sellers, the imbalance in forces drives up market prices. On the other hand, if sellers are more eager than buyers overall, market prices fall. The net force of excess supply and demand determines the direction and speed of prices.
Momentum in stock prices often continues for a significant period of time. Momentum eventually ends when the underlying demand-supply dynamics change for some reason or the other. As with Newton’s laws, it often requires an external force to change the supply-demand dynamic, thereby changing the existing momentum. For example, an adverse regulatory development can affect upward stock momentum, resulting in the sudden evaporation of rising demand and the emergence of excess supply. Another example could be that a stock’s long downward momentum could end due to a large positive earnings surprise, resulting in investors scrambling to buy the stock just as current holders decide they no longer want to sell.
A price trend initiated by some fundamental factor or new development is often strongly influenced by investor behavior and psychology. The inherent reflexivity of markets means that fundamentals and prices influence each other, and causality is not unidirectional. Here are some reasons (not an exhaustive list) why price momentum continues:
(1) Many market participants (retail and institutional) can add more to the existing momentum with trend-following strategies.
(2) Performance chasing can add more force to existing momentum. There are many examples of some institutional investors resisting buying stocks because they believe their valuations are expensive. However, if the stock continues its upward march and becomes a large benchmark stock or peer owns it, the same group of investors is forced to buy it at a higher price because of the performance pain it causes.
(3) Company management can opportunistically take advantage of strong share price increases and raise new capital at higher valuations, thereby strengthening balance sheets and adding to growth capital, resulting in improved fundamentals and higher prices.
(4) Often, a solid uptrend and/or capital raising results in stocks crossing critical market capitalization thresholds and appearing on the radar screens of large institutional investors, leading to greater demand and greater momentum.
Of course, in every stock, momentum eventually fades and ends.
Empirical evidence suggests that momentum as a factor is reasonably consistent and has a better track record than other factors used in investing. A disciplined rule-based proactive approach to leveraging these insights will likely result in a favorable investment outcome. The main features of such an approach are:
– A diversified portfolio of stocks with leading relative momentum,
– Rebalance frequently to check persistence and make adjustments accordingly
– Aware of underlying liquidity to reduce impact costs
– Proactive monitoring to take care of company-specific accidents and market-wide incidents
On a lighter note, if only Newton had extended his great insights from the study of moving physical objects to stock prices, he would surely have discovered how the momentum factor works! So, we would have known this great scientist as the pioneer of momentum investing too!