Wall Street’s most profitable trade has turned ice cold. For years, investors reaped rewards by buying stocks on the rise and betting against struggling ones. Known as the momentum trade, it was particularly lucrative this year, with investors piling into AI darlings like Micron Technology, Nvidia, and Advanced Micro Devices while shorting those likely to struggle with AI adoption. The S&P 500 Momentum Index soared 44% in the second quarter, its best quarterly performance ever, and surged 133% over the past five years, nearly doubling the broad market’s performance. Mega funds and rookie investors alike piled into the trade, some using leverage and options contracts in an effort to amplify their returns, propelling the underlying shares higher. “It is a self-fulfilling prophecy,” said Matthew Tym, managing director at Cantor Fitzgerald, of the trade.
Suddenly, the trade is a loser
The momentum index has tumbled more than 9% since July 1, lagging behind the S&P 500’s 2.8% gain. The index—which tracks stocks in the S&P 500 based on a “momentum score”—is on track for the biggest quarterly underperformance in 25 years. July was the second-worst month for the momentum trade in around 40 years, according to Bank of America estimates, with the only worse month being April 2009, during the global financial crisis.
Hedge funds that bought momentum shares while shorting low-momentum stocks suffered even more. Meanwhile, a basket of the most popular stocks held by hedge funds tracked by Goldman Sachs recorded its biggest one-month underperformance in July relative to the S&P 500 in more than 20 years. These traders had an especially rough day on Aug. 19, which Goldman Sachs told its clients was the worst day for “systematic long-short managers” in more than two years. About half of the losses were because of momentum trades, the bank said.
Why momentum trading works (and doesn’t)
Momentum trading is based on a simple observation: stocks that go up tend to keep outperforming, while those that underperform often remain laggards. “For decades, it didn’t take a lot of sophistication to run a momentum strategy and make a decent living at it,” says Agustin Lebron, senior researcher at EquiLibre, a trading firm. Part of the reason: it takes a while for corporate and other information to spread to various investors, so they slowly build positions, producing buying momentum. “A huge pension fund can’t flip around its positions in a day,” says Lebron. Behavioral biases also account for some of the effect—people tend to sell their winners too early and hold losers too long. Fans of the strategy point to the human tendency to extrapolate from past results and chase investment returns, noting that momentum patterns have been evident in markets for decades, even centuries.
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Some have been doing the trade by buying the strongest investments in a sector while shorting the weakest; others lean into rising markets or asset classes. Still others use a quantitative approach or turn to banks or others who sell ways to make distinct wagers on momentum as a “tradable factor” or a “thematic basket.” “Any strategy has disappointing periods,” says Antti Ilmanen, global co-head of the portfolio solutions group at AQR Capital Management.
The surge in biotech stocks like Moderna helped crush the momentum trade. These shares were heavily shorted but soared after positive news on a cancer vaccine, sending some quant and hedge funds reeling. Moderna is up around 150% so far this month. Some traders have begun to short, or bet against, the very stocks that propelled the momentum trade earlier this year. Net short positions in futures tied to the Nasdaq-100 index among speculators recently climbed to some of the highest levels of the past two decades, according to data from the Commodity Futures Trading Commission. The about-face is a reminder that markets can become treacherous even as indexes climb. Part of the issue: the recent meltdown of Situational Awareness, a hedge fund that had piled into some of the most popular momentum shares, including chip stocks. After a period of market tumult, Nvidia shares rocketed almost 9% after its earnings, showing how quickly sentiment can shift. Some investors say the run-up in share prices driving tech stocks higher reminds them at times of the dot-com frenzy decades ago.
Some investors, like Mike Ogborne of Ogborne Capital Management, have grown cautious about tech stocks. He’s keeping more of his portfolio in cash and is nervous about the surge in tech giants’ spending and rising quarterly capital expenditures.
“It’s a little bit like Cinderella and the clock striking midnight,” Ogborne said. “You don’t know when midnight is going to come around. They don’t send a memo around telling you when the capex cycle is over.”
