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Momentum Investing and the Power of FOMO

The following is adapted from our third-quarter report for the International Equity strategy. Click here to read the full report.

Over the last 18 months, disciplined fundamental investors have been challenged by an episode of price momentum concentrated in a few of the largest stocks in the market. Price momentum refers to a phenomenon where securities whose prices have risen are more likely to keep rising in the short run, while those that have fallen are more likely to experience further declines. The concept of momentum has garnered sufficient adherents to secure its place in the pantheon of portfolio analytics and inspire the creation of numerous indices and ETFs designed to exploit it.

We have deliberately resisted incorporating the momentum factor into our investment process for several reasons. First, simple price momentum does not provide a fundamental basis for making investment decisions. Serial correlation of share price changes has, at best, a weak connection to the underlying business you’re investing in, and nothing to do with what it is worth. Second, momentum investing is literally “chasing” stocks that have already gone up or outperformed (or selling those that already went down or underperformed). This approach leads to higher turnover and trading costs. Lastly, although momentum investing has shown net positive returns over very long periods, there is considerable volatility in its return path. Momentum works until it doesn’t, and when it doesn’t, all the gains you made can be reversed more quickly than you can exit the market. This whipsaw effect makes momentum investing much harder to stomach in practice than it appears in theory.

Of course, there are cases when stock price momentum is linked to company fundamentals. Apple is an example where a profound and structural change is harnessed by a company over a long period, leading to sustained profit growth and extended share price appreciation. Such dynamics are possibly at play in the recent fever for companies linked to the development of artificial intelligence or weight-loss drugs. But such cases are rare and most of the time investors tend to overestimate the number of transformative changes that will actually materialize.

Momentum in the markets is often driven less by fundamentals and more by the fear of missing out (FOMO). In our experience, the FOMO response is most acute when it’s most dangerous—near the peak of market trends, or worse, an investment bubble. Investors who hold the winning stocks are happy to hold on, while those who don’t quickly feel the pressure of “missing out,” amplified by the constant media coverage that acts as free advertising for these market leaders. Passive investors inadvertently pour more capital into these heavyweight stocks in ever-increasing percentages, further amplifying their impact. As a result, the momentum behind these stocks grows ever stronger, and they come to dominate index returns. All (human) investors who measure themselves against a benchmark index feel drawn to jump on the bandwagon. We suspect that FOMO has been a significant element contributing to some of the most damaging drawdowns in the performance record of momentum investing, and we expect it will likely feature in some doozies to come.

We are well aware of the behavioral pitfalls in investing and use a variety of tools to promote objectivity in decision-making. But we can be just as susceptible as other investors to the temptations of momentum. To stiffen our resolve, we’ve made pre-commitments in the form of absolute limits in our risk guidelines, which are primarily aimed at enforcing diversification in our portfolios, but secondarily act as brakes to curb our enthusiasm.

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Why Own International Stocks?

For more than a decade, equity returns in international markets have trailed those of the US. There are various possible explanations, but a central one is that the US, after first staging a faster recovery from the global financial crisis, has tended to produce stronger earnings growth in the years since. Meanwhile, from an international perspective, everything from a strong dollar to geopolitical conflict to volatility in emerging markets to China’s economic slowdown have weighed on relative returns. It also doesn’t help that the arrival of ChatGPT, and the enthusiasm and competition it has inspired for generative artificial intelligence technology, has lately encouraged an almost singular focus on a handful of US tech stocks—out of nearly 2700 index constituents, a mere 0.2% of the companies in the MSCI ACWI Index.

Some investors look at the difference between international and US returns and, expecting that current conditions will persist, wonder what place non-US equities have in a portfolio today. But while it’s easy to fall into that line of thinking, history suggests it is likely wrong. The relative performance of US and non-US stocks has historically been a cyclical phenomenon, and as the chart below shows, their indexes have regularly swapped between leader and laggard over the past 50 years.

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Growth Is Beating Value in the US. Will International Follow?

Non-US markets have underperformed the US for quite some time. This has been exacerbated lately by their diverging style factors.

As seen in the chart above, investors largely favored value stocks as the global economy began to reemerge from the COVID-19 pandemic following emergency-use authorization of the first vaccine in late 2020. This headwind for growth stocks has been most significant, and enduring, in international markets. For example, the MSCI All Country World ex US Growth Index lagged its value counterpart by nearly 30 percentage points in the three years through October 2023. But while the value rally has continued outside the US, 2023 saw investors reembrace US growth stocks despite their relatively high valuations.

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Valuation is in the Eye of the Beholder

The structure of sports leagues in the United States differs from those seen elsewhere in the world. Most importantly, American sports teams compete annually against pretty much the same opposition. The composition of leagues such as the NFL or NBA is largely static, with new franchises entering only rarely and with the agreement of the owners of other teams. The same holds true for various minor leagues, which operate in conjunction with the largest professional leagues, but whose teams don’t move between levels of the sport.

In UK soccer, the sport with which I am involved, in contrast, the league is composed of linked divisions arranged in a hierarchy where membership of each division changes at the end of every season—based on merit, so that the top few teams in each division move up in the hierarchy, and the bottom few clubs move down. The drama around the joy of promotion to a higher division and the misery of relegation to a lower one is part of what makes the sport so compelling; for fans (and owners) of clubs involved in the battle to win one or avoid the other, the chase can be both thrilling and terrifying.