Momentum Stocks Are Outperforming the S&P 500 for the First Time Since 2008. Investors Should Be Concerned.

The recent performance of momentum stocks has marked a significant period of outperformance, reminiscent of the pre-financial crisis era. This streak has understandably unsettled some investors, given the historical tendency of the momentum factor to exhibit bursts of strong performance followed by sharp corrections. As momentum stocks now encompass many key players in the market, there is apprehension that a sudden reversal could exert downward pressure on major indexes such as the S&P 500.

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The concept of factors in investing involves categorizing stocks based on shared characteristics, with momentum being just one among several popular factors including growth, value, quality, dividends, and low volatility.

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During the first quarter of 2024, the MSCI USA Momentum Index has notably outpaced the S&P 500 by over 11 percentage points, marking its strongest quarterly outperformance since June 2008. This surge has raised concerns, particularly given the historical context of such pronounced momentum preceding significant market downturns, such as the 2008 financial crisis and the dot-com bubble burst of 2000.

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Attempting to predict market tops during periods of robust rallies has proven challenging in the past, as evidenced by the observations of veteran investor Bill Gross. The adage "momentum begets momentum" underscores the difficulty in timing market reversals during bullish phases.

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However, there are indications that the momentum factor may have become overvalued relative to expected earnings of its constituent stocks. This valuation metric, highlighted by Rusty Vanneman of Orion Wealth Management, suggests a potential headwind for future returns among current momentum darlings.

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Vanneman suggests a prudent approach for investors sitting on substantial gains in momentum stocks like Nvidia Corp., advocating for diversification into small- and midcap stocks to mitigate potential risks associated with an overheated momentum market.

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The dominance of megacap stocks like Nvidia, Meta Platforms Inc., and Amazon.com Inc. has been instrumental in driving the S&P 500's recent gains, resulting in their increased weighting within momentum-factor indexes. This heightened exposure to a select group of stocks underscores the potential vulnerability of the momentum trade to market dynamics.

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Unlike factors such as quality or value, the composition of momentum-factor indexes undergoes frequent changes, reflecting the evolving market sentiment and performance. This contrasts with the relatively stable composition of value or high-quality stocks over longer periods.

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While today's momentum factor primarily comprises high-quality stocks with solid financial fundamentals, reminiscent of the dot-com bubble era, overvaluation remains a concern. Matt Mishkin of John Hancock Investment Management warns against the growing disregard for fundamentals among investors, cautioning that such a trend may not be sustainable in the long term.

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The inherent volatility of the momentum factor underscores the risk of sudden downturns, particularly when market sentiment becomes excessively exuberant. Analysts like Vanneman emphasize the potential for rapid reversals when momentum reaches unsustainable levels, often characterized by parabolic price increases.

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Looking ahead, seasonal trends suggest a potential cooling off for the momentum factor in April, as noted by Jonathan Krinsky of BTIG. His analysis, based on a long-short basket of momentum stocks, indicates a likelihood of a selloff in the long basket, given the rapid ascent of stocks over recent months. This serves as a reminder of the inherent unpredictability and cyclicality of market trends, urging investors to exercise caution amid the current momentum-driven rally.

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