(The opinions expressed here are those of the author, an investment strategist for Panmure Liberum.) 

LONDON - As the AI frenzy creates new market cap trillionaires and worldwide stock performance continues to be driven by tech winners, investors have developed a severe case of FOMO, leading many to plough ​more funds into equity leaders. But momentum booms ⁠tend to be followed by busts, and the current one is looking dangerously stretched.

Is there a way to avoid getting run over without abandoning the momentum train? A new study suggests ‌yes.

Stock market performance is increasingly dominated by price momentum – meaning past winners typically continue to outperform, while past losers underperform. Even though we’ve recently seen the beginnings of a rotation out of some winners – with the so-called Magnificent 7 tech stocks, ​like Alphabet, Microsoft and Meta, beginning to lag – momentum is still riding high.

Look at the performance of a classic long/short-momentum portfolio – where one buys recent winners and sells short the losers – in the 12 months through June. In the U.S., ​it ​would have had a roughly 40% return in this period, while an international version would have posted 38.0%.

This strong performance is among the best for momentum in any 12-month period since 2000. The problem, of course, is that every time momentum has performed this well during the past 25 years, a crash has swiftly followed – usually because the prevailing market narrative changed.

While the overall ⁠trend for a momentum strategy is up since 2000, there were several sudden, sharp drops, most notably from March to May 2009, but also in April 2020 and in the months after the COVID-19 vaccine was announced in November 2020.

Such momentum crashes can destroy many months – if not years – of outperformance as the stocks that have had the strongest price momentum are abandoned by investors and underperformers have often snapped back aggressively.

DOWNSIDE PROTECTION

Many investors have tried to find solutions to the problem of sudden momentum crashes. In my view, Pascal Büsing and his colleagues at the University of Münster have found a particularly intriguing approach.

The traditional ​momentum strategy sorts stocks by their price ‌performance from 12 months ⁠ago to one month ago. Then it buys ⁠the stocks with the highest past performance and shorts the stocks with the lowest.

Büsing and his colleagues split this price momentum into two parts with different timeframes. The first, longer period is the price performance from 12 ​months ago to the highest share price in the last 12 months (excluding the previous month). They call this the “high-to-price” (HTP) component.

The second part is the “price-to-high” (PTH) component that measures ‌how close the last price is to the 12-month high.

The intuition behind this split is that PTH measures whether a stock ⁠is still riding strong on past performance or if sentiment has already cooled a bit. Avoiding the stocks that are close to their 12-month high should theoretically help avoid momentum crashes.

To see why, consider the market weakness in semiconductor and other AI stocks in early June. While this was not a momentum crash, the typical dynamic was visible. When investors started to worry about overinvestment in data centres and AI, the stocks that dropped the most were AI-related companies like Cloudflare, Coreweave, and Oracle together with semiconductor companies like Samsung, AMD and SK Hynix that gained the most in the weeks before.

Tech stocks that were somewhat more remote from the recent semiconductor frenzy, like ASML, Applied Materials and Tokyo Electron fared better.

Büsing and his team also analysed the worst months for momentum strategies in the United States, finding that most of the negative performance was generated by stocks that are closest to their 12-month high – those that a PTH strategy would invest in – while the HTP strategy that cuts out these stocks and prioritizes longer-term price appreciation tended to perform much better. The study observes the same for international stocks.

What’s the likely driver?

Stocks that experience a steady flow of positive news over an extended period tend to feature ‌in the PTH strategy, and they are less likely to trade close to their 12-month high.

On the other hand, stocks ⁠that react to sporadic positive news or are part of a stock market frenzy tend to trade close to their 12-month high shortly ​after the positive news arrives or while the frenzy is in full swing.

And, based on this study, these are the stocks investors want to avoid.

Doing so can potentially help investors limit the negative hit from momentum crashes, according to the study. It finds that the HTP component captured 84% of the momentum effect, but a long/short HTP-based strategy also avoided the vast majority of drawdowns during crashes.

There are caveats. There is obviously no guarantee that past patterns will ​repeat, and investors are giving ‌up some potential return.

But even though this approach might sacrifice some upside during a boom, the result appears to be a more reliable momentum strategy with ⁠fewer sleepless nights for investors. (The views expressed here are those of Joachim Klement, ​an investment strategist for Panmure Liberum. This piece is for informational purposes only and should not be construed as investment advice.)

(Writing by Joachim Klement; editing by Anna Szymanski)