Saturday, February 1, 2014

How Momentum Investors Create Narrowing Breadth

There is a guy whose investment commentary I follow, call him Mr. Upper East Side. A baby boomer entrepreneur who sold his company for ~ eight figures some time ago and has managed the proceeds himself. When rates were higher, he owned munis and bonds. A good, conservative approach to the nest egg that works as a long term, worry minimizing solution.

Now, the munis bonds steadily mature, but the reinvestment opportunities aren't as good. Dividend yields are low. He is suffering from Baby Boomer Yield Anxiety.

So he trades stocks and invests in real estate partnerships ("syndications") here and there. He doesn't do any original investment research besides the old Peter Lynch method of buying retailers and consumer product marketing companies whose products you like. (A friend calls this the "Prince Racquet" approach because Prince stock was hot in the 70s with yuppies who used the racquets.)

Anyway, because he doesn't have a big information edge that you need for value investing, he prefers to buy what's going up: momentum investing. People who do this watch the lists of stocks trading at new highs. If they are satisfied with their newly released Apple product and AAPL is a new high, then it's a 'go' to purchase.

The problem with low-information momentum investing is that since you don't have a theory of the value of your holdings, you have to put a lot of thought into stop loss rules that get you out of the position when the momentum fades. Mr. UES has a stop loss rule to dump anything that goes down 10 percent from his purchase price or subsequent high price.

I've noticed that when he blows out of a stock that "isn't working" anymore, he'll push most of the proceeds into ideas that are "still working" - going up.

This is what creates narrowing breadth at the end of a rally! Momentum investors are preferentially buying stocks with positive derivatives of price, creating a positive feedback loop concentrated in fewer and fewer stocks. That's how TSLA can go parabolic two years after the price of gold, silver, and commodities have peaked.

Narrowing breadth is a mania concentrated in fewer and fewer speculative vehicles. It's created by momentum investors with stop loss rules who consolidate into their winning positions.

Which stocks peak last? That would be worth a lot to know, because you could predict that a wave of speculative money would come rushing into them when market breadth is narrowing. It could be that these are the companies that resonate the most, psychologically with the current zeitgeist. Or it could be arbitrary, chaotic; a path-dependent result of an accidental blip up in price that attracts buyers and creates a positive feedback loop.


Taylor Conant said...

I enjoy your original thinking.

At least, this is original to me.

CP said...

I've never seen anyone hypothesize an underlying cause of narrowing breadth, in terms of other investors' behavior that in aggregate causes it.

Anyway, it was a new thought for me.

bjdubbs said...

I know who you're talking about. He invested in a syndication that turned out to be a fraud and then followed a guy who traded eminis that turned out to be a fraud. He's a bit of a momentum guy by nature, I think. Definitely an optimist, that's how he succeeded as an entrepreneur.

Market Owl said...

This belief has a lot of merit. The Russell 2000 is still outperforming the S&P 500, which means breadth is still strong. To these eyes, it seems like a stock market top is still far away.

CP said...

Yes, I could see a correlation between entrepreneurship and momentum.

Entrepreneurs need to get in on a trend when it is in the growth phase of its lifecycle:

CP said...

CP said...

In this particular mania, the final four are being called FANG:

Facebook, Amazon, Apple, Google

CP said...

Nasdaq new highs: