Why the 'Magnificent Seven' and other momentum stocks may be hitting a wall

By Mark Hulbert

Riding a wave is exciting as long as it lasts - but watch out when it crashes

Momentum-stock strategies are coming off their worst 20-year stretch in U.S. history, and it's unclear whether they'll ever again be as profitable as they were many decades ago.

I'm referring to strategies based on the hope that stocks which have performed the best over the trailing 12 months will continue beating the market for a few additional months. Such strategies have been phenomenally successful over the past 97 years, according to data from Dartmouth University professor Ken French: Before transaction costs, a portfolio periodically rebalanced to always contain the 10% of stocks with the highest trailing momentum beat the market by 9.4% on an annualized basis from 1927 through 2023.

Over the past two decades, however, this portfolio failed to come anywhere close to its historical average, as you can see from the chart above. This hypothetical portfolio's 20-year annualized alpha relative to the S&P 500 SPX has steadily declined, and at the end of 2023 it was minus 0.8%.

It's tempting to explain this deterioration as market efficiency at work. Investors can "kill the goose that lays the golden egg" after they discover a profitable strategy and increasingly start to follow it. But it's not clear that this is the culprit in this case, according to Itzhak Ben-David, a finance professor at the Ohio State University. In an email, he speculated that "front-running momentum will just make it strong, won't it?"

Ben-David believes that momentum's deterioration traces to something different: A change that investment researcher Morningstar instituted in 2002 to how it assigns star ratings to mutual funds. Prior to the change, Morningstar's "5-Star" rating (its highest) went to the funds with the highest trailing returns, which led to a huge influx of new money into those funds. Since those funds often held many of the same high-performing stocks, this influx in turn led those stocks to rise even further.

After Morningstar's 2002 methodological change, many of the funds earning a 5-Star rating were not at the top of the performance scoreboards. That change therefore diluted the market impact of investors channeling new money into the highest-rated funds, and thereby robbed momentum strategies of much of their fuel.

The full explanation of how Morningstar's methodological change could have had this big of an impact is contained in a recent study published in the Review of Financial Studies. Entitled "Ratings-Driven Demand and Systematic Price Fluctuations," the study was conducted by Ben-David along with three other researchers: Jiacui Li of the University of Utah, Andrea Rossi of the University of Arizona, and Yang Song of the University of Washington.

The study's findings don't mean momentum strategies will never work. According to Ben-David, there are other potential sources of "coordinated capital flows into specific corners of the market" that would have momentum-like consequences, at least for the short term. Artificial-intelligence-related stocks are a recent example of this.

Don't forget that momentum strategies can be risky. Riding a wave is exciting as long as it lasts, but watch out when it crashes. A current example of lost momentum is Tesla Inc. (TSLA), which was riding high when first included in the group of "Magnificent Seven" stocks. But Tesla has since lost favor, and so far this year it's lagging the S&P 500 in a big way - by more than 40%.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com

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-Mark Hulbert

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03-23-24 0949ET

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