Momentum stocks are outperforming S&P 500 by widest margin since 2008. Investors should be concerned.

By Joseph Adinolfi

A selloff in the momentum factor could take the broader market down with it, strategists warn

Momentum stocks are coming off their best stretch of outperformance in years - since just before the financial crisis, in fact. That's making some investors nervous.

They have good reason to be worried. The momentum factor has a reputation for producing streaks of outperformance followed by painful corrections. Now that the factor includes many of the market's most important stocks, some are worried that a sudden turnaround could drag indexes like the S&P 500 lower.

A factor is a grouping of stocks based on a common characteristic. Other popular factors include growth, value, high-quality, dividend-paying and low-volatility.

Strongest quarterly outperformance since 2008

As of Monday, the MSCI USA Momentum Index MTUM has outperformed the S&P 500 SPX by more than 11 percentage points during the first quarter of 2024, according to Dow Jones Market Data. It is up 20.8% since the start of the year, compared with a rise of 9.7% for the S&P 500.

That's the widest margin of outperformance for any quarter since June 2008, according to Dow Jones Market Data. A few months later, the collapse of Lehman Brothers ushered in the most acute phase of the financial crisis.

Over the last two quarters, momentum has outperformed by an even wider margin of 13.8 percentage points, its strongest two-quarter streak relative to the S&P 500 since the six months that ended in March 2000, just as the dot-com bubble was hitting its peak.

Calling a top when markets are rallying aggressively has proven extremely difficult in the past, as former "bond king" Bill Gross said in a recent investing missive. As traders like to say, "momentum begets momentum."

See: Former 'bond king' Bill Gross warns 'irrational exuberance' is driving stocks higher

Still, there is evidence the momentum factor has become expensive relative to the stocks' expected earnings, according to Rusty Vanneman, chief investment officer at Orion Wealth Management. This could weigh on future returns for the current crop of momentum stocks.

The MSCI momentum index is valued at nearly 29 times expected 2024 earnings of its components. That is its highest since late May 2021, when the meme-stock craze was in full swing, according to FactSet data.

During an interview with MarketWatch, Vanneman recommended that investors who are sitting on sizable gains in momentum stocks like Nvidia Corp. (NVDA) consider shifting some of their portfolio into small- and midcap stocks, which have lagged the S&P 500 over the past few years.

Momentum stocks dominate the market

Megacap stocks like Nvidia, Meta Platforms Inc. (META) and Amazon.com Inc. (AMZN) have driven much of the S&P 500's gains over the past year. As a result, they are now among the most heavily weighted stocks in the momentum-factor index.

Outsize gains for those stocks have caused the factor's weighting in the S&P 500 to swell to its highest level ever, according to Piper Sandler.

See: Momentum stocks' share of S&P 500 swells to highest level in history - but that doesn't mean market is in a bubble

The momentum index's five largest holdings are Nvidia, Meta Platforms, Broadcom Inc. (AVGO) , Eli Lilly & Co. (LLY) and Amazon.com.

One thing that separates the momentum from other popular factors like quality or value is that the roster of stocks included in momentum-factor indexes changes often, whereas with value or high-quality stocks, changes tend to happen slowly, over longer periods of time.

MSCI's momentum index is rebalanced every six months. It scores stocks in its target universe - in this case, the MSCI USA Index XX:984000 - based on a "momentum score," which is itself based on the stocks' performance over the past six and 12 months, adjusted for volatility. Stocks with the highest scores are included in the index.

Right now, the momentum factor consists of high-quality stocks - that is, stocks with strong balance sheets and robust earnings growth. This is not unusual, but it does differentiate the momentum factor of today from the dot-com-bubble era, according to Piper Sandler's Michael Krantowitz. Back then, the factor included mostly stocks with negative earnings.

But just because stocks enjoy strong balance sheets and steady earnings growth doesn't mean they can't be overvalued. According to Matt Mishkin, co-chief investment strategist at John Hancock Investment Management, the market's momentum appears to be overriding fundamentals in the minds of investors.

This is not a sustainable dynamic, he said.

"You have to be careful here, because the fundamentals are becoming less important to investors. Instead, what stocks have done over the last six to 12 months is the most important relative driver as of now."

It can even be hazardous, given the momentum factor's reputation for sudden crashes.

"[Momentum] can roll over pretty fast," said Vanneman. "Particularly when it goes parabolic, it doesn't usually plateau."

Although the rally in stocks has shown few signs of slowing down, seasonal trends suggest the momentum factor could hit the skids in April, according to an analysis by Jonathan Krinsky, chief technical strategist at BTIG.

Krinsky used a long-short basket of momentum stocks maintained by Morgan Stanley for his analysis.

This basket is more closely aligned with the original vision for the momentum trade as outlined in a 1993 paper published in the Journal of Finance. The paper found that betting on the top-performing stocks over the past 12 months while betting against the worst performers routinely produced market-beating returns.

Typically, momentum selloffs in April are driven by the short basket rallying. But given the speed of stocks' ascent over the past five months, Krinsky believes a selloff for the long basket is more likely.

-Joseph Adinolfi

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03-30-24 0726ET

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