Where did the ‘mo’ go?

Published August 7, 2024

• Momentum has had a historic run and may have reached its peak.
• Historically, momentum’s volatility has tended to weigh on long run performance.
• An inflection point may be occurring, emphasizing the importance of fundamental stock analysis.

Investor enthusiasm for the perceived winners of the artificial intelligence (AI) revolution has led to one of the narrowest market rallies in history. Stock market gains of the past year and a half have been driven in large part by the momentum factor, which reflects stocks’ recent (12-month) performance trends. Momentum doesn’t last forever, though, and the trend may be waning. 

But let’s be honest. By the time you read this, the market could have fallen back into its previous trend, riding a wave of momentum, focused on a small band of stocks. If this is the case, let the next few hundred words serve as a cautionary tale.

The seed of momentum was planted at the start of 2023. The “inevitable” recession on the heels of the US Federal Reserve’s rate hikes never happened, and OpenAI’s ChatGPT went mainstream. Phrases like “large language models” entered the lexicon on Wall Street and in university dorm rooms alike.

By the fall of 2023, a trend began to take shape. In the massive ocean of stocks, a handful of companies gathered and rode the same current, well ahead of the pack. The trend continued through the first half of 2024.

Momentum’s short-term tailwind is not likely sustainable

In July 2024, momentum’s influence on market performance had reached a near historical high. This level of momentum exposure in the large-cap Russell 1000^® Growth Index, as shown in the chart below, had not been seen since the heights of the internet bubble and the COVID-19 pandemic.

Russell 1000 Growth Index momentum exposure (August 31, 1999–July 31, 2024)

The 18-month period during which momentum rose to these extreme levels provided a performance tailwind for certain investment styles. When comparing momentum against a fundamentally driven risk factor like profitability, which combines several quality-related measures to characterize the efficiency of a company’s operations, the year-to-date performance gap is wide.

Factor returns: Momentum and profitability (January 1–July 9, 2024)

For an investor to outperform the market over the past six quarters would have likely required outsized exposure to a risk factor like momentum. But is this a durable investment strategy?

Momentum’s high volatility may not help outperform over the long term

Despite momentum’s potential for periods of outperformance, outsized exposure to momentum may not be beneficial over the long term. In fact, its performance can be quite erratic. Compared with profitability, momentum is more susceptible to extreme volatility, particularly to the downside. These fluctuations in performance are disruptive to the investor experience, as they can result in more significant drawdowns.

Monthly returns: Momentum and profitability (September 30, 1995–July 31, 2024)

This volatility hurts long-term performance. Profitability has compounding benefits, while the large swings in momentum may erode performance.

Growth of $10,000: Momentum vs. profitability factor (August 31, 1995–July 31, 2024)

Momentum may be at an inflection point

On July 10, the momentum factor began to underperform, just as it has in the past. Such a downshift often needs a catalyst, and in this case, that catalyst appears to have been earnings and management commentary. Change can happen quickly. While we cannot be certain that this is the inflection point, we believe it is only a matter of time before momentum normalizes.

Factor returns: Momentum and profitability (July 10–July 31, 2024)

The potential to provide a better client experience

Momentum is backward looking, therefore only investable in hindsight, which can lead to the behavioral mistake of “buying high.” Instead, we believe a portfolio management process designed to generate excess returns through stock selection and exposure to stock-specific risks may lead to a better long-term outcome for investors.

While recent market extremes have presented headwinds for fundamental investors, we believe the market may be normalizing. Macquarie Focused Large Growth ETF (LRGG) emphasizes a long-term, quality-first approach to investing in the large-cap growth space. The approach is purposeful in not allowing risk factors, such as momentum, to drive long-term returns.

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