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We're told to make investments based on profit potential, revenue growth and age-old valuation tools like price-to-earnings ratio. But what if none of those rules matter any more?
Massive bubbles have popped up in the past few years —both in broad sectors, like mining and energy, and in individual stocks, like Valeant Pharmaceuticals (No. 957). We know now that momentum investing is largely to blame. The strategy throws fundamentals to the wind; investors are taught to follow the herd — to buy because everyone else is buying. This momentum play delivered massive gains for anyone who invested in real estate investment trusts before May, 2013, or in oil and gas stocks before energy markets started cratering in 2014, or in Valeant before its wheels fell off last year.
The trouble is that the reversals are often swift, and when they take hold, momentum strategies are deployed in the other direction — sell because everyone else is selling. That's probably why energy companies were decimated early this year. No one had a clue if oil was really worth $30 (U.S.) per barrel, but the sentiment was ugly, so everyone traded off of it.
The sudden global market collapse early this year was one of the worst reversals in decades, rivalled only by the dot-com bubble and the 2008 financial crisis, according to analysts at CIBC World Markets who studied the momentum investing phenomenon. What did they find? "Historically, momentum crashes last for three to six months, after which momentum regains its winning touch," they wrote in a note to clients. "Here in Canada, momentum appears to rebound at closer to three months."
The takeaway: Don't ignore the prevalence of these strategies. If you're a value investor, you'd better be able to play the very long-term — who knows what herd mentality will take hold next? And when the stock or sector falls out of favour, it takes time for people to find their feet again.
Momentum strategies can also be self-fulfilling. More people are investing in exchange-traded funds, which track broad indexes. If a single stock takes off, its weight in the index will increase, which means ETFs will need to buy it. That pushes the price higher.
For anyone willing to play the herd, the CIBC analysts offer these words of caution: "Ultimately, momentum crashes are all about mean-reversion." The thinking behind any rampant buying or selling will eventually fall apart and stocks will revert to their average multiples, like the normal long-term price-to-earnings ratio. That means making money with a momentum strategy requires getting out before the reversal. It also requires knowing what the masses think. Some people will make educated guesses and get it right, but doing it over and over again is practically impossible. Just ask Bill Ackman, who has lost billions on Valeant.