Newton’s law of stock momentum

Does this sound familiar: Smart guy owns a stock in March at $200, sells it in June at around $600, but then buys it back in July and August for between $900 and $1,000. By September it’s back at $200. Ouch. Tesla this year? Yahoo in 2000? Nope. That was Sir Isaac Newton getting pulled into the great momentum trade of the South Sea Co., which cratered 300 years ago this month. He lost the equivalent of more than $3 million today. Newton, whose second law of motion is about the momentum of a body equaling the force acting on it, didn’t know that works for stocks too.

When bull markets get going, investors come out of the woodwork to pile in. These momentum investors—I call them momos—figure if a stock is going up, it will keep going up. But usually there is some source of hot air inflating stocks: either a structural anomaly that fools investors into thinking ever-rising stock prices are real, or a source of capital that buys, buys, buys—proverbial “dumb money.” Think of it as a giant fireplace bellows, an accordion-like contraption that pumps in fresh oxygen to keep flames growing.

Most simply blame the Federal Reserve—especially today, with its zero-interest-rate policy—for pumping the hot air that gets the momos going. Fair enough, but that’s only part of the story. Long market runs have always allured investors who figure they’re smart to jump in, even if it’s late. Everyone forgets the adage, “Don’t mistake brains for a bull market.”

In some ways, it used to be even easier to get carried away. In 1929 you could buy stocks with as little as 5% down payment, compared with today’s 50% margin limit. Even Groucho Marx, who wouldn’t join any club that would have him as a member, joined the momos and lost big in the crash.

The 1960s and ’70s had the Nifty Fifty bubble. In 1987 it was a rising dollar and the Japanese buying anything not tied down. I remember the story of an investor at a large Japanese insurance company asking a market strategist for a list of his favorite 20 stocks. Handed the list, the investor handed it back saying buy me 100,000 shares of each.

In 2000 it was comments like, “The internet is underhyped.” New trading rules meant no liquidity on Nasdaq, so analysts could breathe on a stock and it would go up 20 points. Also, the deluge of initial public offerings with six-month lockups meant trading wasn’t true supply and demand.

The 2008 financial mess had many fathers, but to me the biggest was the lack of price discovery, or marks, on newfangled derivatives, which meant the party kept going well after problems arose.

Then there’s this year’s mania, when Tesla’s value hit almost $500 billion a few weeks ago despite no operating profit. Well, it’s certainly the waning days of a long technology bull run that started in 2009 (and lots of short covering along the way). But then add how Covid kept people home and focused on technology, plus no sports to bet on, which left day trading as the only game in town, cheered on by the founder of the Barstool Sports blog. The 13 million newbie investors on the Robinhood app have access to fractional shares and zero-commission trades, all through a gamelike interface that includes a big green “Trade” button. Feeding the speculation are trading ideas on r/wallstreetbets, a Reddit channel with 1.5 million members.

This mass of buyers brought Hertz back from the dead (at least temporarily) and chased after SPACs, or special purpose acquisition companies, which are modern-day blind pools that often don’t end well. Today’s momos also chase stock splits, which mean nothing for a company’s actual value. Same for new listing in indexes like the S&P 500. Isaac Newton could explain the math.

But is that enough to drive stocks to the moon? Maybe, but earlier this month the culprit was revealed, a monstrous hot air blowing bellows. SoftBank, which famously lost billions investing in WeWork, bought $4 billion in options to buy technology stocks, representing some $50 billion in underlying shares. Firms that sold SoftBank the options had to hedge themselves by actually buying shares as they went up. Did you catch that circular reasoning? Like all bubbles, it ends when the money runs out.

Last week the stock market was a roller coaster that many will keep riding. But when you see a source of hot air, the bellows, it’s best to let the last ones in become the last one’s out. I like another old Wall Street adage: Your hand should be trembling when you place a stock order at the ticket window. Same if you click “Trade.” Don’t be a momo.

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