Momentum vs. Nihilism

We’ve written before about the pros and cons of momentum-based strategies.  On the plus side, they are relatively easy to implement because it is not particularly difficult to identify trends.  On the minus side, trends can reverse abruptly, though that risk can be mitigated with stop orders or hedges.  From a macro perspective, there are additional risks when those strategies become too popular, since momentum investing inherently ignores fundamentals.  If nothing matters beyond price, then momentum can turn into nihilism. 

One definition of nihilism is “the belief that all values are baseless and that nothing can be known or communicated.”  Obviously, “values” has a different meaning in this context – ethical, as opposed to stock market “valuations” – but the parallel is close enough.  When trends become powerful enough, traders and investors alike can and do ignore excessive valuations.  This is something that has become routine in the current market climate.

A key area of concern is the preponderance of stocks trading at more than 10 times revenue per share.  I recently searched for S&P 500 (SPX) components trading at 10X revenues per share and found 53 of them.  That’s obviously more than 10% of the index components, but because many of the largest index components fit that criterion – including Nvidia (NVDA), Alphabet (GOOG, GOOGL), and Lilly (LLY) – the cumulative weight of those companies in SPX was over 32%.  Yes, nearly one-third of SPX has a valuation that is mind-boggling by historic standards.

For perspective, let’s refer to comments made in 2002 by Scott McNealy, the former CEO of Sun Microsystems, that discussed that stock’s valuation during the internet bubble:

…2 years ago we were selling at 10 times revenues when we were at $64. At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?

In those days, I had a Sun workstation on my desk.  It was state of the art.  Sun stock reached a peak of $250 per share during the bubble.  By December 2001, it fell to its 1998 level of $100, eventually sinking as low as $10.  Ten years after its peak, Sun was sold to Oracle for $7.4 billion, a fraction of its peak valuation.  There is no guarantee that today’s highly valuable tech winners will prevail in the long run, even if the market values them as though they will. 

Otherwise, I’d still be using a Compaq PC to connect to AOL and using Yahoo to search the World Wide Web on my Netscape browser. 

This is how I become concerned that momentum strategies have taken us to some dangerous places.  It is incredibly difficult to fight the current tape, meaning it is far easier to hop onto prevailing up drafts and ride them higher.  Furthermore, even if you think the current valuations are borderline absurd, remember that markets can remain irrational far longer than you can remain solvent.  So, despite my misgivings about stretched fundamentals and an underlying psychology and prevailing investing strategies that allow them to remain so, I can’t affirmatively counsel that one should sell everything and hide in cash.  But remember what I said in the opening paragraph – risks can be mitigated (though not eliminated) with stop orders and hedges.  Bear that in mind if trend following causes you to believe that values are baseless.