Momentum investing: Riding the wave of winning stocks
At any given time in the stock market, there are outperformers, underperformers, and those that perform commensurately (hot, cold, and just right). Contrarian investors look for the cold ones—the laggards. Momentum investors chase the hot ones, with the expectation that today’s winners will keep on winning. The momentum strategy boils down to buying outperformers, dumping underperformers, and constantly refreshing a portfolio to ride the strongest trends.
Sounds like a winning strategy, right? It’s simple in theory, but tricky in practice. Not every stock on the rise is a true momentum play. And as any active trader and chart watcher will tell you, sometimes you don’t know that momentum has shifted until it’s too late. That’s why momentum investing is less about chasing every rally and more about separating lasting trends from short-lived hype.
Key Points
- Momentum investing assumes that narrative-driven trends can persist for an extended period.
- Story stocks may soar for a while, but they can crash quickly when the narrative fades.
- Momentum stock analysis often calls for tools beyond the P/E ratio, such as the PEG ratio and other alternative metrics.
Momentum investing: How it works
Momentum investing assumes stock trends can persist, at least for a while—that winners keep winning and laggards keep lagging. Momentum investors typically:
- Look for stocks that have been outperforming over the past 3 to 12 months
- Rank them by performance
- Build a portfolio of only the top performers
- Rebalance when market conditions change to keep their portfolios targeted toward winning stocks
It’s a simple formula, but the hard part is knowing which rallies will keep running and which run the risk of stalling out.
Momentum investing is controversial among some economists
Many economists argue that, at least in theory, momentum investing shouldn’t work because it contradicts classic theories about the market.
The efficient market hypothesis (EMH) says that everything that’s publicly known about a stock is already baked into its price. Eugene Fama was awarded the 2013 Nobel Prize for Economics for this theory, which claims that past information is already priced in and future news is unknowable. If that’s true, momentum traders shouldn’t be able to predict future returns based on past trends.
The random walk hypothesis (RWH) takes this even further, claiming that market prices are random, like coin flips. It’s been promoted by leading economists such as Burton Malkiel, author of the 1973 book A Random Walk Down Wall Street. But if prices are random, nothing is predictable. Momentum traders assume the opposite—that past trends can hint at future ones.
Explaining it away
Economists who dismiss the momentum phenomenon attribute successful outcomes to a few factors, none of which are necessarily rational or repeatable from a strategic standpoint:
- Risk premium. Some economists claim that momentum stocks are riskier than others, so investors are being rewarded for taking on risk.
- Herd mentality. Others say that momentum stocks are driven by “herd mentality,” overreaction, and confirmation bias—all of which can cause stock prices to be bid higher on a cumulative and sometimes exponential basis.
- Seasonality effects. Seasonal factors—like the January effect, summer slowdowns, or year-end rallies—can also drive trends, sometimes regardless of fundamentals.
Despite academic skepticism, momentum investing has persisted among both retail and institutional investors, even if it clashes with economic theory.
How to spot momentum stocks
Spotting momentum stocks is relatively easy: You have to keep an ear open to Wall Street chatter, usually through financial media outlets such as Reddit (RDDT) and X (formerly Twitter). Most momentum stocks are “story stocks,” driven by a compelling narrative that eventually earns a spotlight on Wall Street. These narratives, centered on a company’s growth potential, form the speculative basis for a company’s future stock price, regardless of its current financial performance.
Such narratives focus on innovative products and ideas, new technologies, or an ambitious growth strategy—factors that investors see as potential growth catalysts. Examples in the bull market of the mid-2020s include AI-focused companies and data “hyperscalers.”
Analyzing momentum stocks with PEG and other alternative metrics
Now comes the tricky part—figuring out whether a momentum stock has enough substance to match the sizzle.
When analyzing stocks, many investors default to the price-to-earnings (P/E) ratio. The P/E, which is sometimes called the earnings multiple, compares a company’s stock price to its earnings per share. In simple terms, it shows how many years of current earnings it would take to equal the price investors are paying. For most established companies, the P/E is effective as a quick value yardstick.
The price is right … or is it?
A stock price on its own is just a number. But when viewed as a ratio—to its earnings, growth, sales, cash flow, or the value of its assets (its book value)—share price can tell you a lot about value.
Explore the most common financial ratios, what they mean, and how investors use them.
For momentum stocks, though, the P/E can be misleading. Many of these companies, despite explosive growth potential, have modest—or even negative—earnings. Investors still pile in, pushing their P/Es to sky-high levels and making it difficult to judge value with this measure alone.
Consider using the price/earnings-to-growth ratio (PEG ratio) instead.
PEG ratio
The PEG ratio builds on the P/E by factoring in a company’s earnings growth rate. The formula is:
PEG ratio = P/E ratio ÷ earnings growth rate
The result is usually expressed as a single digit plus a decimal. In general:
- PEG = 1.0: A stock is fairly valued (in line with a company’s growth rate).
- PEG < 1.0: A stock may be undervalued, which could mean a bargain buy, but only if its growth is sustainable.
- PEG > 1.0: A stock is potentially overvalued, meaning you may be paying more for growth than its historical growth rate can justify. But again, what if growth continues to increase and accelerate?
PEG comes in two flavors:
- Trailing PEG, which uses historical growth rates
- Forward PEG, which relies on analyst estimates of earnings growth over the next few years (typically one to five)
Each approach has limits. Trailing PEG may understate future potential if a company is accelerating, while forward PEG depends on forecasts that can be wrong. Still, PEG gives a clearer sense of whether a stock’s price looks reasonable in light of its growth.
Case in point: NVIDIA (NVDA). Through the mid-2020s, NVIDIA has had a sky-high headline P/E—well over 100 at times—but a forward PEG under 1, suggesting its steep price still lines up with rapid earnings growth.
Alternative fundamental metrics
When most traditional metrics don’t work, analysts dig into their alternative fundamentals toolbox to find metrics that better suit the situation. Measures like cash burn and burn multiple tell you whether a company is using its capital efficiently. Monthly recurring revenue (MRR) highlights the stability or fragility of a company’s income stream. Total addressable market (TAM) shows the scale of its growth opportunity in terms of market share. There are plenty more to consider, and it’s worth doing a deep dive to find the right fundamental tools to match your analytical context.
Risks of momentum investing
Like all investing strategies, momentum investing comes with its unique set of risks. Here are the most common risks investors face when adopting this strategy.
Every story has an end. Stocks riding high on narratives can quickly reverse when the narrative ends or the excitement around it fades. This shift in sentiment can be caused by real fundamental issues (e.g., unexpected financial challenges), news (e.g., product failures or company scandals), or distractions (e.g., other story stocks or major developments) that steal that limelight. When the narrative fades, losses can be sudden.
Narrative-driven bubbles pop. In the late 1990s, Internet companies with little or no revenue commanded sky-high valuations until the dot-com bubble burst. Cryptocurrencies in the 2010s showed similar boom-and-bust cycles. By the mid-2020s, the boom in AI-linked stocks raised similar questions.
A tempered approach: GARP
One way to pursue growth stories without overpaying is by adopting a “growth at a reasonable price” (GARP) strategy. The idea is to look for growth companies whose valuations aren’t wildly out of line with their fundamentals.
Legendary investor Warren Buffett has often argued that growth and value are “joined at the hip,” meaning the two approaches aren’t opposites but complementary. GARP takes that view and puts it into practice: Seek growth, but don’t pay an unreasonable price for it.
How might you gauge what’s reasonable? Although they’re still somewhat speculative, the PEG ratio and alternative fundamentals can help you gauge whether the price of promise exceeds its potential. Essentially, your goal is to capture the upside from a growth story without paying so much that the risk overwhelms the reward.
The bottom line
Momentum investing can be as powerful as it is precarious. A narrative can lift a stock to extreme heights well after its fundamental fuel has run out. The strategy usually comes down to two approaches: avoid names whose valuations stretch too far beyond fundamentals (the GARP route), or put a limit on your exposure to high-flying momentum stocks.
Either way, pair momentum stocks with a dose of caution—the kind that keeps the thrill from turning toxic. Keep a long-term perspective and a clear view of both the risks and rewards.
References
- What Is Momentum Investing? | blackrock.com