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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.

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