Recent weeks have featured a change in market sentiment. The formerly high-flying momentum names have pulled back substantially. At a broad level, we can look at the Invesco tech ETF (QQQ) to see the break in momentum as it dropped from $630 at the start of November to under $600.
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The drop is more pronounced in certain individual names such as Bitcoin (BTC-USD) or Palantir (PLTR).
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While the sell-off in high-valuation names has been largely indiscriminate so far, I think it is worth discerning between different types of momentum.
Momentum is an umbrella category of investments, but within it there are 2 distinctly different types:
- Fundamental momentum
- Price momentum
Both are characterized by high or very high earnings multiples along with upward movement of stock price in recent history. Different traders will have different lookback periods, but both kinds of momentum will feature a stock price that is up significantly in whatever the lookback window happens to be.
The difference is that fundamental momentum is predicated on proper valuation, while price momentum is agnostic to valuation.
Fundamental Momentum vs. Price Momentum
A fundamental momentum investment thesis acknowledges that the price-to-earnings multiple is high but believes there is enough growth in future earnings that the high valuation is justified. The analyst forecasts specific growth numbers coming from specific lines of business and can model or otherwise show that the growth justifies the valuation.
In contrast, price momentum is the belief that a stock will keep going up because it has been going up. Perhaps the investor has a broad idea of why they like a company, but much of the perceived strength is inferred from the upward movement in stock price.
Both can coexist in the same stocks.
NVIDIA (NVDA) undoubtedly has some fundamental momentum investors who are forecasting a growth rate sufficient to justify its high PE multiple.
NVDA also has some price momentum investors who are in it because the stock has performed so remarkably well.
These different groups are impacted differently as market sentiment shifts.
How market sentiment impacts fundamental and price momentum
Fundamental momentum is immune to market sentiment in the long run. The stock price could take a big dip if market sentiment turns negative, but eventually they will be rewarded if they are indeed correct about the company’s growth rate.
Fundamental momentum is not beholden to the opinions of others.
Price momentum, however, is entirely rooted in the opinions of others. The stock price has been going up because other people like it. If sentiment shifts, a price momentum investor will take the same hit as the fundamental momentum investor, but their thesis is entirely broken.
If the only reason to own a stock is because it was going up, there is no longer a reason to hold that stock once it has corrected. As such, price momentum investors are susceptible to getting shaken out regardless of the strength of the underlying company.
Has market sentiment truly shifted?
The price movement in November hints at the start of a sentiment shift. Every bull market has micro-corrections within it, so it is probably too early to tell if this is merely a micro-correction or a true popping of the AI bubble.
Such sentiment shifts usually result from underlying concerns. In this case it seems to be some combination of the following:
- Uncertainty about financing of the vast capex involved in AI buildout
- Uncertainty about the ultimate return on investment for this capex
- Sustainability of the trillions of dollars of annual capex
So far it seems to mostly be a questioning of the above. There is not enough data to definitively point one way or the other. Much of the pullback so far is related to the idea that market pricing was so high on AI companies that it indicated a near certainty of passing the ROIC test (return on invested capital hitting a key threshold).
Now that the outcome is more questioned or no longer considered a given, valuation has to come back down to give proper credence to scenarios where there is a pullback in capex.
As more data arrives, the market is constantly reassessing the probabilities of each outcome. Recent data has been mostly negative for the AI stocks.
- Open AI’s margins seem rather low, with the cost of running LLMs (large language models) potentially higher than the revenues they generate
- Circular financing between the big AI players
- Difficulty of obtaining enough electric power soon enough
These concepts, along with others, and the appearance of well-respected bears like Michael Burry seem to be what has turned sentiment negative.
Time will tell if this was the true inflection point.
If sentiment does turn sustainably negative on the high-flying AI portion of the market, I believe fundamental momentum will materially outperform price momentum.
Defined exit points versus sentiment-driven exit
Most bubbles are built on some underlying truth. The 2000 internet bubble was based on the internet, which indeed was remarkably successful. AI is extremely powerful and will undoubtedly be successful in some fashion.
In each case there are winners and losers. The key is differentiating between those that can attach themselves to the long-term success and those that are merely clinging on to hype.
A price momentum investor may have significant trouble making this differentiation. When the internet bubble popped, Amazon (AMZN) dropped along with all the junk. Thus, someone who is primarily focused on price would have been just as likely to sell out of Amazon as to sell out of Pets.com.
A fundamental momentum investor has a better chance of discerning the great businesses in the wreckage. If fundamentals for an individual company remain strong, the fundamental momentum investor may be able to identify it and hold even if the bubble collapses and takes the stock with it. A fundamental momentum investor’s exit is defined by the fundamental thesis being impaired, not by the market price dropping.
The take-home point
When the market is soaring, both kinds of momentum work. If/when the sentiment reverses, it behooves investors to really know what they own and have a solid fundamental justification for it. I fear price momentum investors may be the most harmed in the next adverse market.
