The Momentum Bubble
Endless passive investment flows validate any prior price, no matter how ridiculous. This amplifies mispricing and makes betting on Momentum a winning trade. Can that last forever?
TLDR Summary
Stocks are the assets with the highest expected returns and active managers notoriously underperform. Those two ingredients are driving people into passive ETFs. These now account for more than half of all funds out there and the rotation from mutual funds to ETFs is not showing any signs of slowing down.
Endless fiscal liquidity creation makes makes the passive investment bid one of the strongest market forces out there. After churning through the economy, much of every deficit dollar ends up in a stock market ETF.
In contrast to active investing, passive investing is valuation indifferent. It validates any prior price because it simply enters ‘market buy’ orders for every asset out there weighted by its current market cap. This amplifies mispricing to both upside and downside. Stocks don’t run out of buyers/sellers when they rise/fall too much. As a result, trends become stronger and last longer, fertile ground for Momentum factor investing.
Over the last 15 years, Momentum (i.e. buying winners and selling losers) has generated alpha of about 3% annually. Rarely has a risk factor been so dominant for so long. And its dominance has escalated recently, with its alpha reaching 10-20% (!) on an annual basis. It’s possible and perhaps likely that this dominance signals that the passive investment trend is reaching limits of what markets can digest.
What is the Momentum factor?
Why do your stocks make money for you? The academic answer to that question is that you are earning the equity risk premium. The companies you invest in can fail and then you are the last in line to have your claims satisfied. In return for bearing that risk, you get compensated with a return that is higher than the interest rate on cash or government bonds.
In 1964, William Sharpe introduced his famous Capital Asset Pricing Model which argues that there is only a single factor determining this equity risk premium, which is market risk. Investors can diversify company-specific risk factors which is why bearing that risk has no systematic positive return. You can hide from company-specific risk. But you can’t hide from market risk. The expected return of a stock is therefore the risk-free rate plus market risk times the company’s exposure to that market risk (aka beta).
Over time, various researchers have tried to amend the CAPM with additional risk factors, including for example Size (small outperforms big), Value (low multiple outperforms high multiple), Volatility (low outperforms high) or Quality (better outperforms worse financial health). Momentum (recent winners outperform recent losers) was introduced as an additional factor in the 1990s.
Should Momentum outperform?
Those introducing Momentum have found statistically significant positive returns associated with the Momentum factor and they also offer justifications why it should be systematically so. The most compelling one is in my opinion of behavioral nature: Buying into an asset that has appreciated a lot may be scary for many investors because they are emotionally anchored to lower prices that were available earlier. This makes those investors scarce who are willing to buy in anyway in and in return it makes them outperform. You make money buying NVIDIA at $170 because everyone else is too afraid to do so. This is the famous wall of worry.
I do however believe there are equally compelling arguments justifying a negative Momentum risk premium. An asset with strong recent returns may attract greed and gambling which should have a negative return. Dozens of people have asked me about Root when it was $180. Nobody did at $70. Buying a violent dip is in my opinion scarier in many cases than buying a violent surge.
The equity risk premium is in my opinion closely associated with the ability and willingness to provide liquidity. If you are able and willing to buy or sell when others can’t, you should be in a strong position to outperform. For example, I believe that selling the current rally has a positive expected return because the primary buyers right now are trapped institutional investors that are forced to chase to keep their client mandates. It’s hard to justify your management fees if you are seemingly at risk of missing out on the greatest bull run since dotcom. Formal or emotional restrictions on buying and selling is what makes investors underperform.
In any case, I believe it is better to think about all these additional risk factors not as permanent and systematic risk premiums, but as factors that outperform or underperform in certain market environments. Investors don’t outperform markets by generally choosing a certain factor. Any historical evidence on that matter relies on generalizing the market environment the evidence was taken from. Instead, investors outperform by exposing themselves to the right factor at the right time.
Momentum rules right now.
The S&P 500 Momentum Index has returned 17.8% annually over the last 10 years while the S&P 500 has ‘only’ returned 13.7% annually. Much of this outperformance has accumulated in just the last 18 months as evident in the chart below.
The strength of the recent performance of Momentum is perhaps illustrated even better in the annual core factor performance as calculated by S&P Dow Jones Indices below:
Momentum has vastly outperformed other core factors in 2024 and 2025 YtD. In fact, there is not a single instance in the last 15 years where another factor has dominated equally much.
As illustrated in the risk vs. return chart below, the factors Momentum, Growth and Quality FCF Aristocrats (that’s mostly Big Tech) have generated up to 300bps more in annual return per year for very little additional (or in some cases actually less) volatility.
In contrast, all the factors in the bottom right corner of the chart above have significantly underperformed the market, i.e. they have offered less return than the market while exhibiting HIGHER volatility. Especially dividend and value stocks have done very poorly and trapped many investors.
Appreciate for a moment what this data suggests: For the last 15 years, you could have outperformed massively simply by buying what has done well before. No financial, commercial or technological analysis needed. An absolute slap in the face for the entire investment profession. And probably a key reason why social media is full with people drawing lines on charts.
This outperformance coincides with a rising share of assets in passive investment products.
It might be obvious to you today that buying the entire market offers a pretty decent long-term return that is very hard to beat systematically. More than a hundred years of stock market history make that very clear.
However, the realization of this truth has actually taken a long time to sink in publicly. It was consensus way into the second half of the twentieth century that only active management can generate returns in stocks. Government bonds were considered the primary passive investment vehicle.
Markowitz’ famous modern portfolio theory was introduced in 1952. But it took a long time until the general public caught up with it. He received the Nobel prize for this work in 1990. Vanguard’s John Bogle created the first index fund in 1975 and it remained very small in $ terms well into the 1980s.
During the last 30 years, passive investment products have massively gained popularity the more educated investors have become and the more transparent the notorious underperformance of active managers has proven. Between 2012 and 2024 alone, the market share of passive in the global mutual fund and ETF market has doubled from 25% to about 50%.
In the US, the passive share is even 60%.
And this process of replacing fund managers with simple ‘market buy’ orders is not slowing down. US mutual funds and ETFs have attracted $170bn in equity fund flows combined during 2024 and 2025 YtD. However, if you look at mutual funds alone, they have lost $850bn over the same period, meaning that ETFs have gained more than $1tn. It’s a massive rotation that is still ongoing, perhaps even still accelerating. The entire mutual fund industry is dying.
The US government is still running deficits of about 6-7% annually, an unprecedented level outside of recessions. After churning through the economy, much of this deficit spending ends up in a stock market ETF.
Why would those two be related?
There are countless passive products out there which employ a variety of strategies. Some of them should probably better be classified as algorithmic instead of passive investing.
Most of them will however simply track the indices, the constituent stocks of which are typically weighted by their market cap. A passive product therefore scatters ‘market buy’ orders across most of the stock market without any valuation sensitivity.
In the absence of passive fund flows, there are natural mechanisms to reign in price excesses. If a stock runs too much compared to its fundamentals, it will at some point run out of buyers. Investors will deem it too expensive for the cash flows they receive in return.
In contrast, passive flows are completely valuation indifferent. As long as the liquidity tap is open, they will keep buying. At any price. Every new day the passive bid shows up, it validates yesterday’s price.
The same is true for downside excesses. If the price of an asset is falling, nobody will catch the knife. Since the weight of this asset in the passive basket is falling, it will get a smaller and smaller share of the passive bid that will show up relentlessly and predictably with every new trading day.
What does that mean going forward?
It seems to me that we are far beyond the point where price discovery is happening properly. Passive flows make Momentum outperform which is in turn exploited by those with an ability to create Momentum in their share price.
There are absolutely ridiculous excesses in the US stock market, especially in so called meme stocks that have a huge community following and seem to have stopped reacting to fundamental news.
We are dealing with an investment paradigm where the actual operating performance of a company is in some cases utterly insignificant compared to the size and passion of its investor community.
For example, just a few days ago, pharma giant Novo Nordisk issued a profit warning for the rest of the year on weak obesity drug sales. They combined that announcement with a commitment to crushing the mass compounding of its blockbuster drugs. Hims & Hers, the obvious target of that incoming attack, barely reacted to this existential threat. In fact, it’s flirting with its all-time high as I write this.
Now, how will this unravel? It’s possible that this is a new long-term paradigm emerging from evolving investor preferences. Shrewd management teams can use these changed preferences to their advantage. Instead of convincing investors with actual operating performance, they can convince them through story telling and targeted marketing. Stocks then become products and investors become customers.
If this proves persistent, it can lower a company’s cost of capital which can turn into real competitive advantages. For example, MicroStrategy has leveraged this strategy to lower its cost of capital below the cost of capital for Bitcoin. As a result, the stock is trading at a premium to its book value which they have turned into a novel business model of becoming a Bitcoin treasury company.
While I believe that I can describe these dynamics fairly well, I don’t think I really understand them. Or at least I don’t think my analyses can take this environment as a given. To be frank with you, if this paradigm shift proves to be permanent, I might as well decide to shut down FA because my approach would be outdated. I do however still believe that the odds favor a meaningful reversion to the mean.
Sincerely,
Rene
I recommend to have a look at mike green work on the matter