I’ve been asked several times recently about why stocks can be recovering so nicely even as recession concerns lurk. The answer is a simple, but counterintuitive one: fundamentals don’t really matter when momentum rules. Price action, not the underlying justification for those prices, is all that’s important.
Remember, financial assets are somewhat unique. For almost any goods or services, demand shrinks as prices rise, and vice versa. With stocks and tradeable commodities, that relationship is flipped upside down. It’s quite normal to see demand for financial assets rise when prices rise. No one wants to miss the opportunity for profits, so That of course can create a self-fulfilling feedback loop – prices rise because demand increases, then demand increases simply because the prices are rising. The common way of describing the real-world effect of this cycle on stock prices is “momentum”.
We’ve all heard the term, “the trend is your friend.” That’s another way of describing the powerful effect of this phenomenon. It can be relatively easy, and quite profitable, to identify trends and follow them. This can be on an intraday or longer-term basis. Frankly, it doesn’t matter if you know what your desired horizon is. Traders follow short-term trends, investors follow longer ones.
Another adage, however, is “markets can remain irrational longer than you can remain solvent.” That’s a way of describing a situation when momentum gets out of control. Fundamentals do eventually matter, but the price action can continue without regard to them for long periods of time. In theory, markets are constantly interpreting all available information to find a stable fair values. In reality, they are subject to a wide range of motivations and opinions that might have little to do with that noble search.
When momentum and sentiment are strongly positive, traders can overlook almost anything. We’ve seen very charitable responses to corporate earnings in recent weeks. In any normal quarter, a company that withdraws guidance gets punished, and punished hard. Instead, because of the tariff-induced uncertainty, companies are frequently doing so without consequence. They are saying that they don’t have enough information to allow investors to make intelligent valuation decisions about their stocks, yet in many cases, investors don’t care.
From a macroeconomic view, today’s numbers have changed investor perceptions about the need for Federal Reserve intervention. Looking at both the IBKR Forecast Trader and the CME FedWatch, we have priced out nearly a full rate cut by the end of the year, three instead of four. That’s certainly not bad news, as we have often stated our preference for a stronger economy rather than one that is sick enough to require aggressive rate cuts. But remember, it’s not as though the markets have been reeling recently from recession fears. When we’re in a situation when good news is good, and bad news is either good or easily ignored, then it is another sign that momentum is in charge.
As we’ve noted, trend following can be perhaps the simplest way to achieve trading profits. But it is important to remember that blindly following trends can become treacherous. Trends can change abruptly and unpredictably. There’s nothing wrong with playing along with momentum, but when the price action gets stretched – and a nine-day streak often represents the maximum length of a short-term trend – it is important to use risk discipline like stops or hedges.
Disclosure: Interactive Brokers
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