February 2024 Commentary:
The Power of Momentum
In physics, Momentum describes the tendency of an object to keep moving in its current direction unless acted upon by an external force. When we speak about Momentum in the context of financial markets, we refer to the tendency of winning stocks to continue performing well in the near term. A critical difference between the analogous use and its original meaning is that a stock only exhibits Momentum within a specific time frame (hence the importance of the caveat, “in the near term”). It is an observed property of a trend—a trend enabled by a variety of externalities—not a property inherent to the stock itself. As every investor letter cautions, “past performance is not necessarily indicative of future results.” If this is true, then why is Momentum a predictively significant factor at all? How can we be sure that an external force won’t act and bring the stock’s recent performance to a halt?
Critics argue that the outperformance of momentum strategies may diminish over time as more investors become aware of the anomaly and seek to exploit it, potentially eroding the excess returns associated with momentum-based strategies. With this in mind, if a stock that has performed well recently is to continue performing well in the near term, at least one of two things must hold true: either (1) the conditions under which the stock performed well must persist in the near term, or (2) new conditions must be similarly conducive to the market’s interest in the stock. However, both can certainly be true at the same time, and as we look ahead at the coming months, it appears as though both conditions apply to a significant subset of the companies that drove the index rallies in 2023.
Over the course of the past 12 months, the S&P’s returns have been driven largely by the performance of “the Magnificent 7” (Apple, Microsoft, Amazon, Nvidia, Meta, Tesla, and Alphabet). Will these names prove to have “momentum” from the past year that carries them even higher over the course of 2024? The market consensus expects their earnings growth to step up by 40% over the coming 18-24 months, so it appears as though the Street seems to think so, even factoring in that much of that expected bottom line growth may already be priced in. That being said, countless other tech stocks—Adobe, Salesforce, Intel, and Qualcomm, to name only a few—earned the favor of investors for many of the same reasons: buzz around AI, strong margins, and sticky recurring revenue models. Given the recent broad-based rallies we’ve seen, Value investing is going to be significantly more difficult in the near term, and the fundamental quality of these businesses will continue to drive their stock performance.
Quality—strong, diversified revenue streams, low debt, high margins—drove tech companies higher than any other sector in 2023, and will continue to do so in 2024. Yes, investors looking for get-rich-quick returns piled into companies like Nvidia as the Gospel of Artificial Intelligence spread like wildfire, but the fundamental strength of these companies’ business models made that fervor seem a little more reasonable, and will be key for their continued outperformance in the remainder of this year.
While the Fed’s Dot Plot suggests that rate cuts are imminent, in our view, they’ll be slow to come, and few and far between. Not only did the Labor Department’s February report indicate that core PPI increased by 0.5% in January (its largest increase since August), but high fiscal spending in the next 4-6 quarters and the attendant debt will need to be financed somehow, so although yes, inflation is cooling, and yes, a recession is likely sometime in the latter half of this year, rates are going to stay high by any relative measure for the foreseeable future.
Additionally, while inflation is decreasing (though evidently less steadily than we might have hoped) and will act as a boon for the U.S. consumer’s real disposable income, declining inflation also means rising real rates. As the borrowing cost per unit of output increases, naturally, the companies that win in an environment like this are—we’ll say it again—companies with low debt, high margins, and products that consumers and businesses need to function. So coincidentally or not (you decide), it appears as though the quality stocks that investors defensively favored under a rate hiking regime will be the same stocks that investors favor as that regime slowly tapers off into a possible recession.
In conclusion, the intricate dance between momentum and market forces underscores a nuanced landscape that investors must navigate with cautious optimism. The continued performance of companies like the Mag-7, buoyed by robust earnings growth expectations and fundamental quality, seems poised to validate the principle of momentum in the near term, despite—or perhaps because of—looming uncertainties and the ever-present specter of rate adjustments. The intersection of decreasing inflation, albeit gradual, and high interest rates creates a peculiar environment that paradoxically favors the very qualities—low debt, high margins, essential products—that propelled tech giants to their current lofty heights. As we peer into the remainder of 2024, the momentum factor, intertwined with the fundamental strengths of leading tech companies, appears to offer a beacon for navigating the choppy waters of market volatility and the shifting sands of economic policy. Thus, while the future remains uncertain and external forces unpredictable, the convergence of momentum and quality may well chart the course for sustained outperformance in a market increasingly characterized by its search for true value amidst the echoes of past success.
Sincerely,
The Team at Appomattox
A quick word about the above: we’d like to shift gears on what we hope to achieve in our monthly editorials. While our quarterly commentaries will continue to reflect on the markets more broadly and explain our thinking in terms of portfolio positioning for the subsequent quarter, we’re going to use our monthly commentaries as an opportunity to circulate think-pieces on topics, ideas, and specific news stories that the Appomattox team has been discussing. We hope you enjoy this change, but we welcome your feedback!
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