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Like in Newton’s laws, the stock market also often takes an external force to change demand-supply dynamics, thereby altering the existing momentum.
While Isaac Newton’s laws are meant to understand, explain, and predict the behaviour of physical objects, they can also be drawn upon to understand the direction and momentum of stock prices at the conceptual level.
Authored by Harshad Patwardhan:
“I can calculate the motions of heavenly bodies but not the madness of the people.”
Isaac Newton is believed to have made these famous remarks in 1720 after losing a fortune in a crash following the bursting of the South Sea bubble. He shouldn’t have found the madness of the people in the stock market so inscrutable. To know why, read on…
We all have studied Newton’s laws of motion in school physics, but I bet most of you have forgotten about them. To refresh your memory, let me reproduce the broad concepts behind his first two laws of motion:
Newton’s first law
An object at rest stays at rest, and an object in motion continues in motion unless acted upon by an unbalanced external force.
Newton’s second law
The acceleration of an object is directly proportional to the applied force and inversely proportional to its mass.
While these laws are meant to understand, explain, and predict the behaviour of physical objects, they can also be drawn upon to understand the direction and momentum of stock prices at the conceptual level. The market price is set when incremental demand is matched by incremental supply. If, in the aggregate, the buyers are keener than sellers, the imbalance in forces causes market prices to rise. On the other hand, if sellers are keener than buyers in aggregate, market prices fall. The net force of incremental supply and demand determines prices’ direction and momentum.
Momentum in stock prices often tends to persist for a significant period. The momentum eventually ends when the underlying demand-supply dynamics shift for some reason or another. Like in Newton’s laws, it often takes an external force to change demand-supply dynamics, thereby altering the existing momentum. For example, adverse regulatory developments might affect upward stock momentum, resulting in sudden evaporation of incremental demand and the emergence of incremental supply. Another example could be that a stock’s long downward momentum might end due to a big positive earnings surprise, resulting in investors scrambling to buy the stock just as current holders decide they no longer wish to sell.
A price trend that may have started due to some fundamental factor or new development is often accentuated by investor behaviour and psychology. The inherent reflexivity of markets means that fundamentals and prices influence each other, and the causality is not unidirectional. Here are a few reasons (not an exhaustive list) why the price momentum tends to persist:
(1) Many market participants (retail and institutional) with trend-following strategies can further add to the existing momentum.
(2) Performance chasing can add further force to existing momentum. There have been many examples of a few institutional investors resisting buying a stock because they think its valuations are expensive. However, if the stock continues its upward march and it happens to be a big benchmark stock or peers happen to own it, the same set of investors are forced to buy it at higher prices due to the performance pain it causes.
(3) Company management can opportunistically take advantage of strongly rising stock prices and raise fresh capital at high valuations, thereby strengthening the balance sheet and adding to growth capital, resulting in a virtuous cycle of improving fundamentals and rising prices.
(4) Often, the solid upward trend and/or capital raising results in stocks crossing the critical market capitalisation threshold and appearing on the radar screen of bigger institutional investors, leading to more demand and further momentum.
Of course, in every stock, momentum eventually fades and ends.
Empirical evidence suggests that momentum as a factor is reasonably persistent and has a better track record than many other factors used in investing. A disciplined rule-based active approach to capitalize on this insight would likely result in a favourable investment outcome. Salient features of such an approach are
– diversified portfolio of stocks with leading relative momentum,
– rebalanced often to test persistency and make adjustments accordingly
– cognisant of underlying liquidity to reduce impact costs
– active supervision to take care of untoward company-specific accidents and market-wide incidents
On a lighter note, if only Newton had extended his great insights from the study of moving physical objects to moving stock prices, he would have certainly figured out how the momentum factor works! Then, we would have known this great scientist also as a pioneer of momentum investing!
(The author is chief investment officer at Union Asset Management Company Pvt Ltd. Views expressed in the article are his personal)
Disclaimer:Disclaimer: The views and investment tips by experts in this News18.com report are their own and not those of the website or its management. Users are advised to check with certified experts before taking any investment decisions.
