“ONE of the most mysterious market phenomena is momentum – the tendency for fast-rising stocks to keep going up. How come such an obvious market anomaly is not arbitraged away?
I have referred in previous columns to the work of Paul Woolley and Dimitri Vayanos of the London School of Economics on this issue, and they have a new piece in the latest issue of Central Banking Journal. Their idea is that the anomaly is the result of investors using agents (professional fund managers) to manage their money. They choose those managers on the basis of past performance. That past performance will inevitably result from good/lucky stock selection. So when they fire one poorly-performing fund manager and select an outperforming one, the inevitable result will be that cash will flow into the stocks owned by the outperforming managers (the previous winners) and out of the ones selected by the poor performers (the previous losers). The classic example was in the late 1990s when money was taken away from value managers and given to growth managers who were buying technology stocks.
This process helps to explain asset bubbles. Eventually, prices depart so far from fair value that a shock occurs and the process reverses – often quite quickly, as fund managers stampede out of once favoured stocks. The evidence suggests that momentum works over periods of up to two years but reversal effects predominate after that.
For me, the theory, while telling part of the story, misses the key factor of credit expansion which Charles Kindleberger outlines in his classic Manias, Panics and Crashes. There were no asset bubbles during the Bretton Woods era but there have been many in the period of rapid credit growth since.
In the second part of their essay, Woolley and Vayanos deal with another interesting theme – the expanded role of finance in the modern economy. They argue that…”
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