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Momentum Trading vs. Greater Fool Theory

Momentum Trading vs. Greater Fool Theory

Posted May 30, 2024 at 11:15 am
Steve Sosnick
Interactive Brokers

Over the past few weeks we have seen a dramatic increase in the trading of speculative stocks.  The recent meme-stock mini-craze got much attention, but the volumes and activity in a wide range of small-cap stocks have seen a marked upsurge as well.  Clearly, volume begets volume.  We know that many of you are participating because we have seen an upsurge of customer orders in names like GME, AMC, FFIE, and a slew of other idiosyncratic stocks.  If so, ask yourself whether you’re relying on momentum trading or the “greater fool theory”.

Momentum trading is a well-respected strategy.  In its simplest form, it is highly related to trend following.  I’ve called that “Newton’s First Law of Markets”, where a market in motion remains in motion unless acted upon by an outside force.  Thus, if a stock is trending higher, it behooves traders to utilize a long bias, and vice versa.  That’s hardly foolproof, of course, since those pesky outside forces tend to arise at inopportune times, but the logic is time-tested. 

Those trends often arise for excellent reasons.  Think about the market’s current poster child, Nvidia (NVDA).  That stock has had a remarkable uptrend lasting well over a year, but there is a fundamental reason for the advance – NVDA has posted a perhaps unprecedented streak of beating market consensus for revenues and profits, raising its guidance, then beating the raised guidance and raising it once more.  At some point expectations will exceed reality, but how and when remain a mystery.  In a broad market sense, we see secular trends that relate to the economy and/or monetary policy that propel them in one direction or another. 

But there are times when those trends arise for non-obvious reasons and become over-extended quickly and precariously.  Exhibit A will be FFIE, Faraday Future Intelligent Electric.  They describe themselves as a mobility ecosystem company.  Unfortunately, FFIE has been unprofitable since coming public in 2020 and has reverse split its stock 1:3 in March and 1:80 in August.  Healthy companies don’t need reverse splits to remain eligible for exchange listings.  As a result, we have a one-year chart that looks like this:

FFIE, 1-Year Chart, Daily Candles, with Reverse Splits Notated

FFIE, 1-Year Chart, Daily Candles, with Reverse Splits Notated

Source: Interactive Brokers

Not a pretty chart, to be sure.  For better or worse, this trend was well-defined.  But look what happened recently:

FFIE, 20-Day Chart, 30-Minute Candles

FFIE, 20-Day Chart, 30-Minute Candles

Source: Interactive Brokers

Ummm, that got interesting, no?  I’m frankly not sure what caused the stock to lift from its doldrums around 4 cents, but we can see that once it did lift, it began to do so exponentially.  We don’t typically see stocks go from under a nickel to nearly $4, then back towards $1 within the course of a week – all on immense volume. 

This is where I find it difficult to separate momentum investing from the greater fool theory.  Whenever we invest or trade we hope that someone will pay a higher price for our shares in the future than we paid today.  But why?  If a company is steadily earning money, then there is a solid rationale to expect that it will ultimately be worth more on a per share basis at some point.  If the economy is improving and monetary conditions are sufficient, then it is reasonable to expect that the market as a whole will be higher eventually.  

But if you’re buying shares in a fundamentally questionable enterprise simply because they are rising, especially if that rise is parabolic, then you are simply hoping that someone will get suckered into paying more than you did.  It might work, but there is no reason to believe that it will.  That is literally the greater fool theory.   It is not investing.  This is not to say that one can’t make money by jumping onto fast moving situations – some of you undoubtedly did – but please be realistic about the potential for risk and reward.  Someone top-ticked FFIE on May 17th and lost big.  They proved to be the greatest fool that day.  Please don’t let that be you!

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5 thoughts on “Momentum Trading vs. Greater Fool Theory”

  • TraderTech6

    Generally a sound hypothesis, but if one is using indicators such as MACD and can catch a move like this early, with minimal risk, you’re the one selling to the greater fools. As long as you’re using trailing stops and look for exhaustion targets (daily or weekly resistance 2 or 3 points, etc.), one can make out well from these types of moves. An example was DNMR. This used to be a high flying stock, dropping from $55 during the pandemic all the way down to $0.60. Right around 60 cents, it based, got a daily signal, and rallied to $1.84. Was very doable to buy at 65 to 70 cents, and sell on the MACD crossover around $1.70. That’s a heck of a return for a week or two. You certainly don’t want to be the sucker top-ticking FFIE at $4 thinking it’s going to $20 for sure, but buying at 30 cents and selling out at $2 or $3? That’s good momentum trading.

  • Anonymous

    I concur with the trader above. However, we were all once the sucker buying at the top and either figured things out or quit You could call it life’s lessons

  • Anonymous

    i would guess that it is a short squeeze

  • Bob

    Good article. Do you have an opinion on CAVA? It seems like CAVA is the playground of billionaires with too much money on their hands. The valuation seems to be quite absurd. I don’t own it, but a friend of mine does. I told him that I would sell it since I don’t see anywhere close to reasonable valuation. I said that if he wants to hold onto it, he should initiate a 20% trailing stop from the previous high. If you analyze the pullbacks after March of this year, the worst one was in April for a little less than 19%. According to William O’Neal’s book “How to Make Money in Stocks,” he recommends a 7% trailing stop. While that would allow an investor to escape with more profits, in theory – bar a 40% drop at the open, it seems to me that it would also be subject to much more frequent fills due to normal daily price fluctuations. For investors looking to move back into the stock, it would lead to frequent whipsaws. In general, I don’t believe in momentum investing. I prefer Growth At a Reasonable Price (GARP). investing strategy. It emphasizes growth, but tempers that with future P/E values that are less than expected earnings growth.

  • Anonymous

    That is why momentum moves on small caps are typically good fades once the initial volume frenzy is over.

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