Why Momentum Stocks Don’t Go Sideways

For the last few weeks—and especially this week—we have urged caution about the near-term outlook for stocks. 

We don't have a crystal ball that tells us what will happen next, but we do have three decades of active experience in the markets and have seen many patterns before.   

We are now seeing very strong patterns that tell us a break in momentum IS coming relatively soon… 

At the end of February, we republished a note we had published several years ago discussing the psychology of “momentum” stocks. You can read that note here. 

We published it because we were beginning to see the return of the "stonks," crazy price action in momentum stocks that were pulling in more investors. 

This activity has only increased in the two weeks since we published that note. 

On that note, we explained the physics of momentum investing and why it works. 

Today, we want to emphasize a point that was from that note — momentum stocks do NOT correct by going sideways. 

What do we mean? 

Let’s revisit our favorite chart – the chart of stock market leader NVIDIA Corporation (NASDAQ: NVDA). 

We have recently been using price-only charts, but this one has a few other useful pieces of data, including the volume and the "relative strength index" (RSI). (You can read about this indicator here.) 

You can see in the chart that NVDA has had a HUGE run! We all know this, and (hopefully) many of you have taken advantage of some of it… 

In the last week, though, the stock has begun to taper off.   

It is not down much, but the high was seven trading days ago. That was on March 8, also a day when the stock showed a huge intra-day reversal. That means that it closed much lower than where it opened. 

Here is the intraday chart for NVDA from March 8… 

The stock had closed the previous day at $926. It opened at $947, traded through $970, but then quickly retreated and headed down -10% or almost—$100 to $875. 

Historically, this kind of reversal can signify a change in the trend. 

Also, the fact that it has now been lower for more than a week can signal a likelihood of a reversal and a move lower. 

If the previous statement is true—that momentum stocks don't correct by going sideways—then NVDA is likely headed lower. 

How do we support our statement? 

Well, factually, it is correct. If you look at stocks with a combination of upward momentum indicators (RSI above 90, high standard deviation distance from moving averages, etc.) and look at the next month – they almost NEVER go sideways. 

That is data we will share in a future note… 

Right now, though, we want to talk about the psychology of why they don’t go sideways. 

We have previously talked about understanding the "cohorts" of stock ownership.   

This is looking at who owns the stock at what price. The moving averages can tell us a lot about the cohorts. This is knowable data. 

What is unknowable is the motivations of those particular cohorts at any given moment. 

What we can tell you, though, is that we are 100% confident that in almost every situation where we see the kind of momentum we have seen in NVDA (and a host of other stocks recently), you are seeing buyers who are buying because they expect it to go up more. Soon. 

These buyers look at how much it has increased in the past day, week, month, or quarter and say, "Wow!"   

On March 1, you could have bought NVDA for $800 a share. It was +19% in the previous seven trading days, +30% during the last month, and +62% year-to-date! 

Furthermore, it proceeded to go higher! At the high on March 8 (just six trading days later), you were sitting on a (momentary) gain of +21%!   Even now, you are sitting on a +10% gain. 

The people who bought starting on March 6 (nine trading days ago) are flat or underwater. That was NOT their expectation. As more days go on of sideways movement, they will lose their motivation for buying. 

Remember, many were not buying NVDA because of the long-term prospects but because they expected it to go up soon. 

How do we know this?   

We know this because when you see a market correction in an overbought stock, it doesn't correct sideways. 

These investors lose their motivation to own and then move on to selling the shares. This removes the motivation of new incremental momentum buyers (it is no longer going up), and even more investors get "bored." 

Now, as the shares drift lower, you see more investors underwater. NOW, they begin to panic. 

They either want to keep their gains or don't book losses, as many bought higher. 

Elements of this psychology happen in ANY stock but are magnified in momentum stocks a hundred times! 

Have you made money recently in any "momentum" stocks? Tell us more in the comments section online (scroll to the bottom of the post).

Momentum situations can yield a lot of money. They can go much higher than anyone could ever expect.   

The key, though, is making sure you KEEP those profits. Respect the physics of momentum stocks and take some profits!