Goldman Sachs and Morgan Stanley are both paying attention: Is the "strongest trade" in U.S. stocks starting to change this year?
Morgan Stanley and Goldman Sachs warned that the momentum stock sell-off that began last week and the de-leveraging of hedge funds are not one-time events. Although the current severity may not be as drastic as the crash triggered by DeepSeek from late February to early March, considering the ongoing high short leverage, recent momentum strategies may have more room for decline
Is the "strongest trade" in the US stock market starting to reverse this year?
Morgan Stanley and Goldman Sachs' quantitative strategy teams warn that the momentum stock sell-off and hedge fund deleveraging that began last week are not one-off events. Since June 30, the Morgan Stanley Momentum Index has retraced by -6.5%, while Goldman Sachs' high beta momentum hedge index has seen a decline of 8.3% since the beginning of the month.
Momentum strategies have performed strongly in the US stock market this year. Year-to-date, while the S&P 500 has only risen by 5%, Goldman Sachs' momentum strategy index has increased by 20% during the same period. If the timeframe is extended to 18 months, with the S&P 500 up 30%, Goldman Sachs' high beta momentum hedge index (GSPRHIMO) has seen an astonishing increase of 80%.
Currently, it is difficult to identify a clear catalyst for this round of adjustment.
Rich Privorotsky, head of Goldman Sachs' European Delta One, believes that the trading strategy of "strong dollar, high oil prices, weak gold, and small-cap stocks outperforming large-cap stocks" is forming a self-reinforcing trend, while systematic trading and high-leverage trading (i.e., trading strategies reliant on large capital flows) are overshadowing fundamental factors, all of which are driving the reversal of momentum strategies.
Historical Data Reveals Deeper Adjustment Risks
Chris Metli, head of Morgan Stanley QDS, stated that while the severity of the current events may not match the crash triggered by DeepSeek from late February to early March (when the MSZZMOMO basket plummeted by 21%), the ongoing high short leverage suggests that there may be more room for declines in the near term.
Historical statistics show that after a 6% pullback, momentum strategies typically yield slightly negative returns (-1%) in the following month. More notably, the typical peak-to-trough decline of the momentum index (MSZZMOMO) is 23%, lasting about 30 trading days.
The current pullback has entered its fifth day, and the 6% decline is consistent with the historical median level during the same period, indicating that if the pullback continues, there is still further downside potential.
Morgan Stanley also found that when the momentum index (MSZZMOMO) declines and bond yields rise, future returns from momentum strategies tend to be more negative. On Tuesday, the decline in momentum strategies and the rise in small-cap stocks coincided with rising yields, a combination that has historically been unfavorable for momentum strategies
According to Morgan Stanley's data, the current momentum strategy seems to be in a stage of excessive concentration and is prone to reversal, especially when the market experiences higher short-term volatility. Therefore, momentum may continue to be under pressure in the short term.
Concentration Risk Intensifies Market Vulnerability
Morgan Stanley's analysis shows that the overlap between momentum strategies of different durations is increasing, with 31 stocks currently appearing in the long momentum baskets across all four durations, a level of overlap that has been at the 84th percentile since mid-2017. On Tuesday, 84% of these stocks experienced declines.
In the 96 months since mid-2017, only 16 months have seen the same level of cross-duration long momentum concentration, which is typically a negative signal for long-short momentum pairing strategies, especially for shorter-duration long-short momentum strategies. The 1-month momentum strategy (MSZZ1MMO) has median returns that are negative over the next 1, 2, and 3 months.
On the short side, although the overlap is not as extreme, the overlapping stocks are experiencing extreme price movements: all 25 stocks appearing in the short momentum baskets across four durations rose on the day, with a median intraday return of 2.9%.
Pure momentum strategies (such as MSCBSMMU) experience more severe drawdowns than industry momentum strategies (such as MSZZMOMO), reflecting the differences in responses of different strategies under varying market conditions
