Momentum Driving Stock Prices

Momentum Driving Stock Prices

Bangalore was on weekend lockdown due to COVID-19. So, with nowhere to go outside, i decided to indulge in my favourite activity of analysing data in S&P Capital IQ to identify peculiar trends in stock movements in the last 50 years.

When i looked at the stock movements of large companies like IBM, Xerox, and Tesla, i found a significant contradiction. As a company’s financial position, fundamentals and prospects improve, the stock price would diverge from its book value as investors are ready to pay a premium for intrinsic value by looking at its growth potential. However, when investors decide to pay a bonus more than the stock’s intrinsic value, the function of the stock price becomes more dependent on the mood and momentum of the market and less on the stock’s fundamentals. Thus, such high-quality stocks become speculative and exhibit high volatility.

I can substantiate my hypotheses with three stocks – IBM (1962), Xerox (1970), and Tesla (2020). All these stocks were hot favourites in that era. However, for IBM, the share price in 1963 declined from 607 to 300, and for Xerox, it plummeted from 116 to 65 in 1970.

None of the above stocks had any fundamentals/long-term growth issues; the price drop reflects the lack of investors’ confidence in the premium valuation they decided to pay above the intrinsic value.

Thus, blue-chip stocks that trade multiple times over and above the intrinsic value are primarily speculative. Their prices depend on the mood and momentum and not on their fundamentals.