SOME shoppers queue all night to buy goods in the January sales. When it comes to stockmarkets, however, investors take the opposite approach: they flock to buy shares that have risen in price.

This “momentum effect” has been in existence for over a century and has been observed across many countries (see article). Investors who buy the best-performing shares over the previous year earn much higher returns (ten percentage points a year) than those who buy the laggards of the preceding 12 months. This anomaly flies in the face of academic theory, in the form of the efficient-market hypothesis, which suggests that past price movements should provide no guide to future changes. It cannot be explained away by saying that high-performing stocks are more risky, or by arguing that the trading costs involved in such a strategy would eat up all the profits.

Although the momentum effect has been amply documented it has never been properly explained. Perhaps investors are slow to react when the fortunes of companies change; one good set of results can be dismissed as a fluke, but after two or three bumper periods the share turns into a wonder stock. Another possibility is that fund managers create the momentum effect by “window-dressing” their portfolios with the market's recent favourites (it looks much better to close a quarter owning the market leaders).

A second puzzle is why the effect has not been arbitraged away. The answer probably lies in timing. Clearly the momentum effect cannot last for ever or share prices would head for infinity. Over long periods (more than three years or so) an opposite anomaly known as the value effect occurs: shares that are depressed in price tend to rebound. Momentum-chasing investors may get caught out by the switch from one effect to the other, especially when they have used borrowed money to try to enhance returns.

Forever blowing bubbles

Whatever the rationale, the momentum effect tells us something significant about markets. The efficient-market hypothesis is a useful reminder that the average investor cannot expect to beat the market after expenses. As a result, low-cost vehicles like index-trackers and exchange-traded funds have become popular. But the mere fact that the market is hard to beat does not make it rational. Analysing an irrational market is extremely difficult, as those who tried to call the top of the dotcom boom discovered in the late 1990s. An irrational market sends misleading signals, causing capital to be allocated in the wrong places—for example, encouraging the building of homes in America, Spain and Ireland for which there was scant underlying (as opposed to speculative) demand. The companies that find it easiest to raise cash thanks to these market signals may not be those with the best business prospects.

For investors, such second-guessing is complicated enough. But what about regulators? Momentum effects are yet another reason to refrain from imposing restrictions on short-sellers. Doing that merely prevents (or more often delays) prices from finding the right level. All too often, as with the failed energy giant, Enron, the short-sellers were the only ones brave enough to be sceptical of market favourites.

At the overall market level, momentum effects help to explain why bubbles develop. Put that together with borrowed money and you have a disaster in the making, like the credit crunch. Too often, central banks have tended to give speculative buyers a one-way bet—cutting interest rates when markets falter, but leaving them unchanged when asset prices boom. Even now, many still stick to the creed of Alan Greenspan, a former Federal Reserve chairman, who thought central bankers should not try to pop bubbles but act to cushion the economy when they burst. It is certainly hard to spot bubbles; but central banks already grapple with other imponderables, such as the size of the output gap or the level of structural unemployment. And asset bubbles can be deflated through limits on some sorts of borrowing rather than just interest-rate hikes. Economies can get carried away by momentum.