What comes up must come down, right? As the seven-year bull market finds its strength tested the past two weeks, many momentum stocks, which have seen their share prices soar, found their valuations crashing back to earth rather abruptly. Investors placing their bets on high-flying momentum stocks are putting their portfolios at significant risk. Most investors will agree that we are closer to the end of the bull market than the beginning, and so it is time to put momentum stocks in the Danger Zone.
Momentum Stocks Are Risky Bets
The main idea behind momentum investing is that yesterday’s price movement will repeat in the future. As a stock moves up, momentum increases, and investors pile in, driving the price even higher. This investment strategy overlooks the actual economics of the business underlying the stock. As such, momentum strategies are based on speculation. The problem with speculation is that there tends not to be any method for predicting when the speculative fervor will end and, when it ends, it tends to swing from positive to negative very quickly, and stocks get crushed.
When The Bull Market Takes A Rest, Momentum Stocks Get Wiped Out
Prior to August 17, the markets had traded relatively flat on the year. However in the following six days, the three major market indices, The Dow Jones, S&P 500, and Nasdaq would each enter correction territory. When the dust settled, a total of $2 trillion in market value had been wiped away. Figure 1 shows how some of the market’s best performing stocks of the year faired much worse than the overall market.
Figure 1: High Flyers’ Valuations Slashed in Correction
Sources: New Constructs, LLC and market data
The four stocks in Figure 1 receive our Dangerous-or-worse rating; yet all of them had seen year-to-date share increases ranging from 30% to over 150%. These stocks were trading, not based on fundamentals, but on momentum. When the overall market’s momentum stopped, these stocks felt the brunt of the decline.
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