While the recent performance of the broader market has been shaky, the losses have been nothing compared to those registered by some of the leading momentum stocks from the first quarter. Momentum names are notorious for delivering outsized gains while the fundamental story is intact, then cratering once the news flow turns south.
This past week, the leading stocks in this category have been knocked off of their highs not by company-specific news — aside from Fossil (NASDAQ:FOSL) — but rather the sudden increase in investors’ aversion to risk. The table below shows the returns of some top momentum stocks through the five sessions ended Wednesday:
|Stock||Ticker||Oct. 3 low-April 30||May Intraday peak to MAy 9|
There are a few lessons to be gleaned from this. The narrative surrounding these stocks has been that strong earnings growth would provide a measure of insulation from trends in the economy and broader market. As experienced investors know, of course, this kind of thinking can be dangerous since even fast-growing stocks become highly vulnerable to market weakness once they reach a certain valuation level.
Note in this case that the downturn in the momentum names has coincided with the jump in the VIX index to its highest level in two months. While the VIX move hasn’t been that large on an absolute basis, it doesn’t have to be once P/E ratios climb into the 30s. And with the exception of Fossil, these stocks remain rich even after the drubbing they have absorbed in the past week:
|2012 P/E||2013 P/E|
The second takeaway is that investors now are demonstrating a willingness to dump shares of their winners to raise cash — something we haven’t seen since the third quarter of last year. No matter how you slice it, this is a negative indicator for broader market performance in the months ahead.
Third, a look at the charts of momentum stocks of the past shows a similar story: As long as the main uptrend is intact, there still is an opportunity to make money from the long side. Take Netflix (NASDAQ:NFLX). The stock experienced high volatility throughout 2010 and 2011, but the end of the run wasn’t truly signaled until it broke the uptrend in late July of last year. A look through the five-year charts of other well-known momentum names such as Green Mountain Coffee Roasters (NASDAQ:GMCR), Deckers Outdoor (NASDAQ:DECK), Crocs (NASDAQ:CROX) and Research in Motion (NASDAQ:RIMM) reveals a similar pattern to what we see in this Netflix chart:
This is relevant now because in the case of all of the stocks in the tables above – with the notable exception of Fossil — the broad uptrend remains intact. Ulta Salon Cosmetics & Fragrance (NASDAQ:ULTA) is a prime example:
This doesn’t mean it’s time to run out and buy these stocks after a few days of weakness. With an average forward P/E ratio of 29.7, clearly they carry more than their share of risks. Instead, the best approach is to view these as what they are right now — trading vehicles — and keep an eye on the breakdown levels that could signal the point of no return. While in many cases these levels are far from the current price — which is in itself instructive by showing how far these stocks need to go to truly break down — the table below nonetheless shows the key reference points for some of the market’s leading momentum stocks:
|Wednesday close||breakdown level|
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.