Momo (NASDAQ:MOMO), like many Chinese internet stocks, was enjoying a stellar year. From the start of the year, Momo stock roared higher from $25 to as high as $55 in June.

Since then, however, Momo has suffered a considerable setback. Trump’s trade war talk has cast a dark shadow over Chinese equities in general. The Xtrackers Harvest CSI 300 China A ETF (NYSEARCA:ASHR) has dropped 20% from its 2018 highs, and the Chinese Yuan has depreciated sharply in recent weeks.

That hasn’t been the only thing weighing on Momo, however. In June, short-selling fund Spruce Point Capital took aim at Momo stock. Spruce Point blasted the company with a strongly bearish report.

Spruce Point suggested that Momo was only worth $23-$32/share, far below its recent trading levels. In the week of Spruce Point’s report, Momo stock dropped as much as 15%. What should investors think, and what is the outlook for the company going forward?

Spruce Point Kills the Momentum

Spruce Point’s research report runs 70 pages. It’d be far beyond the scope of this article to address all of their concerns. However, let’s run through some of the highlights.

The report begins by suggesting that Momo stock ran up to unsustainable heights because its American shareholders don’t understand the business.

It’s true that oftentimes Chinese companies list in the U.S., where it is more difficult for non-Mandarin speaking investors to research their businesses. That can be fine. There is good reason to want to list in the world’s most prestigious market.

But sometimes companies list in the U.S. because they know their business would face more scrutiny with a shareholder base that spoke the local language. Spruce Point says as much. They claim to have used forensic researchers in China to dig further into Momo’s story.

The report states that Momo had numerous insiders bail out of the company recently and that it was charged in China with deceptive filings. What might be going on? Spruce Point alleges the presence of illegal gambling operations, undisclosed “talent agencies,” and reported related-party transactions that disagree with the company’s disclosures to authorities in China.

Does Momo Have a Valid Defense?

Spruce Point leveled some serious accusations, and not surprisingly, the stock tanked as a result. Spruce Point summed it up well:

“Momo’s investor base is compromised of two distinct cohorts, fundamental investors taking management’s word at face value and momentum/swing traders trying to play the stock’s trend. Both of these groups are oblivious to the serious risks underpinning a Momo investment.”

Judging by the stock’s sharp drop, that analysis appears to be accurate.

Unfortunately the company has done little so far to defend itself. It published a press release following the negative report. However, the press release contained just three paragraphs and did nothing to rebut Spruce Point’s charges on a point-by-point basis.

Instead, they simply stated that: “Based upon this review and evaluation, the Company believes that the report contains numerous errors, unsubstantiated statements and misleading conclusions and interpretations regarding events relating to the Company.”

Thus, it’s hard to judge the validity of Spruce Point’s allegations. Presumably, Momo will offer much more insight into these specific matters when they report earnings next month. Analysts, in particular, are likely to offer questions regarding some of the more troubling issues that Spruce Point raised.

Tech Stocks Face a Correction

Put the Momo-specific concerns aside for a minute. High volatility growth stocks such as Momo, as a group, face a big threat.

It appears that the long-running FAANG trade may be running into trouble. And this really shouldn’t come as a surprise. The large-cap tech stocks have been outperforming for so long that ETF specialists have created levered tech trackers such as the BMO REX MicroSectors FANG Index 3X Leveraged ETN (NASDAQ:FNGU) to cash in on the momentum.

However, when stocks get so popular, they tend to correct. We’re seeing that this earnings season. Netflix (NASDAQ:NFLX) whiffed on subscriber growth this quarter. NFLX stock is down to close to 15% from its highs earlier in July.

Facebook (NASDAQ:FB) suffered an even worse fate on Wednesday. The company came up short on earnings, sending FB stock down sharply after hours.

Once the conference call started, things went from bad to worse, as the company warned that revenue growth is slowing down sharply. In fact, Facebook sees cost growth outpacing revenue growth in the near term.

FB stock plunged as much as 25% in the after hours session Wednesday. That’s an almost unthinkable rout for a company of Facebook’s size and importance.

Arguably even more importantly, it dims the outlook for internet companies around the globe. We’ll see how tech stocks trade, but in the immediate wake of Facebook’s earnings, NASDAQ futures plummeted. And with good reason.

Facebook is one of the world’s two largest internet advertising companies. If it can’t make ad-based revenues work like they used to, that would be very bad news for smaller players such as Momo that are still trying to carve out strongly profitable niches.

So much of the run-up in internet stocks came because revenues were seen as an infinitely growing pie. Facebook’s earnings miss could really dent sentiment across social media stocks for quite a long time to come.

Momo Stock Verdict

I wouldn’t go anywhere near Momo stock right now. Spruce Point’s 70 page report needs to be addressed. Simply stating that it contains errors isn’t enough. And indeed, it is hard to research the specific allegations that Spruce Point made unless you understand the local language and culture.

Momo has an interesting business model and has reported great numbers. It’s not hard to see why investors have rushed to buy Momo stock. But I see no rush to get in ahead of earnings. As it is, Facebook’s earnings fiasco is likely to put tech stocks in the penalty box for awhile.

If you’re interested in buying Momo stock, why not wait out the tech correction? Stocks such as Momo are likely to decline as it is. And by waiting, you can see how strong of a defense Momo’s management can make to the allegations against the company.

At the time of this writing, the author owned FB stock and had no positions in the other aforementioned securities.