NEW YORK (Reuters) - Investors in some of the past year’s hottest U.S. stocks have been given a savage lesson in the risks of so-called “momentum trading”.
A group of 24 such companies compiled by Credit Suisse has lost $63 billion in market value, or almost 19 percent, so far in March. One of them, streaming video service Netflix (NFLX.O), has declined on 15 of the last 17 trading days, while another, online travel service Priceline PCLN.O, is on pace to for its worst month in nearly two years, while Twitter (TWTR.N) on Wednesday sank below its November first-day closing price for the first time since December, when the company had publicly traded for less than a month.
The sell off may well have further to go, investors warn.
For one thing, the initial public offering market looks vulnerable after King Digital Entertainment KING.N, maker of the popular Candy Crush online game, cratered on its debut, losing 15 percent in its first day of trade on Wednesday, and another 2.7 percent on Thursday. If such raisings get pulled or pared back it will likely hurt the banks’ underwriting fees.
But while it all stands as a warning to those who joined crowded trades in richly priced stocks, it is good news for short sellers who are prepared to bet against what they see as over-valued stocks, and for investors who spend their time searching for unrecognized gems trading at bargain-basement levels.
It also indicates that the investing world may be returning to more normal rules, that includes sharper assessments of the risk in different sectors, now that the Federal Reserve’s bond-buying stimulus program is being reduced and there is less “easy money” sloshing around.
“The weakness in momentum stocks does have an implication for the broader market,” said Joshua Brown, vice president of investments at Fusion Analytics in New York. “The best way to gauge general risk appetite is to look at momentum sectors.”
Investors and strategists stress that the pain in the momentum area is mostly isolated to that world. The wider stock market isn’t in the crosshairs - and some sectors are benefiting as money is switched.
“It would normally be concerning to see this,” said Frank Gretz, market analyst at brokerage Wellington Shields & Co in New York. “Instead, other companies are stepping up and new leaders are emerging. Enough is holding together that I haven’t given up on the bull market even with the leadership coming down.”
The S&P 500 .SPX is within a few percent of record levels and inflows into equity funds remain positive. Investors have moved into utilities, financials and telecom stocks.
In Credit Suisse’s analysis of the 24 stocks, all but 1 of the companies derive at least 55 percent of their present value from their future growth prospects. Essentially, they’re big bets on the future, typical of biotech and IT names.
Some of the stocks have unenviable characteristics. Servicenow (NOW.N) and Incyte (INCY.O) are characterized as “worst in class” by Credit Suisse’s proprietary analytical models - which means they’re considered low quality names with weak price momentum and pricey in value. Others, like Pandora Media (P.N), are considered “momentum traps,” that are expensive and lower-quality, but have strong momentum.
But it’s far from certain that such names have a lot further to fall. The bull market has been resilient, and that has helped stocks like electric car maker Tesla Motors (TSLA.O) weather bouts of weakness as it did in the fall of 2013, when its shares lost 40 percent before streaking again to new highs.
John Hempton, chief investment officer of Bronte Capital, a small hedge fund based in Sydney, Australia - who is also a prominent short seller - said he was loath to say that momentum had “cracked.”
“If you go back to dot-com, there were five times it cracked before it really cracked, and if you shorted each of those cracks, you got yourself carried out,” he said of the Internet stocks boom in the late 1990s and the bust beginning in 2000.
He did say, however, that he has been shorting a number of biotechnology names. Other investors, too, have been reducing their presence in the sector as reflected by a nearly 14 percent slide in the Nasdaq Biotech index .NBI since late February.
“We owned biotechs for the last year and had a wonderful ride. We sold them because valuations got stretched,” said David Kotok, chairman and chief investment officer at Cumberland Advisors.
He isn’t ready to get back in yet. “Let’s induce some fear. Let’s correct some prices. Let people start to question what to do. Then there’s a re-entry time,” he said.
In the IPO market, investors have been fed a steady diet of new public offerings from companies yet to turn a profit. More than 50 IPOs have priced in 2014, and two-thirds of those are unprofitable, according to Renaissance Capital, an IPO investment advisor.
King Digital is actually profitable but suffers from concerns that Candy Crush may be a fad.
“Candy Crush is a reminder that the market sometimes gets frothy and that this is not free money,” said Sam Kendall, global head of equity capital markets at UBS.
Hempton said he was less concerned about the technology names coming to market than the biotech shares.
“Everything that I have seen <in tech> is at least plausible that it could earn money. People are still funding projects that are real bets,” he said. “In biotech at the moment, people are funding projects because they can sell them to the stock market.”
Activity from short-sellers indicate that many do not believe the correction in momentum names has fully shaken out the group’s excess.
The 24 stocks identified by Credit Suisse have seen a slight increase in short bets in the last week, according to Markit. This group, on average, shows 18.8 percent of the shares available for borrowing being used for shorting, up 0.6 percentage points in the last week.
However, some of the names have seen shorts shaken out by periods in which they rallied. In the early part of 2013, more than 24 percent of Tesla shares were being shorted. That’s been halved as the stock has rocketed higher, boosting its forward price-to-earnings ratio to 113.
By most measures, shares are overvalued. But a full-scale retreat does not seem to be in the cards at this point. Scott Wallace, chief investment officer at Chicago-based hedge fund Shorepath Capital, has boosted his position in Facebook (FB.O) and is looking at biotechs more closely.
“It’s periods like these when you should start to think about great long term franchises and start to add to them,” he said. “I had zero exposure to biotech going into this, and now I’m doing my homework on a few of them.”
(This version corrects second paragraph to show Twitter recently closed below its first-day close for the first time since December, not ever)
Reporting by Ryan Vlastelica and David Gaffen; Additional reporting by Nicola Leske, David Randall and Tim McLaughlin; Editing by Dan Burns, Martin; Howell