Momentum investing has been a popular strategy on Wall Street, especially at times when money is cheap, and new investment themes hype investor imagination. The strategy can be very rewarding for investors who catch the train early, and leave it on time, before momentum turns in the wrong direction. But it can be very costly to investors who catch the train late, after the momentum shifts.
Coal and iron ore stocks like Walter Energy (NYSE:WLT) and Cliffs Natural Resources (NYSE:CLF) are two cases in point. Back in early 2011 both stocks were heading for the moon. Investors couldn't get enough shares of the two companies hyped by analyst reports that predicted an ever-saturated demand out of China. The rest is history. Today, both stocks trade at a fraction of their early 2011 levels, and analysts are rushing to downgrade the two companies. Last week, Morgan Stanley cut Cliffs Natural to "underweight" from "equal wait," with whatever that means after the sharp correction in the price of the stock. But how can investors detect momentum shifts? What are the warning signs? What happens to the stocks once momentum shifts?
Qtrly Revenue Growth (yoy)
Qtrly Earnings Growth (yoy)
Momentum stocks have one thing in common: High growth. For a while, quarterly revenue growth beats investor expectations, stirring and hyping their enthusiasm. Eventually, the time comes that growth slows, failing to meet investors' expectations, setting the stage for a shift in momentum - just take a look at the growth rates of the two stocks. But what causes this growth slowdown?
In "How the Mighty Fall," Jim Collins identifies five signals -- stages of decline: Hubris Born of Success, leadership becomes arrogant, as it considers success an entitlement - stock heads to the moon as investors chase after the stock; Undisciplined Pursuit of More, reckless behavior sets the company at great risk - stock continues to climb; Denial of Risk and Peril, failure of leadership to recognize and address risks - stock peaks; Grasping for Salvation, a sharp decline visible to the public - investors flee in all directions-stock falls sharply; and Capitulation to Irrelevance or Death - growth declines - stock out of favor.
The rise and fall of telecommunications and networking stocks in the late 1990s and the early 2000 is the case in point. After almost a decade of fast growth, the leadership of Cisco Systems (NASDAQ:CSCO), Ciena Corp (NYSE:CIEN), JDS Uniphase (JDSU), Corning (NYSE:GLW), and Alcatel-Lucent (ALU) became complacent and arrogant with success, setting the stage for the eventual slowdown and downfall to irrelevance.
More recently, the rise of U.S. momentum stocks like Netflix (NASDAQ:NFLX), OpenTable Inc. (NASDAQ:OPEN), Molycorp (MCP), and Lululemon (LULU) seem to follow the same pattern - though for Netflix, Open Table, and Molycorp the momentum has already shifted; the same may be true for a number of Chinese momentum stocks like Youku.com Inc. (NYSE:YOKU), Sina Corporation (NASDAQ:SINA), Baidu, Inc. (BIDU), E-Commerce China Dangdang Inc. (NYSE:DANG), Renren Inc (NYSE:RENN) and Sohu.com Inc. (NASDAQ:SOHU) seem to follow the same pattern.
In almost all cases, once momentum shifts hot stocks rarely come back. Just take a look at the prices of Cisco, Corning, and Alcatel-Lucent. That's why I'll stay away from the stocks of Cliffs Natural and Walter Industry until I see promising signs that corporate growth returns.
Disclosure: I am long GLW. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.