3 High Risk Trades to Avoid: China Stocks, Commodities and Momentum Investing

by: BubbleBustInvesting

by Panos Mourdoukoutas

Trading in financial markets is always risky. Investors may lose part or all of the funds committed to a particular trade. But trade in some asset classes that had a big run up in the last two years is more risky than others, as traders are exposed to events that raise the probability of large losses (e.g., the disclosure of accounting irregularities, a change in government regulations, a change in the economic environment, and a shift in momentum). Here we identify three trades that fall into this category:

  1. Buying Chinese stocks listed in the U.S. As we discussed in a previous article, buying Chinese companies traded in U.S. exchanges is a high-risk strategy, as these companies are subject to frequent changes in rules and regulations that undermine their ability to stay in business and maintain profitability. Smaller Chinese companies, especially those listed through ”reverse mergers,” are conducive to accounting fraud and manipulation. This realization prompted some discount brokers to take certain Chinese stocks off the margin list last Wednesday—resulting in hefty losses for popular Chinese companies, like Sina Corporation (NASDAQ:SINA), down 11.28 percent; Baidu, Inc. (NASDAQ:BIDU), down 3.2 percent; Youku.com, Inc. (NYSE:YOKU) down 11.35 percent; and Sohu.com Inc. (NASDAQ:SOHU), down 5 percent.
  2. Buying commodities. For more than two years, commodities had everything going their way. This is especially true for precious metals: ultra-accommodating monetary and fiscal policy, a falling dollar, a growing world economy, inflationary expectations, and soaring sovereign debt. Ishares silver trust (NYSEARCA:SLV) is up 350 percent since early 2009; SPDR Gold Shares (NYSEARCA:GLD) is up 100 percent; and Freeport-McMoRan Copper and Gold (NYSE:FCX) soared 400 percent. But the commodity rally may be over. Monetary policy is no longer ultra-accommodating, and some have raised rates (China, Brazil, and India). The dollar is stabilizing, the world economy is slowing, and inflationary expectations are tapering off. In addition, changes in margin requirements may limit the flow of funds into commodities, as was the case with cotton and silver at the end of April.
  3. Buying momentum stocks. Momentum investing is a strategy based on hype about an investment theme, a new product or a new industry that captures and captivates the investor mind-- at times when money is cheap. In the late 1990s, the theme was telecommunications and networking, with momentum funds flowing into companies like Cisco Systems (NASDAQ:CSCO), Ciena Corp (NASDAQ:CIEN), JDS Uniphase Corp (JDSU), Corning, Inc. and Ariba Inc. (NASDAQ:ARBA). Now the theme is social media and web-based companies, like Netflix, Inc. (NASDAQ:NFLX), Open Table Inc. (NASDAQ:OPEN), and LinkedIn Corp (NYSE:LNKD).

Momentum investing can be very rewarding as long as it lasts. But it can result in hefty losses once it fades away, especially for investors who got in at the top. Ten years after the momentum for telecom and networking stocks faded away, Cisco Systems is down to $15 from $70, Ciena down to $3 (adjusted for a reverse split) from $600, JDS down to $2 (adjusted for a reverse stock split) from $700, and Ariba down to $5 (adjusted for a reverse stock split) from $800!

Disclosure: I am short SLV, GLD, NFLX.