Momentum Stocks: Caution Ahead

The recent pickup in volatility is a useful reminder of the risks lurking in one area of the market: momentum stocks, both traditional ones and some less obvious “momentum” names.

As I write in my new weekly commentary, “Stocks Struggle as U.S. Economy Continues to Disappoint,” while volatility remains below the long-term average, it’s on the rise in both the stock and bond markets. This is due to somewhat mundane issues, including slower economic growth, disappointing earnings and anticipation of an eventual rate hike by the Federal Reserve (Fed).

Amidst this increasing volatility, stocks that are the most expensive and have been driven by momentum (i.e. the expectation that increases will be followed by additional gains and vice versa) have been the hardest hit.

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One case in point is biotech. Biotech is an obvious example of the momentum trade. It is a high “beta” or risky industry that has been a strong relative performer for many years. Through the close of the week ended March 20, the Nasdaq Biotech Index had surged 20% year-to-date. The following week, despite a relatively modest pullback in stocks, the Nasdaq Biotech Index fell roughly 5%.

But there also are less obvious momentum names. As I’ve pointed out recently, yield plays– such as those in the utilities sector – were some of the best-performing stocks last year. While investors don’t typically think of these stocks as “momentum” names, their relative valuations are stretched. In addition, like biotech, they have benefited from a steady inflow of money and warrant caution.

The bottom line: While an uptick in volatility doesn’t herald an end to the bull market, it does imply that investors may want to revisit their investment positioning and exercise more caution toward momentum plays of all shapes and sizes.