After a huge rally in 2013, momentum stocks lost some steam in 2014. The reversal can be traced back to worries over valuations, bubble fears, a pack of discouraging U.S. economic indicators in the beginning of the year, a brutal winter, geo-political concerns, slowdown in China, continued QE tapering in the U.S. and the possibility of a short-term rate hike in mid next year.
If these were not enough, the latest subdued U.S. job report signaled sluggish economic recovery dragging down high momentum or high flying stocks last Friday. Most of these stocks belong to the tech and biotech sectors listed on the Nasdaq index which tumbled 2.6% in Friday’s session. In fact, the Nasdaq saw its worst session since November 2011 in Friday trading.
Focusing on momentum plays is an investment strategy that calls for the expected continuation of an existing trend. It means that a momentum investor believes that increasing prices of a security will be pursued by added gains or vice versa thus resulting in huge investments in top performers or sharp sell-offs in poor performers.
Analysts identified excessive valuation as a culprit of these high flying tech stocks’ slump. As per Reuters, price-to-earnings ratios for some high momentum stocks are much more than the broader market.
For example, Facebook’s P/E is 92.8, Netflix P/E is 182.2 and LinkedIn’s P/E is 743 over the trailing 12-month period, while P/E for the S&P 500 is 18.6. Thus, a sharp correction in these tech stocks seemed inevitable this year.
Earnings concern may be another reason for these sharp sell-offs. Expectations for the Q1 earnings season as whole remain muted, with total earnings expected to be down -2.6% from the same period last year on 1.0% higher revenues and modestly lower margins.
On top of all of this, as following the trend for over a year, estimates for Q1 fell sharply during the quarter. For instance, the current projection of 2.6% decline in total earnings in Q1 is actually tapered from 2.1% growth projected in January.
Out of some notable sectors, Finance, Technology, Energy, Medical and Basic Materials are expected to witness earnings declines. This indicates why the market is due for a sharp correction before the earnings season (read: 3 Tech ETFs to Watch on the Microsoft Earnings Beat).