Momentum stocks tap the brakes — what does it mean?

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Recent weakness in momentum stocks and highflying sectors such as biotech has raised concerns that cracks are developing under the surface of major U.S. equity indices such as the S&P 500.

Monday’s sell-off in high valuation, momentum-driven names “is significant, for it is the market resetting valuations along a host of still developing changes to expectations,” said ConvergEx Group analysts in a note.

For example, investors are positioning for interest rates to rise sooner than expected following a press conference last week with new Fed chair Janet Yellen. She said rates could rise “around six months” after the central bank completely winds down its asset purchases.

However, it may be too early to tell if the worm is turning for momentum stocks. Still, equity investors now believe that interest rates will move modestly higher in the next year, ConvergEx said.

“That lowers the value of businesses where the payoffs are more distant, whether they be an electric car company or a smaller biotech name. Also, price volatility is increasing, so portfolios with defined risk parameters must sell down their juicier names to manage value-at-risk,” the analysts wrote.

“Finally, first quarter earnings season is scarcely three weeks away, and high valuation names invariably come with high expectations; no one wants to be left holding the bag on a revenue or bottom line miss,” they added. “All this means one thing: rotation to names with lower volatility until the reset is complete. Given how far many momentum names have run in recent months, this process could last weeks rather than days.”

In particular, the recent pullback in iShares Nasdaq Biotechnology ETF (IBB) has attracted attention because the biotech sector has been such a strong performer, gaining more than 60% last year. Trading volume in the biotech ETF jumped during a two-day sell-off.

Investors are also keeping an eye on other stocks and sectors exhibiting price momentum, such as Tesla (TSLA), Facebook (FB) Netflix (NFLX) and Guggenheim Solar ETF (TAN).

“These are all stocks that have had enormous gains over the last year; those are high-valuation stocks, and when you talk about a risk-off trade where people are withdrawing capital from riskier areas, that where people pull from first, stocks that have had significant run ups,” said Matthew Kaufler, portfolio manager at Federated Investors, in a Reuters report.

The momentum stocks of recent months have been hit hard lately, “action which is not indicative of a healthy market,” said Tarquin Coe, technical analyst at Investors Intelligence.

More volatile high-beta stocks have been leading the way over the past year, a sign that investors are comfortable with taking on risk.

The chart below shows the relative performance of the PowerShares S&P 500 High Beta Portfolio ETF (SPHB) versus the S&P 500. When the chart is rising, it means high-beta stocks are outperforming.

Yet in March, defensive sectors such as utilities and consumer staples have been among the best performers.

“There continues to be some selling pressure in what are typically regarded as higher beta segments of the market as we head into quarter’s end. In short, it feels like managers are ‘selling the winners,'” said Paul Weisbruch at Street One Financial. Along with weakness in Global X Social Media ETF (SOCL) and tech stocks in general, he reports outflows in ETFs tracking biotech and high-yield corporate bonds. Conversely, Financial Select Sector SPDR ETF (XLF) has experienced inflows lately, Weisbruch said.

On Monday, many of the stocks involved in the sell-off have fast revenue growth, minimal profitability and recent outsized returns, according to ConvergEx Group.

“It’s all fun and games with volatility until someone loses an eye. When momentum stocks are rising, they have higher-than-average volatility and no one cares. Pullbacks are brief, the brave buy more, and then it’s off to new highs. But when that smile turns upside down, a different dynamic takes hold,” the analysts wrote.

“The bottom line is that the selloff in momentum names isn’t the mindless change in direction of a herd of wildebeest on the African plains. There are fundamentals at work: changes in interest rate forecasts, higher organic volatility, and near term catalysts,” they said. “Therefore, expect more of it through the end of the quarter. This doesn’t mean overall market levels will decline as precipitously as these names; there will be more rotation into sectors like financials which benefit from a steeper yield curve, just to call out one example.”

Some portfolios on Covestor’s investing marketplace designed to potentially limit volatility include Risk Protection Multi-Manager Portfolio and Low Beta Portfolio.

To learn more about our emerging portfolio managers and Covestor’s services, open a trial account.

Photo Credit: jurvetson

DISCLAIMER: The investments discussed are held in client accounts as of February 28, 2013. These investments may or may not be currently held in client accounts. The information in this material is not intended to be personalized financial advice and should not be solely relied on for making financial decisions. All investments involve risk, the amount of which may vary significantly. Past performance is no guarantee of future results.