Tuesday, December 7, 2010
Performance chasing is a dangerous game. Yet nearly everyone on Wall Street plays it this time of year. Their bonuses depend on it.
Hedge-fund traders, mutual-fund managers, pension-fund managers, and even your local stock brokers plow client money into stocks like Chipotle Mexican Grill (CMG), Apple (APPL), and Netflix (NFLX) because those are the stocks that have gone up all year. They're the stocks that have posted huge gains. And they're the stocks momentum traders will jump into over the next three weeks in an attempt to boost their yearly results and justify the fees they charge clients.
After all, an object in motion tends to stay in motion. And a stock on a momentum roll tends to stay on a momentum roll. So traders pile into the trades and the stocks shoot even higher.
A stock like Chipotle, which at $241 per share trades at a whopping 45 times earnings, could rally another 20 points by the end of the year… and trade at 50 times earnings. That's the power of the year-end momentum trade. So you want to be careful trying to short these stocks at this time of year.
Short sales probably won't work too well.
But going into the new year, momentum fades. Stocks that were Wall Street darlings one year rarely repeat that performance the next. So momentum stocks get sold. Money managers dump the high fliers and start hunting for value.
All of a sudden, a turbo-charged taco cart isn't worth 50 times earnings. Momentum traders are selling. Value investors are nowhere to be found. And the stock gets hammered.
That's the risk. When a momentum trade hits a brick wall, it happens instantly and without warning. One day the stock makes an all-time high, the next day it's down 20% or more.
There's nothing at all wrong with the companies. Chipotle, Apple, and Netflix are all well run, profitable businesses. But the traders are pumping their values up to levels that just don't make sense.
Think about it… If you were interested in buying a Mexican food restaurant, would you be willing to wait 45 years to get your original investment back?
Yes, I know Chipotle has a high earnings growth rate, which lessens the payback period. But we're still talking about paying a huge price for a burrito vendor.
Any rational mind has to struggle with the idea.
Between now and the end of the year, however, momentum traders are running the show. So the high flying stocks are likely to move even higher. Betting against them could be painful. Nimble traders might make a few bucks buying the momentum names on any pullbacks.
But we're not too far from the point where momentum trades start to implode. It seems to happen earlier every year. And that's where the real money is made. Shorting high priced stocks just before momentum traders rush for the exits is a tremendously profitable endeavor.
I'm on the sidelines of this trade right now. That's a good place from which to watch the show.
There's probably some upside in the momentum stocks for the next couple weeks. But investors would be playing a game of Russian Roulette. The risk far outweighs the reward.
Instead, I'm looking for a good spot to short the stocks and profit on the downside.
You need to be patient here. I'll let you know when the timing is right.
Best regards and good trading,
In this classic Growth Stock Wire essay, Jeff reveals a foolproof, three-pronged approach to betting on a stock falling, also called "shorting." Using this method, he has earned his readers enormous gains for over four years. Get in on his secrets here: My Strategy for Successful Short Selling.
"Anyone who has been on the wrong end of a short squeeze knows the pain of being run over by a crowd of stampeding bears as they rush to cover a bad trade," Jeff says. Make sure it never happens to you here: The Only Safe Way to Profit on a Short Squeeze.
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