The taper could affect momentum stocks like Keurig Green Mountain

On top of the mountain, again

The below graph reflects the performance of a highly traded momentum stock, Keurig Green Mountain. This stock attracted tremendous speculative attention in 2011, as its price skyrocketed from $20 per share to over $100 per share in less than a year. That was an extremely attractive investment return, though if traders didn’t sell at the peak in 2011, they ended up giving it all back in 2012. This article considers the risks associated with investing in high momentum stocks in the current environment of declining Fed bond purchases.

For an overview on these risk factors, please see Key strategy: 4 key risk factors as the Fed tapers.

Dance to the music—but keep one eye on the exit sign

It’s hard to avoid the temptation of easy money, which appears to be there for the taking when new concept stocks with new business models have skyrocketing returns. Keurig Blue Mountain is one of these opportunities. Theory says that investors—on average—can’t time the market. This would suggest that—on average—Keurig Blue Mountain investors made as much as they lost when the stock rallied, then collapsed. That’s a simple mathematical identity. However, the question remains whether or not the day traders, trading momentum, fared much better than passive investors, or investors focused in company size, or value versus growth considerations.

Momentum in general

The market-neutral Dow Momentum index might suggest that momentum traders simply make money while momentum is positive and give it back when momentum exposure turns negative. As the graph points out, momentum investors probably felt that they had invested the money printing press from 2004 through 2009, when momentum exposure led to ongoing gains. From 2009 through 2010, adherence to the same momentum allocation strategy would have meant then within one year, they gave it all back—just like Keurig Green Mountain in 2001 through 2012.

Looking forward—rate shock?

Perhaps momentum exposure will continue to generate positive returns, as it did from 2004 through 2009. Perhaps short-term traders will continue to push Keurig Green Mountain to even higher new highs. However, as the graph suggests, this type of strategy brings with it tremendous risks of drastic losses when the momentum factor in general collapses, or when stock-specific momentum, in the case of Keurig Green Mountain, fails as it did in 2011.

For a more in-depth analysis of the four factors noted in this series, please see Key strategy: 4 key risk factors as the Fed tapers.

Equity outlook: Constructive macro view

Despite problems in Ukraine and China, and despite the modest consumption data in the USA, U.S. labor markets appear to be well into recovery—with the exception of the long-term unemployed. From this perspective, it would appear that the U.S. is probably the most attractive major investment market at the moment. While the fixed investment environment of the U.S. is still quite poor, corporate profits and household net worth have hit record levels. Hopefully, all of this wealth and liquidity can find their way into a new wave of profitable investment opportunities and significantly augment the improvement in the current economic recovery. For investors who see a virtuous cycle of employment, consumption and investment in the works, the continued outperformance of growth stocks over value stocks could remain the prevailing trend, favoring the iShares Russell 1000 Growth Index (IWF) and growth-oriented companies such as Google (GOOG) or Apple (AAPL).

Equity outlook: Cautious macro view

Given the China- and Russia-related uncertainties, investors may wish to consider limiting excessive exposure to broad equity markets, as reflected in the iShares Russell 2000 Index (IWM), the State Street Global Advisors S&P 500 SPDR (SPY), the Dow Jones SPDRs (DIA), and the iShares S&P 500 (IVV). Accordingly, investors may wish to consider shifting equity exposure to more defensive consumer staples–related shares, as reflected in the iShares Russell 1000 Value Index (IWD), such as Walmart (WMT).