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What Do Weakening Momentum Stocks Mean for the Market?


Momentum stocks and IPOs have performed poorly recently, leaving investors worried that the market could begin to sell off.

Weakness in both momentum stocks and the IPO market could drag US equities off of their highs in coming months. Stocks such as Tesla Motors Inc (NASDAQ:TSLA) and Netflix, Inc. (NASDAQ:NFLX) have been responsible for keeping investor sentiment elevated, even in times of uncertainty. Similarly, the success of highly anticipated IPOs -- as seen with Twitter Inc (NYSE:TWTR) and Potbelly Corp (NASDAQ:PBPB) -- has kept the market optimistic that valuations still have room to grow. Now the questions is, however, what do investors do when both of those aspects of the market begin to weaken?

A relative strength indicator has been constructed below comparing an index of momentum stocks vs. the SPDR S&P 500 ETF Trust (NYSEARCA:SPY) over the past year. The indicator was on a steady uptrend throughout 2013, but suddenly began to weaken at the beginning of 2014. The consistent rise of momentum stocks led to a sort of exponential rise in US equities during the past year. What is even more impressive is that the move was done in the face of fears the Federal Reserve would tighten monetary policy, and concern that the market was reaching new highs repeatedly without any sign of pullback.

Meanwhile, highly anticipated IPOs had great showings on their first day as public companies, proving that investors still had a healthy appetite for risk. IPO research firm Renaissance Capital said that the average IPO showed a return of 30% in the third quarter of 2013. It also reported that there were 152 IPOs through the first three quarters of last year, an activity level comparable to the one seen during the tech bubble. This trend, however, has not kept pace in 2014.

King Digital Entertainment PLC (NYSE:KING), maker of the popular game Candy Crush Saga, sharply dropped during its IPO in March. King's IPO was the largest US tech IPO since Twitter, and is the worst-performing one of the new year, souring investor sentiment. The drop has been a difficult reminder that a company going public doesn't automatically mean free money, especially when there are fears that the broader market is overvalued.

The sudden loss of interest in both momentum stocks and hot IPOs signals that investors may be rotating their capital into more defensive names, leaving the market vulnerable at record highs. Utility stocks have outperformed US indices the past few months, a trend that occurs when investors are looking for safety. Issues in developing economies and geopolitical risks in Russia are partially the reason for utility sector strength, but weakness in momentum stocks and IPOs has also played a part. Investors are indicating that they are satisfied with slow growth and a steady dividend, as opposed to, say, the roller-coaster ride that has been biotech stocks recently.

Ultimately, the shift away from riskier investments does not predict that equity markets will soon correct lower. Rather, risk just happens to be out of favor after more than a year of leading the market higher. The rotation could mean that stocks consolidate and begin the next uptrend on a valid catalyst, but it also wouldn't be a surprise if US equity indices fell by 10%, giving investors the chance to take profits that they have been desperately looking for.
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