Momentum continued to get beaten up today. $FB finished down 7% after buying the Oculus Rift for $2 Billion. $TWTR fell 7% in sympathy, $TSLA is down 3%. Many high flying momentum names are now below their 52 week highs by more than 10%, but it’s impossible to say whether that’s the end or just the beginning of these declines.
These steep declines are part of the natural life cycle of a momentum stock. Momentum stocks first get pushed to unrealistic heights and then eventually they drop quickly back to earth. There’s not a lot of fundamental logic applied to momentum stocks, so it’s just as hard to determine where the decline will stop as it is to know how high the positive momentum can reach. The same things that make momentum so exciting on the way up are what make it so dangerous on the way down.
Normally earnings power would provide support for a falling stock. However, in the case of momentum names, price gets disjointed from earnings as investors focus completely on growth potential. Even at today’s prices the disconnect between price and earnings is still extreme for many momentum names. For some of these stocks, prices would still have to decline by a significant amount before they fall back into the same orbit as earnings power.
Below is a chart of how much ten momentum names would need to decline from today’s prices in order to trade at 30x 2015 earnings. That would still be an expensive multiple on profits that wont be earned for another two years. Still, since many of these companies haven’t focused on attaining profitability, 30x earnings is a significant drop from here.
It may seem overly bearish to suggest that prices will fall to reflect real current earnings power, because up until now these companies have been given the benefit of the doubt that they will eventually produce profits to justify their prices. On the way up investors give that luxury, but on the way down people tend to become a little more stingy.