Danger Zone: Momentum Investors And The Financial Sector

Check out this week’s Danger Zone Interview with Chuck Jaffe of pay $410 million to settle accusations of illegal activity in California electricity markets. That settlement is the largest ever reached with the Federal Energy Regulatory Commission since it received new powers in the wake of the Enron Corp. fiasco.
 
High Volume Momentum Stocks Suffer
As regulators close the loopholes that allowed for these illegal activities, many others (besides those being fined and prosecuted) will suffer.
 
For one, momentum investors who piggybacked institutional trading trends to bag quick profits on high volume run-ups will be out of luck. These high-flying momentum stocks present long-term risks that have been routinely ignored over the last decade by investors who have have become addicted to the illusion of quick and easy profits. As the trading volume from the Wall Street players dries up, a lot of the hot air in momentum stocks will disappear. Rapid upward price movements will be less frequent while many high-flying stocks drop to earth.
 
For examples of large investment firms propping up stock prices and fueling large moves, see my recent Danger Zone articles on InnerWorkings (INWK) and Tangoe (TNGO). Both stocks had heavy institutional ownership and rapid upward price moves driven by Wall Street propaganda and momentum traders. Soon after we revealed how disconnected the price moves were from the companies’ fundamentals the stocks fell 30+%.
 
Big broker-dealers, even the divisions not under investigation, will suffer as well. Many of these companies’ activities, like equity research, were tied to and subsidized by the outsized profits from illegal activities. As those funds dry up, so do the businesses that relied on them.
 
Declining trading volume also hurts revenues. High volume traders are lucrative clients for these brokers, and they won’t like losing them. Even after SAC plead guilty, Bank of America (BAC) JPM, and GS continued to do business with the hedge fund. They need to keep that business to keep profits up.
 
Smaller trading firms could suffer as well. E*TRADE (ETFC) and Scottrade depend heavily on commissions and transaction fees for their revenue streams. ETFC swung to a loss in 2012 largely due to an 11% decrease in commissions and fees due to declining trading activity.
 
Return to Value Investing
Momentum strategies have become increasingly crowded in recent years, but that trend is on a decline. Closing the loopholes for illegal trading and market manipulation means the big hedge funds and banks have less means to  stoke the volume for momentum trades. Recent results from E*TRADE show that individual investors are trading less frequently.
 
As it becomes harder for institutional investors to beat the market illegally, it will become harder for individual investors to profit from piggybacking off those trades. When this happens, investors large and small will need to find another way to generate returns.
 
I see a return to value investing coming for the market. We know from Warren Buffet and others that, when done right, value investing can deliver large returns. Though not as sexy as momentum trading, value investing brings peace of mind and long-term trust in one’s decisions. Given all the turmoil and treachery we have seen in the markets, I think investors are ready for some peace of mind and will look increasingly to advisors and strategies they can trust.
 
Sam McBride contributed to this article.
 
Disclosure: David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, or theme.

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Written By: David Trainer