How To Profit From The End Of Momentum

“The times, they are a-changing.” 

#-ad_banner-#Watching the stock market closely over the last week brought Bob Dylan’s words to mind. The Dow Jones Industrial Average plunged over 600 points in six trading sessions, and the high-flying Nasdaq Composite Index sustained its largest drop in over two years.

What’s more, five of the 14 IPOs slated for the past two weeks postponed their launches due to the sell-off. The majority of this selling was by hedge funds slashing their risk exposure, according to The Wall Street Journal, sending shivers of fear into even the most hardened of stock market players.

This selling is different than what we witnessed in January. The January selling was triggered by the fear of a change in Federal Reserve policy and simple profit-taking. Last year’s bull market prompted many investors to simply wait until January to cash in so they could delay paying taxes on their fat gains for another year.

In contrast, the current selling appears to be a shift from high-flying growth stocks to defensive stocks. I think this selling is signaling that the smart money is starting to position itself for a flat to down stock market in 2014.

Biotechs and other high-momentum stocks like many internet/high tech names have been slammed lower — but stodgy stocks like McDonald’s (NYSE: MCD), IBM (NYSE: IBM) and Procter & Gamble (NYSE: PG) have been inching higher.

In addition, hedge funds have reduced their overall long exposure to equities from 58% to 46%, according to Credit Suisse. In the United States, net long positions are at their lowest levels since August 2012.

Most telling is that the CBOE Volatility Index (VIX), also known as the fear gauge, had soared 30% since April 2, to just over 17, before drifting back down.

Believe it or not, this is great news.

Savvy investors welcome this shift for two primary reasons. First, it may allow stocks to be purchased at a sharp discount from their recent heady highs. Second, investors can profit from the fear by shorting stocks. 

One of the most amazing things about the stock market is it really doesn’t matter which way it moves — active investors can still make money. While many passive investors are trapped in long-only mutual funds and similar products, active investors retain the flexibility to capture profits in both bullish and bearish markets.

I expect the markets to continue downward, closing the year flat or lower. This will be my bias until the market proves it wrong — namely, until the major indices take out the all-time highs. 

I’m not yet expecting a sharp plunge or crash from here — just a slow drift downward into the fall months. This certainly doesn’t mean stock will not rally during the slow grind downward. They certainly may — but the edge will be shorting any sharp rallies.

Obviously, in these conditions, searching for shorting opportunities in the previous high-flying momentum stocks makes sense. 

My favorite short play in these conditions is to short the iShares MSCI USA Momentum Factor ETF (NYSE: MTUM). Built on mid- and large-cap momentum stocks, MTUM is down almost 4% for the year. Containing 125 stocks that exhibit higher momentum characteristics than the overall market, this ETF is composed primarily of the same stocks that hedge funds are in the process of dumping.

Source: BlackRock

Launched last April, the ETF is relatively new, but it has grown to nearly $195 million in net assets, representing a portfolio with a total market cap of $3.8 trillion. Due to its composition, I think MTUM will continue to be pressured downward even if the overall market regains its footing.

Risks to Consider: Shorting is dangerous since it goes against the inherent upward drift of stocks. It can be very lucrative since markets often sell off faster than they climb higher. While I expect this shift away from the momentum stocks to continue, it’s important to note that the fundamentals supporting the overall stock market remain intact. Always use stop-loss orders and diversify when investing. This is particularly critical if you have short positions.

Action to Take –> Shorting the MTUM ETF within the channel makes good investing sense right now. Remember to expect updrafts in price on the way to the targeted $51. I will remain confident in the position until the stops at $61.50 are hit.

P.S. An eccentric Texas woman who dodged the 2008 financial collapse says the market is ripe for a pullback. This is the same analyst who’s produced annual returns of up to 510% and has picked winning investments roughly 85% of the time. To learn how she’s protecting her portfolio today, click here.