A Prime Example Of The Dangers Of Momentum Investing

A prime example of how momentum stocks can take the escalator up, but the elevator down!

There's something about the greed within man that loves "hot stock tips" and "getting rich quick". 

Even the timeless book, The Bible in Proverbs cautions us against "quick riches", yet people still don't want to heed that timeless wisdom. 

So they chase everything that's zipping upward, no matter what it is. They don't know (or care) if it makes money, how much cash the company has, the amount of debt they have on their books, etc. If it's going up...they're buying!

Now don't get me wrong...the stock I'm using as an example today (NVIDIA) is fundamentally sound, it was just WAY overpriced relative to its future earnings. 

In other words, the stock was grossly mispriced by the market. After all, it was a mere $24 per share in early-2016 and just a couple of years later, it's selling for almost $300 per share! Sure, it was growing earnings quickly but the stock was going up quicker than the most optimistic earnings could ever justify. 

So what happened? NVDA came tumbling down! Which reminds me: Wall Street has a saying, "Stocks take the escalator up, but the elevator down". And you'll especially find this to be true about overvalued momentum stocks like NVDA. 

NVDA fell over 50% within 30 days! That's a quick unwind. And a ton of traders and speculative investors just got badly burned. 

You see, this is how this works. The more a stock rapidly rises, the more media hype and attention it receives. Therefore, it lures in more and more participants as the stock marches higher. So at the top, there are a TON of investors that are super-bullish on the stock and can't ever see a day when it would fall. And that's about when the top is in and the massive sell-off begins which takes them by surprise. 

Why do these stocks "take the escalator" down? You see, when the trend was upward there were people that wanted to buy and some that wanted to take profits and sell. So picture a somewhat even distribution of buyers and sellers. 

But when the stock starts tanking hard, who wants to hit the buy button when it's falling like a rock? Instead, everyone wants to head for the exits at once. So picture a massive amount of sell orders, yet almost no buy orders. 

It's almost like a building burning down. Everyone wants out but no one wants in. Except in this case, it's the stock price that's going up in flames!

On top of the stock getting WAY ahead of itself, another catalyst for the stock has gotten the rug pulled out from under it. 

You see, one of the big stories is that crypto-miners were using tons of NVIDIA products to mine cryptocurrencies. Well, that was fine when bitcoin zipped up close to $20,000 per coin. But then when bitcoin crashed from near $20,000 down to $6,000, that was the beginning of the end. Why? 

It costs so much in computing power and energy costs to mine a coin that most crypto-miners need anywhere from $5500 per coin up to $7000 per coin just to breakeven. The problem? Bitcoin has recently broken a very strong area of support at the $6,000 level, and in yesterday's trading session alone...bitcoin dropped 11% to the $4800 area! 

So with bitcoin crashing to below production costs, these miners don't have any incentive to mine new coins and they certainly won't be needing to buy more NVIDIA products. In fact, if bitcoin and other cryptos stay too low for too long, you'll see many of these miners quit. And that will be even worse for NVDA since that was such a fast growing segment of their business. 

My advice would be to stay away from NVDA and other momentum stocks because they're all ripe for a massive fall like we're seeing unfold with NVDA right now. 

God bless!

Comments (1)
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wjm7605
wjm7605

I shared this story with my brother since he holds NVDA. He said he is going to wait for it to go back up since it is still fundamentally sound company. I shared with him the "rubber banding" of the overly negative sentiment when a bubble bursts.
I also shared with him that this looks a lot like MSFT from the 90's when their bubble burst. It took 16 years before it reached its former peak again:

https://s3-us-west-2.amazonaws.com/maven-user-photos/seanhyman/fundamentals/oH1aOpCEt02hT7h6FWfJ2A/dlbCmzPUO0CHGbMbGBPIbw