Technology stocks, once the darlings of Wall Street, are now facing intense investor scrutiny. Over the last three months, key tech stocks, such as Twitter (TWTR), Netflix (NFLX), and Amazon (AMZN), experienced significant declines in their stock prices. Twitter is down more than 44%, Netflix is down nearly 20%, and Amazon is down about 17% (all since March). Investors wonder why these stocks, which have for the most part defied common trading theory, are just now beginning their rapid descents, also known as price “corrections.” I believe that the recent collapse of these stocks can be partly attributed to momentum investing strategies, as well as a series of financial issues inherent within each of the companies. In this article I will explain momentum investing strategies and “momentum stocks,” and their effect on the integrity of the stock market.

What Is Momentum Investing?

Momentum investing is based upon trends. Investors employing a momentum investing strategy believe that if a stock is “hot,” having performed positively over a recent time period, it will inevitably continue to do so into the near future; the same holds true for “cold” stocks. The principal idea is that once a stock drifts in a certain direction, it is more likely to continue in said direction than it is to veer off into the abyss. Momentum investors attempt to monetize these trends by buying, or selling, at times where companies’ stock prices largely diverge from their fundamental valuations. Because of this, momentum-investing strategies are often based on a short-term buying and selling procedures; thus, I advise new investors to avoid momentum-based investment strategies until they have the required trading skills to adequately approach them.

What Is A Momentum Stock?

In today’s market, the term “momentum stocks” refers to popular tech companies such as Netflix and Twitter. These stocks are traded at high volumes and, therefore, reflect investor outlooks more so than other stocks. The prices of these momentum stocks are driven by investor manipulation: buying during upward trends and selling during downward trends. Therefore, the magnitude of a stock’s price fluctuation tends to signify the scale of current market momentum. Furthermore, large selloffs or purchases of specific companies can lead to sector momentum, in which a particular industry, such as social media, rises or falls as a whole.

How Does Momentum Investing Affect The Stock Market?

Momentum investors buy and sell stocks after analyzing a company’s individual performance, rather than the performance of a sector, or of the market, as a whole. In addition, momentum investing often ignores important financial indicators such as the price-to-earnings ratio (P/E) of a stock. P/E ratios are used to gauge confidence in a company’s future growth prospects, as well as to establish a standard of comparison for companies in the same industry. In the case of momentum stocks, P/E ratios are often inexplicably high. For example, during Twitter’s recent crash, its shares were trading at 323x forward earnings per share, whereas the market average is about 20x. Thus, momentum investing often leads to the overvaluation of a company’s stock price, in respect to its earnings. Additionally, as I previously explained, since momentum investors follow similar trends, any large price changes are important to quickly identify if you wish to make money. Once a stock breaks equilibrium, investors will continue to push its price higher or lower, depending on the circumstances (hence the integral “momentum” aspect of trading). The aforementioned tech momentum stocks, Twitter, Netflix, and Amazon, are members of the NASDAQ. However, other indices contain momentum stocks too, and whether you like it or not, the performance of the market can be directly tied to how momentum stocks, and sectors, perform on a daily basis.