Momentum Stocks May Be Setting Up For A Breather

There’s little doubt that the equity markets have benefited from the recent lack of volatility. The extraordinary calm has allowed the market to continue its slow steady rise that has persisted for much of 2017. It’s an increasingly narrow market rally that has seen fewer and fewer stocks fueling the S&P 500’s gains. Apple (AAPL), Amazon (AMZN) and Facebook (FB) alone have delivered roughly one-third of the broader market’s 2017 returns.

That’s been good news for momentum, the smart beta factor that bets that stocks that have gone up will continue to go up. The iShares Edge MSCI USA Momentum Factor ETF (MTUM) has risen nearly 18% in 2017, more than double that of the size, quality or value factors.

The momentum factor has enjoyed a perfect storm of market conditions lately, but it’s worth asking if other factors are ready to begin leading again. If volatility remains muted, it’s reasonable to think that momentum could continue to extend its gains, but there are a few circumstances to consider that could point to a change in leadership.

• Rising interest rates - It looks like it’s a foregone conclusion that the Fed will raise rates again at the June meeting, but beyond that it’s anyone’s guess. If the Fed futures market is to be believed, a June hike is a near certainty with a roughly 50-50 chance of a second hike sometime in the 2nd half of the year. Some Fed members have gone on record saying three hikes in 2017 are in order while others are less sure. So far, the economic news has been good but wage growth has been tepid and lifting rates too quickly could push the economy back in the wrong direction, a scenario in which momentum stocks would almost certainly underperform.
• Political events - In case you haven’t turned on the news in the last six months, the situation in Washington is unsettled to say the least. The markets rallied following the election on the belief that Trump’s pro-growth, low regulation environment could fuel corporate America but, thus far, much of his policy change has progressed slowly at best. His health care reform bill could cost millions coverage if it becomes law. Any tax reform legislation at this point looks like it won’t come anytime in the near future. The ongoing Russia investigation and the withdrawal from the Paris climate accord have the potential to be significantly damaging economic events. Any one of these things could quickly create a volatile market environment.
• Slowing economy - The latest quarterly earnings season has been largely positive and much of the recent data suggests that the economy is in the sweet spot of steady growth, modest inflation and record low unemployment. Look a little deeper and you’ll find pockets of weakness that could signal larger problems. Home sales and building data was especially weak this month. Auto sales, which had been steadily rising since 2010, are down again in 2017 despite manufacturer incentives. This data could just be a blip or it could be seasonal. Or it could be a sign of a bigger problem brewing.

Big tech has driven a lot of the momentum ETF’s recent gains (tech accounts for one-third of the portfolio). More economically sensitive areas of the market such as financials and health care account for another 35% putting the fund at particular risk for a decline if investors begin taking risky assets off the table.

For now, the good times continue to roll but don’t be surprised if the market begins to shift later this year.