"The trend is your friend."

So say the momentum traders, the action junkies, the rocket-stock aficionados. When a stock is going up, they posit, you should buy, because stocks have momentum. If they've gone up in the past, they tend to keep going up. But is that really true?

In his classic text on the advantages and disadvantages of various investing strategies, Investment Fables, Professor Aswath Damodaran of the Stern School of Business at NYU states his doubts. After crunching the numbers, he concludes that while it's true in general that a stock that has been going up keeps going up, "timing can make the difference between success and failure" when you trade on momentum.

When a stock rockets on a better-than-expected earnings release, for example, seconds can count. Good news can spark a nearly instantaneous rise in price, and the profits go only to the quickest mouse-clickers. Gun-shy traders face a different problem. Stocks that have risen for six months straight tend to continue rising for a while -- but if you wait six months to identify the "trend," you have by definition foregone all the profits to be made whilst the trend was forming.

In short, momentum trading is risky. Citing statistical data, Damodaran further explains that: "Momentum stocks have an average beta almost twice that of the rest of the market ... and are much more volatile."

What goes up ...
But why is this true? Why don't momentum stocks keep to their trajectory?

They're powered by momentum traders who buy in in hopes of catching an early trend. To "get in on the action," they bid higher and higher prices, pushing up the stock's asking price.

The problem is that this process works both ways. Traders who buy a stock because it's going up may quickly turn around and abandon the stock when it stalls. At that point, a tidal wave of selling starts. Sellers, desperate to get out of the stock, will offer to sell it for progressively lower prices, forcing the price downward.

... must come down
Last month's implosion of hedge fund Amaranth provided a perfect example of how momentum can turn on a dime. Star natural-gas trader Brian Hunter made boffo profits investing in natural-gas futures as the price rose, but as reported by The Wall Street Journal, his gains were by and large "paper profits." After making a winning trade, rather than take cash off the table, Hunter spent his "paper" winnings to buy even more futures contracts. Because of the size of his trades (Amaranth reportedly took positions 10 times larger than those taken by better-financed players such Goldman Sachs (NYSE:GS)), Hunter's successive purchases helped to support the prices on the contracts he already owned -- he was both creating and profiting from the momentum.

Situations such as the one Amaranth created -- situations in which momentum stocks thrive -- are inherently unstable. And once the upwards cycle stalls, as it inevitably does, the plunge is swift and painful. In Amaranth's case, the latest damage report puts the fund's losses at $6 billion.

Good news (for the alert)
The good news? Unlike hedge funds, with their limited oversight and opaque disclosures, momentum stocks give investors a clear warning sign before they collapse: a ridiculously high P/E ratio. Let's take a look at a few famous bubble-era names; see if you can spot the pattern:

P/E in March 2000

Current P/E ratio

Decline in price*

Applied Materials (NASDAQ:AMAT)

104

21

(58%)

Cisco (NASDAQ:CSCO)

237

26

(64%)

Nokia (NYSE:NOK)

122

16

(56%)

Oracle

183

26

(54%)

Schwab (NASDAQ:SCHW)

104

26

(44%)

*March 15, 2000, to Oct. 3, 2006.
All data courtesy of Capital IQ, a division of Standard & Poor's.


It doesn't necessarily take a triple-digit P/E ratio to confirm that a stock is "priced for perfection." I should also emphasize that a high P/E doesn't mean a company is bad. In fact, at Motley Fool Stock Advisor, we recommended one of the companies named above -- at a fraction of the price it sold for in March 2000. But when you see triple-digit P/E, take heed. It's a flashing warning light, and it reads: "DANGER! Buy at your own risk."

History repeats itself
Momentum stocks exist in all markets, today's included. For example, running a simple screen for triple-digit P/E ratios on highly valued companies, I quickly identified two candidates to be wary of in today's market: on-demand software provider Salesforce.com (NYSE:CRM) and Internet search engine Baidu.com (NASDAQ:BIDU). Each stock flashes the telltale warning of a triple-digit P/E. And even if the firms achieve the growth rates analysts project for them (50% and 63% per year, respectively), they still appear grossly overvalued. At these prices, it won't take much of a stumble to send either company's stock plummeting back to reality.

We may be Fools, but we aren't crazy. To make it into our Stock Advisor portfolio, a company needs some substance to it -- and preferably a down-to-earth price. We think anyone armed with basic math skills and a little common sense can profit handsomely by buying great businesses at reasonable prices -- and we've proven this by beating the market 60% to 21% over the past four years. If you'd like to share in our success, and avoid a portfolio blowup, you're welcome to try the service out for one full month, free of charge. To get started, click here now.

Fool contributor Rich Smith has no position in any of the companies mentioned in this article. If he did, The Motley Fool would require him to tell you so. We're sticklers about things like that. Charles Schwab is a Stock Advisor recommendation.