(Bloomberg) -- The sharp selloff in momentum stocks may be nearing its end, creating an opportunity for investors to start rebuilding positions in artificial intelligence and semiconductor shares, according to UBS' trading desk.
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Hedge funds have already started to unwind long positions in momentum and semiconductors stocks by about 5% of gross market value, one of the largest reductions on record, according to UBS' prime brokerage data. That has left net positioning in semiconductor and software stocks back at April levels.
Despite the pullback, improving AI fundamentals are a signal to buy the dip, Michael Romano, head of hedge fund equity derivative sales at UBS, said in a note to clients. But he advises investors to gradually enter into positions rather than rush back all at once. Momentum strategies involve buying winning stocks and shorting the biggest losers.
"The momentum de-risk was and remains a conviction call," Romano wrote. "Scaling into a position is prudent."
UBS' basket of momentum stocks includes Sandisk Corp., Broadcom Inc., Oracle Corp., KKR & Co. Inc., Datadog Inc. and Microsoft Corp., among others.
Romano noted that positioning is becoming increasingly supportive of a rebound in such stocks. However, a recovery in AI and momentum shares could come at the expense of recent market leaders. UBS' prime brokerage data indicate that much of the recent buying in banks, industrials and other cyclical stocks reflected short covering rather than new long positions, suggesting those sectors could retreat as investors rotate back into AI-related stocks
Meanwhile, UBS' basket of software stocks has climbed about 20% since the end of June, underscoring how sensitive these names remain to positioning shifts, according to Romano.
He expects the momentum unwind to bottom by the end of July, if it hasn't already. Supporting that view, UBS' gauge of momentum staged a dramatic intraday reversal on Friday, swinging from a 3.5% loss to a 2.5% gain in just two hours.
"I'd expect a liquidity bubble to the upside when things turn," Romano wrote.
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