Low-Quality Momentum Stocks Soar: Are Markets too Frothy?

Stocks Mixed: Tariffs, Earnings Season, Powell’s Future Dominate the Headlines

Stocks are mixed thus far this week amid a flurry of trade policy headlines, the start of earnings season, and rumors about Fed Chair Jerome Powell’s future. Last night, President Donald Trump announced that a deal had been signed with Japan. Japan will invest $550 billion in the US (of which the US will receive 90% of the profits). Additionally, the US will levy a 15% tariff on Japanese goods. President Trump’s August 2^nd trade deadline is approaching quickly for the countries that have not yet signed deals with the United States.

That said, Treasury Secretary Scott Bessent has promised that there are several trade deals likely to be signed in the current days, and for larger deals like the EU, the August deadline is flexible, reiterating that the US would rather wait longer for better deals than rush them. Meanwhile, stocks flushed lower midday Tuesday after a fake rumor surfaced that embroiled Fed Chair Jerome Powell had been fired. Powell has been facing an onslaught of criticism amid his ‘hawkish’ monetary policy. However, many rate-sensitive areas have rallied over the past few days, including housing stocks and small caps, signaling that rate cuts may be on the horizon.

Are Momentum Stocks Signaling Short-term Market Froth?

While the price action of the major indices remains bearish, momentum stocks signal that it may be time for Wall Street investors to take their foot off the gas pedal. Below are four reasons:

·       Signs of frothiness appear amid rallies in heavily shorted “retail stocks”: One sign of an overheated market that I have witnessed over the years is when “junk off the bottom” starts to rally. That is, cheap, beaten-down, heavily shorted, unprofitable stocks begin to rally. For instance, OpenDoor Technologies (OPEN) ripped as much as 500% this month. Meanwhile, similar, heavily-shorted and beaten-down stocks like Krispy Kreme (DNUT), Beyond (BYON), Kohls (KSS), and Beyond Meat (BYND) are experiencing relief rallies.

·       Options speculation frothiness: Additionally, “0DTE” (zero days until expiration) options now account for around two-thirds of all daily options volumes. Such froth suggests that retail investors may have a case of “irrational exuberance” in the short-term.

·       Gravity: The S&P 500 Index has trended above its 20-day moving average for roughly two months. Historically, gravity takes hold at this juncture, and stocks are due for some profit-taking.

·       Back half of July seasonality: Since 1950, the S&P 500 Index has been strong in the first half of July before paring gains in the back half of the month.

Markets Can Stay Irrational

As the old Wall Street adage goes, “Markets can stay irrational longer than you can stay solvent.” The clues above do not mean to sell everything or to go short, but instead be aware that the music can stop at any moment, and risk management is warranted.

Bottom Line

Signs of ‘irrational exuberance’ are emerging in US stock markets as low-quality momentum stocks squeeze shorts and rampant short-term options trading proliferates.

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This article originally published on Zacks Investment Research (zacks.com).

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