Return of Meme Stock Mania Has Traders on Alert for Market Froth

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(Bloomberg) -- The reemergence of meme stock mania last week has professional investors facing a quandary: ride the excitement of retail traders or take it as the latest warning sign that the frothy markets are due for a pullback.

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The speculative stocks caught up in the frenzy this week, like Opendoor Technologies Inc. and Kohl’s Corp., gave up some of their gains as the week went on, but most are still trading at their highest levels in months. The broader S&P 500 Index and Nasdaq 100 Index are doing even better, sitting at all-time highs after charging back from the early April selloff set off by President Donald Trump’s tariff announcements.

There are indicators that investors are abandoning restraint and betting on further gains. The amount that investors are borrowing to buy stocks on the New York Stock Exchange, known as margin debt, has exceeded the tech-bubble highs to reach a new record, according to data from the Financial Industry Regulatory Authority.

But signs of fatigue are creeping in. The latest meme stock rally seemed to lose steam after just a few days, and Bitcoin, one of the most visible symbols of the speculative fever, has recently fallen back from its record highs. Some Wall Street trading desks have been urging clients to scoop up discounted protection against possible losses. The current run has stretched valuations, with the S&P 500 trading at nearly 23 times forward earnings, well above the ten-year average of around 18, signaling that stocks have gotten significantly more expensive.

“I’m seeing it and just starting to just tuck my horns in a little bit,” said Eric Diton, president and managing director of the Wealth Alliance. “I’m longer-term bullish, but I’m just short-term cautious. I really think we’re overdue for some kind of a pullback again because of the excessive speculation.”

For help in navigating the volatility, some market watchers are looking for comparisons with the most famous meme stock moment back in January 2021, when GameStop Corp. and AMC Entertainment Corp. captured the world’s attention.

That buying was fueled by retail traders who were flush with stimulus checks and stuck at home, swapping tips on social media. It came after a banner year in the markets, in 2020, but ended up being only the beginning of an even bigger rally in 2021, when the S&P 500 rose another 27%. There was, though, eventually a reckoning in 2022 when the index plunged 19%, notching the worst yearly performance since the great financial crisis.

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“With all the bull market euphoria and risk appetite, they tend to go on until they don’t, so it’s notoriously difficult to predict when it turns,” Victor Haghani, chief investment officer of Elm Wealth and a founding partner of Long Term Capital Management, said. “We know we’re in it, but to me it does not signal whether it’s near the end or not near the end. It’s the question of when, not if, the market goes back to a more sensible level.”

There were many echoes of the 2021 frenzy last week as retail traders sought out small, often troubled companies that had been heavily shorted by hedge funds. Some of the factors behind GameStop’s ascent have only grown more prominent as zero commission trading and short-term options have become more widely available and popular.

That was reflected in the volume of trading last week. On the busiest day, 1.8 billion shares of Opendoor traded, accounting for nearly 10% of all US stock market volume. Back in 2021, at the peak, a more modest 800 million shares of GameStop changed hands, even though the trading in both stocks was off a similarly small base, according to data compiled by Bloomberg.

This time around, though, the excitement appears to have come and gone more quickly and the macroeconomic backdrop is decidedly different. Interest rates are much higher, which leaves investors anticipating that the Federal Reserve will lower its benchmark rate later this year, a move that could give the rally further momentum.

“We’re at a place now where the Fed is likely to be cutting interest rates going forward despite the fact that we have high valuations, which tells me valuations might even go higher,” said Don Calcagni, chief investment officer at Mercer Advisors Inc. “If the Fed brings down interest rates, that’s going to be a very nice tailwind for equities broadly.”

While the markets are contending with the higher tariff levels put in the place by the Trump administration, the deals with most countries have ended better than was feared back in April. On top of that, inflation appears to be in check and earnings growth intact.

“The meme stuff is kind of disturbing, you know, there’s no way around that. But I think the risk is that people focus too much on that,” said Alec Young, chief investment strategist at Mapsignals. “Markets don’t trade on good or bad, they trade on better or worse, and on the trade news every deal is better than what was priced in early April.”

Of course, if the Fed doesn’t cut interest rates this year or if any of the other market tailwinds falter as a result of tariffs or inflation, markets could see a pullback.

“That’s when the market’s going to have to really do some reassessment,” Calcagni said.

Still, a brief pullback of a few percentage points could be a sign of a healthy market and even give investors opportunities to buy stocks at a discount.

“I’d view any near-term pullback as very buyable against the current backdrop,” Ross Mayfield, investment strategist at Baird, said.

--With assistance from Norah Mulinda.