Over the last week or so, we have noticed the press (and traders in general) throwing out the term “froth” when describing recent market activity.

“Froth in Retail Options Markets Now Dwarfs Levels of August Boom” – Bloomberg

“Tencent bulls are betting on both froth and fundamentals.” – Reuters

“The danger for those of us calling out frothy markets isn’t only that high prices could be justified by fast-growing profits, but that bubbles can always become more extreme.” – The Wall Street Journal

“A red-hot reception for initial public offerings may offer another sign of froth in a rallying stock market.” – MarketWatch

The term is a catchall for irrational volatility (usually bullish) that isn’t backed up by the underlying fundamentals.

I remember Wade and myself having a very similar conversation with each other in 2007, which sounds prescient in hindsight, and it is a very good comparison for us to keep in mind as we think about what to expect this time around.

We want to be realistic about the fact that there are signs that market euphoria is getting out of control. And we want to run through a few examples of how that is manifesting right now.

However, to paraphrase an old quote attributed to John Maynard Keynes: The markets can remain frothy longer than you can remain bullish. So, we still need to avoid getting ahead of the crowd.

Is froth a sell signal?

No.

Or at least it’s not a very good one. However, we would argue that it is an important indicator to help us manage risk exposure.

Signal #1: Small Retail Traders Creating Feedback Loops

As you likely have already heard, Gamestop (NYSE:GME), Blackberry (NYSE:BB) and AMC (NYSE:AMC) all experienced dramatic short squeezes this week as small traders organized on Reddit threads and Stocktwits to drive the price of those stocks higher.

A short squeeze occurs when the price of a heavily shorted stock starts to rise, and short traders have to cover their position.

A short trade is covered by buying the stock, which leads to a feedback loop of more shorts buying the stock to prevent more losses, which raises the price, which then causes more shorts to cover and new buyers to demand shares, and so forth.

A short squeeze is usually triggered by news of a corporate action (merger or acquisition) or a surprising earnings report.

For example, in 2008, Volkswagen briefly became the most valuable public company in the world following a massive short squeeze when traders learned Porsche was buying a larger percentage of the company.

The reason that this week’s short squeezes are a concern is that they are being driven by an organic rush of small, individual traders who are chasing momentum rather than any legitimate news.

You can see how GME’s price has changed over the last few days regardless of the fundamentals in Fig. 1 below.

On Tuesday, the stock swung back and forth over 87%. GME opened up 140% Wednesday morning, then fell 30% in the first hour of trading.

Fig. 1 – Daily Chart of Gamestop (GME) 

The short squeezes aren’t limited to a few heavily shorted retail companies, either. There are more and more penny stocks traded outside the normal exchanges that are doubling (or halving) in just a few minutes lately.

The available evidence strongly points to a large number of very small traders who are distorting prices. Sounds familiar, doesn’t it?

Signal #2: Financial “Innovations” Absorbing Capital Flow

The market leading up to the 2008 crash was being cannibalized in a big way by traders buying Mortgage-Backed Securities (MBS) and Credit Default Swaps (CDS) on those securities.

These assets had the hallmarks of classic bubble investments. They were difficult to trade, complex, poorly understood by most professionals, and had asymmetric risk.

These days, we have Special Purpose Acquisition Companies (SPAC) popping up all over the place with very similar problems that caused the MBS/CDS crisis.

There are even SPAC ETFs now for traders who want to invest in a pool of these companies that have no operations and exist only to potentially acquire some other firm, launch it as a public company, or complete some other financial transaction.

Since no company would ever willingly sell itself to a SPAC for less than it was worth, these are almost guaranteed money-losers for the investors on average. And yet the funds are flowing in.

At this point, everyone is trying to get into the game. For example, Shaquille O’Neal and former Speaker of the House Paul Ryan have their own SPACs … If that doesn’t bring back memories of the dotcom boom, we don’t know what would.

According to Refinitiv, there has been more than $18 billion raised by SPACs so far this year (yes, just the first three weeks of 2021). That puts the market on track to set new all-time records for SPACs within the first few months this year.

We remember when the ancestors of these kinds of companies operated on the shadier side of the financial world. So-called “blank check” companies and reverse mergers had a pretty bad reputation for positive returns for anyone who wasn’t collecting fees from the transactions themselves.

And the amount of fraud associated with the old companies led to big crackdowns on the industry in the 1980s and 1990s.

Signal #3: Rich Valuations

This is an issue we have been talking about for a while. Investors are bullish, which is good for us as option sellers, but valuations are sky-high.

As we have pointed out each week this month, the S&P 500 P/E ratio is near the same level it was at the dot-com crisis and is comparable with the kind of spikes we saw during the financial crisis.

However, there are a few key differences with valuations today versus prior bubbles, which we think help justify our “wait and see” strategy.

For one, corporate profits have staged a surprising comeback. As you can see in the following chart, the St. Louis Fed is tracking corporate profits (even with capital consumption and inventory adjustments) back to pre-pandemic levels.

This is very unlike the crashes in 2001 and 2008 where the recovery took much longer.

Fig. 2 – Corporate Profits 

Also, interest rates are very low and fiscal stimulus is very high, which is supporting profits (and probably helping to fuel the bubble) in the short term.

We don’t know yet whether these measures can bridge the market all the way until the economy and employment normalize or not, but it gives us another reason to maintain bullish exposure to stocks.

The Bottom Line

The market is showing a lot of signs of froth, “irrational exuberance” and volatility spikes.

However, for now we feel that the risks are offset by the potential for income. Our plan continues to be remaining flexible about our exposure with contingency plans to take advantage of any declines.

Market conditions don’t look good for chasing some of the runaway stocks and sectors where risk is the highest, but there are plenty of opportunities in other areas.

On the date of publication, John Jagerson & Wade Hansen did not hold (either directly or indirectly) any positions in the securities mentioned in this article.

John Jagerson & Wade Hansen are just two guys with a passion for helping investors gain confidence — and make bigger profits with options. In just 15 months, John & Wade achieved an amazing feat: 100 straight winners — making money on every single trade. If that sounds like a good strategy, go here to find out how they did it.