Markets expert warns it's 'dangerous' for investors to 'follow the momentum play'

Yahoo Finance's Alexis Christoforous and Brian Sozzi speak to Megan Horneman, Verdence Capital Advisors Director of Portfolio Strategy, about overall markets and what investors should keep a lookout for.

Video Transcript

BRIAN SOZZI: Now I want to bring in Megan Horneman. She is director of portfolio strategy at Verdance Capital Advisors. Megan, good to see you again. And as I mentioned at the top of the show, the markets are coming off the worst of the session. As you take a step back and you study these markets, you look at valuations, do you think the market is-- is simply getting frothy?

MEGAN HORNEMAN: I think in the near term, you definitely could see a period of consolidation. If you look at some of the technicals in the market, whether it's the low put to call ratio, which tends to signal some complacency entering the market or it's some of those momentum indicators that are signaling overbought conditions. We have had such a significant run off of the bottom.

Some of these US indices, for example, are up 40%, 50%, 60% from the lows. And the NASDAQ, you know, has actually entered positive territory for the year.

Now, what history does show us is that when you have such a steep decline like we saw in March, you do tend to see a pretty big momentum rally after that. However, you do tend to see, once you get into these types of levels, that there is room for some near-term consolidation as people look at valuations that are at heightened levels.

ALEXIS CHRISTOFOUROS: Megan, where might we see that momentum coming from in terms of sectors? Are you are you going to start to see a rotation out of the cyclicals and maybe into, I don't know, defensive plays, maybe elsewhere outside of US equities perhaps?

MEGAN HORNEMAN: So you have seen some of that momentum shift-- or that style shift in recent weeks, actually. You've seen some of those sectors that didn't participate in the beginning of this rally start to participate in this. So there is some positive signs that we are seeing the breadth of the market a bit better.

We think that rotation can continue because people will be looking for value where people have left that behind. So we think that'll continue, not only within the US for example in the small and mid-cap space, the value space but also internationally as well.

BRIAN SOZZI: Megan, I I've got market melt-ups on my brain this week. I'm looking for them. I'm seeking them out. And you know, I look at what Zoom did yesterday, came out, beat big, the stock pretty much went up in a straight line. To me, that's somewhat of a market melt-up. Where-- where are you seeing pockets of overvaluation? Is it stay at home stocks? Is it those five big cap tech stocks that have essentially powered the market off the lows?

MEGAN HORNEMAN: Yeah, I think it's definitely those big-- big cap stocks that came off of the low so strong and made up the majority of the start of this rally. That's called a momentum play. And it's dangerous to follow that because that can quickly shift when sentiment shifts. So we're waiting for a better entry point into some of those areas before we would feel comfortable adding there.

But you have to remember as well, this melt-up is being driven by, you know, a couple of things, and really two in particular. The first one is that the Federal Reserve is pushing investors into the equity market. When you have about 90% of the stocks in the Russell 1000 paying a dividend higher than the 10-year bond yield, that's-- the Federal Reserve's doing what they were-- set out to do, and that's to push people into risk assets.

The other factor is that when we came into this pandemic, the one thing that was really unknown was the human element and the emotion on how they would return to the economy. So while a lot of the economic data is backward-looking, we can look at things like air travel, turnstiles in New York City public transportation. We can look at the amount of people, their weekly gas demand. And we can see that appetite that consumers are, as far as going back out and re-entering the economy. And that's a positive. And that's what the equity markets are holding onto right now. Now, once we start getting that-- the real hard data in June and July, that may test the sentiment as well.

ALEXIS CHRISTOFOUROS: Megan, how important is tomorrow's May jobs report to this market? Again, because it is backward-looking, how much of it are you really, you know, looking at in terms of trying to guide the way you're going to be looking at your portfolio?

MEGAN HORNEMAN: So right now, the backward-looking data, we-- it's-- while it's important, we're more focused on the forward-looking data, so things like today with the continuing claims. That was discouraging because you did see that tick up. While the number of jobless claims came down, you did see that continuing claims tick up. So that's a bit more important.

Some of the other underlying forward looking labor market indicators that we'll look are-- we'll look at is in some of the business surveys. So while an unemployment report is always important to look at, we're really going to be focusing on some of these other forward-looking economic-- or labor market indicators to see if-- what the impact on the economy is.

BRIAN SOZZI: Megan, given the stimulus we have seen-- that has been pumped into this market, do you think we break through the February highs before year end or maybe even earlier? Look, the S&P 500, what 7.6% away from those February highs now.

MEGAN HORNEMAN: It's-- it's certainly possible. I mean, I think when we were looking at the depths of the lows in March, that if anybody had to foresee that we'd see a, you know, 50%, 60% rally as quickly as we have out of those lows, I think some people would be surprised at that. So I think it's definitely possible. But there's going to come a time where the underlying fundamentals need to support these valuations. And that's what really is going to be tested in the coming months, because as I mentioned, we'll start to get some of the hard data from when these states started to reopen.

ALEXIS CHRISTOFOUROS: What about some possible headwinds in addition to, we know, the ongoing pandemic? How much of a threat is the trade tensions we're seeing between the US and China? And how is that sort of part of your thinking when it comes to the market?

MEGAN HORNEMAN: So there are several things, I think, over the next couple of months that are a risk to the market. As I mentioned already from a technical perspective, it's signaling the market's a bit complacent and overbought at these times. You mentioned the US-China trade tensions. That's always a concern. That's been a concern for quite some time now, even before the pandemic.

There's also seasonality that comes into play. So these are risks that we think could go into the summer months.

And the other thing is sometimes it's just a valuation correction. You can't foresee that. You just have to be careful that you're not going into that valuation correction buying the most expensive stocks. So we're looking-- we're sitting back right now, patiently waiting for a better entry point. And we think you could see that in the coming months.

BRIAN SOZZI: Market-- Megan, 10 seconds here. Jobs report comes in better than expected. What's your first instinct, buy or sell?

MEGAN HORNEMAN: I would stay where you are. I wouldn't buy though because the valuations are too high at this time. I would wait to see if there's a bit more of a pullback in the market.

BRIAN SOZZI: All right, let's leave it there. Megan Horneman, director of portfolio strategy at Verdance Capital Advisors. Always good to see you. We'll talk to you soon.