Stocks led by four wounded horsemen

Struggling financial firms Citi, BofA, Fannie Mae and Freddie Mac are dominating late summer Wall Street trading. Uh-oh. Who says speculation is dead?

(CNNMoney.com) -- They say you can't trust the government. Don't tell that to Wall Street traders.

A bizarre trend has emerged during these hazy, lazy days of late summer. Overall market volume is unsurprisingly wafer-thin, but a big chunk of trading has been in just four financial companies that have received a healthy dose of support from Washington in order to make it through the credit crisis.

For the past few days, Citigroup (C, Fortune 500) (which taxpayers now own a third of), mortgage giants Fannie Mae (FNM, Fortune 500) and Freddie Mac (FRE, Fortune 500) (which were placed under government conservatorship last September) and Bank of America (BAC, Fortune 500) (which has needed $45 billion in bailout funds) have been far and away the most actively traded stocks on the New York Stock Exchange.

In fact, these four wounded horsemen of the financial sector comprised 40% of the overall trading volume on the NYSE on Tuesday. These stocks haven't just been active, they've been surging.

This is kind of scary. It suggests that the late-summer portion of the almost six-month long market rally is being fueled more by speculation and momentum, not real optimism about a potential recovery in the financial sector and the overall economy.

"Anecdotally, I don't know anyone that really loves the market but it continues to go up," said John Norris, managing director of wealth management with Oakworth Capital Bank in Birmingham, Ala. "Whenever you have a concentration in a small group of stocks, it's worrisome. Perhaps it could be a sign that this rally is set to peter out."

Sure, there are legitimate reasons to be a little more excited about the outlook for the economy and markets. It does seem like the housing market may finally have hit bottom. Business spending appears to be picking up.

Nonetheless, experts said it would be more encouraging if the rally moved beyond this Gang of Four.

"People are taking more risk, which is a positive. And you can't fight the tape. But this rally is too selective," said Keith Springer, president of Capital Financial Advisory Services, a Sacramento, Calif.-based investment advisory firm. "The broader the rally, the more support it's going to have."

What's more, it's reasonable to worry that the market has simply done a 180 from last fall and earlier this year. After the Lehman Brothers' collapse, traders ignored anything that wasn't a sign of the impending apocalypse. Now, investors seem to be dismissing any news that suggests a recovery won't be robust.

Consumers still are reluctant to take out their wallets for anything but essentials -- or government-subsidized new cars.

Shares of Fannie Mae and Freddie Mac have been ablaze in August while Citigroup and Bank of America have enjoyed scorching rerurns as well.


And while Fannie, Freddie and the big banks probably no longer need to have a priest sitting by their deathbeds getting ready to read them their last rites, they're far from being healthy just yet.

"You have to scratch your head a little bit. All this volume has been in four huge financials that really have stunk," Norris said. "But there is nothing out there to suggest huge spike in economic activity. We're getting way ahead of ourselves."

Of course, many of the investors that are buying Citi, BofA, Fannie and Freddie probably aren't doing so based on any notion that they're going to all report strong financial results in the near-term. It's a speculative bet that the worst is at least over.

You could argue that all four stocks were oversold earlier this year and are now just returning back to some semblance of a fair price. That may be true. But momentum has driven the stocks up so much in light (not to mention volatile) trading.

"This rally is starting to get me very concerned. We've gotten the bounce that would be appropriate given how far things fell after last fall. Financials were mercilessly destroyed," said Gary Hager, founder and chief executive officer of Integrated Wealth Management, a financial planning firm based in Edison, N.J. "But things are starting to get out of hand and some of them have run up too far."

So you can't help but worry about what happens once more traders return from vacation. If investors decide enough is enough with this "cash for trash" rally and seek to lock in gains, these stocks could be in for a bloodletting. Momentum works both ways after all.

"I think you're seeing people buy with their left hand but their right hand is on the sell button waiting to get out. So if the market falls there could be little support on the down side," Springer said.

However, not everybody thinks that the financials, or the broader market, are doomed for another big plunge this fall.

Hager said that while he expects some sort of sell-off, there still is enough cash on the sidelines that could limit the pain. He added that "too many good things are starting to happen" in the economy to lead to another massive correction.

Eric Ross, director of U.S. research for Canaccord Adams, an investment bank, agreed. He said people cannot underestimate how important an improvement in housing will be for the financial services industry and broader economy.

Given that housing is what led us into this recession, Ross said that better home sales and prices should lead to a more stable banking sector. And if lenders can get back on track, that will go a long way toward fixing the problems in the economy.

Finally, Ross said that even though many experts (including him) believe that some pause in the market rally is inevitable, it's almost impossible to try and pinpoint when the pullback would start. In other words, stocks could continue heading higher despite the complaints about how frothy the market is.

"I don't think there's a rational investor out there who doesn't realize this market is overbought. But it could be overbought for months and months and months," Ross said.