By Paul R. La Monica

It's a stock market only a sanitation worker could love.

Of late, investors scrounging for stocks have preferred junk -- smaller companies with poor fundamentals and exorbitant valuations -- over quality companies with healthy sales and earnings growth, solid balance sheets, and more attractive prices.

Goldman Sachs pointed out in a recent report that a basket of heavily shorted stocks, often considered the trashiest of the trash, had surged 24% in just the past month. What's more, the small-cap Russell 2000 index is up 10.6% over the past three months, more than doubling the 4.2% rise in the Invesco S&P 500 Quality exchange-traded fund, home to profitable large-caps such as Apple, Mastercard, GE Aerospace, and Procter & Gamble. That is despite the fact that about 40% of the companies in the Russell 2000 are losing money.

Don't expect this trend to last. "The [small-cap] benchmarks are drowning in garbage," said analysts at Kailash Capital Research in a recent report. "Durability beats drama [over time.]"

Sticking with durable, high-quality stocks isn't always easy, especially when speculative markets make winners out of shiny new objects, including recent initial public offerings and profitless tech companies. But investors only need to think back to the popping of the dot-com bubble in 2000, when the Nasdaq Composite fell nearly 40%, a period that this one is beginning to resemble. "There are pockets of speculation," says Matt Morse, chief equity strategist at Grimes & Co. "Retail investors are making up a bigger share of daily trading volume too. It's not unlike what we saw in the late 1990s."

Even the artificial-intelligence trade, which has been producing profits, may be more junky than it seems. Citigroup cautioned in a report this month that it is starting to see some red flags there, what they dubbed "potential micro bubbles building under the surface." With that in mind, Citi has an equal-weighted portfolio of what it calls "AI at a reasonable price." The list includes some of the obvious early AI winners, such as Nvidia, Advanced Micro Devices, Meta Platforms, and Amazon.com, but also more attractively valued AI adopters like Booking Holdings, Instacart owner Maplebear, Match Group, and Pinterest, which all have price/earnings ratios below the S&P 500's 22.3.

Others, however, argue that it's worth pivoting away from tech and toward even cheaper stocks, especially if stocks are setting up for a fall. "There is some market vulnerability," Andrew Krei, co-chief investment officer at Crescent Grove Advisors, told Barron's. "So what do you do? Incrementally rotate away from more expensive parts of the market and look at value."

Along those lines, the Kailash analysts highlighted better-quality smaller stocks that are generating above-average returns on equity, including human resources services firm TriNet Group, movie theater operator Cinemark Holdings, and cash and valuables security firm Brink's. All three trade for under 14 times earnings.

Trash may be having a moment, but quality will have your portfolio smelling like roses.

Write to Paul R. La Monica at paul.lamonica@barrons.com

This content was created by Barron's, which is operated by Dow Jones & Co. Barron's is published independently from Dow Jones Newswires and The Wall Street Journal.

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October 23, 2025 02:00 ET (06:00 GMT)

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