Momentum led the market in Q2

Jeff Nelson is a senior portfolio manager of equities at Northwestern Mutual Wealth Management Company. Jack Gorski is a portfolio manager of equities.

In Q2, momentum was the name of the game

The first half of 2026 was largely driven by momentum in the equity markets, with technology leading the way in the second quarter. The sector rose 31.80 percent in Q2 and was the only sector to outperform the S&P 500, which gained 15.20 percent. Artificial intelligence (AI) spending has been a major focus for investors, with 12 companies in the sector rising more than 100 percent. We call this group the triple-digit dozen, or TDD. While their earnings growth was strong, some key financial measures suggest these big winners may not be as strong as the broader market in other important ways.

Dividends, earnings, and cash flow are common measures investors can use to indicate the quality of a company’s financials. As shown by the table below, the TDD were significant outliers in all three categories—12-month forward yield, forward price-to-earnings (P/E) ratio, and price-to-cash flow when compared to both the S&P 500 and their sector peers. While we acknowledge a lower yield makes sense for some of these tech companies as they prioritize internally funding their AI growth initiatives rather than paying a dividend, the 12-month forward yield of the top dozen is more than a full percent below the average of the S&P 500. From a valuation perspective, both the average forward P/E ratio as well as the price-to-cash flow of the TDD are more than double those of the sector and the S&P 500.

Momentum dominated beyond just technology

A similar pattern appears when looking at the 50 top-performing stocks across all sectors in the second quarter. Those top 50 stocks were up an average of 79 percent yet had a forward yield less than half that of the S&P 500, a forward P/E almost double that of the S&P 500, and a price-to-cash-flow ratio more than twice the index.

This momentum pattern was not simply limited to technology, as the above table shows. Across the full market, the top 50 performers in Q2 also looked expensive compared with the S&P 500. They rose sharply, but their lower forward yield, higher forward P/E, and higher price-to-cash-flow ratio suggest investors were paying much more for each dollar of earnings or cash flow. In plain English, the strongest performers were often the stocks investors were most willing to pay up for.

Momentum strength has been at the expense of quality and valuation

Our investment framework uses a proprietary quantitative model that focuses on three main factors: momentum, quality, and valuation. Momentum looks at whether a stock’s price has been rising. Quality looks at the financial strength of a company. Valuation looks at whether a stock appears expensive or inexpensive compared with its fundamentals. Each factor can perform differently depending on the market and economic environment. But using all three together can help create a smoother and more resilient return pattern over full market cycles.

This powerful momentum environment has left both quality and value on the back burner. Specifically, the quality factor delivered flat year-over-year returns through the end of Q2, while the valuation factor experienced a mid-single-digit drawdown. This divergence indicates that market participants are aggressively buying stocks with strong price momentum, with less attention paid to company fundamental health or valuation metrics. We like to let the model speak for itself and therefore do not make efforts to time factor rotations. However, we do like to call attention to the fact that while momentum can work very well on the way up, it can be equally destructive on the way down.

The chart below shows just how unusual the recent market backdrop has been. Over the trailing 12 months, stocks with stronger price momentum have meaningfully outperformed those with weaker momentum. In other words, investors have been rewarding stocks that were already going up, and they have done so to an extent that stands out across the 20-year period shown.

The chart below is another way of showing the performance disparity over the last 12 months. The white line shows the price change of stocks that rank in the top half of momentum, while the orange line shows the price change of stocks ranked in the bottom half of momentum. These are equal-weighted portfolios, so not biased by a company’s market cap, and show the extreme gap that has occurred for the top half contingent.

The quality chart below tells a different story. While momentum has been very strong, quality has not delivered the same level of outperformance. That means investors have not been giving as much extra reward to companies with stronger financial profiles. This is important for investors because quality can matter more when markets become more volatile or when investors begin focusing again on company fundamentals.

Finally, the below valuation chart shows that cheaper-looking stocks have also lagged. In this environment, investors have generally favored stocks with strong price trends over stocks that appear more attractively priced based on fundamentals. That does not mean valuation no longer matters. It means valuation has been out of favor recently, which can happen during periods when market enthusiasm is concentrated in a smaller group of high-growth stocks.

Why diversification matters when momentum is strong

Quality and valuation command the largest allocations based on structural factor weights in our quantitative model. Historically, these two factors serve as primary drivers of long-term equity outperformance. They have also offered strong downside protection and historically superior Sharpe ratios—a calculation that helps investors assess how much return they received for the amount of volatility or risk an investment carries—compared to momentum. At the same time, we include momentum because it can help diversify the model. Momentum has had a low to negative long-term correlation with quality and valuation, which means it often behaves differently from those two factors. While we do not expect these factors to always work at the same time, we do pay particular attention when their returns move to extreme levels.

The percentile charts below help put today’s market in historical context. A percentile rank shows where current returns fall compared with past periods. For example, a very high percentile means the factor has performed better than it has during most other periods in the 20-year history. A very low percentile means the factor has performed worse than it has during most other periods.

Upon mapping out the data, an extreme performance divergence arises: Momentum has surged to its highest relative return on record. At the same time, quality and valuation have compressed to the 15th and 6th percentiles, respectively. This unprecedented gap between factors strongly suggests that a major trend reversal may be overdue.

The above chart reinforces that momentum is unusually stretched by historical standards. Momentum has reached its highest relative return on record, which means the recent advantage for momentum stocks is not just strong—it is extreme compared with the past 20 years.

On the other hand, the chart below shows that quality has moved in the opposite direction. At the 15th percentile, quality has been weaker than it has been during most rolling 12-month periods in the last 20 years.

The same holds true for valuation, which has compressed to the 6th percentile. That gap between very strong momentum at a time when quality and valuation are near 20-year lows supports why we believe investors should be careful about assuming recent market leadership will continue indefinitely.

The bottom line for investors

Chasing performance is a common mistake when momentum becomes stretched. Buying stocks simply because “they keep going up” can expose a portfolio to the risk that market leadership suddenly changes.

To help manage that risk, we believe investors should diversify across a range of style factors that do not all move together rather than concentrate too heavily in one area. Historically, momentum drawdowns are extremely hard, or even impossible, to predict. They can also happen quickly and be severe.

When these rotations occur, investors often turn back to company fundamentals with a renewed focus on quality and valuation. While earnings growth for the top performers has clearly been very strong, history would suggest companies that rank well in valuation and quality are at levels that would seem attractive going forward.

Frequently Asked Questions

What are momentum stocks?

Momentum stocks are stocks that have recently risen in price and continue to attract investor interest. Momentum can be powerful during strong market trends, but it can also reverse quickly when market leadership changes.

Why can momentum create risk for investors?

Momentum can encourage investors to chase stocks that have already performed well. If those stocks become expensive or crowded, a shift in sentiment can lead to sharp losses.

What do quality and valuation mean in investing?

Quality generally refers to a company’s financial strength, including measures such as earnings, cash flow, profitability and balance sheet health. Valuation looks at whether a stock appears expensive or inexpensive compared with its fundamentals.

Why does diversification matter when momentum is strong?

Diversification can help reduce the risk of relying too heavily on one part of the market. When momentum is strong, owning a mix of factors, sectors and investment styles may help investors stay better positioned if leadership changes.