(Bloomberg) — The new Trump administration is on the rise, with mass deportations of undocumented immigrants and the threat of unleashing a global trade war among its immediate priorities. Fighting in Europe and the Middle East continues. And bond traders are scaling back their bets on lower interest rates as the U.S. economy risks another bout of inflation.
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But despite all these risks, investors seem largely unperturbed as the S&P 500 Index set another record this week. Traders are also piling into the riskiest parts of the market, with the small-cap Russell 2000 Index nearly doubling the S&P 500’s performance over the past two weeks and nearing its first record high since 2021. Meanwhile, the Cboe Volatility Index is at levels that historically indicate serenity among traders.
This level of optimism in light of these broader concerns surprises even some Wall Street professionals. It is also a cause for concern for them.
“One of my biggest concerns is extreme bullishness, and we’re seeing signs of that,” said Eric Diton, president and director of the Wealth Alliance. “We know from history that when investors are too optimistic and everyone is in the market, the question is who is buying to drive the market up?”
With the S&P 500 posting 53 records this year — or about one every five days — unbridled optimism in the stock market isn’t exactly new. Yet signs of exuberance are beginning to appear.
Wall Street fortune tellers are expecting another year of double-digit gains after the S&P 500 posted back-to-back gains of more than 20% in 2023 and 2024. The index has only seen such a rally once, during the dot-com bubble. Household stock ownership as a percentage of total assets is at a record level – and so is a percentage of Americans who expect stocks to rise over the next 12 months. Data from Bank of America shows that retail customers have a large portion of their investments in equities and are taking more risk.
“Investors appear to be avoiding virtually any risk-averse strategy,” Richard Bernstein Advisors wrote in a letter to clients this week.
Muddy prospects
The risk momentum in equities has recently been concentrated mainly in small caps. Since Donald Trump’s victory, the group — a laggard for most of the year — has caught up with the broader market’s rush and is now up 20% through 2024, compared with the S&P 500’s 26% gain. expects the group to benefit from the new government’s protectionist trade tactics as they are the least exposed to international markets.
The point is that while there is a logic to the small cap rally based on the new administration’s so-called “America First” agenda, it is not the whole story. The group’s earnings prospects aren’t great, and uncertainty is mounting about how Trump’s plans would affect economic growth, inflation and the central bank’s interest rate path.
Small businesses are particularly sensitive to monetary policy because they typically rely on debt financing. And the Federal Reserve has indicated it is slowing the expected pace of future interest rate cuts. That may not be an ideal backdrop for small caps, which are considered among the riskiest corners of the market.
“In terms of traders, this seems like a group for dating, but not for marrying,” said Steve Sosnick, chief strategist at Interactive Brokers.
There are also other fault lines opening up in the market. Semiconductor stocks, which have led U.S. stocks in recent years, are being closely watched. The enthusiasm for all things artificial intelligence, which fueled much of their rally, has started to calm down. Meanwhile, chip makers will be on the front lines of any trade war, given the global nature of their supply chains.
“While technology remains at the top of the leaderboard year to date, it has been near the bottom over the past one and three months,” Jonathan Krinsky, chief market engineer at BTIG, wrote in a note to clients. “Bulls really need to see the semis stabilize here to avoid a bigger collapse in 2025.”
Keeping the faith
That said, optimists still see plenty of reasons to remain confident. They point to a healthy broadening of market leadership, with stocks from sectors other than technology or AI gradually taking over. And while valuations are high, they are not quite at the highest level yet. While the S&P 500’s 10-year annualized yield has risen sharply, it’s not yet at the point where investors might want to jump ship, according to Bloomberg’s Cameron Crise.
Then there are expectations that the Trump administration’s plans for lower corporate taxes, looser regulations and a softer stance on antitrust policy will more than offset any headwinds. Taurus also derive confidence from Trump’s own tendency to use the stock market as a scoreboard for his success. Wall Street’s enthusiastic response to Trump’s selection of Scott Bessent as his nominee for Treasury secretary was based on the idea that he would temper the administration’s aggressive trade and economic proposals.
Another factor that could drive enthusiasm for stocks is investors’ memories of how they did during Trump’s previous term — and the belief that it will happen again, despite the differences between 2016 and 2024.
“People’s experiences with the stock market during Trump’s last term are distorting their perception of what to expect in this frothy market,” said Alex Atanasiu, portfolio manager at Glenmede Investment Management. “At that point the market recovered and this time the valuations are even higher. We have had two strong years and it is risky to assume that the market has the same kind of legs.”
Taken together, these factors can fuel the feeling of euphoria and keep the rally alive for some time – whether it is rational or not. The recommendation from market professionals is simple: be careful at these levels and read the tea leaves carefully.
“Anyone who doesn’t think we’re in a highly speculative period, or even a bubble, isn’t really paying attention,” said Richard Bernstein, founder and chief investment officer at Richard Bernstein Advisors. “Look at crypto. There is nothing fundamental going on.”
