The new Trump administration is coming in hot, with mass deportations of undocumented immigrants and threats of triggering a global trade war among its immediate priorities. Fighting continues in Europe and the Middle East. And bond traders are scaling back bets on lower interest rates as the US economy risks a fresh bout of inflation.
But despite all of these risks, investors seem largely unperturbed, with the S&P 500 Index setting another record just this week. Traders are piling into the riskiest parts of the market, too, with the small-capitalization Russell 2000 Index nearly doubling the S&P 500’s performance over the past two weeks and approaching its first record since 2021. Meanwhile, the Cboe Volatility Index is at levels that historically indicate serenity among traders.
This degree of optimism in the face of those wider concerns is surprising even some Wall Street pros. To them, it’s also a cause for alarm.
“One of my top concerns is extreme bullishness, and we are seeing signs of that,” said Eric Diton, president and managing director of the Wealth Alliance. “We know from history that when investors are too bullish, and everyone is in the market, the question is who is buying to drive it higher?”
With the S&P 500 clocking 53 records this year — or about one every five days — rampant optimism in the stock market is hardly new. Still, signs of exuberance are starting to appear.
Wall Street’s soothsayers expect another year of double-digit gains after the S&P 500 posted back-to-back advances of over 20% in 2023 and 2024. The index has delivered such a rally only once, during the dot-com bubble. Households’ equity holdings as a share of total assets are at a record — and so is a percentage of Americans expecting stocks to rise in the next 12 months. Data from Bank of America show retail clients have a high chunk of their investments in equities and are taking on more risk.
“Investors seem to be shunning virtually any risk-averse strategy,” Richard Bernstein Advisors wrote in a note to clients this week.
Muddy Outlook
Risk-on momentum in equities has lately been concentrated in small caps. Since Donald Trump’s victory, the group — a laggard for most of the year — has caught up in a hurry with the broader market, and is now up 20% in 2024, compared with the S&P 500’s 26% advance. The group is expected to benefit from the new administration’s protectionist trade tactics because they’re least exposed to international markets.
The thing is, while there’s a logic to small-caps rallying based on the incoming administration’s so-called “America First” agenda, that isn’t the whole story. The group’s earnings outlook isn’t great, and uncertainty is on the rise about how Trump’s plans would impact economic growth, inflation and the central bank’s interest-rate path.
Small companies are particularly sensitive to monetary policy because they tend to rely on debt financing. And the Federal Reserve has indicated that it’s slowing the expected pace of future rate cuts. That may not be an ideal backdrop for small caps, which are considered among the riskiest nooks in the market.
“In trader talk, this seems like a group to date, but not to marry,” said Steve Sosnick, chief strategist at Interactive Brokers.
There are other fault lines in the market opening up as well. Semiconductor stocks, which have led US equities over the past couple years, are under closer scrutiny. The fervor for all things related to artificial intelligence that fueled much of their rally has started to calm down. Meanwhile, chipmakers are going to be on the front line of any trade war, given the global nature of their supply chain.
“While tech remains near the top of the leader-board on a year-to-date basis, it’s near the bottom over the last one and three months,” Jonathan Krinsky, chief market technician at BTIG, wrote in a note to clients. “Bulls really need to see semis stabilize here to prevent a bigger breakdown into 2025.”
Keeping the Faith
That being said, optimists still see plenty of reasons to keep faith. They point to the healthy broadening of market leadership, with stocks from industries other than technology or AI gradually taking over. And valuations, while stretched, are not quite at peak levels. While the S&P 500’s 10-year annualized return has climbed sharply, it’s not at the point where investors might want to abandon ship just yet, according to Bloomberg’s Cameron Crise.
Then there’s the expectation that the Trump administration’s plans for lower corporate taxes, looser regulations and a softer stance on antitrust policies will more than offset any headwinds. Bulls also take confidence from Trump’s own penchant for using the stock market as a scoreboard for his success. Wall Street’s enthusiastic reaction to Trump picking Scott Bessent as his nominee for Treasury secretary was predicated on the idea that he would temper the administration’s aggressive trade and economic proposals.
Read more: Trump’s Scoreboard Is S&P 500, and It’s Wall Street’s Best Hope
Another factor that may be driving the enthusiasm for equities is investors’ memories of how they did in Trump’s previous term — and the belief that it’ll happen again, despite the differences between 2016 and 2024.
“People’s experience with the stock market in Trump’s last term is skewing their perception of what to expect in this frothy market,” said Alex Atanasiu, portfolio manager at Glenmede Investment Management. “At that time, the market was recovering, and this time valuations are even higher, we have had two strong years and it is risky to assume the market has the same kind of legs.”
All together, these factors can feed the sense of euphoria and keep the rally alive for some time — whether it’s rational or not. The recommendation from market pros is simple: Be cautious at these levels and read the tea leaves carefully.
“Anyone who thinks we are not in a highly speculative period, if not 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 there.”
