The new Trump administration is about to make a strong comeback, with primary tasks including mass deportation of illegal immigrants and threats of triggering a global trade war. Conflicts in Europe and the Middle East continue. As the U.S. economy faces the risk of a new round of inflation, bond traders are reducing their bets on low interest rates.
But despite all these risks, U.S. stock investors seem largely unaffected, with the S&P 500 having just set a new record last week. Traders are also flocking into the highest-risk areas of the market, with the small-cap Russell 2000 index rising almost twice as much as the S&P 500 in the past two weeks, nearing its first record since 2021. Meanwhile, the Chicago Board Options Exchange Volatility Index is at historically calm levels.
Even some Wall Street professionals are surprised by this level of optimism, given the broader concerns. For them, this is also a worrying reason.
Eric Diton, president and managing director of Wealth Alliance, stated, "One of my biggest concerns is extreme optimism, and we are seeing signs of that. History tells us that when investors are too optimistic and everyone jumps into the market, the question is, who is left to buy to push the stock prices up?"
Stock market enthusiasm hits historical highs
This year, the S&P 500 has set a record 53 times, refreshing about every five days. The widespread optimism in the stock market is not a new phenomenon. Nevertheless, signs of prosperity are beginning to emerge.
After the S&P 500 rose more than 20% in both 2023 and 2024, Wall Street prophets expect double-digit gains in the coming year, a performance seen only during the dot-com bubble. The proportion of household stock holdings relative to total assets has hit a historical high, as has the percentage of Americans expecting stock prices to rise over the next 12 months.
Data from Bank of America shows that a significant portion of retail clients' investments is in stocks, and they are taking on greater risks.
Richard Bernstein Advisors wrote in a report to clients last week, "Investors seem to be avoiding almost all risk-averse strategies."
Uncertain outlook
The risk appetite for U.S. stocks has recently centered on small-cap stocks. Since Trump's victory, this sector has quickly caught up with the broader market, rising 20% year to date compared to the S&P 500's 26%. Given its minimal exposure to international markets, these stocks are expected to benefit from the new government's trade protectionist strategies.
Small-cap stocks are nearing historical highs
The issue is that while the rise of small-cap stocks makes sense based on the new government's so-called "America First" agenda, it is not the whole story. The earnings outlook for this sector is not optimistic, and the uncertainty about how Trump's plans will affect economic growth, inflation, and the Fed's interest rate path is rising.
Small companies are particularly sensitive to monetary policy as they often rely on debt financing. The Federal Reserve has indicated that it is slowing its expectations for future rate cuts. This may not be an ideal backdrop for small-cap stocks, which are considered one of the highest-risk corners of the market.
Steve Sosnick, chief strategist at Interactive Brokers, said, "In trader terms, this seems like a date you can go on, but not marry."
Other cracks are also appearing in the market. Semiconductor stocks, which have led the U.S. stock market in recent years, are now under stricter scrutiny, and the AI boom that propelled their sharp rise has begun to cool. Meanwhile, given their global supply chain, chip manufacturers will be on the front lines of any trade war.
Jonathan Krinsky, chief market technician at BTIG, wrote in a report to clients, "While tech stocks have remained close to the lead so far this year, they have approached the bottom in the past one to three months. Bulls really need to see semiconductor stocks stabilize here to prevent a larger collapse in 2025."
Maintain confidence
That said, optimists still see many reasons to remain confident. They point out the healthy expansion of market leadership, the gradual dominance of stocks outside the tech or AI sectors, and although valuations have been stretched, they have not yet reached peak levels. Although the S&P 500's 10-year annualized return has surged, it is not enough for investors to give up just yet.
People expect the Trump administration's plans to lower corporate taxes, ease regulations, and take a more lenient stance on antitrust policies to outweigh any headwinds. Bulls are also confident that Trump will use the stock market as a scoreboard for measuring his success or failure. Wall Street's enthusiastic response to Trump's nomination of Bensent as Treasury Secretary is based on the idea that he will temper the government's aggressive trade and economic proposals.
Another factor that could drive enthusiasm in the stock market is investors' memories of their performance during Trump's previous term and the belief that this could happen again, despite the differences between 2016 and 2024.
Alex Atanasiu, portfolio manager at Glenmede Investment Management, stated, "People's experiences with Trump's last term in the stock market are distorting their views on the current bubble market. At that time, the market was recovering, and this time valuations are higher; we have experienced two years of strong growth, and assuming the market has the same potential is risky."
In summary, these factors may exacerbate market optimism and sustain the rise of U.S. stocks for a while, regardless of whether it is justified. The advice from market professionals is simple: remain cautious at current levels and carefully assess the situation.
Richard Bernstein Advisors founder and chief investment officer Richard Bernstein said, "Anyone who thinks we are not in a highly speculative period, or even in a bubble, is not really paying attention to the market; these people should look at cryptocurrencies, where there are no fundamental factors at all."
Article reposted from: Jin Ten Data