Equity markets are charging to new record highs, with the S&P 500 up 28% year-to-date and the NASDAQ Composite crossing the key 20,000 mark, up 34% this year. The rally is underpinned by a potent mix of drivers:
- Cooling inflation and Fed pivot: Easing inflation has fueled expectations that the Fed will continue to reduce policy restrictiveness in pursuit of a soft landing.
- Resilient US economy: The US economy remains robust, defying earlier fears of a recession.
- AI and tech dominance: Optimism around AI and tech stocks, which comprise a significant portion of the market, continues to power market gains.
- Seasonal tailwinds: Historical patterns related to holiday spending and year-end portfolio adjustments often support equity strength during this part of the year.
- Trump 2.0 narrative: Hopes for a more business-friendly regulatory environment, increased M&A activity, and potential tax cuts are adding fuel to the rally.
The big question now is how long this momentum can last. There are growing signs that the rally could face headwinds, and investors may want to prepare for potential volatility ahead.
Risks on the Horizon
- High valuations: The Buffett Indicator, a widely-watched measure of market valuation that compare market capitalization to the country’s gross domestic product (GDP), suggests that stock prices are running ahead of economic fundamentals and has surpassed levels witnessed during the dot-com bubble or the Great Financial Crisis. With valuations elevated, there is less room for error. If earnings disappoint or economic growth slows, markets could face a sharp correction.
- The Fed may not ease as expected: While markets expect the Fed to cut rates, there is a risk that inflationary pressures could change the central bank’s plans. Recent CPI reports show that inflation is still sticky, and if Trump’s policies—like higher fiscal spending or tariffs—are enacted, inflation could re-accelerate. This would give the Fed less room to ease, potentially leading to a hawkish surprise for markets.
- Regulatory disappointment: Investors are counting on regulatory changes to fuel M&A activity and support corporate earnings. However, these changes could be slower or smaller than expected, especially if political priorities shift. Companies relying on regulatory boosts for growth could face a re-pricing of expectations.
Positioning Your Portfolio
In light of these risks, it may be time to reconsider how to position portfolios for both opportunity and protection. Here are some strategies to consider:
Tap into the Opportunity, Cautiously
If the market’s strong gains are giving you FOMO (fear of missing out) and you are tempted to jump in, but feel stressed about the potential emotional toll of market volatility, consider Dollar-Cost Averaging (DCA). This strategy allows you to invest gradually over time, reducing the pressure to time the market perfectly while still positioning for long-term growth. DCA helps mitigate the emotional stress by smoothing out the impact of market ups and downs, ensuring you stay invested without trying to catch the peak.
Hedge with Options
If you're concerned about a potential downturn and losing your gains, options could provide an effective hedge. With the VIX (volatility index) at low levels, option premiums are relatively cheap. Investors can use this to their advantage by buying put options on key holdings or market indices. This strategy provides protection against downside risks while allowing for continued upside participation. Our Options Strategist, Koen Hoorelbeke, discusses options on index futures as a key risk management tool in this article.
Rotate Selectively within Tech
Tech and AI stocks have been key market drivers, but not all companies are equal. We wrote about the evolving AI narrative recently, talking about the AI momentum is spreading from semiconductors to software and which other related sectors could benefit as the AI theme rages on.
Diversify within Growth, and into Quality and Value
While tech and AI have led the rally, consumer discretionary and financials have also joined the momentum. These sectors offer exposure to growth at more reasonable valuations, providing an opportunity for portfolio rebalancing.
Instead of chasing momentum, investors may want to focus on sectors with lower valuations and strong fundamentals. Consumer staples, healthcare, and utilities tend to offer more defensive characteristics that can hold up well during market pullbacks.
Prepare for a Reflationary Tilt
If Trump’s policies—such as higher fiscal spending and trade tariffs—come into play, certain tangible assets could offer a hedge against inflation. Commodities, energy, and real estate tend to perform well in reflationary environments due to their intrinsic value and limited supply. Investors may want to increase exposure to these tangible assets, such as gold, energy stocks, and property (REITs), to protect against inflationary pressures.
