Beware of the Bull: Trump’s Administration and the Risk of a Stock Market Bubble

The new Trump administration has entered with aggressive plans, including efforts for mass deportations of undocumented immigrants and potential threats of a global trade war. As conflict persists in Europe and the Middle East, there’s also worry about the US economy facing inflation again. In this scenario, bond traders are becoming more cautious about their expectations for lower interest rates.

Despite these looming concerns, investors appear largely unfazed, as evidenced by the S&P 500 Index reaching record highs again recently. Traders are eager to dive into riskier areas of the market; the small-cap Russell 2000 Index has soared nearly twice the performance of the S&P 500 over the last two weeks and is nearing its first record since 2021. Meanwhile, the Cboe Volatility Index shows a level of calm that suggests traders are not worried at all.

This level of confidence amid significant risks puzzles many on Wall Street and raises alarms for some experts. Eric Diton, president of Wealth Alliance, expressed concern over the extreme bullishness in the market. He remarked, "When investors are overly optimistic, with everyone already in the market, we must ask: who is left to buy and push it higher?"

Over the past year, the S&P 500 has set a notable 53 records, nearly one every five days, indicating persistent investor optimism. But now, signs of excessive exuberance are becoming apparent. Analysts anticipate yet another year of double-digit gains, following robust increases of over 20% in both 2023 and 2024—a feat not seen since the dot-com bubble. Households’ equity holdings as a percentage of total assets are at an all-time high, as is the fraction of Americans expecting a rising stock market in the coming year. Reports from Bank of America indicate that retail investors are leaning heavily into equities and embracing greater risk.

"Investors today seem to be ignoring any strategies that could protect them from risk," concluded a recent note from Richard Bernstein Advisors.

Uncertain Times Ahead

Currently, this risk-on mentality has been particularly evident in small-cap stocks. This segment, which lagged behind for much of the year, has made significant gains since Trump’s election, rising 20% in 2024 in contrast to the S&P 500’s 26% growth. Small-cap stocks are seen as beneficiaries of the administration's protectionist trade stance, as they have less exposure to global markets.

However, while there are arguments supporting this small-cap rally based on an “America First” strategy, the overall earnings outlook for small companies remains uncertain. Rising doubts also persist about how Trump’s policies will affect economic growth, inflation, and the Federal Reserve’s approach to interest rates. Since small-cap companies often rely on borrowing, they are highly sensitive to changes in monetary policy, especially given the Fed’s hints at slowing the pace of future rate cuts.

Steve Sosnick, chief strategist at Interactive Brokers, summed this up by saying, "This is a temporary fling, not a long-term commitment."

Additionally, other sectors are starting to show vulnerabilities. Semiconductor stocks, which have been leaders in the US market over the past few years, are now facing increased scrutiny. The strong interest in tech and AI that drove these stocks has begun to wane, and companies in this space are particularly vulnerable to the effects of a trade war, given their global supply chains.

As Jonathan Krinsky, BTIG’s chief market technician noted, "While technology stocks lead the year-to-date gains, they are lagging significantly over the last few months. Without stabilization among semiconductor stocks, there is potential for a more substantial downturn in 2025."

Optimism Still Prevails

Nevertheless, market optimists highlight numerous reasons to maintain faith. Many observers point to a broadening range of market leadership, with companies from sectors outside technology and AI starting to gain traction. While current valuations are elevated, they are not yet at extreme levels. Though the 10-year return for the S&P 500 has risen sharply, experts like Bloomberg’s Cameron Crise argue that investors do not need to panic just yet.

Furthermore, proponents believe the planned lower corporate taxes and reduced regulations from the Trump administration will ultimately outweigh potential headwinds in the economy. There is also widespread confidence that Trump views the stock market as a measure of his success, which reinforces optimism among investors. Wall Street greeted Trump’s selection of Scott Bessent for Treasury Secretary with approval, anticipating this choice would ease some of the more aggressive trade and economic strategies.

However, one significant aspect influencing investor enthusiasm is the memory of the stock market’s performance during Trump’s previous term, leading some to erroneously believe a similar outcome is likely this time. According to Alex Atanasiu, a portfolio manager at Glenmede Investment Management, “People’s experiences from the previous term are distorting their expectations for this market, which is more inflated now.”

In summary, even as factors fueling market exuberance persist, it is essential to remain vigilant. The stock market could very well be in a speculative period or, as some suggest, potentially in a bubble. Richard Bernstein cautions, "Anyone believing we are not in a highly speculative moment isn't paying attention; look at cryptocurrency as a glaring example of speculative frenzy without fundamentals."

Trump, Stock, Market