The new Trump administration is about to gain strength, and its top priorities include large-scale expulsion of illegal immigrants and threatening to trigger a global trade war. Conflicts in Europe and the Middle East continue. As the US 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, investors in US stocks seem largely unaffected, with the S&P 500 just setting a new record last week. Traders are also pouring into the riskiest sector of the market, small-cap stocksRussell 2000 IndexThe increase over the past two weeks is almost double that of the S&P 500, and is close to the first record since 2021. Meanwhile, the Chicago Board Options Exchange Volatility Index is at its calmest level in history.

This level of optimism surprised even some Wall Street professionals in the face of these broader concerns. For them, this is also a cause for concern.

Eric Diton, president and managing director of Wealth Alliance, said, “One of my biggest concerns is extreme optimism, and we are seeing signs of it. We know from history that when investors are overly optimistic and everyone enters the market, the question is who else is buying to drive the share price higher?”

This year, the S&P 500 Index set a new historical record 53 times, about every five days. The general optimism in the stock market is nothing new. Despite this, signs of prosperity are beginning to show.

After the S&P 500 index rose more than 20% twice in a row in 2023 and 2024, Wall Street forecasters expect to achieve double-digit gains in the coming year. The index only experienced such gains during the internet bubble period. Household stock holdings as a share of total assets reached a record high. Also at a record high was the proportion of Americans whose stock prices are expected to rise in the next 12 months.

Bank of America data shows that a large portion of retail clients' investments are in stocks and are taking greater risks.

Richard Bernstein Advisors wrote in a report to clients last week, “Investors seem to be avoiding almost all risk aversion strategies.”

An uncertain future

Risk appetite in US stocks has recently focused on small-cap stocks. Since Trump's victory, the sector has quickly caught up with the wider market, and has risen 20% so far this year, while the S&P 500 has risen 26%. As the sector has minimal exposure to international markets, these stocks are expected to benefit from the new government's protectionist strategy.

The problem is, while the rise in small-cap stocks has its logic based on the new administration's so-called “America First” agenda, that's not all. The sector's earnings prospects are not promising, and uncertainty about how Trump's plans will affect economic growth, inflation, and the Federal Reserve's interest rate path is rising.

Smaller companies are particularly sensitive to monetary policy because they often rely on debt financing. The Federal Reserve has indicated that it is slowing down the expected pace of future interest rate cuts. This may not be the ideal backdrop for small caps, which are considered one of the riskiest corners of the market.

Steve Sosnick, chief strategist at Yingtou Securities, said, “In the words of traders, this seems like someone you can date, but you can't get married to.”

Other cracks have also appeared in the market. Semiconductor stocks, which have led the US stock market in the past few years, are being scrutinized more closely, and the artificial intelligence boom that has driven their sharp rise has begun to cool down. Meanwhile, given the global nature of their supply chains, chipmakers will be on the front lines of any trade war.

BTIG Chief MarketTechnical analysisTeacher Jonathan Krinsky wrote in a report to clients, “Although technology stocks are still close to leading positions so far this year, they have been close to the bottom in the past one to three months. The bulls really need to see semiconductor stocks stabilize here to prevent a bigger crash in 2025.”

Stay confident

Having said that, optimists still see plenty of reasons to stay confident. They pointed out that due to the healthy expansion of market leadership, stocks in non-tech or artificial intelligence industries are gradually dominating, and that although valuations have been raised, they have yet to reach peak levels. Although the 10-year annualized return of the S&P 500 index has risen sharply, it's not enough for investors to give up now.

The Trump administration's plans to lower corporate taxes, relax regulations, and take a more moderate stance on antitrust policies are expected to outweigh any headwinds. Bulls are also confident about Trump's tendency to use the stock market as a scoreboard to measure his success. Wall Street's enthusiastic response to Trump's nomination for Secretary of the Treasury was based on the idea that he would ease the government's aggressive trade and economic proposals.

Another factor that may be driving enthusiasm in the stock market is investors' memories of how they performed during Trump's previous term and their belief that this will happen again, although 2016 and 2024 are different.

Alex Atanasiu, portfolio manager at Glenmede Investment Management, said, “People's experiences with Trump's stock market performance during his last term are distorting their views on current bubble market expectations. At that time, the market was recovering, and this time the valuation was higher. We had already experienced two years of strong growth, and it would be risky to assume that the market had the same potential.”

All in all, these factors are likely to increase market optimism and keep US stocks rising for some time, whether it is reasonable or not. The advice from market professionals is simple: stay cautious at current levels and carefully evaluate the situation.

Richard Bernstein, founder and chief investment officer of Richard Bernstein Advisors, said, “Anyone who thinks we're not in a highly speculative period, or even a bubble period, doesn't really pay attention to the market. These people should look at cryptocurrencies; there aren't any fundamental factors there.”