US Stock Market Resilience Amid Challenges: A Look at Record Highs and Underlying Risks

US stock market investors have displayed remarkable composure in the face of a barrage of challenges. Trade tensions, slowing growth, and valuation bubble fears have all failed to halt the S&P 500 (SPX)'s relentless climb to record highs.

The benchmark US stock index hasn't seen a drop of at least 2% for 107 consecutive trading days, the longest streak since July 2024. Bloomberg-compiled data shows that even the tariff turmoil in early April barely registered. The index has since surged 34%, adding nearly $16 trillion to market capitalization.

But risks lurk everywhere: including sticky inflation and a slowing US jobs market. Federal Reserve Chair Jerome Powell reiterated on Tuesday that policymakers may face a difficult path in weighing further interest-rate cuts, a risk that triggered an S&P 500 pullback and grabbed market attention. But little lately seems to faze traders, with the index notching more than five months without back-to-back declines of at least 1%.

Even a rise in the unemployment rate to its highest level since 2021 has failed to shake the market – the S&P 500 has notched 28 record highs this year through Monday.

Rate-Cut Bets, Corporate Earnings, and AI Spending Underpin Market

Despite Powell’s cautious tone, traders seem confident that borrowing costs will decline, having almost fully priced in another 50 basis points of cuts for 2025. The stock market’s resilience also stems from a consensus that the US economy has weathered the worst of the Trump tariff policies and that improving corporate earnings and an artificial intelligence (AI) boom will bolster economic growth.

The risk is that policymakers could temper expectations for further rate cuts, disappointing Wall Street.

“Right now, investors seem willing to ignore all bad news, but complacency is a risk to the stock market rally,” said Julie Biel, portfolio manager at Kayne Anderson Rudnick. “If inflation gains in the coming months exceed traders’ expectations, that could force the Fed to cut rates by less than investors anticipate.”

For now, the stock market rally shows no signs of abating. EPFR Global and Bank of America-compiled data show that fund managers plowed nearly $58 billion into US stocks in the week ended Sept. 17, the biggest weekly inflow this year.

Short Covering Fuels September Gains, Overbought Signals Emerge

The S&P 500 has even defied September’s reputation as the stock market’s worst month. While stock market moves are often difficult to explain, there’s a clear driver behind this rally: short covering.

Bloomberg data going back to 2008 shows that Goldman Sachs Group Inc.’s basket of the most-shorted stocks has surged 14% this month, far outpacing the S&P 500’s 3% gain and is on track for its best September since 2010. That means some investors covered their short positions ahead of the Federal Reserve’s interest-rate decision.

Currently, the 14-day relative strength index (RSI) for Goldman’s basket of the most-shorted stocks has climbed to the highest overbought level since the peak of the meme-stock craze in early 2021 -- when retail traders drove inexplicable, wild stock swings. Typically, such overbought levels suggest a pullback is coming.

Investor Complacency Signals Emerge, Institutions: Rally May Pause But Isn’t Over

Other signals suggest investors have grown complacent amid optimism about robust consumer spending and healthy corporate earnings. Wall Street’s core fear gauge -- the Chicago Board Options Exchange Volatility Index, or VIX -- is far below its 10-year average and also below the key 20 threshold at which traders start to fret.

As the stock market has reached new highs, hedge funds and large speculators have increased their bets that the market will remain calm. Data from the US Commodity Futures Trading Commission (CFTC) shows that net short positions on the VIX reached 102,000 contracts in the week ended Sept. 16, near the level of August 2022.

Chris Murphy, co-head of derivatives strategy at Susquehanna, said the combination of heavy shorting of the VIX and the big rally in the most-shorted stocks means the gains may come to an abrupt halt -- even if temporarily.

“While all signs point to the market needing a pullback soon, this is likely temporary -- as current optimism is far from extreme, skepticism remains prevalent, and the S&P 500 still has significant upside. This is good news for stock bulls,” Murphy said.