Risk assets may enter the "danger zone" while Wall Street celebrates, "sounding the alarm."

According to the Zhitong Finance APP, even market bulls are beginning to acknowledge that the prices of U.S. stocks and bonds are too high. While many believe that an optimistic macroeconomic outlook will keep the party going until next year, they also cautiously think that the inevitable aftereffects will soon appear. But not now.

The three major stock indices on Wall Street hit record highs last week, continuing a hot rally that began more than a year ago. Since the Federal Reserve abandoned interest rate hikes last October, the Nasdaq index has risen by more than 50%, and the stock price of the world's largest company, Nvidia (NVDA.US), has soared by 250%.

Notably, this year is one of the best years for the S&P 500 index since 1928. Meanwhile, the yield spread between investment-grade and junk bonds relative to U.S. Treasuries has narrowed to extremely low levels. In some respects, they are the narrowest ever.

There is no absolutely reliable way to measure how overvalued a market is. But according to any reasonable assessment, these are warning signs.

"Reverse Goldilocks"

Morgan Stanley analysts still recommend buying U.S. stocks and bonds rather than those from other regions. However, they also point out that there is enormous uncertainty surrounding the "substance, severity, and sequence of fiscal, trade, and immigration policies" of the incoming Trump administration, making next year's "bull-bear divergence" unusually large.

The analysts' baseline forecast for the S&P 500 index is 6,500 points, about a 10% increase from Monday's close. However, their bull and bear market predictions show a potential upside of 24% and a downside risk of 23%, which indeed represents a significant divergence.

HSBC analysts are also optimistic about risk assets and believe that Wall Street has further upside potential in 2025, especially in the first half of the year. However, they warn that the U.S. market is on the edge of a "danger zone."

They constructed an interest rate swap model that shows what would happen if rates rise above a certain point. If this trigger mechanism is activated (and remains activated), a "reverse Goldilocks" scenario would emerge, putting pressure on riskier assets such as stocks, credit, and emerging market debt.

In the current model, the danger zone is triggered by a 10-year U.S. Treasury yield slightly below 4.5%, which is exactly where we are now.

They wrote on Monday, "In short, if we are to sustain growth above 4.5%... this is likely to cause a 'catastrophe' across all major asset classes," adding, "This is the biggest risk facing our constructive view at present."

Keep Dancing

Although Wall Street analysts are cautiously optimistic about their forecasts, an increasing number of investors are becoming pure bulls. According to the latest survey by the American Association of Individual Investors (AAII), bullish sentiment, or the expectation that the stock market will rise over the next six months, has reached an "abnormally high" 49.8%.

In the decades since AAII began conducting sentiment surveys in 1987, bullish sentiment readings have only exceeded the 50% threshold about 10% of the time Asset management companies may be reluctant to dampen this enthusiasm. Even if they correctly predict a pullback, they still need to accurately forecast when it will happen. Achieving this often relies more on luck than on fundamentals, technicals, history, mean reversion, or standard deviation analysis. This is because the simple FOMO ("fear of missing out") sentiment is a powerful force that can keep investors' optimism spinning like a carousel, lasting longer than it should.

In investing, acting too early often makes one look like a fool rather than a prophet. Therefore, it takes a brave fund manager to suggest that their clients reduce exposure to assets or markets with long-term upward trends.

Charles "Chuck" Prince, former CEO of Citigroup, remarked on the leveraged buyout market in July 2007, when signs of stress began to emerge, saying, "As long as the music is playing, you’ve got to get up and dance. We’re still dancing."

Today, the music is starting to sound a bit discordant, but investors still seem eager to go along with it