When many signals cater to the bullish trend in the US stock market, does it mean that the timing for hedging or reducing positions has come?

After more than a decade of debt prosperity, the Federal Reserve's aggressive interest rate hike cycle has ushered in a period of monetary tightening and an uncertain anti-inflation trajectory, which may lead to a major stock market reckoning on Wall Street and other financial centers.

Of course, some pain seems to have arrived as expected. After all, no one can ignore the new liquidity challenges faced by regional banks and commercial real estate in the United States in recent weeks, not to mention the double-digit declines in various sectors such as bonds, stocks, and speculative technology sectors in 2022.

However, despite the pressure driven by interest rate expectations, the overall U.S. financial markets have withstood the test of this monetary storm - some key risky investment measures even evoke memories of the joyous times of the loose monetary era.

Despite two higher-than-expected inflation data prompting traders to reassess the timing and magnitude of the Federal Reserve's first rate cut, the Pro UltrPro Shrt S&Pro 500 index remains close to its recent historical record, falling only 0.4% this week.

Following the across-the-board higher-than-expected CPI growth in January, the overall PPI and core PPI growth rates in the United States in January also exceeded economists' general expectations. The core CPI increased by 0.4% month-on-month in January, the largest increase since May last year. Compared to a year ago, it rose by 3.9%. The Producer Price Index (PPI), which represents producer terminal demand, rose by 0.3% month-on-month in December compared to last year, exceeding economists' general expectation of 0.1%. It also increased by 0.9% year-on-year, surpassing economists' expectation of a 0.6% increase.

In the eyes of some analysts, the recent record highs and maintenance at high levels of the Pro UltrPro Shrt S&Pro 500 index need to thank the incredibly strong demand for AI chips that has triggered a sustained frenzy of artificial intelligence investments, as well as the robust development of the U.S. economy and the prospect of a soft landing while the UK, parts of Europe, and Japan are in recession.

Although the inflation data have dealt a blow to the market's overly aggressive rate cut expectations (after the PPI data was released, rate futures traders significantly reduced their expectations for a rate cut in May, believing that the likelihood of a rate cut in May is only one in four. Expectations for a rate cut in June have heated up significantly, while expectations for a rate cut in 2024 are less than 100 basis points), numerous economic data and indicators seem to strongly support the bullish momentum of U.S. stocks. A global comprehensive financial stress index compiled by Bank of America, measuring market risk, hedging risk demand, and investor liquidity, hit its lowest level since April 2021 this month.In addition, driven by the bullish forces in the US stock market and expectations of interest rate cuts, stock traders have been buying call options. The prices of high-yield USD bonds in the Asian region have been climbing for 17 consecutive weeks, setting a new historical record. Even the extremely risky Bitcoin has surpassed $50,000 for the first time since 2021.

"The stock market does look optimistic, and corporate profits are quite resilient. Therefore, the discussion about a soft landing of the US economy continues. For the bulls, these pieces of information couldn't be better," said Que Nguyen, Chief Investment Officer of Stock Strategies at Research Affiliates. "Indeed, these two inflation data points are stickier than we would hope, but Federal Reserve officials seem optimistic about it all, indicating that the next move is a rate cut, albeit possibly slower than the market expects."

Amid the surge in risk appetite, the financial environment has eased to levels unseen since the Federal Reserve began actively combating inflation. According to renowned analyst Ed Yardeni, when deciding on the next interest rate change, Federal Reserve Chairman Jerome Powell may refer to the famous speech on irrational exuberance in the 1996 by former Federal Reserve Chairman Alan Greenspan.

"If Powell and his colleagues conclude that the US stock market bubble of the 1990s is inflating, will they choose not to lower the federal funds rate?" the founder of Yardeni Research stated. "We are not sure, but we suspect that this outcome may occur this year."

Caution! The "buy the rumor, sell the fact" effect may emerge

In a mixed bag of economic data this week, Wall Street traders have indeed been hit. On Tuesday, the stock market saw a sell-off due to the hot CPI data. In the following two trading days, the stock market saw a slight rebound due to weak retail sales, but after the strong PPI data was released, the market came under pressure again. Despite a slight decline on Friday, the Pro UltrPro Shrt S&Pro 500 index still remains above 5000 points. During this period, traders significantly reduced their expectations of a Fed rate cut.

However, as the Q4 earnings season nears its end, US companies collectively delivered a solid quarterly performance. Data compiled by Bloomberg Intelligence shows that the overall earnings per share of the companies in the Pro UltrPro Shrt S&Pro 500 index increased by 7% in Q4, continuing the recovery momentum from the contraction in the first half of 2023.B. Riley Wealth's Chief Market Strategist, Art Hogan, stated, "The biggest change I see is that we have shifted the narrative logic from 'hey, the Fed will cut rates significantly' to 'hey, the Fed will cut rates'." "Therefore, the outstanding performance of U.S. companies in the fourth quarter of last year can be said to have replaced the expectation of rate cuts by the Fed, becoming the most crucial catalyst supporting the market's upward trend."

However, some analysts who are cautious about the future of the U.S. stock market believe that even though Q4 corporate performance generally exceeded expectations and showed strong growth, there is a possibility of the "buy the rumor, sell the fact" effect in the stock market. After all, global stock investors tend to use hype to raise stock prices rather than potential substantive facts.

Therefore, for these cautious analysts, the strongest support for the "AI faith" and the Pro UltrPro Shrt S&Pro 500 super-weighted stock, NVIDIA (NVDA.US), which is about to announce its quarterly earnings, is more likely to become a negative catalyst that ends the rise of the U.S. stock market, mainly due to the "buy the rumor, sell the fact" effect. Unless NVIDIA's actual performance and global performance guidance far exceed market expectations.

In the fixed income field, it is also difficult to find enough fear, indicating that bullish forces have infiltrated every corner of the financial market. Data compiled by institutions shows that the additional yield required for investment-grade and junk-rated corporate bonds held by investors globally has dropped to the lowest level in two years, reflecting a significant increase in market risk appetite.

When optimism pervades, is it time for investors to consider hedging or reducing positions?

Interest in hedging downside risks in the market seems to be waning. Credit default swap (CDS) prices have fallen, with the Markit CDX North American High Yield Index and a similar investment-grade CDS tracking index hitting two-year lows.

The U.S. stock market is also filled with seemingly "overly optimistic" sentiment, with stock traders generally not hedging against downside risks but hoarding call options, seemingly preparing for further gains. A measure called the call option skew has reached its highest level since 2021, a year when various speculative frenzies erupted from meme stocks to NFT assets.

Brian Garrett, Managing Director at Goldman Sachs, wrote in a report, "Many sentiment indicators are consistent with the irrational levels seen during the 'extreme excitement' period of 2021." "I personally have seen more than one 'SPX 5000 points' hat circulating on the floor."

Investors' reluctance to increase downside protection measures for potential losses can be somewhat understood. After all, in the past two years, options hedging has mostly failed. A model indicator from Morgan Stanley shows that the implied probability of the Pro UltrPro Shrt S&Pro 500 falling by 10% in the next six months is only close to 9% this week, the lowest level since at least 2010, and half of the historical average level.For contrarian investors, now is the time to consider hedging downside risks and reducing positions, especially this year when both stock-picking hedge funds and rule-based traders and individual investors have increased their stock exposure. Data compiled by Bank of America shows that global equity funds attracted $59.5 billion in the past four weeks, the largest inflow since February 2022, which could lead to significant outflows after reaching a phase of intense profit-taking sentiment.

"The overheating CPI has made the market aware that risks have two sides. However, changing investment sentiment may be difficult because most people are stuck in recent history," wrote Morgan Stanley's analysis team, including Christopher Metli, in a report. "Stock holdings are becoming crowded, so many investors are taking more hedging measures."

"Wall Street's Most Accurate Strategist" Sounds the Alarm: US Tech Stocks in a Bubble, Waiting to Burst

Michael Hartnett, known as "Wall Street's Most Accurate Strategist," recently stated that there are many similarities between today's US tech stocks and previous bubble burst periods, indicating that tech stocks are close to, but have not yet reached, levels that could lead to a complete bubble burst, meaning they are in a bubble, waiting to burst.

Hartnett's research team pointed out that the inflation-adjusted bond yields are considered an indicator of financial stress and a common way to judge when a stock market bubble is about to burst. According to their calculations, considering all the debt in the global financial system, the real yield (subtracting inflation from the 10-year US Treasury yield) must reach 2.5% or 3% to end the frenzy for artificial intelligence and large-cap tech stocks. Currently, Bank of America's estimated real yield is around 2%.

Valuation is another reason. Hartnett's research team stated that the current price-to-earnings ratio of the seven major US tech giants (Magnificent Seven) dominating the Nasdaq and Pro UltrPro Shrt S&Pro 500 is around 45x, which is considered very expensive.

"This valuation level is very expensive, although it is far from the 67x price-to-earnings ratio of the Japanese stock market in 1989 and the 65x price-to-earnings ratio before the crash of the Nasdaq Composite Index in 2000. However, it is undeniable that bubble bursts do occur after reaching temporary high points in valuations, not necessarily historical peaks, and the timing of historical bubble bursts has never been the same," analysts led by Hartnett stated.