The US stock market rally seems unstoppable, so why is the bearishness continuing?

The US stock market rally that marked the first half of 2023 continues into the second half, keeping bullish investors clinging to the optimism that has helped the technology-heavy Nasdaq 100 index up 42% for the year to date, while bears try to hit the spot where momentum failed. and the trend shifts to the downside.

The dichotomy between so-called stock market bulls – who are optimists and buy stocks in the hope that stock prices will rise – and bears – who believe the market is heading downwards and may try to profit from falling stocks – has grown wider.

“[It’s] it almost resembles a political landscape where each side looks at the other with anger and hatred, unable to find common ground,” said Liz Young, chief investment strategist at SoFi, in a Thursday note. “Understandably so, given the sheer volume of conflicting data – not the least of which is a sudden feverish stock market rally in the face of leading economic indicators and bond market signals that clearly raised red flags.”

US stocks extended this week’s rally after encouraging inflation readings supported the possibility of an end to Federal Reserve rate hikes may be in sight, while the likelihood of a soft landing, in which inflation returns to near the central bank’s 2% target without a recession, improved.

The S&P 500 SPX, -0.10% on Thursday topped the 4,500 mark for the first time since April 2022 while climbing to a fresh 15-month high. For the week, it has gained 2.4%, while the Nasdaq Composite COMP, -0.18% has gained 3.2% and the Dow Jones Industrial Average DJIA, +0.33% has gained 2.3%, according to FactSet data.

See: Inflation in the US has cooled significantly. Big. Here’s what’s not so great.

Market analysts told MarketWatch that the debate between bulls and bears will not rest and sentiment will not turn “fully bullish” until uncertainties around monetary policy, economic indicators and Treasury yield curve inversions are resolved.

“We still have a cycle of monetary tightening which may or may not be finished. We have leading economic indicators pointing to contraction – there are a lot of different signals out there, including an inversion of the yield curve, which is still telling us we are not out of the woods yet,” Young said in a follow-up interview on Friday. “The debate will continue and I happen to be more cautious on this one, especially with valuations at these levels.”

“This means that for now, the market is likely to take two steps forward, one step back, unless an event turns investor sentiment negative again, as it was much of the past year,” said Melissa Brown, managing director of applied research at Qontigo. .

Megacap tech stocks’ valuations surged including Nvidia Corp. NVDA, -1.10%, Meta Platforms META, -1.45%, Alphabet Inc. GOOGL, +0.71%, has pushed the S&P 500 more than 17% higher so far this year amid growing optimism around artificial intelligence (AI). There’s a risk, though, that investors pay an “inflated valuation” for stocks based on AI’s enthusiasm, but if they don’t get “satisfaction” from it in the next 12 months, the valuation may not look as attractive anymore, Young said.

“When you buy a stock, you’re usually buying it based on earnings expectations 12 months ahead, and while AI may be a completely transformative theme that permeates through different industries, it probably won’t change it. [technology landscape] entirely by the end of this year,” he said. “So what can go wrong is the expectation of the timeframe.”

See: Nasdaq makes major changes to its most popular index. Here’s how it can impact your portfolio.

Qontigo’s Brown also pointed to the current volatility in the stock market, which has fallen substantially since late March when worries about the banking sector dissipated following the sudden collapse of Silicon Valley Bank. The CBOE VIX Volatility Index, -1.98% was at 13.31 on Friday, having recently dropped to its lowest in more than three years. In general, a VIX reading below 20 indicates an environment that is considered low risk, while a reading above 20 indicates periods of higher volatility.

However, Brown says his model shows that there is a widening gap between fundamental models — which analyze market volatility based on macroeconomic conditions — and statistical models — which allow data to tell where volatility is.

“The statistical model predicts much higher risk than the fundamental model and this is the first time this has happened in at least six years and possibly longer. So what that tells us is that there is volatility lurking somewhere… it’s bubbling under the surface,” Brown told MarketWatch by phone on Friday.

A looming lack of liquidity is another major concern as investors are now “significantly overbought” relative to liquidity, especially among megacap growth stocks, said Raheel Siddiqui, senior research analyst with global equity research at Neuberger Berman.

Siddiqui, said in his third quarter equity market outlook, that investor euphoria is likely to evaporate as liquidity dries up, which is expected soon thanks to the potential for a historic draw in the coming weeks. He was referring to the Fed’s plans to shrink the balance sheet each month, otherwise known as quantitative tightening, the issuance of new debt by the Treasury to replenish the Treasury’s General Account after Congress raised the debt limit, and the European Central Bank’s plans to withdraw €477 billion in TLTRO financing from the system. banking.

See: ‘Strong liquidity squeeze’ threatens stock markets after final debt ceiling deal

“In our view, this could be bad news for equities in the near term,” said Siddiqui.

Stock market optimism eased but remained above average for the sixth week in a row American Association of Individual Investors (AAII) Sentiment Survey.. Neutral sentiment and bearish sentiment both improved in the week to Wednesday.

However, Young at SoFi said there has been a significant “reversal” of investors who are bearish and persistently bearish and have moved into the bullish camp. “While the absolute levels of bulls vs. bears on the chart don’t seem extreme, the almost instantaneous reversals in both are quite extreme,” he said (see chart below).

SOURCES: SOFI, BLOOMBERG

“Generally, a big, fast move can be followed by a big, fast move back the other way as the market and investors try to settle down to some kind of middle ground,” Young said.