The U.S. stock market has experienced a historic surge, reaching new record highs. However, signs of overheating sentiment indicate the rally may be approaching a phase of moderation.
This rebound from the March low, partly driven by expectations of eased U.S.-Iran tensions and significant corporate profit growth, has pushed investor sentiment close to the "euphoric" zone identified by a quantitative model from Bloomberg Intelligence strategists. The model tracks six indicators, with three currently pushing sentiment to this elevated level: high-yield corporate bond spreads, low volatility, and pair correlations.
This does not necessarily imply an imminent crash. Such conditions have historically been accompanied by further market gains, albeit at a more moderate pace. According to the Bloomberg Intelligence "Market Pulse" model, during periods between 2012 and 2023 when the sentiment gauge was repeatedly at high levels, the Russell 3000 Index delivered an average return of 2.9% over the subsequent three months. During these periods, large-cap stocks typically outperformed, with the S&P 500 Index beating the small-cap Russell 2000 Index by approximately 178 basis points.
Nevertheless, the current rally differs from past advances. Historically, monthly gains of this magnitude have usually occurred following deep market pullbacks, such as in April 2009 and April 2020, when stocks rebounded from crisis-induced lows. This time, however, the market is achieving new highs from an already elevated base, a dynamic that could potentially constrain future upside.
"When multiple risk-on trades dominate simultaneously—such as growth stocks outperforming value stocks and cyclical stocks outperforming defensive stocks—it often signals a later stage in a cycle rather than a new beginning," wrote Bloomberg Intelligence's Christopher Cain and Nathaniel Welnhofer. "History suggests returns can still be positive, but the appeal diminishes, and market leadership tends to narrow back towards large-cap stocks."
The S&P 500 Index rose more than 10% in April, marking its fifth-largest monthly gain in the past 35 years, with the benchmark climbing to a record high. Within less than a week into May, the index has gained an additional 2.2%.
Despite soaring energy prices casting a shadow over the outlook for the remainder of the year, this rally is not without fundamental support. First-quarter earnings are projected to have grown nearly 27% year-over-year, more than double the 12.4% growth forecasted before the earnings season began. As of Wednesday's close, over 83% of companies have reported results that beat expectations, the best performance since 2021, while the proportion of companies missing expectations is near a more than 30-year low.
However, market breadth remains narrow, with the recent advance largely driven by major technology stocks. Among S&P 500 constituents, only about half are trading above their 50-day moving averages.
Many on Wall Street believe broader participation from more stocks is necessary to sustain the current market uptrend.
