“Gosh, All a kid has to do these days is spit straight and he gets forty-thousand dollars to sign” – Cy Young

A Market Untethered from Fundamentals

It’s been another very strong week for markets, at the time of writing on Friday, February 14, 2025, the S&P500 has been up 1.29%, with the Nasdaq up 1.67%. We believe the market has been especially resilient given some of the macro headwinds and ever-changing political messaging to come out of the White House, but, investors have taken this in stride, discounting and parsing through a lot of the dire predictions out there and have been rewarded for their resilience. Another reason we believe markets have held up are the positive earnings surprises we are getting out of the S&P500 earnings season. Going into this last quarter, earnings expectations had seen large revisions to the positive, Factset’s earnings scorecard reported 63% of reporting companies had better bottom-line results, with 77% of the group reporting better on revenue that previously guided 【0】. This type of earnings momentum carries a lot of positive guidance for the future outlook of the stock market and economy as a whole. And as we continue to see markets shrug their shoulders in the face of a developing contrarian indicators, such as higher CPI, PPI and lower than expected retail sales data, we think that it becomes ever more vulnerable to switching investor focus, from the micro of earnings to the macro headwinds developing for economic growth. But as Cy Young points out, it can’t be this easy can it?

One thing in particular we have noted in 2025 is the strength of retail traders that are dominating price action and continuing to show up running to buy the dip, a strategy that has worked very well over the past few years. However, we think this could be fueling speculative excess, especially as institutional investors remain on the sidelines. Bloomberg Intelligence’s Market Mania Indicator, a composite measure of speculative trading activity, retail option flows, and leverage usage reached levels not seen since the 2000 dot-com bubble【1】.

More concerning, the equity risk premium (ERP), which measures the excess return investors demand over risk-free Treasuries, has turned negative【2】. This signals that investors are willing to accept lower expected returns for holding equities than they would receive in guaranteed government bonds, historically, this is a clear warning sign of excessive optimism. Additionally, the cyclically adjusted price-to-earnings (CAPE) ratio, which smooths earnings over a 10-year period, is hovering above 38【3】, placing it in the top decile of valuation norms. Historically, markets at these levels have struggled to generate positive annual returns.

The last time we saw this combination, negative ERP, high CAPE, and euphoric retail trading was during the peak of the dot-com bubble in 2000 and 2008 crash. In both instances, the market suffered significant drawdowns, with the Nasdaq declining over 75% after 2000 and the S&P500 falling over 50% during the 2008 Great Financial Crises【4】. That being said, we are not structurally negative on equities for the year, however, we are downgrading our overweight to neutral for the rest of the quarter, until we see how markets digest the macro economic environment and navigate some of the political uncertainty that have emerged.

Where Is Institutional Capital?

Despite the relentless rally, institutional investors are noticeably absent. Hedge funds and asset managers are not participating in this risk-on frenzy at levels consistent with past bull markets【5】. In fact, institutional positioning, as measured by CFTC futures positioning data and fund flow reports, remains cautious【6】. This lack of institutional conviction suggests that the current rally is not supported by strong hands but rather by momentum-chasing retail traders, a recipe for increased volatility and potential downside risk.

Moreover, high valuations suggest that the market is pricing in perfection, leaving little room for disappointment. Earnings growth expectations are elevated, yet economic and monetary policy uncertainties loom【7】. If earnings fail to meet expectations or if liquidity conditions tighten, the market could experience a sharp re-pricing.

Historical Parallels: What Happened When These Indicators Flashed Red?

Markets do not operate in a vacuum, and history provides valuable lessons on what happens when valuation excess and speculative fervor dominate:

1. Dot-Com Bubble (1999-2000): CAPE exceeded 44, retail trading volume surged, and speculative IPOs with no earnings soared. When the Federal Reserve raised rates and liquidity tightened, the market collapsed, wiping out $5 trillion in wealth【8】

2. The 2008 Great Financial Crisis: The equity risk premium was close to zero at the start of the year as U.S Government bond yields rose above equity market earnings yields. The lack of caution and continued purchases of equities even in the face of serios macro and financial contagion drove the equity risk premium below zero resulting in sharp corrections and a serious downturn in the equity markets 【9】

3. 2021 Meme Stock Frenzy: A short-lived mania driven by retail traders, fueled by zero-commission trading, options speculation, and government stimulus. The fallout led to a sharp correction in overvalued stocks【10】

These examples illustrate that when valuations and speculation decouple from fundamentals, markets tend to correct sharply.

Strategic Actionable Steps for Investors

In this environment, investors should take proactive measures to de-risk their portfolios while maintaining exposure to assets that can navigate periods of uncertainty:

1. Lower Exposure to High-Valuation Equities

Reduce exposure to stocks with extreme valuations, particularly unprofitable growth companies and speculative technology names【11】. Shift allocations toward high-quality, cash-generating businesses with strong balance sheets.

2. Increase Allocations to Defensive Assets

Sectors such as consumer staples, healthcare, and utilities tend to outperform during periods of market turmoil【12】.Consider defensive equity strategies that prioritize dividend growth and earnings stability.

3. Fixed Income Offers Relative Value

With the equity risk premium negative, fixed income provides an attractive alternative. High-quality corporate bonds and U.S. Treasuries offer favorable risk-adjusted returns【13】.

Shorter-duration bonds can help mitigate interest rate risk while preserving capital.

4. Tactical Alternative Investments

Consider exposure to real assets, such as commodities and infrastructure, which provide inflation hedging and diversification【14】.

5. Utilize Active Management for Downside Protection

Passive investing thrived in a liquidity-driven market, but active strategies can help navigate volatility. Funds with the flexibility to adjust positioning, hedge risk, and identify mispriced assets will be essential in a more turbulent market environment.

A Bull Case for Fixed Income and Defensive Strategies

With valuations stretched and risk-reward skewed against equities, fixed income and defensive strategies offer a compelling case:

Fixed Income Is Back: After years of ultra-low yields, bonds now provide attractive returns. The yield on the 10-year U.S. Treasury exceeds many equity dividend yields, offering a compelling risk-adjusted return【15】.

Dividend-Paying Stocks Provide Stability: Companies with consistent dividend payouts and strong cash flows tend to outperform in market downturns【16】.

The Role of Tactical Income Strategies: Funds like the Modern Capital Tactical Income Fund are designed to reduce volatility, provide consistent income, and hedge against market downturns through a combination of fixed income, alternative assets, and tactical allocations【17】.

Conclusion: Prepare for Volatility

The current market regime is starting to look a little long in the tooth still unable to find a clear direction, which we believe could mean that short term dislocation is likely, and in the event that would occur over the next few weeks, we would see as a buying opportunity to flush out some of the excessive speculation, high valuations and bring back institutional conviction. And while the rally could continue in the short term for the next two weeks, we see a lot of headline risk manifesting after earnings season that could produce an environment that lacks catalysts to continue moving higher. This is why for the moment we are hinting some caution, even though we are still structurally constructive and bullish on equities for the remainder of the year. We just don’t like the current technical, macro and certain fundamental backdrop of the group of equities that are leading this market. That being said, it’s possible we enter into a broadening on the back of sector rotation, rather than an outright selloff. But history suggests that markets at these levels are vulnerable to correction. Investors should take a disciplined approach by reducing exposure to concentrated asset positions and could benefit from increasing allocations to defensive sectors, and leveraging fixed income to enhance portfolio stability.

As market euphoria wanes, those who take a strategic approach will be best positioned to capitalize on a return to fundamentals, securing opportunities to invest in leading technology and consumer stocks at more attractive valuations.