Risks to Wall Street's rally abound despite record high

NEW YORK (Reuters) - The benchmark S&P 500 index hit a record high on Thursday as an almost giddy euphoria over the prospects of a U.S. interest rate cut fueled the appetite for equities, but there are plenty of pitfalls that could throw the stock market off course.

FILE PHOTO: Street signs for Broad St. and Wall St. are seen outside of the New York Stock Exchange (NYSE) in New York, U.S., March 7, 2019. REUTERS/Brendan McDermid

From the high expectations for something positive on the U.S.-China trade front at next week’s Group of 20 summit, to rising geopolitical concerns and a worrying U.S. profit picture, the potential for missteps and stumbles is great.

Moreover, the rally appears to be based more on hope than reality, strategists said.

“This is probably one of the riskiest points you’re ever going to see in the stock market,” said Michael O’Rourke, chief market strategist at JonesTrading in Greenwich, Connecticut. “The price level here is not supported by fundamentals. It’s supported by sentiment and hype and hopefulness about monetary policy.”

The S&P 500 on Thursday finished at a record closing high and the 10-year Treasury yield dipped below 2% for the first time in more than 2-1/2 years a day after the Federal Reserve signaled the potential for a rate cut as soon as its next meeting in July as it said it was ready to battle risks to the economy, including the U.S.-China trade war.

There were other signs of the risk-on sentiment driving the market. Though it rose slightly on Thursday, the Cboe Volatility index, known as Wall Street’s favorite fear gauge, is near its lowest level since early May. And Apple Inc, a technology bellwether, on Thursday briefly hit $200 a share for the first time since early May, though the iPhone maker is viewed as a major potential casualty in Trump’s trade war, should it worsen.

O’Rourke warned that some factors are a double-edged sword. While the market has embraced potential rate cuts, there is a downside to such cuts because they would be more likely if economic conditions deteriorate further, which is also a risk for stocks, he said. On the other hand, a trade deal with China may reduce the need for a Fed rate cut.

The recent gains in stocks follow a sharp selloff in May amid an escalation in the trade dispute between the world’s two biggest economies, which stoked fears of a global economic slowdown.

The rally has come as earnings projections have weakened, making valuations more expensive. The S&P 500 index is trading at 17.1 times forward earnings, up from 16.3 at the start of the month, according to IBES data from Refinitiv, before the optimism over a rate cut took hold.

Strategists said the current risk-on trade will be put to the test in the coming weeks.

A lot is riding on the upcoming Group of 20 meeting, when U.S. President Donald Trump and China’s president, Xi Jinping, are due to meet on the sidelines of the June 28-29 summit in Japan.

Investors are likely to embrace even the smallest sign of progress, said Mike Mullaney, director of global markets research at Boston Partners.

But “if something happens and breaks down, then all bets are off as far as risk is concerned. We go back to a risk-off trade because it brings this whole trade war back into the consideration of investors’ minds,” he said.

Adding to the uncertainty for stocks are worries about a potential military confrontation between Tehran and Washington. Oil prices jumped more than 5% on Thursday after Iran shot down a U.S. military drone.

Rising oil prices are a negative for stocks because they cut into consumer spending, said Quincy Krosby, chief market strategist at Prudential Financial in Newark, New Jersey.

That’s among the many reasons investors are likely to hedge their bets when it comes to buying stocks, cyclicals in particular, she said.

The prospect of “further escalation of Middle East geopolitical risk creates uncertainty,” Krosby said.

Reporting by Caroline Valetkevitch; additional reporting by Lewis Krauskopf; editing by Alden Bentley and Leslie Adler