The sharp rally that has propelled U.S. stocks to record highs may be creating conditions for a market pullback, according to Philip Straehl, Chief Investment Officer at Morningstar Wealth, who says several indicators suggest investor optimism has reached unusually elevated levels.
While the benchmark S&P 500 has climbed 18% since its March 30 low, driven largely by a powerful rally in artificial intelligence-related companies and semiconductor stocks, Straehl believes the pace of gains is beginning to outstrip market fundamentals.
“I think it’s one signal that there might be excessive optimism in the market today, and so I think it leaves us with a cautious outlook for markets from this point on,” Straehl told Business Insider.
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His warning comes after one of the strongest momentum-driven rallies in decades, which has reached levels not seen since the dot-com era.
According to Morningstar Wealth, the S&P 500 Momentum Index recorded its strongest two-month performance on record during April and May, returning 34%. The index, which tracks the 100 best-performing stocks in the S&P 500 over recent months, surpassed even the gains recorded during the height of the dot-com boom in 1999 and 2000.
Momentum investing typically attracts investors seeking to capitalize on stocks already rising rapidly. While the strategy can generate substantial gains during bull markets, analysts also view extreme momentum as a potential warning signal because it often reflects fear of missing out (FOMO) rather than improving corporate fundamentals.
History shows that periods of exceptionally strong momentum have sometimes preceded sharp market corrections as valuations become increasingly difficult to justify.
The recent weakness in semiconductor shares illustrates how quickly investor sentiment can reverse. After leading the market higher for months, memory chip stocks and other AI-related semiconductor companies have experienced increased volatility since early June, reflecting growing concerns about valuations following Samsung Electronics’ earnings report and questions about the sustainability of AI infrastructure spending.
The broader market’s advance has been fueled largely by companies benefiting from surging investment in artificial intelligence. Since the March lows, the iShares Semiconductor ETF has gained as much as 106%, dramatically outperforming the broader market as investors poured money into companies expected to benefit from expanding AI data centers, cloud computing and high-performance chips.
Technology giants including Nvidia, Broadcom, and other semiconductor companies have become major drivers of the S&P 500’s gains, helping push U.S. equities to fresh highs. However, Straehl believes the concentration of gains among AI-related stocks has also increased market vulnerability should investor expectations moderate.
Three Indicators Point to Growing Risks
Straehl said his market outlook is based on what he describes as a “mosaic” of indicators rather than any single measure. His assessment focuses on three broad areas: investor sentiment, market valuations, and capital supply.
The first pillar, investor sentiment, suggests markets have become increasingly speculative.
Beyond the surge in the Momentum Index, Straehl pointed to rising activity in zero-day options and leveraged exchange-traded funds (ETFs), both of which have become popular vehicles for traders seeking to amplify short-term market moves.
Zero-day options, which expire on the same day they are traded, have grown rapidly in popularity because they allow investors to make highly leveraged bets on intraday market movements. Market observers have warned that heavy use of these contracts can amplify volatility during periods of market stress.
Leveraged ETFs, which use derivatives to magnify daily returns, have also attracted strong inflows, another sign that investors are becoming more willing to take aggressive risks.
Valuations Appear Stretched
Straehl also expressed concern about equity valuations. He said several widely followed valuation metrics now suggest the market is trading at historically elevated levels.
Among the indicators he highlighted were the Shiller price-to-earnings (CAPE) ratio, price-to-book multiples, price-to-sales ratios, and the equity risk premium. The Shiller CAPE ratio smooths corporate earnings over a 10-year period to provide a longer-term assessment of market valuation. Elevated readings have historically been associated with periods of lower long-term investment returns.
The equity risk premium, which measures the additional return investors receive for holding stocks instead of relatively risk-free government bonds, has also narrowed considerably as stock prices have risen, suggesting investors are receiving less compensation for assuming greater market risk.
Straehl described current valuation levels as “extreme,” indicating that future gains could become harder to sustain unless corporate earnings continue to grow rapidly.
Capital Markets Remain Active
The third component of Morningstar’s framework examines capital supply. Straehl noted that companies have increasingly taken advantage of favorable market conditions to raise money through equity offerings, debt issuance, and merger activity.
Recent examples include SpaceX’s initial public offering, Google’s $85 billion secondary share offering, and a wave of large merger and acquisition transactions. Heavy issuance often signals that corporate executives believe market valuations are attractive enough to justify raising fresh capital.
Although Straehl said current issuance has not yet reached historically extreme levels, he believes it represents another indication that companies are seeking to capitalize on strong investor demand.
Together, the indicators suggest investors should become more disciplined rather than assuming the recent rally will continue indefinitely.
“The overall reward for risk is not really good,” Straehl said.
“Our view is that you have to be more selective in today’s environment.”
His assessment does not necessarily imply that a market correction is imminent. Instead, it reflects growing concern that after months of powerful gains, particularly in AI-related technology stocks, equity markets have become increasingly dependent on optimistic expectations and elevated valuations. For investors, that could mean future returns become more uneven, with greater importance placed on company fundamentals, earnings growth and reasonable valuations rather than simply following momentum-driven trades.