Veteran manager highlights stock flaw post-rally

The S&P 500’s Unstoppable Rise and the Growing Concerns

The S&P 500's remarkable ascent from early April through July 2025 has left many investors bewildered. This spring, the stock market experienced a significant decline of nearly 20% due to the introduction of new tariffs. There was widespread concern that these tariff-induced inflationary pressures could lead to economic stagnation or even a recession.

Despite the ongoing worries about high tariffs and the slowing U.S. economy, stocks have continued to rise since April 9, when President Donald Trump paused several reciprocal tariffs, allowing for potential trade agreements. This development has left many investors who anticipated a market correction feeling sidelined, questioning whether it's too late to enter the market.

Veteran hedge fund manager Doug Kass, with decades of experience in the financial industry, understands this sentiment. He previously served as the research director for Omega Advisors, one of the most renowned hedge funds. Recently, Kass addressed the current stock market rally, its driving factors, and the risks that every investor should consider following the S&P 500’s impressive performance.

The Role of Animal Spirits and Computer Algorithms

In the past, stock trading was primarily conducted by humans on major exchanges like the New York Stock Exchange. However, today, the market is increasingly influenced by computer algorithms designed to capitalize on every fluctuation in stock prices. These programs, along with financial products such as short-term options, are created by Wall Street firms to exploit both greed and fear.

Kass described the recent market movement as a "steel cage match" where bulls have dominated, similar to the legendary wrestlers Muhammad Ali and Hulk Hogan. However, he noted that the bear market has developed a sense of skepticism over the last three months, as retail traders, zero-day expiration option traders, and volatility-controlled funds have consistently bought dips, fueling a cycle of momentum and fear of missing out (FOMO).

This dynamic has led to a self-fulfilling upward trend, with computers trading among themselves and speculators seeking quick gains from the options market. The result is a surge in FOMO for those who sold during the downturn or hesitated to invest, hoping for a better entry point.

Explosive Gains in High-Risk Sectors

The gains in the stock market have been particularly striking in high-risk sectors, especially emerging industries such as cryptocurrency, artificial intelligence, space exploration, and quantum computing. For example, Circle Internet, a stablecoin player, has seen a 132% increase since its June IPO. CoreWeave, an AI cloud computing company, has risen 165% since April 8. Rocket Lab, which launches small payloads into orbit, has gained 188% since its early April lows. Quantum Computing has surged 278% since its March bottom.

What do these companies have in common? None of them have yet turned a profit, raising concerns about the sustainability of their growth.

Economic Challenges That May Not Be Ignored

The S&P 500’s 24% gain in 2024 was fueled by increased spending on artificial intelligence, the promise of earnings growth tied to AI-driven efficiency, and the expectation of lower interest rates as the Federal Reserve shifted from a hawkish to a dovish stance. However, the Fed has not yet cut rates in 2025, despite reducing them by 1% at the end of 2024, creating a headwind for the market.

AI spending remains robust, with Alphabet recently increasing its capital expenditure outlook for this year to $85 billion from $75 billion. Nevertheless, signs of economic strain have emerged:

• Layoffs reached 247,256 in Q2, the highest since the pandemic.
• The unemployment rate rose to 4.1%, up from 3.4% in 2023.
• The World Bank predicts U.S. GDP growth will be just 1.4% in 2025, down from 2.8% in 2024.
• Tariffs, although less severe than feared, still represent a significant tax hike.

These economic challenges pose a risk to the stock market, especially after its substantial gains.

Valuations and the Potential for a Correction

Market participants have largely ignored the inflationary threat, assuming that trade deals will mitigate the impact and that corporations can offset any margin losses through a weaker U.S. dollar or cost-cutting measures. Those betting on the U.S. economy avoiding a worst-case scenario—slow growth with inflation or even a recession—have benefited significantly.

However, valuations for many stocks have risen sharply. According to FactSet, the S&P 500’s forward one-year price-to-earnings ratio is 22.4. Historically, such a high P/E ratio has depressed future stock market returns. Without a significant increase in earnings estimates, which are now largely expected, stocks may face a period of consolidation.

Kass has taken a cautious approach, recently selling off numerous long positions in housing, financials, private equity, and selected technology stocks. He has built up a cash reserve, believing that the risk outweighs the reward. He emphasizes the importance of maintaining a margin of safety in investing.

While the market can remain irrational for longer than expected, sitting in cash has not been a winning strategy lately. Kass acknowledges that he is often wrong and always in doubt. However, he points out that earnings estimates are declining, even as stock prices continue to rise. Having some cash available to take advantage of any weakness could still prove beneficial.