Rare event could derail S&P 500 record-setting rally

The stock market has had a record-setting run following President Trump's decision to pause reciprocal tariffs on April 9.

The move to de-escalate trade tensions reversed a brutal selloff in the S&P 500 that at its worst had sent the benchmark index tumbling 19%, nearly into bear market drop territory.

The market decline was severe enough to trigger oversold readings on most sentiment measures, and many market watchers were savvy enough to recommend buying into the fear. However, far fewer likely expected the rally to persist amid a tidal wave of economic concerns and global uncertainty.

Yet, that's precisely what the S&P 500 has done.

Rather than backfill gains, it has essentially beelined higher, creating a V-shaped bottom that has surprised many who remain with cash on the sidelines watching, hoping for a chance to buy.

The index's advance is remarkable, but stocks don't rise or fall in a straight line, and mounting evidence suggests that the S&P rally could stall soon, especially after one particularly rare signal flashed on Friday.

The S&P 500 has set a new all-time record high on June 27. The rally triggered a rare overbought signal.

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The S&P 500 rallies as optimism returns

A raging bull market lifted the S&P 500 by over 20% in back-to-back years in 2023 and 2024, including a robust 24% gain last year.

The gains were fueled by optimism that the Federal Reserve would switch to market-friendly interest rate cuts, thanks to falling inflation, and abandon the hawkish monetary policy it adopted in 2022 in its war against inflation.

A tsunami of artificial intelligence spending also supported gains as companies raced to develop AI chatbots and agentic AI apps.

Those bullish arguments looked much flimsier this spring.

The Fed cut interest rates in September, November, and December last year; however, it paused additional reductions this year because it feared tariffs would spark price increases.

In May, Personal Consumption Expenditures (PCE) price index, excluding energy and food because of their volatility, showed inflation was 2.7%, up from 2.6% in April, and over the Fed's 2% inflation target.

The Fed's pause removed some excitement that lower rates would spark business investment and lower interest expenses on variable debt—bad news for corporate sales and earnings growth that contributes to higher stock prices.

Similarly, earlier this year, fears mounted that major hyperscalers, including Amazon's AWS, Meta Platforms, Google Cloud, and Microsoft's Azure, would pare back AI spending on servers and AI chips after two years of huge spending growth.

Those concerns strengthened after the launch of the Chinese-built Deepseek-R1, a rival to OpenAI's ChatGPT and Google's Gemini, in January.

DeepSeek was reportedly built for only $6 million using cheaper, legacy semiconductor chips, rather than Nvidia's latest fastest Blackwell lineup of graphic processing units (GPUs).

However, concerns over the Fed and AI spending have decreased since April.

Cloud network providers, including hyperscalers, have mostly reinforced their capex plans for this year.

Amazon has affirmed a capex run rate of over $100 billion. Meta Platforms increased its planned spend to as much as $72 billion from $65 billion previously. Microsoft confirmed in June that it still plans to spend $80 billion. And Google will likely spend about $75 billion.

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Meanwhile, while the Fed didn't cut rates again in June, it maintained its closely-watched dot-plot forecast plans to cut rates twice before year-end.

Some Fed members have also recently expressed interest in cutting as soon as July, and most believe a Fed cut will likely happen in September, suggesting lower rates are getting closer by the day.

With rates potentially heading lower soon and AI spending mostly intact, tariff worries are the last remaining hurdle, and those concerns have also ratcheted back following trade progress with the UK and China.

The S&P 500 flashes a rare overbought signal

The S&P 500 has clearly climbed the proverbial wall of worry, closing at a new all-time high of 6,173.07 on June 27.

The bad news, however, is that the rally has lifted the S&P 500's valuation back toward levels seen when the index made its previous all-time high in February.

The S&P 500's forward price to earnings (P/E) ratio is 21.9, up from about 19 in April. In February, it was above 22, according to FactSet.

The index's average P/E ratio over the past five and ten years is 19.9 and 18.4, respectively. Unfortunately, it's historically harder to come by gains in the year following a P/E ratio above 22

Clearly, the S&P 500 isn't as cheap as it was in April, and that could create a headwind for stocks, particularly given sentiment measures aren't oversold like they were then.

CNN's Fear/Greed Index registered “Extreme Fear” in April, but it's at “Greed” now. The American Association of Individual Investors survey saw bearish outlooks for the coming six months surge to 61.9% in April, the third highest on record and the highest reading since the stock market bottomed in March 2009 during the Great Financial Crisis. Now, bearishness is more neutral at 40%.

Increasing investor giddiness may make it harder for the S&P 500 to continue rallying, at least in the short term.

This is especially true given that another relatively rare signal, a relative strength index (RSI) (14) reading above 70, flashed a warning on Friday. RSI (14) measures price action over the preceding 14 trading periods and can signal when stocks become overbought and oversold.

An RSI above 70 on the S&P 500 signals buyer beware, while a reading below 30, like in April when the RSI on the SPDR S&P 500 ETF Trust (SPY) dropped to about 21, suggests selling is overdone.

Currently, the RSI on the S&P 500 is 70.2.

For perspective, it last exceeded 70 on December 4, before a 4% retreat through January 10. It reached 69.97 on May 19, before a short-and-fast 2.7% drop.

Of course, nothing is guaranteed. Stocks can always fall further than anyone expects and remain overbought for a while. John Maynard Keynes famously wrote, “Markets can remain irrational longer than you can remain solvent.”

Nevertheless, the high RSI reading may suggest that the S&P 500 rally may stall in the coming weeks. In the intermediate or long term, well, gains or losses will likely depend on whether high tariffs fuel inflation, causing the Fed to stay on the sidelines, and whether business spending forecasts stay strong or weaken.