Wall Street may be getting a bit too excited about the stock market's hot start to the new year.
The S&P 500 has already jumped nearly 3% for 2020, rising more than 1% this week to reach fresh record highs. But as the market keeps going up, traders are becoming overly optimistic about equities, data compiled by Ned Davis Research shows.
The Ned Davis Daily Trading Sentiment Composite — which measures how optimistic or pessimistic traders are — currently sits at 80, squarely in "excessive optimism" territory. The measure also hit its highest level since June 2018 recently. Historically, the S&P 500 has lost an average of 5% annually since 2006 when the composite is above 62.5, or showing excessive optimism.
Ned Davis Research's data is not the only one showing potential euphoria in the market, either. Other experts point out that valuations are at historic highs on some measures while earnings expectations are lackluster at best. Some also note trade tensions between China and the U.S. could flare up once again even after the signing of a phase one agreement. If investors are not careful, they could suffer steep losses after the market's recent rally.
"Shorter-term sentiment is extremely optimistic," Ned Davis, senior investment analyst and founder of Ned Davis Research, said in a note. "Investors tend to be optimistic entering a new year, with lots of inflows to IRA's and pension plans, but this still shows very high and rising short-term risks."
Equities have largely refused to go down in 2020 thus far. Through 12 trading days this year, the S&P 500 has closed lower just four times. The biggest of those four declines came on Jan. 3, when the broad average slid 0.7%.
The S&P 500 has also gone a long time without posting a big drawdown. The average's last one-day pullback of at least 1% happened Oct. 8, when it plunged more than 1.5%. That amounts to 70 trading days since the market's most-recent 1% drop.
Investors have been lifting stock prices since mid-October amid hopes that China and the U.S. would strike some sort of trade deal. Those expectations materialized on Wednesday, with both sides signing a so-called phase one trade agreement.
However, the deal does not remove existing U.S. tariffs on Chinese goods. It also lets the Trump administration raise tariffs targeting China if the country does not hold up its end of the deal. These aspects of the agreement have led some market analysts to call it "fragile" as the possibility for more levies remains. Still, the market continues to notch record highs.
"There's a lot of momentum in the market right now. I think people are looking for something to kind of bring us down a little bit," said Christian Fromhertz, CEO of The Tribeca Trade Group. "How does that end? We don't really know."
That momentum has been provided in large part by mega-cap stocks such as Microsoft, Apple and Google-parent Alphabet. Microsoft and Apple are both trading around record highs, while Alphabet's market capitalization broke above $1 trillion for the first time on Thursday.
"Risk wise there is not necessarily any fundamental that could tip things, but I do think sentiment has gotten a bit frothy," said Liz Ann Sonders, chief investment strategist at Charles Schwab. "That in it of itself doesn't suggest a problem for the market, but it does establish some vulnerability than if investors were more skeptical."
This recent run-up also puts more pressure on corporate earnings. The corporate reporting season kicked off last week with big banks such as J.P. Morgan Chase, Citigroup, Morgan Stanley and Bank of America all posting quarterly numbers that exceeded expectations.
In all, about 8.7% of S&P 500 companies have reported earnings thus far. Of those companies, 72% have posted calendar fourth-quarter earnings that beat analyst expectations, FactSet data shows.
Still, overall S&P 500 earnings are still forecast to fall by more than 2% for the fourth quarter following last week's reports. Without solid earnings growth, it will be hard for investors to justify the market's high valuations.
"While equities are clearing enjoying a strong period of momentum and investors obviously seem comfortable w/higher multiples, it's hard to see the present ~19x valuation sustaining," wrote Adam Crisafulli, founder of Vital Knowledge.
The forward S&P 500 price-to-earnings ratio — a widely used valuation metric on Wall Street — currently sits around 18.6, its highest level since January 2018. Meanwhile, the market cap-to-GDP ratio — which measures the stock market's size relative to the economy — is at an all-time high.
To be sure, Piper Sandler's Craig Johnson points out that just because the market is overbought, it does not mean this bullish trend will end any time soon. "Historically, overbought conditions can persist for meaningful periods before either a time or price correction develops," he said.
Mark Newton, managing member at Newton Advisors, is far more worried. In a note to clients Friday, he said the market's relentless rally to record highs is "eerily" reminiscent of the melt-up experienced in January 2018. Back then, the S&P 500 surged 8.2% before a steep correction that ran between February and March of that year.
This "blow-off showing no evidence of stalling," Newton said in the note. "No news really matters to shake markets, and bad economic news or earnings, not to mention geopolitical threats matter for a few hours only before the relentless rally continues unabated."
"Make no mistake, this market move is NOT normal, and is NOT something which should be able to continue technically into and through February without a major hiccup," Newton added.
—CNBC's Michael Bloom and Nate Rattner contributed to this report.