A recession, investor FOMO, and inflation are threatening the stock market's red-hot rally

• The stock market's red-hot rally could be in danger, Wall Street experts have warned.
• Recession risks are still alive, and too-hot inflation could pose headwinds.
• Meanwhile, valuations are high, thanks in large part to the AI frenzy still gripping Wall Street.

The stock market's red-hot rally faces a host of risks that could derail the last four months of stellar performance.

Wall Street experts have been sounding the alarm that stocks are overvalued and the economy remains in a precarious position — even as some investors continue to feel confident about a soft-landing.

But recession risks are very much alive, even if the economy looks resilient on the surface. The bond market has been sounding the alarm for a recession since late 2022, with the notorious 2-10 Treasury yield curve briefly reflecting its steepest inversion since 1981.

The "full model," another recession indicator based on a handful of economic data points, is flashing an 85% chance a downturn could hit the economy this year, the highest odds of a recession seen since the Great Financial Crisis.

According to Paul Dietrich, the chief investment strategist of B. Riley Wealth Management, even a mild recession could send the S&P 500 tumbling by over a third. He pointed to the recession that struck the economy in the early 2000s, where GDP dipped just 1%, though the S&P 500 cratered nearly in half as the bubble in internet stocks burst.

"Even in a mild recession, investors holding the S&P 500 index should expect to lose over a third of their retirement investments in stocks," Dietrich wrote in a note last week.

Inflation has also disappointed economists — another factor that could help send stocks tumbling from their highs. Consumer prices came in hotter than expected in January, rising 3.1% year-over-year. Core inflation rose 3.9%, the largest jump in eight months.

Higher prices have dampened the outlook for Fed rate cuts this year, which central bankers will only consider if they're confident inflation is returning to its 2% target.

That means investors have a good chance of being disappointed with the amount and timing of interest rate cuts, which could deliver a hefty blow to stocks. Markets are still pricing in a 32% chance rates could be cut by 100 basis-points by the end of the year, more than what the Fed has officially forecast, according to the CME FedWatch tool.

"The real problem — and one that most people hadn't even begun to consider — is that if inflation re-accelerates and goes higher again then the Fed will be forced to resume raising rates, which would have a major impact on stock prices," Chris Zaccarelli, CIO of Independent Advisor Alliance, wrote in a note this week.

It doesn't help that stocks keep notching new highs, with the S&P 500 closing at another record on Thursday. Investors are in a frenzy over artificial intelligence, which has catapulted the Magnificent Seven stocks to dizzying heights in the last year.

But the market is likely being driven by investor hype more than anything, Dietrich said, meaning many stocks are probably overvalued.

"So many investors get caught up in the excitement, momentum, and enthusiasm of a stock market that is running like the Kentucky Derby," Dietrich said in a note last week. "It is that irrational Fear Of Missing Out, or 'FOMO,' that fuels this behavior."

The Magnificent Seven reflect one of the biggest "speculative orgies" the market has seen in decades, investing veteran Bill Smead told Business Insider in December. Smead said he predicts the most expensive stocks on the market eventually will see 70% of their value wiped out.

John Hussman, the Wall Street investor who called the 2000 and 2008 market downturns, also warned stocks could plunge as valuations look extreme.

"Without making forecasts, it's fair to say that we would not be surprised by a near-term market loss on the order of 10% or more in the S&P 500, nor would we be surprised by a full-cycle market loss on the order to 50-65%, nor a US recession that the consensus seems to have ruled out," he said in a note this month.

Those risks may be lost on some investors, who are feeling pretty optimistic that momentum in stocks can continue. 42% of investors said they felt optimistic about the stock market over the next six months, according to the AAII's latest Investor Sentiment Survey.

Meanwhile, 81% of individual investors think the Dow will end the year higher, according to a survey from the Yale School of Management, the most bullish investors have been since March 2007.