Morgan Stanley identifies three risks to the stock market rally.
Firstly, a cooling labour market is evident, with recent jobs data showing weaker hiring than expected, revisions downward for previous months, and a decrease in job openings. This suggests a potential slowdown in economic growth.
Secondly, Q2 earnings appear skewed, with strong gains concentrated in a few sectors such as tech, communication services, and financials. Many other companies are experiencing flat or modest profit growth, despite headline earnings looking strong.
Potential For A Stagflationary Pause
Thirdly, there is a potential for a stagflationary pause, with rising tariffs and ongoing inflation risks threatening to erode economic momentum later this year. The current market strength may be concealing delayed economic difficulties.
Despite these risks, the impact on the US equity rally has been minimal. The market reached another record high recently following inflation data showing figures above target and an increase in the core rate.
We are seeing a clear disconnect between underlying economic signals and market highs. The July 2025 jobs report, which showed hiring at only 150,000 against expectations of 180,000, confirms the labor market is cooling. This weakness is being ignored, creating an opportunity for traders who anticipate a correction.
The Rallys Fragile Foundation
The rally’s foundation appears fragile, as it rests on just a few mega-cap stocks. Looking back at Q2 2025 earnings, the top ten S&P 500 companies drove nearly 80% of all profit growth, while the median company’s earnings were flat. We should consider buying puts on equal-weight index ETFs, which would be more exposed to a broad slowdown than the cap-weighted indexes.
Furthermore, the threat of stagflation is growing, with the most recent July 2025 CPI data showing core inflation ticking up to 3.8%. This sticky inflation prevents the Federal Reserve from cutting rates to support a slowing economy. Such a policy bind often precedes market volatility.
Given this environment, we see complacency in the options market. The VIX is currently trading near 13, a level reminiscent of early 2024 before market turbulence, making protective options relatively cheap. This suggests it is a good time to buy downside protection.
Traders should look at purchasing put options on the SPY or QQQ with expirations in October and November 2025. This strategy offers an inexpensive way to hedge against the risks that the broader market is currently disregarding. For those anticipating a sharp move regardless of direction, straddles on the handful of mega-caps driving the market could also prove profitable.
