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How do you solve a problem like euphoria?

Investors – even ones who don’t like classic Rodgers and Hammerstein show tunes – should start asking themselves that question. The problem these days isn’t how to find upbeat data. It’s how to avoid being swept away by so much good news.

Start with the nasty recession that was supposed to hit us in 2023. As you may have noticed, it didn’t. Instead, jobs have remained plentiful in Canada and the United States. Meanwhile, the runaway inflation of two years ago has defied gloomy forecasts and faded steadily away.

In yet more positive news, the artificial intelligence boom is powering a market frenzy. This week’s eye-popping results from chip maker Nvidia Corp. NVDA-Q testify to the monumental amounts of money pouring into AI.

Small wonder, then, that people on three continents are snapping up stocks. The U.S.-based S&P 500 Index hit a record this week. So did the Stoxx Europe 600. Even Japan’s Nikkei 225, the graveyard of high hopes, has finally managed to surpass its 1989 high.

But all of this excitement raises an obvious question: Are investors getting carried away?

Maybe so. There is a lot to like in the current economy. There is also a risk that people are seeing only the positives.

The optimists who are driving today’s markets seem to be counting on two incompatible outcomes – a strong economy and falling interest rates – to jolt stocks even higher.

Let’s think this through: Yes, the Federal Reserve, the Bank of Canada and other central banks will slash interest rates if their economies slow and threaten to slide into a recession. However, it’s difficult to see why authorities would rush to cut interest rates if economic growth continues to power ahead and the threat of renewed inflation still lingers.

Given the trade-offs involved, investors will probably get only half of what they want in 2024. They will either face a strong economy with punishingly high interest rates or a weakening economy with low interest rates. Neither seems like a great reason to suddenly turn your portfolio upside down and bet a lot more on stocks.

Investors may want to ponder other risks, too. The most glaring danger is the market’s reliance on an extremely small group of big winners. The sizzling record of U.S. stocks in recent years rests largely on seven names – Apple Inc. AAPL-Q, Alphabet Inc. GOOGL-Q, Inc. AMZN-Q, Meta Platforms Inc. META-Q, Microsoft Corp. MSFT-Q, Nvidia and Tesla Inc. TSLA-Q.

It’s not clear how long the already expensive Magnificent Seven can keep on powering big gains. Maybe prosperity will broaden and other companies will join in, but the U.S. market as a whole is no bargain.

According to Citigroup, U.S. stocks now trade for 37 times their average annual earnings of the past 10 years. This is roughly double their historical norm and not far off the levels they hit during the dot-com bubble of the late 1990s.

As you may recall, the dot-com euphoria gave way to more than a decade of zero returns for U.S. investors. Another “lost decade” may be in the works, warned a report this week from Richard Bernstein Advisors in New York. It suggests investors veer away from the Magnificent Seven in favour of cheaper sectors and markets.

This seems like sensible advice. International markets from Canada to Japan are far cheaper than the U.S. on just about any metric you choose. If nothing else, international diversification insures you against the danger the Magnificent Seven will fall short of lofty expectations.

If that’s not enough to put your euphoria in its place, you may want to contemplate the uncertain outlook for the U.S. economy. It has been the standout success story as COVID-19 has faded and how it goes will have a lot to say about prosperity globally.

The problem right now is that its direction is anyone’s guess. “It is a nearly impossible time to be forecasting the [U.S.] economy,” griped Eric Lascelles, chief economist at RBC Global Asset Management, in a report this month. As he pointed out, you can cite “never before wrong” indicators on both sides of the debate over whether the U.S. economy is headed for a hard landing.

Steven Blitz, chief U.S. economist at market researcher T.S. Lombard, makes a similar point. He argues that investors have been lulled into a false sense of security by the failure of normally reliable macroeconomic indicators such as the yield curve, a measure of how short-term bond yields compare with long-term yields.

Historically, an inverted yield curve (when short-term yields rise above long-term ones) has been a nearly infallible indicator of a U.S. recession ahead. But the yield curve has been inverted for more than a year with no such downturn.

Mr. Blitz argues that is because inflation has distorted the signal. He argues the real yield curve – that is, adjusted for inflation – only flipped negative last month. If history is any guide, a recession is still likely.

Personally, I’m keeping my eye on temporary workers. In the past, a fall in the number of temps has provided reliable warning of a U.S. downturn ahead. And, yes, the temp numbers have been falling hard in recent months. That may not be a guarantee of recession to come, but it is enough to make me mix some caution with my glee.

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