Stocks Are Hitting Records in Goldilocks Market. Beware the 3 Bears.

A scene from the floor of the New York Stock Exchange on Tuesday. (Michael M. Santiago/Getty Images)

The S&P 500 and Nasdaq Composite have rallied to record highs in a Goldilocks stock market seen as priced “just right” given the balance of risks. But any narrative about Goldilocks must also include the three bears that threaten the fairy tale’s happy ending.

Enter strategists at Goldman Sachs in London. While investors dismiss negatives such as tariffs, geopolitical worries, and high valuations, focusing instead on positives like a still solid economy, strong earnings growth and euphoria about artificial intelligence, they see potential trouble.

In a report earlier this week, they laid out three bearish scenarios for the second half of the year that investors might be ignoring. They include a shock to economic growth that hits stocks, interest rates remaining higher for longer, and an even steeper decline in the U.S. dollar.

The Goldman strategists warn that the combination of tariffs and fiscal stimulus from President Donald Trump’s tax and spending bill could lead to more inflation. Add in the possibility that the Federal Reserve doesn’t cut interest rates this year, and that could create a stagflationary environment: stagnant growth plus higher prices.

A stuttering, inflation-ridden economy could also put more pressure on the dollar, which has already fallen 10% this year against a basket of other major currencies.

So how should investors prepare for higher inflation and interest rates, slower growth and a weaker greenback? The Goldman strategists recommend bonds with shorter durations to mitigate rate risk. They also like bank and infrastructure stocks, as well as gold and exposure to select emerging markets, particularly China.

Others also think that investors need to tread cautiously now that the market is back in record territory.

“I’m surprised that the rebound has been this quick after the nasty and sharp selloff post Liberation Day,” said Aleks Spencer, chief investment officer with Bogart Wealth, a financial planning firm in McLean, Va., in an interview with Barron’s. “I’m not surprised by the direction of the move but I am of the magnitude.”

The S&P 500 is now trading at 24 times earnings estimates for this year, not far from where it was in February. That is well above the price-to-earnings ratio of 19 that stocks tumbled to in April.

“We’re neutral on equities right now. There is no need to get more aggressive here,” said Adam Phillips, managing director of investments with Torrance, Calif.-based EP Wealth Advisors, in an interview*.*

“This is a delicate environment where one or two headlines could cause some investors to run for the exits,” Phillips said. “We’re not going to revisit the lows from April necessarily but you may not want to come back in at these levels.”

The market is once again priced for perfection. That is often a recipe for a pullback. To quote the police sergeant on the popular 80s TV show Hill Street Blues: “Be careful out there.”

Write to Paul R. La Monica at paul.lamonica@barrons.com