3 Reasons the Market Can Rally, 2 Ways to Diversify If It Doesn't

Key Points

• These three main components suggest that the S&P 500 may have enough momentum to keep breaking out into new highs.
• Downside protection is advised; however, careful investors are more likely to make it out okay if they're wrong.
• This is where small-cap stocks and bond exposure will be useful for the coming months.

As the S&P 500 and the Nasdaq-100 indexes trade near and new all-time highs now, many investors may wonder whether any bullish outlooks could already be priced into the overall stock market’s valuation. The truth is that, while there are a few key reasons why higher prices might occur, investors should also consider the best ways to hedge their current portfolios.

Initially, three key reasons should be addressed, emphasizing the potential benefits and bullish outlook before considering insurance. These factors are likely to influence investors to act in the SPDR S&P 500 ETF Trust NYSEARCA: SPY in the upcoming months and quarters. However, there are two other worthy mentions to keep in mind in case unforeseen events cancel the party earlier than is now anticipated.

These alternative plays, offering both protection and diversification, are represented in the iShares Russell 2000 ETF NYSEARCA: IWM, which focuses on the small-cap segment of the market. This segment has lagged behind in the current secular bull run that has benefited the rest of the S&P 500. If a genuine risk-off situation occurs, investors might find opportunities for alpha in the bond markets via the iShares 20+ Year Treasury Bond ETF NASDAQ: TLT, providing the balance they seek.

Reasons to Be Bullish: Positioning, Dollar Trends, and Risk Appetite

Winners Are Now Long

One of the most useful indicators of sentiment and positioning in the stock market is the Commitment of Traders report (COT), which shows how long or short banks and large speculators are in the futures market. Right now, there is a divergence that hasn’t been seen since April 2025, right before the Liberation Day sell-off.

This time, however, the positioning was reversed: commercials, such as banks and prime brokers, held long positions concentrated more than at any other point this year. Conversely, speculators like hedge funds and wealthy individuals are at their shortest market positions of the year.

History shows that commercials tend to get these directional bets right, something investors should consider when deciding whether the S&P 500 has any more room to move higher.

A Dollar Short Squeeze Is Coming

Another indicator to consider is the fact that short dollar positions are now the most ample they’ve been since 2023. Seeing the dollar index rally by double-digits in a single two-week period might start to trigger what’s known as a “short squeeze,” meaning bears would be forced to buy back dollars to close their shorts.

This additional buying pressure would ensure a further dollar rally, which in theory should have a similar effect on the stock market, considering that a stronger dollar could boost consumer, business, and government spending. This has a positive impact on the economy (and earnings per share), which may be something these futures buyers are betting on.

Risk Appetite Is Still High

Last but not least, an unorthodox measure of risk appetite can be spotted in the price of the iShares S&P 500 Value ETF NYSEARCA: IVE versus the iShares S&P 500 Growth ETF NYSEARCA: IVW, which shows growth stocks have now outperformed value stocks by the widest margin in over half a decade.

This means that the broader market is betting on further growth in the overall economy and valuations alike, leaving those safer consumer staples stocks behind to be undervalued and forgotten. Given the significant focus on risk in overall mass psychology, it’s hard to imagine a world where the S&P 500 doesn’t keep making new highs.

What If the Bulls Are Wrong? Small Caps and Bonds Offer Balance

What happens if this view and commercial futures buyers are wrong? Given that small-caps have underperformed the broader S&P 500 by 15% over the past year, a thorough discussion is necessary to determine whether they will need to close the gap more aggressively if these three factors do drive stocks higher.

However, the small-cap iShares Russell 2000 ETF doesn’t only promise potential outsized returns, but also some downside protection as well.

The reason is that, because they already trade at such a discount relative to the bigger indexes, there isn’t really a lot more downside to be priced in from today. This cannot be said for the others.

In any case, the best scenario investors can find themselves in is that small caps rally more aggressively than the S&P 500, protect themselves with decreased downside potential, but also get an additional layer just in case.

This additional layer of protection and upside is the iShares 20+ Year Treasury Bond ETF.

Why? If the Federal Reserve cuts interest rates before 2025 is over, bonds will rally along with the small-caps ETF.

If there is a broader risk-off stock sell-off, then small-caps won’t do as badly as the S&P 500 on a downturn, and bonds may rally simultaneously as capital initiates a flight to safety behavior as well.