Morgan Stanley has highlighted three key risks to the current stock market rally. Firstly, the labor market is showing signs of cooling. Recent job data indicates weaker hiring than expected, revisions have lowered figures for previous months, and job openings are decreasing. This points to a slowing economic growth. Secondly, Q2 earnings data seems uneven, with solid profits mainly found in a few sectors like technology, communication services, and financials. Many other companies report flat or only modest earnings, even though overall figures appear strong.

Potential for a Stagflation Risk

Thirdly, the economy might face a stagflation risk. Rising tariffs and ongoing inflation could slow economic momentum later this year. The current strength in the market might be masking underlying economic challenges. Despite these risks, the US stock rally remains mostly unaffected. The market recently hit another record high after inflation data came out above expectations along with an increase in the core inflation rate. There’s a noticeable gap between the signals from the economy and the highs of the market. The July 2025 jobs report showed hiring at only 150,000, while analysts expected 180,000, confirming that the labor market is cooling. This weakness is being overlooked, creating opportunities for traders who foresee a correction.

The Rally’s Fragile Foundation

The foundation of the rally seems fragile, as it relies heavily on just a few major companies. In Q2 2025, the top ten companies in the S&P 500 accounted for nearly 80% of profit growth, while the average company’s earnings stayed flat. Traders might consider buying put options on equal-weight index ETFs, which could be more sensitive to a general slowdown than their capitalization-weighted counterparts. Moreover, the risk of stagflation is increasing. The latest CPI data from July 2025 indicates core inflation has risen to 3.8%. This persistent inflation makes it hard for the Federal Reserve to lower interest rates to help a weakening economy, which often leads to market fluctuations. In this context, there’s a sense of complacency in the options market. The VIX is currently around 13, a level reminiscent of early 2024, before market volatility began. This makes protective options quite affordable, signaling a good time to seek downside protection. Traders should consider buying put options on the SPY or QQQ with expiration dates in October and November 2025. This approach offers a cost-effective way to hedge against risks that the wider market is currently ignoring. For those expecting a significant market movement, regardless of direction, straddles on the few major companies driving market performance may also be a smart choice. Create your live VT Markets account and start trading now.

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