Equity Markets Rally Amid Deteriorating Leading Indicators: Is the Party Over?

The U.S. equity market, led by the S&P 500, has staged a robust rebound in 2025, fueled by aggressive rate-cut expectations, resilient tech stocks, and a narrow band of "Magnificent Seven" leaders. Yet, beneath this optimism lies a growing disconnect: key leading economic indicators, including the Conference Board LEI, are flashing warnings of a potential slowdown. As investors grapple with this divergence, the question looms: Is the current rally built on fragile foundations, or does it reflect a market already pricing in a soft landing?

The S&P 500's Waning Momentum

The S&P 500's recent performance has been a tale of two forces. On one hand, the index has surged 25% from April's tariff-driven lows, with tech stocks accounting for over 70% of the gains. Goldman Sachs Research now projects the S&P 500 to reach 6,600 in six months and 6,900 in 12 months, driven by anticipated Fed rate cuts and lower bond yields. However, Bloomberg data reveals a critical flaw: the rally has lost momentum. The index has gone 17 sessions without a 1% move, the longest stretch since December 2024.

Technical indicators underscore the fragility. The S&P 500's share of stocks above their 20- and 50-day moving averages has declined, and market breadth has narrowed to levels last seen in 2023. The median stock in the index is more than 10% below its 52-week high, a classic sign of leadership concentrated in a handful of names. Analysts warn of a "catch down" scenario—where narrow leadership gives way to broader corrections—if earnings forecasts for large-cap stocks weaken.

The Conference Board LEI's Recession Signal

While equities soar, the Conference Board Leading Economic Index (LEI) tells a darker story. The LEI for the U.S. fell 0.3% to 98.8 in June 2025, marking a 2.8% decline over the first half of the year. This deterioration has triggered a recession signal under the 3Ds rule (Duration, Depth, Diffusion). The six-month growth rate of the LEI is now -2.8%, and the diffusion index—measuring how widespread the decline is among the index's components—has remained below 50 for three consecutive months. A reading below 50 indicates that most components of the LEI are weakening.

The LEI's decline is driven by three pillars:
1. Consumer Sentiment: Consumer expectations have plummeted, reflecting fears of higher prices from tariffs and stagnant wage growth.
2. Manufacturing Weakness: New orders for consumer goods and materials have contracted for three consecutive months, signaling softening demand.
3. Labor Market Pressures: Initial unemployment claims have risen for the third month, hinting at early signs of job market strain.

The Conference Board projects U.S. real GDP growth to slow to 1.6% in 2025, down from 2.8% in 2024, with tariffs expected to amplify inflationary pressures in Q3. While a formal recession is not yet forecast, the LEI's seven-month lead time means current trends could translate to a downturn by late 2025.

Tariffs and Trade Policy: A Double-Edged Sword

President Donald Trump's trade policies, including retaliatory tariffs on imports, have created a paradox: they have boosted near-term equity valuations (as investors price in corporate resilience) but also exacerbated inflation and global economic uncertainty. J.P. Morgan Research estimates a 40% probability of a U.S. recession in H2 2025, citing tariffs as a key drag on growth.

The pass-through of tariffs to consumer prices has been more pronounced than expected, particularly in goods-related sectors. Companies have mitigated impacts via inventory management and pricing strategies, but these are short-term fixes. Goldman Sachs notes that large-cap firms are better positioned to absorb these costs, but small-cap and mid-cap stocks face higher risks.

The Divergence Dilemma: Equity Valuations vs. Economic Fundamentals

The most alarming aspect of 2025's market environment is the widening gap between equity valuations and economic fundamentals. The S&P 500's forward P/E ratio has risen to 22x, driven by expectations of lower real bond yields and Fed rate cuts. Yet, the CEI (which reflects current economic conditions) has grown by only 0.8% in H1 2025, and the LAG index (a backward-looking indicator) has stabilized at 119.9, suggesting past economic challenges are only now beginning to fade.

This divergence raises critical questions:
- Are investors pricing in a soft landing, or are they overestimating the Fed's ability to navigate policy?
- Can the "Magnificent Seven" continue to prop up the index as broader market participation wanes?
- What role will tariffs play in reshaping global supply chains and corporate earnings?

Investment Implications: Defensive vs. Equity Exposure

Given the current environment, investors must balance optimism with caution. Here's a strategic framework:

1. Defensive Assets for Diversification:
2. Quality Dividend Stocks: High-yield, low-volatility sectors like utilities and consumer staples offer downside protection.
3. Floating Rate Debt: Companies with floating-rate liabilities (e.g., banks, leveraged loans) could benefit from Fed rate cuts.

4. Short-Duration Bonds: These insulate portfolios from interest rate volatility while maintaining liquidity.

5. Selective Equity Exposure:

6. AI and Tech Leaders: Sectors tied to AI infrastructure (semiconductors, cloud computing) remain strong, given their role in driving productivity.

7. Supply Chain Resilience Plays: Companies with diversified manufacturing bases and pricing power (e.g., industrial conglomerates) may outperform in a tariff-driven world.

8. Hedging Against Recession Signals:

9. Gold and Treasury Inflation-Protected Securities (TIPS): These act as inflation hedges and typically perform well during economic uncertainty.
10. Put Options on the S&P 500: A small allocation to downside protection can mitigate losses if the "catch down" scenario materializes.

Conclusion: A Market at a Crossroads

The S&P 500's rally in 2025 is a testament to the resilience of large-cap stocks and the Fed's accommodative stance. However, the Conference Board LEI, rising unemployment claims, and tariff risks paint a picture of a slowing economy. Investors must navigate this duality by diversifying across asset classes, prioritizing quality, and maintaining a disciplined approach to risk management.

As the Fed's July 30 policy decision approaches and earnings season unfolds, the coming weeks will be pivotal. A broadening equity rally could validate current valuations, but a continuation of narrow leadership or a deterioration in economic data may force a reevaluation of risk tolerance. In this environment, adaptability—not blind optimism—will be the hallmark of successful investors.