These 4 bearish scenarios could rock the stock market by the end of the year

• Despite the S&P 500's year-to-date gain of 19%, there are plenty of risks in the stock market.
• DataTrek Research highlighted four bearish scenarios that could dent the stock market rally.
• "Stocks are priced for near perfection in what will always be an imperfect and unpredictable world."

The S&P 500 has surged 19% year-to-date after a lousy 2022, but there are still plenty of risks that could rock the stock market over the next 12 months.

That's according to DataTrek Research co-founder Nicholas Colas, who highlighted in a Wednesday note bearish scenarios that could put a dent in the strong year-to-date rally.

"While we remain positive, it always pays to consider the other side of the trade," Colas said, adding that the S&P 500's current forward price-to-earnings ratio of 20.3x means stocks are priced for near perfection.

"That [valuation] would be OK if [earnings] estimates were going up, as they were in 2020 and 2021, but they are not. In fact, the Street's S&P earnings estimates for 2024 made a new all-time low just last week," Colas said. "Stocks are priced for near perfection in what will always be an imperfect and unpredictable world."

These are four scenarios that investors should prepare for, and how to hedge them.

1. Investors start to take profits

"Perhaps nothing 'goes wrong', but the S&P 500 still flatlines or declines a few percent over the rest of the year," Colas said. That could be driven by investors taking profits and rotating out of technology stocks and into laggards, like financials or industrials. 

With big tech making up about a third of the S&P 500, a collective 10% decline in the sector could spark a 5% sell-off in the stock market. To hedge away the risk, he recommends investors own financials or industrial stocks to benefit from a potential rotation.

2.  Sticky inflation

If inflation proves stickier than expected, that would force the Federal Reserve to reaccelerate rate hikes, even if they risk pushing the US economy into a recession.

That would jolt investors, who expect just one more increase and that a recession could be avoided. Driving this sticky inflation scenario could be a rebound in oil prices, combined with rising shelter prices.

To hedge, Colas recommends investors own the energy sector.

3. A surprise slowdown in the jobs market

Colas warned a surprise drop in US labor markets and economic growth could be driven by the fact that monetary policy works with long and variable lags. And since the Fed hiked rates by more than 500 basis points over the past year, those lags could start to show up.

"A few months of sub-par readings for job growth and consumer demand could be enough to convince corporate managers that a recession is at hand. This would push them to accelerate layoffs, creating the start of a spiral into recession," he said.

A potential hedge is to own US Treasurys.

4. Real interest rates continue to rise

Real interest rates should continue to rise as the Fed reduces the size of its balance sheet.

"So far, higher real rates have not hurt equity valuations, but that could change" if real interest rates reach a level where investors determine that bonds are legitimate competition for stocks, Colas said. Additionally, higher real rates could boost the value of the US dollar, which would put pressure on corporate profits.

Investors can hedge this risk by selling stocks into strength and avoid duration risk in fixed income.

"None of these scenarios are our base case but, as we said at the top of this discussion, they are still important topics and you may have a more cautious outlook than we do... we did not include 'unknown unknown' shocks related to adverse geopolitical events, but those always lurk in the background as well," he added.