The stock market has been flipped upside down

• The stock market has been flipped upside down in 2023 as investors taunt the Federal Reserve.
• JPMorgan's Marko Kolanovic highlighted that even as monetary policy gets tighter, investors are still chasing the most speculative stocks.
• "There is an old adage 'don't fight the Fed,' but this behavior is not just fighting but also taunting the Fed," Kolanovic said.

The stock market has been completely flipped upside down so far in 2023 as risky assets that struggled last year stage a big comeback, even in the face of continued rate hikes from the Federal Reserve.

Some of the biggest losers in 2022 like bitcoin, EV stocks, and shares of generally unprofitable or struggling companies have soared in the first six weeks of 2023. Bitcoin is up 51% year-to-date, while Tesla and the First Trust Cloud Computing ETF are up 72% and 17% over the same time period.

Meanwhile, the hype trade is back in a big way this year as artificial intelligence captures the imagination of consumers following the successful release of OpenAI's ChatGPT. Shares of companies with even a vague association with AI have popped as investors are overcome with FOMO.

Small-cap firms BigBear.ai and Soundhound AI have jumped 491% and 107% respectively year-to-date. Meanwhile, C3.ai has surged 117% year-to-date. None of these companies are profitable and it is not certain how they will capitalize off of the excitement surrounding ChatGPT.

Even meme stocks are back. Names like GameStop (up 16% year-to-date), Bed Bath & Beyond (down 28%, but was briefly up more than 120% despite possible imminent bankruptcy), and AMC (up 30% year-to-date) are soaring despite big risks and little sign of a turnaround of these businesses.

This is the type of investor behavior one expects to see when interest rates are closer to 0% rather than 5%, and it's especially weird given the many predictions that a recession is just around the corner.

Similar to the heyday of the meme stock era, the latest speculative frenzy is again being driven by retail investors with a growing sense of FOMO. Individual traders are dusting off their 2021 playbook and attempting to recreate the magic that sent shares of unprofitable companies soaring.

Retail investors are spending a record $1.5 billion per day buying stocks so far this year, according to data from Vanda Track. And according to JPMorgan's Marko Kolanovic, "retail activity (volumes) are near record high with over 20% of all market volume coming from retail orders."

According to Kolanovic, the wild surges in speculative assets, even as interest rates continue to move higher, amount to investors daring Fed chairman Jerome Powell to respond to still-hot asset prices.

"There is an old adage 'don't fight the Fed,' but this behavior is not just fighting but also taunting the Fed with crypto, meme stocks, and unprofitable companies responding best to Fed communications," Kolanovic wrote in a recent note.

This week, members of the Fed signaled that more interest rate hikes will likely be needed to combat inflation that is still well above its long-term target of 2%. And don't forget that the Fed is reducing its balance sheet each month by about $100 billion, essentially sucking liquidity out of markets.

The current trajectory of how investors are acting in the face of an ever-tightening US monetary policy suggests to Kolanovic that a big market volatility event could be imminent.

"Based on historical regressions, the move in 2-year interest rates since the [February 1] Fed meeting should result in a ~5%-10% sell-off in [the] Nasdaq," Kolanovic warned. "The risk-reward of holding bonds at this level of short-term yields looks better than equity than any time since the great financial crisis."

Kolanovic isn't the only Wall Street strategist ringing the alarm bell on the recent behavior of investors bidding up speculative stocks.

Fairlead Strategies founder Katie Stockton told CNBC on Wednesday that investor sentiment has gotten "extremely greedy," evidenced primarily by the recent pop in bitcoin, which is trading near six-month highs.

"That greedy sentiment makes for a fragile tape," Stockton said.

And the tape is no doubt fragile, as various pieces of economic data in the past week have jolted stocks lower by more than 1% on more than one occasion. On Tuesday, the January CPI data let to an initial 1% sell-off in the S&P 500 before those losses were reversed. And on Thursday, stocks once again fell about 1% on higher-than-expected inflation readings from the Producer Price Index.

But what could ultimately break this "fragile" tape is the Fed's reaction to the incoming data and speculative investment behavior.

On Thursday, Fed President James Bullard supported the idea of hiking interest rates by 50 basis points at its next meeting, rather than the 25 basis points the market expects. Stocks immediately sold-off following Bullard's comments.