When stocks are selling at valuation extremes and consumer optimism is at one of the highest levels in 50 years, there’s not a lot that needs to go haywire to create havoc in the financial markets, cautions Jim Stack, a leading money manager, market historian and editor of InvesTech Research.

Bull markets always peak when skies are bluest, and any investor who forgets that is doomed to repeat the painful lessons from the past. Excessive optimism and high valuations do not cause a bear market — they’re simply anecdotal evidence that sets the stage. And that stage is becoming more unstable.

With 8 rate hikes under their belt, and a 74% probability of another rate hike in December, Federal Reserve officials are gradually tightening the noose on this second longest economic recovery in U.S. history.

Meanwhile, volatility (the number of days experiencing over a 1% or 2% move) is up sharply from last year, and likely to increase more dramatically in coming months if the rosy economic headlines suddenly clash with the rising probability of a bear market.

Few would dispute that the economy remains on a healthy track as we head toward the end of the year, but that’s not necessarily positive for either the stock market or investors.

Consumer Confidence, as measured by the Conference Board, has climbed to the highest level in nearly two decades. And why is this an ominous sign?

Looking back at previous market cycles, Consumer Confidence has always tended to soar toward the end of an economic recovery. The only survey results that were higher than they are now occurred in early 2000, right at the peak of the Technology Bubble.

As a measure of risk, margin debt, which consists of broker loans used by investors to buy stocks, has climbed to levels well above those seen in prior bull markets. Margin debt as a percent of GDP typically peaks coincidentally with or ahead of the stock market.

This leverage has started to unwind from its peak earlier this year, and if history holds true, a sharp drop toward support would provide convincing evidence that a bear market may be emerging.

While leading macroeconomic evidence — including consumer confidence and the government’s own Leading Economic Index — are not yet confirming a probable recession, we know historically that bear market technical warnings almost always led the economic warning flags.

With our penchant for being ahead of the curve, we believe that any errors should be on the side of caution. Thus, we are reducing the target market exposure of our InvesTech Model Portfolio  from 63% to a 55%. This is the lowest market exposure for our model portfolio since this bull market began over 9 years ago in March 2009.

Jim Stack's InvesTech Research here…