Investors are growing confident that the U.S. economy will pull off a “soft landing,” where higher interest rates cool inflation without stifling economic growth. At a glance, it seems that everything is in place for that optimistic scenario: inflation has eased, the economy is still expanding, consumer confidence is up, and retail sales remain robust. Stock markets hover near record highs, with expectations that the Federal Reserve may soon cut interest rates. But beneath this seemingly smooth surface, some cracks are starting to appear.

According to Michael Darda, chief economist and macro strategist at Roth Capital Partners, the U.S. economy might be skating on “thinner ice“ than investors realize.

Cracks in the Surface

Darda warned on Yahoo Finance’s “Stocks in Translation” podcast that while the data looks promising, there are underlying concerns that many investors are overlooking. A rising unemployment rate, along with elevated corporate earnings expectations, contributed to stock market pullbacks in August and September. These declines reflect how fragile this economic optimism may be.

“It’s not unprecedented to have what looks like a soft landing morph into a recession,” Darda noted. “Many have been lulled into thinking the soft landing will be a permanent state of affairs for the business cycle, but there are cracks forming.”

This cautious outlook became more apparent when the S&P 500 dropped by 2% earlier in the week, dragged down by disappointing earnings from companies like Nvidia (NVDA). While AI and tech stocks soared earlier this year, the latest earnings reports have failed to satisfy the market’s high expectations, signaling potential instability ahead.

Earnings Frenzy: A Dangerous Game

Darda points to the recent market performance as an indicator of investor overconfidence. For months, investors have flocked to high-flying stocks, particularly in tech and artificial intelligence. However, the problem with this approach, according to Darda, is that “expectations have gone up so much, it’s impossible to beat them indefinitely.” The stock market’s recent drawdowns reflect just how dangerous it can be when companies fail to live up to their inflated expectations.

“We’re in a bit of a frenzy here,” Darda said. “If earnings don’t continue to exceed expectations or if the business cycle falters, we could see a significant market correction.”

Rising Unemployment: A Hidden Recession Signal?

It’s not just earnings that are raising concerns. Last month’s July jobs report revealed an unexpected rise in unemployment to 4.3%, the highest level in nearly three years. This triggered the Sahm Rule, a key recession indicator that has accurately predicted every recession since the 1970s. The Sahm Rule is triggered when unemployment rises 0.5% from its previous 12-month low, and with the U.S. rate climbing from 3.4% to 4.3%, this signal is flashing red.

While some economists argue that the uptick in unemployment could be linked to increased labor force participation from rising immigration, Darda remains cautious. “The rise in unemployment is still concerning,” he said, adding that even a small uptick can be a warning sign. “We’re up to 4.3% from a cyclical trough of 3.4%. These kinds of movements suggest the economy, if it’s still growing, is growing below trend.”

He also emphasized that the current unemployment rate, while historically low, should not be taken as a sign of economic health in isolation. “There’s a fine line between slow growth and a full-blown recession,” Darda explained.

Choppy Waters Ahead

Looking forward, investors should brace for more volatility. With the next August jobs report set to be released soon, Darda expects more market fluctuations in the coming weeks. “I think we’re heading into an environment where volatility is going to stay elevated. The risk of a material pullback or correction is high.”

While investor optimism remains, particularly around tech stocks and hopes for a soft landing, Darda’s message is clear: don’t get too comfortable. “With what we’ve seen over the last two years, from these valuation levels, and based on where I think we are in the business cycle, we’re likely heading into choppy waters.”

The U.S. economy may still appear strong on the surface, but as rising unemployment, high earnings expectations, and stock market pullbacks reveal, it could be on much thinner ice than many believe. Investors would be wise to proceed with caution as the cracks in the economic landscape continue to deepen.