Since late March, the S&P 500 has surged by 20%, marking nine consecutive weeks of gains. Despite this upward trend, troubling signals about President Trump’s economic management have emerged, raising concerns among investors.
April saw inflation soar to a three-year high, largely driven by increased oil prices, leading to speculation that the Federal Reserve may need to hike interest rates. Compounding these issues, economic growth in the first quarter fell markedly short of expectations; an inflation-adjusted annual GDP rate of just 1.6% was reported, significantly below the 10-year average of 2.6%. Notably, since Trump’s return to office, quarterly GDP growth has averaged a mere 1.9%, highlighting a slowdown stifled in part by tariffs enacted by his administration.
This scenario, where high inflation coincides with sluggish economic performance, poses a dual threat. Increased inflation pressures could compel the Federal Reserve to raise interest rates, posing another potential obstacle to economic growth. Analysts suggest that if economic growth continues to lag, corporate earnings growth is likely to follow suit, raising alarms for investors; since corporate earnings largely dictate stock valuations, this trend could lead to declining prices.
The price-to-earnings valuations of the S&P 500 are currently at a level not seen since the dot-com crash. The cyclically adjusted price-to-earnings (CAPE) ratio, which factors in inflation-adjusted earnings over the past decade, has hit an alarming 39.6 as of May, a figure tied for the highest since September 2000. Historical data shows that the S&P 500 has been in this territory only about 3% of the time since its inception in 1957, often leading to significant losses in the years that followed.
Statistical insights reveal that the index typically experiences declines in the one- and two-year periods following monthly CAPE ratios above 39. For instance, over these time frames, the S&P 500’s worst return has plummeted as far as 43%. Significantly, there has never been a profitable investment scenario over a three-year period when beginning with such elevated valuations.
That said, some analysts argue against alarmism. For example, profit margins reached a 15-year high in Q1, with projections suggesting further expansion as advancements in artificial intelligence potentially spur productivity. The CAPE ratio, being a retrospective measure, does not account for the possibility of accelerated earnings growth. In this view, the current high CAPE ratios might be tolerable if investors believe robust earnings are on the horizon.
However, caution is advised. The S&P 500’s elevated price levels create an environment rife for declines, even amid optimistic forecasts. Investors are urged to be prudent, focusing on acquiring stocks with solid long-term earnings perspectives and ensuring these stocks are priced favorably. In these turbulent economic waters, now may not be the time for high-risk investments.
