A recent research paper from the Federal Reserve warns that the tariffs imposed by President Trump are likely to hinder economic growth and increase unemployment. This forecast is particularly alarming in the context of the S&P 500, which has seen significant gains, rising by 16% year to date despite the average tariff rate reaching its highest level since the 1940s. The prevailing enthusiasm surrounding artificial intelligence (AI) has been strong enough to overshadow concerns about economic stability. However, analysts are increasingly noting a growing disconnect between stock market performance and underlying business fundamentals.
The study published by the Federal Reserve points to unfavorable outcomes in economic metrics as a result of the tariffs, which have introduced uncertainty into the market. President Trump has previously touted tariffs as a tool for fostering national wealth and security, claiming historical precedence for such measures. However, these assertions are contradicted by data indicating that real GDP per capita has increased significantly since the early 20th century, reflecting an overall improvement in living standards.
Experts argue that the anticipated revenue from tariffs, projected to be $210 billion by 2026, pales in comparison to the $2.6 trillion collected from individual income taxes last year. Proposals to replace individual taxes with tariff revenues or to issue dividend payments of $2,000 to many Americans appear largely impractical and financially unfeasible.
A retrospective analysis covering 150 years of data from the Federal Reserve Bank of San Francisco underscores the notion that tariffs generally lead to adverse economic effects such as increased unemployment and slowed growth. Economic uncertainty tends to dampen consumer sentiment, which in turn stifles demand and hampers hiring efforts by companies. This trend is already manifesting, with consumer sentiment dipping to one of its lowest levels in history in November and unemployment climbing to 4.4%, the highest it has been in four years.
The S&P 500’s heightened valuation further complicates matters. Late last year, the index recorded a forward price-to-earnings ratio exceeding 23 for only the third time in forty years, a sign that has historically preceded significant market downturns. Past occurrences of similar valuation levels, such as during the dot-com bubble and the COVID-19 bear market, resulted in declines of 49% and 25%, respectively.
Although the S&P 500’s valuation has since slightly decreased to 22.6 times forward earnings, it remains substantially above the 40-year average of 15.9. Investors may be banking on the potential for profit margins to expand through heightened efficiency from AI, which could lead to quicker-than-expected earnings growth.
Nonetheless, historical patterns indicate that the stock market may face challenges in the near future, especially following such elevated valuation levels. Research suggests that average returns for the S&P 500 post-valuation peaks above 22 tend to hover around 2.9% annually over the following three years, significantly lower than the long-term average return of about 10%.
Given the current economic climate, investors are encouraged to exercise caution. While divesting entirely from stocks isn’t advisable, prioritizing a portfolio that consists of high-conviction stocks—those deemed resilient enough to withstand market turbulence—could be prudent. Additionally, creating a cash reserve may position investors favorably to capitalize on potential future market corrections.
