The S&P 500 (SNPINDEX: ^GSPC) has climbed 16% so far this year, even as President Trump has pushed the average U.S. tariff rate to its highest level since the 1940s. For now, enthusiasm around artificial intelligence (AI) has more than outweighed worries about the broader economy. But there’s an increasingly sharp disconnect between stock prices and underlying business fundamentals.
The Federal Reserve recently released research indicating that President Trump’s tariffs are likely to raise unemployment and slow economic growth. That finding is especially worrisome because the S&P 500 is currently trading near one of its priciest valuations in the past 40 years. Weakening economic conditions combined with an expensive stock market could spell trouble for investors.
What the Federal Reserve’s research says about tariffs
Earlier this year, President Trump said, “From 1789 to 1913, we were a tariff-backed nation, and the United States was proportionately the wealthiest it has ever been.”
That claim doesn’t hold up to the data. Real GDP per person has increased roughly tenfold since 1900, meaning Americans, on average, enjoy a much higher standard of living today than they did in that earlier period.
Trump has made similar arguments at other times. “Tariff power will bring America national security and wealth the likes of which has never been seen before,” he wrote on social media in November. He has even floated the idea of using tariffs to eliminate the individual income tax entirely, or alternatively to fund $2,000 dividend checks for most Americans (excluding high earners).
The math simply doesn’t work. New tariffs are projected to generate about $210 billion in 2026. That’s nowhere close to replacing individual income taxes, which totaled $2.6 trillion last year. It’s also far short of what would be needed to send out $2,000 dividend payments, which the Tax Foundation estimates would cost more than $600 billion, depending on which Americans qualify.
On top of the revenue gap, there’s a deeper issue: Historical data suggests tariffs don’t make a country richer. A recent study from the Federal Reserve Bank of San Francisco looked at 150 years of economic history and concluded that higher tariffs tend to lead to higher unemployment and slower economic growth.
The study links those outcomes to greater economic uncertainty. When uncertainty rises, consumer confidence usually falls. That weakens demand and makes businesses more cautious about hiring. We’re already seeing some of those patterns: Consumer sentiment fell to its second-lowest level on record in November, following a rise in the unemployment rate to 4.4% in October, the highest in four years.
An expensive S&P 500 in a slowing economy
In late October, the S&P 500’s forward price-to-earnings (P/E) ratio moved above 23 for only the third time in four decades. The prior two instances did not end well for investors. The first preceded the bursting of the dot-com bubble, after which the index eventually dropped 49%. The second came just before the COVID-19 bear market, when the index ultimately fell 25%.
Since then, the S&P 500’s valuation has cooled slightly to 22.6 times forward earnings, but that’s still well above its 40-year average of 15.9, according to Yardeni Research. Some investors may feel more comfortable paying higher multiples today because they expect profit margins to widen as AI improves efficiency, potentially allowing earnings to grow faster than anticipated.
Even so, history implies the stock market may face a tougher stretch in the near term. After the S&P 500’s forward P/E climbs above 22, the index has delivered an average return of just 2.9% annually over the next three years, according to Torsten Slok, chief economist at Apollo Global Management. That’s far below the long-term average of about 10% a year.
How investors can respond right now
Today’s backdrop—a richly valued stock market, rising tariffs, and a growing risk of slower economic growth—calls for caution, but not panic. This is not necessarily a signal to dump every stock you own.
Instead, it’s a smart moment to:
- Audit your portfolio and make sure it’s concentrated in high-conviction companies you’re comfortable holding through a downturn.
- Build up a cash reserve so you’re prepared to take advantage of lower prices if a market sell-off occurs.
Having a watchlist and some dry powder means you’ll be ready to buy quality businesses at better valuations if volatility returns.
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