The Stock Market Sounds an Alarm as Investors Get Bad News About President Trump's Economy. History Says This Will Happen Next.

The S&P 500 (SNPINDEX: ^GSPC) and the Nasdaq Composite (NASDAQINDEX: ^IXIC) added 13% and 14%, respectively, through the first eight months of 2026. That puts both indexes on track for a fourth consecutive year of double-digit gains. But the bull market may be in jeopardy.

Investors recently got bad news about President Trump's economy. Inflation is not cooling as quickly as experts anticipated, raising the odds of interest rate hikes. That is consequential for two reasons. First, new rate-hike cycles have often coincided with stock market corrections. Second, the stock market is already very expensive by historical standards.

Here's what investors should know.

Image source: Official White House Photo.

Sticky inflation could force the Federal Reserve to raise interest rates

The Personal Consumption Expenditure (PCE) price index is the Federal Reserve's preferred inflation gauge. The Consumer Price Index (CPI) is based on consumer surveys about out-of-pocket spending, but the PCE price index is based on business surveys that include out-of-pocket spending as well as third-party expenditures made on behalf of consumers.

PCE inflation measured 2.9% in January 2026, but it has accelerated over the year. The primary reason for the acceleration is the Iran war, which has pushed up energy prices by disrupting a key shipping route for global oil supplies. However, President Trump's tariffs have also contributed meaningfully to inflation, according to research from several Federal Reserve banks.

PCE inflation measured 3.7% in July. That is bad news for a few reasons. It marks the 65th straight month in which PCE inflation has exceeded the Federal Reserve's 2% target. It was slightly above the consensus estimate, which called for PCE inflation of 3.6%. And the July reading was unchanged from the June reading, suggesting sticky inflation.

Here's the big picture: PCE inflation has been above target for over five years, and it could remain so for some time due to the Iran war and tariffs. The longer PCE inflation remains high, the more likely it becomes that elevated energy prices will bleed into other areas of the economy, such as transportation and manufacturing.

July inflation data increased the odds that the Federal Reserve will raise interest rates this year, according to CME Group's FedWatch tool. In fact, futures traders are now betting on two quarter-point rate hikes in the remaining months of 2026, one in September and another in December.

So what? New rate-hike cycles have generally been bad news for the stock market. Since 1987, following the first rate hike in a cycle, the S&P 500 and Nasdaq Composite have declined by 10% and 14%, respectively, at some point during the next year. In other words, the indexes have usually fallen into correction territory under those circumstances.

The stock market sounds an alarm last witnessed during the dot-com crash

The S&P 500 recorded a cyclically adjusted price-to-earnings (CAPE) ratio of 40.6 in July, the highest level since September 2000, a pivotal turning point when losses associated with the dot-com bust began to spread across the broader stock market. The S&P 500 and Nasdaq Composite ultimately plummeted 49% and 78%, respectively, during the dot-com crash.

The chart below shows the average return in the S&P 500 over different time periods after recording a monthly CAPE ratio above 40. The chart also shows the average return in the Nasdaq Composite under the same circumstances.

Data source: Robert Shiller, YCharts. The chart shows how the S&P 500 and Nasdaq Composite performed during the one-, two-, and three-year periods following incidents in which the S&P 500's monthly CAPE ratio topped 40.

The chart above suggests that the stock market could decline sharply in the next few years. In fact, if the S&P 500 and Nasdaq Composite perform in line with their historical averages, the indexes will drop 30% and 51%, respectively, by August 2029.

Of course, past results are never a guarantee of future returns, and the data in the chart is based on a small sample size. Since the S&P 500 was created in 1957, there have been only 25 months when the index had a CAPE multiple above 40. Put differently, the S&P 500 has been this expensive only 3% of the time in the past.

Nevertheless, investors would be unwise to ignore historical data entirely, especially when the Federal Reserve is expected to raise interest rates twice in the remaining months of the year. Now more than ever, investors should focus on buying stocks that not only have durable competitive moats but also trade at reasonable prices.

Trevor Jennewine has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends CME Group. The Motley Fool has a disclosure policy.