The Stock Market Sounds an Alarm, and the Federal Reserve Delivers Bad News About President Trump's Tariffs

The S&P 500 (SNPINDEX: ^GSPC) has advanced 16% year to date despite President Trump raising the average tariff rate to its highest level since the 1940s. So far, excitement about artificial intelligence (AI) has more than offset any misgivings about the economy. But there is a growing disconnect between the stock market and business fundamentals.

The Federal Reserve recently published a study that suggests President Trump's tariffs will increase unemployment and slow economic growth. The research is particularly concerning because the S&P 500 recently achieved one of its most expensive valuations in 40 years. The combination of economic weakness and an expensive stock market could lead to trouble for investors.

Image source: Official White House photo.

Research from the Federal Reserve says tariffs will increase unemployment and slow economic growth

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 statement is patently false. Real GDP per person has increased tenfold since 1900, which means Americans generally have a much higher living standard today.

Trump has made similar claims on other occasions. "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. Trump has even proposed using tariffs to eliminate individual income tax, or else to pay Americans (excluding high earners) a $2,000 dividend check.

Unfortunately, those plans are disconnected from reality. The new tariffs are projected to bring in $210 billion in 2026. That sum is nowhere near enough to offset individual income tax, which totaled $2.6 trillion last year. Nor is it enough to cover $2,000 dividend checks, which would cost more than $600 billion, depending on who actually gets the payments, according to the Tax Foundation.

However, there is a more fundamental problem with Trump's tariffs: Historical information suggests they will not make America wealthier. A recent study from the Federal Reserve Bank of San Francisco examines 150 years' worth of data and arrives at this conclusion: Tariffs will lead to higher unemployment and slower economic growth.

The study attributes those outcomes to economic uncertainty. Consumer sentiment tends to worsen during periods of uncertainty, which reduces economic growth by suppressing demand and prompting companies to hire fewer people. Indeed, those circumstances are already coming to fruition: Consumer sentiment fell to the second-lowest reading in history in November after the unemployment rate increased to 4.4% in October, the highest level in four years.

The S&P 500's historically high valuation makes the prospect of slower economic growth even more concerning

In late October, the S&P 500 recorded a forward price-to-earnings (P/E) ratio above 23 for only the third time in four decades. The other two incidents ended poorly. The first time was before the dot-com bubble burst; the index eventually fell 49%. The second time was before the COVID-19 bear market; the index eventually fell 25%.

The S&P 500's valuation has since moderated to 22.6 times forward earnings, but that is still a premium to the 40-year average of 15.9, according to Yardeni Research. It is possible investors are more comfortable with higher valuations today because profit margins are likely to expand as AI makes companies more efficient, meaning earnings could increase more quickly than anticipated in the future.

However, history suggests the stock market is likely to struggle in the near term. After topping 22 times forward earnings, the S&P 500 has returned an average of 2.9% annually in the next three years, according to Torsten Slok, chief economist at Apollo Global Management. That's well below the long-term average of about 10% annually.

The current market environment warrants caution, but that does not mean investors should sell all their stocks. Instead, now is a good time to make sure your portfolio includes only high-conviction stocks that you would be comfortable holding through a downturn. Now is also a good time to build a cash position. Doing so will let you capitalize on the next sell-off.

Trevor Jennewine has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.