Here's Why the Market Could Crash Under Trump

With the S&P 500 up roughly 8% year to date as of Tuesday morning, President Donald Trump's second year back in office has been pretty good for stocks. And that's despite the high levels of uncertainty surrounding his erratic trade policies, military activities, and attempts to interfere with the Federal Reserve's independence.

The resilience can be partially credited to the boom in generative artificial intelligence (AI), which has many of America's largest companies pouring hundreds of billions into data center construction, sending chip and memory stocks soaring. But this won't last forever. Let's discuss some reasons why the current market rally could soon go into reverse.

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Valuations are at historic highs

Trump's booming stock market might be on borrowed time. And one of the biggest clues is the cyclically adjusted price-to-earnings (CAPE) ratio, a metric that compares stock valuations over 10 years to account for the business cycle. Right now, it stands at an eyewatering 41, which is higher than the peak of 32.6 reached during the Great Depression and second only to the all-time high of 44 reached during the dot-com bubble.

That situation has plenty of parallels with today. Back then, the tech industry was rapidly adopting a technology that had just burst into the mainstream, called the internet. And infrastructure companies boomed as demand for networking equipment rose. Meanwhile, a slew of highly speculative consumer-facing internet companies went public at high valuations, despite not demonstrating meaningful revenue or profit growth.

Eventually, the bubble burst, and the tech-heavy Nasdaq Composite index plummeted by 77% from its peak.

Data center spending looks unsustainable

Today, generative AI is filling the same role the internet played 20 years ago. And while the technology promises to be transformational, there are signs that the current level of investment is getting ahead of itself.

Wall Street expects hyperscalers to pour an eye-popping $700 billion into AI-related capital expenditures this year, and that number is expected to rise. The problem is that spending is beginning to exceed their operating cash flow, forcing them to look to external financing sources, like the debt market. This will make the stocks riskier because debt has to be repaid -- regardless of whether the capital investments it funded actually pay off.

The data center build-out could also start to hurt profit margins by introducing interest expense (from debt) and soaring depreciation expense as computing hardware ages and becomes obsolete.

Inflation and interest rates

While an individual company's performance largely depends on its revenue and earnings growth, market indexes are much more influenced by macroeconomic factors like inflation and interest rates. These two are intertwined because when inflation rises, the Federal Reserve often responds by increasing its benchmark interest rate.

This strategy helps keep consumer prices under control. But it can also drag down stock performance by making equities less attractive compared to risk-free assets like Treasury bonds. Unfortunately, the data increasingly suggests higher rates may be on the horizon.

The Consumer Price Index (CPI) report for June puts the annual inflation rate at 4.2%, which is well above the Federal Reserve's target of 2%. And while Trump's potential deal to end the war in Iran and reopen the Strait of Hormuz could help bring energy costs down, experts believe it could take years to repair the damage done to energy infrastructure in the region, adding structural inflation to the economy that will be difficult to shake.

While the Fed has elected to keep rates steady for now, the ongoing macroeconomic pressures could force rate hikes later this year or in 2027.

What should investors do?

It is impossible to reliably time the market. But with so many negative macroeconmic trends converging at the same time, a market crash (which represents a drop of 10% to 20%) could happen within the next few years. And it could be triggered by an eventual cooling of AI-related spending.

The good news is that while market drawdowns can be stressful, U.S. markets have always bounced back stronger than ever over the long term. Investors can prepare for a future crash by avoiding speculative, overvalued tech stocks and seeking stable, resilient businesses that can succeed no matter what happens in the economy. It also makes sense to keep cash on hand to potentially bet on the inevitable rebound.

Will Ebiefung 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.