The Stock Market May Do Something Last Seen During the Great Recession. A Sharp Decline Could Follow.

November has historically been the best month for the U.S. stock market. The S&P 500 (SNPINDEX: ^GSPC) has added an average of 2.2% during November since 1980, which is a full percentage point more than the next closest month, according to Argus Research.

However, the S&P 500 has declined over 1.2% month to date due to festering concerns about the economy and stock market valuations. That disappointing start puts the index on pace for its worst November since the Great Recession in 2008, and history says that the index may be headed for bear market territory.

Here's what investors should know.

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Investors are worried that the Federal Reserve won't cut interest rates in December

President Donald Trump has repeatedly said that foreign exporters will pay most tariffs for the privilege of doing business in the U.S. But the administration is backpedaling on that theory, long rejected by most economists. The White House reportedly plans to eliminate duties on certain produce and textiles to ease prices, a tacit admission that Americans are paying Trump's tariffs.

Indeed, Goldman Sachs estimates that U.S. companies and consumers will collectively pay 77% of tariffs by the end of 2025, with consumers alone bearing more than 50% of the burden. Furthermore, the consensus among more than 60 economists surveyed by The Wall Street Journal says that inflation will remain above 3% through the middle of next year.

That is well above the 2% target set by the Federal Reserve, which has the market worried that the FOMC will not cut rates at the December meeting. Last month, the futures market put the odds near 100% that policymakers would cut rates by 25 basis points at the October and December meetings. The October cut happened as expected, but the odds of a second cut in December have dropped to 50%.

History says that the S&P 500 is headed toward a bear market

Rising prices and the government shutdown coincided with the University of Michigan Index of Consumer Sentiment measuring 50.3 in November, the second lowest reading in history. Investors interpreted that as very bad news, because consumer spending is the primary engine that drives GDP growth. However, the stock market has another problem.

In late October, the S&P 500 achieved a forward price-to-earnings (P/E) multiple above 23, something that has happened only once in the last 25 years. The index drifted above 23 times forward earnings in mid-2020, when investors underestimated how much the COVID-19 pandemic would disrupt global supply chains. That situation ended badly. The S&P 500 dropped into a bear market and ultimately declined 25%.

Of course, it took nearly 18 months for that bear market to manifest, so elevated valuations do not necessarily portend an immediate drawdown in the stock market. Nevertheless, the current situation could easily lead to a bear market if the economy continues to weaken in the coming months. The Trump administration's trade policies could tip the scale in the wrong direction.

Tariffs imposed by President Trump have raised the average tax on U.S. imports to the highest level since the 1930s. Since the most severe duties were announced on April 2, inflation has increased in every month, hiring has slowed to a pace last seen in 2010 (if the pandemic is excluded), layoffs reached a 22-year high in October, and consumer sentiment is approaching a record low.

A Bloomberg report summarized the situation: "Trump's tariffs policies have both contributed to price pressures and uncertainty among businesses, undermining incentives to hire."

With the government shutdown now over, economic data will once again begin flowing. If concerns about prices and jobs continue to weigh on consumers, we may see a bear market in the near future. Investors should prepare themselves for that possibility by avoiding overvalued stocks and building a cash position in their portfolios.

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