The Stock Market Sounds an Alarm as Investors Get Bad News About President Trump's Tariffs. History Says the S&P 500 Will Do This in 2026.

The S&P 500 (SNPINDEX: ^GSPC) added 16% in 2025, marking the third consecutive year in which the benchmark index has recorded double-digit gains. Unfortunately, investors have reason to think 2026 will more challenging. Evidence suggests President Trump's tariffs are hurting the economy, and the stock market just flashed a warning last seen during the dot-com crash in 2000.

Here's what investors should know.

Image source: Official White House Photo.

President Trump's tariffs have coincided with reduced manufacturing activity, higher unemployment, and record-low consumer sentiment

In 2025, President Donald Trump broke with decades of trade-policy precedent and imposed sweeping tariffs that raised the average tax on U.S. imports to 16.8%, the highest level since 1935, per the Budget Lab at Yale. And Trump -- who once called tariffs "the most beautiful word" in the dictionary -- has made many misleading or inaccurate statements to drum up support for his signature trade policies.

• Trump said foreign exporters would absorb the tariffs for the "privilege of access" to the American market. However, Goldman Sachs says U.S. companies and consumers collectively paid 82% of the tariffs in October 2025, and 67% of the burden will fall on consumers alone by July 2026.
• Trump said tariffs would bring manufacturing work back to America. However, the Institute for Supply Management (ISM) says U.S. manufacturing activity has now contracted in nine consecutive months due to economic uncertainty created by tariffs.
• Trump said tariffs would protect American workers and create millions of jobs. However, unemployment is at a four-year high and (excluding the pandemic) hiring slowed more profoundly in 2025 than any other year since the Great Recession in 2009, according to the Bureau of Labor Statistics.
• Trump said tariffs would make America wealthy again and people would be "very happy" with the result. However, consumer sentiment in 2025 recorded its lowest annual average since the University of Michigan started collecting data in 1960.

Importantly, U.S. GDP increased an annual 4.3% during the third quarter, the most robust growth in two years. President Trump credited tariffs for the booming economy. However, GDP growth was artificially high because imports (which are subtracted from GDP) were artificially low. Why were imports low? Companies stockpiled inventory ahead of tariffs earlier this year.

Empirical evidence says tariffs will be an economic headwind. Researchers at the Federal Reserve Bank of San Francisco reviewed 150 years' worth of data and arrived at this conclusion: Tariffs have historically led to higher unemployment and slower economic growth. And anything that bodes ill for the economy also bodes ill for the stock market.

The stock market flashes a warning last seen during the dot-com crash

Economist Robert Shiller, Nobel laureate and Sterling Professor Emeritus at Yale University, developed the cyclically adjusted price-to-earnings (CAPE) ratio as means of determining whether entire stock market indexes were overvalued. While traditional price-to-earnings (PE) ratios are based on profits from the last four quarters, CAPE ratios eliminate natural volatility in the business cycle by averaging inflation-adjusted profits from the past decade.

In December, the S&P 500 had an average CAPE ratio of 39.4, the most expensive multiple since the dot-com crash in October 2000. In fact, the S&P 500 has recorded a monthly CAPE multiple above 39 only 25 times over the course of history, and the index generally declined during the next year.

The chart below shows the S&P 500's best, worst, and average returns over different time periods following occasions when its monthly CAPE multiple exceeded 39.

Data source: Robert Shiller. The chart shows the S&P 500's best, worst, and average returns over different time periods following a monthly CAPE ratio above 39.

As shown above, monthly CAPE ratios above 39 do not mean the S&P 500 is doomed to crash immediately. While the index has declined by an average of 4% during the year following such a high valuation, its returns have ranged from positive 16% to negative 28% under those conditions.

However, the picture becomes increasingly grim over longer time horizons. After recording a monthly CAPE multiple above 39, the S&P 500 has dropped by an average of 20% during the next two years and 30% during the next three years. Even worse, the index has never generated a positive three-year return under those conditions.

Here's the big picture: The S&P 500's historically high valuation is a warning for investors, especially because President Trump's tariffs may slow economic growth in the future. That does not mean investors should sell all their stocks. But now is a good time to sell stocks in which you lack conviction. It's also a good time to build a cash position in your portfolio.

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.