The Stock Market Sounds an Alarm as Investors Get a Grim Update on President Trump's Economy

Since late March, the S&P 500 (SNPINDEX: ^GSPC) has advanced 20% while closing higher in nine straight weeks. But the good times may not last. Investors just got bad news about President Trump's economy:

• Inflation hit a three-year high in April because of elevated oil prices, which may force the Federal Reserve to raise interest rates.
• Economic growth was well below average in the first quarter, as tariffs slowed business investments and consumer spending.

Against that backdrop, the stock market is sounding an alarm: The S&P 500 trades at its most expensive valuation since the dot-com crash, and history says the index could decline sharply. Here's what investors should know.

President Donald J. Trump delivers remarks to a joint session of Congress. Image source: Official White House Photo.

PCE inflation just accelerated to its highest level in three years

The Personal Consumption Expenditure (PCE) Price Index, the Federal Reserve's preferred inflation gauge, recorded a year-on-year increase of 3.8% in April, primarily because of elevated energy prices tied to the Iran war. That's the highest reading in three years.

That news comes at a bad time, because economic growth has slowed under President Trump, in part because of tariffs his administration has imposed. The Commerce Department says GDP increased 1.6% on an annual basis in the first quarter, well below the 10-year average of 2.6%. Since Trump returned to office, quarterly annualized GDP growth has averaged 1.9%.

Below-average economic growth would be disappointing under any circumstance, but it's particularly bad news today because inflation is increasing at the same time. High inflation may force the Federal Reserve to raise interest rates. Indeed, futures traders are betting on at least one quarter-point rate increase in the next year. That would create another headwind to economic growth.

Weak economic growth will eventually translate into slower corporate earnings growth. That's bad news for investors, because corporate earnings are the primary determinant of stock prices over time.

The S&P 500 is more expensive today than it has been since the dot-com crash

In 1988, Nobel Prize-winning economist Robert Shiller and his colleague John Campbell introduced the cyclically adjusted price-to-earnings (CAPE) ratio. Whereas the traditional price-to-earnings ratio is based on earnings from the past year, the CAPE ratio removes short-term noise by incorporating inflation-adjusted earnings from the past decade.

In May, the S&P 500 had an average CAPE ratio of 39.6, tied for the highest reading since the dot-com crash in September 2000. There have been only 27 instances where the S&P 500's monthly CAPE multiple has topped 39 since the index was created in 1957, which means the stock market has been this expensive only about 3% of the time.

Unfortunately, past incidents generally preceded substantial losses. The following chart shows the S&P 500's best, worst, and average returns over different periods following monthly CAPE readings above 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.

The chart makes two important points: First, the S&P 500 has usually declined over the one- and two-year periods following a monthly CAPE reading above 39. Second, the S&P 500 has never been a profitable investment over any three-year period when starting from such an expensive valuation.

Of course, there is no guarantee history will repeat itself. S&P 500 profit margins hit a 15-year high in the first quarter, and Wall Street expects margins to expand further in the coming quarters as artificial intelligence drives productivity. The CAPE ratio is a backward-looking metric, so it doesn't account for the possibility that earnings will grow faster in the future.

With profit margins expanding, investors may tolerate higher CAPE multiples today because they anticipate more robust earnings growth tomorrow. In that scenario, the CAPE ratio could gradually decline to a more reasonable level while the S&P 500 continues moving higher.

Yet it would be unwise to ignore this warning completely. The S&P 500 is undeniably expensive by historical standards, which leaves the stock market vulnerable to declines even in the best-case scenario. Now is not the time to make risky trades. Instead, investors should focus on owning stocks whose earnings are likely to be materially higher five to 10 years from now, and only if those stocks trade at reasonable prices.

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.