President Trump’s erratic attitude towards his signature tariffs sent the US stock market tumbling last week. Investors trying to adjust their stock portfolios to cope with the ongoing uncertainty found that the coping strategies from Trump’s first term were almost of no use.
As soon as the “Know-It-All” took office for his second term, he promised to impose hefty tariffs on trading partners, but then quickly changed his mind, either postponing or completely cancelling them. Everything else changed as well.
Firstly, the tariffs he proposed will affect a broader range of goods than in his first term. But more importantly, investors are in a completely different mode. Volatility is higher. The S&P 500 index is in a hot upward trend, having risen by 53% in total in 2023 and 2024, and pushing valuations to bull market highs. In contrast, in 2017, the S&P index rose by only 8.7% in total over the past two years.
For Tim Hayes, chief global investment strategist at Ned Davis Research, this means taking a defensive approach to the allocation of risky assets. He said, “If tariffs trigger a trade war, leading to rising bond yields, a deteriorating macro environment, and investors pulling out of the technology sector and the US market as a whole,” the firm’s investment model might call for a reduction in stock allocation.
This cautious attitude highlights that the macro environment has also changed. Inflation rates are getting higher and higher. Interest rates are much higher. The federal deficit is more of a headache than it was eight years ago. In short, although the economy is developing steadily, the background of the stock market is more severe.
Todd Sohn, ETF and technical strategist at Strategas Securities LLC, said: “In the third year of a bull market, we are in an environment of high expectations, while in 2017 we were just emerging from a bear market.”
According to data compiled by Mislav Matejka, the global head of equity strategy at JPMorgan Chase, asset managers’ exposure to stock futures is currently above 40 percentage points. In 2017, this ratio was below 10 percentage points. This indicates that investors have less money to buy stocks in the coming months than they did when Trump first took office.
One thing is certain: investor expectations for the stock market have never been so high at the start of a presidential term. Charlie Bilello, chief market strategist at Creative Planning, said that at the end of January, the cyclically adjusted price-to-earnings ratio (commonly known as the CAPE ratio) was close to 38, which is at an “extremely high” level.
He added: “Historically, this means that stock returns over the next 10 years will be below average.”
The position situation is similar. The equity risk premium (ERP) of US stocks – an indicator measuring the difference in expected returns between stocks and bonds – has dropped to a negative value, a situation that has not occurred since the early 2000s. Whether this is a negative indicator for stock prices depends on the economic cycle. A lower figure can be seen as a sign that corporate profits will rise. Or, it may mean that stocks have risen too fast, far exceeding their actual value.
However, so far, the fourth-quarter earnings season has shown an unsettling trend. Fewer and fewer US companies have beaten earnings expectations, tariff negotiations have dominated earnings calls, and the outlook for 2025 has already begun to take a hit.
Shares of Ford Motor Company and General Motors plunged after they released their financial reports, as people were concerned about how these tariffs would affect this year’s earnings. Industrial giant Caterpillar, seen as a bellwether for trade tensions, warned that revenue would decline under demand pressure – and that the price hikes of its high-priced equipment would only make the situation worse.
Meanwhile, some investors are scouring the stock market for niches with less valuation bubbles and more favorable historical patterns. Scott Welch, chief investment officer of Certuity, is reallocating funds to a forgotten corner of the market that typically shines when the Federal Reserve cuts interest rates: mid-cap stocks.
“The pricing of the big tech stocks is perfect, so it doesn’t take much to cause a shock,” Welch said in an interview. “They have rebounded because they have strong earnings and cash flow. But nothing is eternal.”
Large-scale macro risks such as Trump’s tariffs often lead to overall fluctuations in the stock market. In fact, at the end of 2018, when the trade tensions between China and the United States intensified and the direction of the Federal Reserve’s interest rate policy put broad pressure on the stock market, stock prices became highly correlated. At that time, the Cboe’s three-month implied correlation index soared, and the S&P 500 index recorded its biggest annual decline since the global financial crisis.
