Research from the Federal Reserve Bank of New York shows an ominous correlation between stock performance and the introduction of tariffs during Trump’s first term.
| The motley fool
Wall St ends higher; markets digest Trump’s tariff threats, Fed minutes
STORY: U.S. stocks closed higher Tuesday as technology stocks rallied as investors digested President-elect Donald Trump’s tariff promises and the Federal Reserve’s latest minutes. The Dow Jones added about a third of a percent, while the S&P 500 and Nasdaq each added about six-tenths of a percent. In an overnight development, Trump said he would impose a conditional 25% tariff on Canada
In less than four weeks, President-elect Donald Trump will be sworn in as the 47th president becoming only the second American leader to ever serve non-consecutive terms. However, Wall Street decided to start the party a little earlier.
It has been iconic since Election Day Dow Jones Industrial AverageThe benchmark S&P 500 and the growth-stock-dependent Nasdaq have all soared to record highs. This continues the robust gains that Wall Street’s major indexes made during Trump’s first term. Between January 20, 2017 and January 20, 2021, the Dow Jones, S&P 500 and Nasdaq Composite rose 57%, 70% and 142%, respectively.
But to quote Wall Street’s favorite warning: “Past performance is no guarantee of future results.”
While stocks have done well with Trump in the Oval Office, there are genuine concerns that his desire to impose tariffs on day one could undermine American companies and cause the stock market to collapse. Based on what history tells us, this isn’t outside the realm of possibility.
Trump’s previous tariffs had a damaging effect on stocks
Last month, President-elect Trump presented his plan to… 25% rate on imports from its immediate neighboring countries, Canada and Mexico, and on import duties of 35% on imported goods from China, the world’s second largest economy.
The overall purpose of tariffs is to make American-made goods more price competitive with goods brought in from outside our borders. They are also intended to encourage multinational companies to produce their goods destined for the US within the confines of our borders.
But according to an analysis by Liberty Street Economics, which publishes research for the Federal Reserve Bank of New York, Trump’s tariffs have previously had a decisive negative impact on U.S. stocks exposed to countries where they were targeted.
The four authors of Do import tariffs protect American companies? make a point to distinguish between the impact of tariffs on outputs versus inputs. An output tariff is an additional cost added to the final price of a good, such as a car imported into the country. Meanwhile, an input tariff would impact the cost of producing a final product (for example, higher costs for imported steel). The authors note that higher input tariffs make it difficult for U.S. manufacturers to compete on price with foreign companies.
The authors also examined the stock market returns of all publicly traded US companies on the day Trump announced tariffs in 2018 and 2019. They found a clear negative shift in stock prices on the days tariffs were announced, with this effect being most pronounced for companies that were exposed to China.
Additionally, the authors noted a correlation between companies that performed poorly on the days when rates were announced and “future real performance.” Specifically, these companies experienced a decline in profits, employment, revenue and labor productivity between 2019 and 2021, based on the authors’ calculations.
In other words, history would suggest that tariffs implemented on day one of Donald Trump’s second term could be a downside catalyst for the Dow Jones. S&P500and Nasdaq Composite.
Stocks are pricey, raising concerns about a correction
Unfortunately, history has delivered a double whammy for investors. Although comparing the historical performance of stocks on the days when tariffs are announced during Trump’s first term provides a limited data set, one of Wall Street’s most important valuation indicators, which can be tested over 153 years. offers sufficient reason for concern.
In other words, there’s another reason for investors to be nervous about the market besides rates: stock valuations are relatively high.
Many investors are probably familiar with the price-earnings ratio (P/E)which divides the share price of a listed company into the earnings per share (EPS) over the last twelve months. The traditional price-to-earnings ratio is a fairly effective valuation tool that helps investors determine whether a stock is cheap or expensive compared to its peers and broad market indexes.
The disadvantage of the price-earnings ratio is that it can easily be disrupted by shocking events. For example, the lockdowns that occurred during the early stages of the COVID-19 pandemic made trailing twelve-month earnings per share relatively useless for most companies for about a year.
This is where the S&P 500’s Shiller P/E Ratio, also known as the cyclically adjusted P/E Ratio (CAPE ratio), can come in handy.
S&P 500 Shiller CAPE ratio data Ygraphs.
The Shiller P/E ratio is based on the average inflation-adjusted EPS over the past ten years. When looking at inflation-adjusted earnings data over a decade, shock events are an indisputable point when assessing the valuation of stocks as a whole.
As of the closing bell on December 20, the S&P 500’s Shiller P/E stood at 37.68, which is more than double the 153-year average of 17.19. But what’s more concerning is how the stock market has responded to previous instances of the Shiller P/E reaching the 30 mark.
What happens when stock prices are high?
Dating from January 1871, there are There have only been six instances where the S&P 500’s Shiller P/E has topped 30 during a bull market rally, including the present. Each prior event was ultimately followed by a 20% to 89% decline in the S&P 500, Dow Jones Industrial Average and/or Nasdaq Composite.
To be clear, the Shiller P/E does not give us any clues as to when the stock market downturn will begin. Sometimes stocks have extended valuations for a few weeks before plummeting, such as during the two-month period leading up to the start of the Great Depression in 1929. Meanwhile, the Shiller P/E was above 30 for four years before the dot-com bubble burst. . Still, this historical valuation metric suggests that stocks can fall – and they do It would have made no difference which presidential candidate won in November.
Investing in stocks for the long term usually works
However, history can also be a beacon of hope and inspiration, depending on your investment horizon.
As much as investors would like to avoid stock market corrections, bear markets and crashes, they are ultimately a normal and unavoidable aspect of the investment cycle. But what’s important to note is that the ups and downs that come with investing are not linear.
For example, the analysts at Bespoke Investment Group calculated the average calendar day length of the S&P 500 bull and bear markets since the beginning of the Great Depression and discovered night and day differences between the two.
On the one hand, the 27 bear markets in the S&P 500 between September 1929 and June 2023 lasted an average of only 286 calendar days (about 9.5 months), with the longest bear market lasting 630 calendar days. On the other side of the coin, the typical S&P 500 bull market has endured 1,011 calendar days in the 94 years examined. Furthermore, 14 of the 27 bull markets (if you include the current bull market and extrapolate to the present) have lasted longer than the longest bear market.
^SPX data Ygraphs. YCharts S&P 500 return data starts in 1950.
An analysis from Crestmont Research looked even further back at stock performance over long periods of time and came to an even more encouraging conclusion.
Crestmont calculated the twenty-year rolling total return (including dividends) of the S&P 500 since the early 20th century. Although the S&P did not officially exist until 1923, researchers were able to track the performance of its components in other indexes to meet the backtest until 1900. This twenty-year timeline yielded 105 end periods (1919 through 2023).
What Crestmont’s annually updated dataset shows is that all 105 rolling 20-year periods would have produced positive total returns. Hypothetically speaking, if you had bought an S&P 500 index fund just before the start of the Great Depression in 1929, or before Black Monday in 1987, and held that stake for twenty years, you would still have made money.
The Crestmont Research dataset also convincingly shows that the stock market can make patient investors richer, regardless of which political party is in power. No matter how you arrange the political puzzle piecesthe total returns over 20 years have always been decisively positive.
Sean Williams 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 one disclosure policy.
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