After months of wild swings, the S&P 500 index is back near its record high as investors expect an easing in tariff tensions and the continued ascendance of the technology sector.
As Alfred E. Neuman put it: What, me worry?
There are warning signs, however. The price-earnings ratio of the S&P 500 is once more signaling overvaluation. The effective tariff rate has risen to 15.6% and corporate profits are averaging a healthy 13% with a lower rate of 5% to 7% among smaller and midsize firms.
In addition, with geopolitical tensions boiling over in the Middle East and emerging signs of inflation beneath benign price index readings, equity valuations are vulnerable to abrupt turns in trade policy, inflation and global security dilemmas.
As calculated by the economist Robert Shiller, recent spikes in the price-earnings ratio include the runup of the late-1990s tech bubble, the euphoria before the 2018 trade war and then the 2022 recovery from the pandemic.
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The current level of euphoria is similar to the 2018 disruption of trade that sent the global economy into a manufacturing recession.
By 2019, the price-earnings ratio had dropped by four points, only to lose four additional points when the pandemic broke out the next year.
From our point of view, it’s difficult to accept current equity valuations at face value given the soft earnings environment that followed the 2018 trade tiff.
While we remain bullish on the American tech sector, that area of the economy and all the investment that will accompany it is not sufficient to warrant equity prices at these levels.
We expect the euphoria to recede only when U.S. inventories are exhausted and household spending decreases as the tariffs take effect.
The consensus forecast is for real gross domestic product growth to drop from a 2.1% annual rate in the first quarter to 0.9% by the fourth quarter.
We would argue that neither the near-term nor long-term effect of tariffs on the economy has yet to be fully absorbed by the equity markets.
Instead, the constant policy changes have the market anticipating a correction to every announcement.
This level of uncertainty appears to have peaked a week after the “Liberation Day” announcements on April 2. This might account for the market’s nonchalance and we-can-get-through-this attitude toward tariffs.
Although GDP growth in the first quarter had already slowed, it is apparent that as long as the labor market remains at full employment and inflation remains moderate, equity valuations will remain elevated.
Small-cap corporations
Still, the disparate performance of other stock market indices might be hinting at how the tariffs will take their toll on the economy.
While the large-cap S&P 500 and tech-centered Nasdaq are bouncing back toward their February peaks and the Dow Jones Industrials have managed to be 1.8% higher than last Nov. 1, the small-cap Russell 2000 index is 3.4% lower.
The Russell 2000 might be telling us that the first to be hit by the tariffs will be the smaller companies that cannot afford to increase inventories in the face of tariffs or to withstand shrinking profit margins.
Based on analysis by the Bureau of Labor Statistics, small businesses in the 10 years to 2024 employed an average of 46% of the covered workforce and contributed 55% of the jobs created.
Employment in small businesses was also hit the hardest during the pandemic. While a trade war will affect the tech labor force and overweight 401(k) accounts, it will be small businesses and their employees who will bear the brunt of tariffs.
