In less than two years, the US president has launched a trade war against most of the US’s allies, led the country into direct military conflict in the Middle East and repeatedly pressured two successive Federal Reserve chairmen to lower interest rates, despite the inflationary effects of his other two policies.
Amid this tumultuous backdrop, however, the S&P 500 continues to rally, up an impressive 33% since Trump won the presidential election on November 5, 2024. The explosive growth of new industries, such as artificial intelligence (AI), has allowed Wall Street to ignore the growing political uncertainty until now.
However, the risks are rising and the question now is whether the US stock market is facing another major crash.
The Contradiction of Trump Policy
Under Donald Trump, US economic policy has begun to deviate significantly from several of the administration’s stated goals, including deflating inflation and reducing the national debt.
The escalation of the war in Iran has pushed US inflation to 3.4% year-on-year in July, well above the Federal Reserve’s 2% target. Persistently high inflation makes it more difficult for the Fed to decide to cut interest rates.
The reason is that while lower interest rates can support the economy by reducing borrowing costs, they can also further increase inflationary pressures, worsening the overall economic picture.
The example of Turkey
Turkey is a typical example of the risks that can arise from such a policy. During 2021-2023, the country cut interest rates while inflation remained at exceptionally high levels, exacerbating a massive cost-of-living crisis from which it is still struggling to recover.
President Trump appears to have not learned from the mistakes of other countries. As part of his ongoing pressure campaign, the US president is now threatening to cut trade with all countries that have a trade surplus with the US if the Federal Reserve does not cut interest rates.
If such an extreme policy were implemented, it could trigger a new surge in inflation and make any rate cuts even more difficult.
Can Wall Street withstand new political uncertainty?
Historically, the course of stock markets has been influenced more by economic fundamentals, innovation and corporate profitability than by the direct effects of government policy.
However, there are now growing signs that the Trump administration’s unorthodox decisions are starting to spill over into the real economy. One of the most important signs that the market is starting to worry comes from the bond market.
Bond yields are rising significantly, with the yield on the 10-year US Treasury note now hovering near 4.80%. US Treasury bonds are considered the benchmark for the risk-free interest rate in the US economy. When their yields rise, so do the costs of borrowing for businesses and households.
This development comes at a particularly difficult time for the technology industry, which is investing hundreds of billions of dollars in capital expenditures to build artificial intelligence data centers.
S&P 500 at All-Time High Valuations
The risk of a stock market crash is further compounded by the S&P 500’s all-time high valuation. The cyclically adjusted price-to-earnings (CAPE) ratio is currently at 41.4, compared to a historical average of 17.4.
That’s near the all-time high of 44, which was set in 1999, just before the dot-com bubble turned into one of the biggest stock market crashes of modern times.
That doesn’t mean a crash is certain or can be accurately predicted, but it does indicate that the safety margins for investors have narrowed significantly.
What investors should do now
The basic principle of the markets remains that time in the market trumps the effort to predict the market. Even if the probability of a crash increases, no one can know exactly when it will occur.
This creates the risk that investors will sell too early and miss out on a potential new uptrend. Trump’s policy choices appear to be becoming more, not less, aggressive.
In this environment, investors can limit the risk to their portfolios through greater diversification, choosing profitable businesses with reasonable valuations and limited room for further decline.
At the same time, maintaining a certain amount of liquidity could prove useful, so that funds are available for purchases in case stocks decline significantly in the coming months.
The S&P 500 Trap
The question now is whether investors should buy the S&P 500.
The key message for investors is that, in an environment of high valuations, rising bond yields, persistent inflation, and heightened political uncertainty, diversification and quality company selection become even more important.
Whether the market is indeed on the verge of another major crash remains unclear. What does appear to be the case, however, is that the factors that have historically preceded major corrections are starting to converge again.
