(Bloomberg) — President Donald Trump’s mercurial approach to his signature tariffs whipsawed markets last week. And investors trying to position their equity portfolios to manage this ongoing uncertainty are finding the playbook from his first term offers little help.
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What hasn’t changed is Trump’s strategy of pledging aggressive levies on trading partners and then quickly backtracking, either delaying them or canceling them completely. What has changed is basically everything else.
For starters, the tariffs he’s proposed are going to impact a wider range of goods than during his first term. But more importantly, investors are in a completely different paradigm. Volatility is higher. The S&P 500 Index is on a red-hot winning streak, rising 53% combined in 2023 and 2024 and pushing valuations to lofty bull market levels. Compare that with 2017, when the S&P was coming off a combined gain of just 8.7% over the previous two years, giving stock prices far more room to run as Trump took office.
To Tim Hayes, chief global investment strategist at Ned Davis Research, that means a defensive approach to allocating to risk assets. He said the firm’s investment model will likely call for cutting equity allocations “if tariffs produce a trade war that leads to rising bond yields, a worsening macro environment and an exodus” from the technology sector and the US markets more generally.
The caution underscores how the macro setup has changed too. Inflation is running hotter. Interest rates are much higher. And the federal deficit is a far bigger headache than it was eight years ago. Taken together, the backdrop for stocks is significantly more fraught, even as the economy hums along.
“We are in an environment of really high expectations in the third year of a bull market, whereas in 2017 we were coming out of a bear market,” said Todd Sohn, ETF and technical strategist at Strategas Securities LLC. “When you have any form of fragility, any catalyst can upset markets.”
Asset managers’ exposure to equity futures is currently above the 40th percentile, according to data compiled by Mislav Matejka, head of global equity strategy at JPMorgan Chase & Co. In 2017, it was below the 10th percentile. This means investors now have less dry powder to buy equities in the months ahead than they did the first time Trump took office.
By one barometer, investors’ expectations for the stock market have never been this high at the start of a presidential term. The cyclically-adjusted price-to-earnings ratio, more commonly known as the CAPE ratio, stood at nearly 38 in late January, an “extremely high” level, according to Charlie Bilello, chief market strategist at Creative Planning.
“Historically, that has meant below average future returns for stocks when looking out 10 years,” he added.
Positioning tells a similar story. The US equity risk premium (ERP) — a measure of the differential between the expected returns of stocks and bonds — is deep into negative territory, something that hasn’t happened since the early 2000s. Whether that’s a negative indicator for share prices depends on the economic cycle. A lower number can be seen as indicating that corporate profits are going to rise. Or it could mean that stocks are climbing too rapidly and are far above their actual value.
Yet, the fourth-quarter earnings season so far is showing a troubling trend. Fewer US companies are topping their earnings estimates, tariff talks are dominating earnings calls, and outlooks for 2025 have already started to take a hit.
Shares of Ford Motor Co. (F) and General Motors Co. (GM) tumbled after the carmakers reported, amid concerns about how these levies would hurt earnings this year. Industrial giant Caterpillar Inc. (CAT), which is considered a proxy for trade tensions, warned that revenues will be lower amid demand pressures — and higher prices for the big-ticket equipment it sells will only make that situation worse.
Meanwhile, some investors are looking at niches within the stock market where valuations are less frothy and historical patterns more favorable. Scott Welch, chief investment officer at Certuity, is reallocating funds into a forgotten corner of the market that usually shines when the Federal Reserve cuts interest rates: mid-cap stocks.
“Megacap tech has been priced for perfection so it wouldn’t take much to cause a disruption,” Welch said in an interview. “They’ve bounced back because they have strong earnings and cash flows. But nothing lasts forever.”
Large-scale macro risks, like Trump’s tariffs, can often cause the stock market to move as a monolith. Indeed, share prices became highly correlated in late 2018, when trade tensions simmered with China and the path of the Fed’s interest-rate policy weighed on equities broadly. An index of three-month implied correlations from Cboe, the Chicago-based exchange, spiked at that time, and the S&P 500 posted its worst annual decline since the global financial crisis.
Right now, that correlation index is hovering near record lows, meaning stocks aren’t moving in unison. That’s typically a healthy sign for markets, indicating company-specific fundamentals are holding greater sway over macroeconomic developments. The downside, however, is that it encourages investors to take on more risk.
Ultimately, the biggest challenge for investors in this situation is reading the political winds and figuring out which way the Trump administration will go with tariffs and trade policy. The lack of clarity is pushing many Wall Street pros to keep it all on their radar — but not act yet.
“We always tell investors not to concentrate on politics because they rarely have an immediate impact on equities,” said Mark Newton, head of technical strategy at Fundstrat. “Every year has its share of scary things that investors need to worry about, but overall the equity market has been resilient.”
