Fed Chair Jerome Powell Warned Investors About the Stock Market -- President Trump's Tariffs Make the Warning More Dire

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Key Points

• In September, Federal Reserve Chairman Jerome Powell warned investors that stocks were richly valued, an ominous pronouncement given that tariffs have left the economy on shaky ground

• In November, the Consumer Sentiment Index recorded its second-lowest measurement in history, reflecting concerns about the weakening jobs market and rising prices.

• Wall Street analysts collectively expect the S&P 500 to advance 20% in the next year, but that forecast may be overly optimistic given elevated valuations and the weak economy.

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In September, Federal Reserve Chairman Jerome Powell warned investors, "Equity prices are fairly highly valued." At the time, the S&P 500 (SNPINDEX: ^GSPC) was trading at 22.5 times forward earnings. Its multiple has since fallen to 21.5 times forward earnings, but that is still a big premium to the 10-year average of 18.7, per FactSet Research.

While an elevated valuation alone may not be cause for alarm, Powell's warning is particularly concerning because President Trump's tariffs have left the economy on shaky ground. Consider the changes in inflation and employment that have occurred since the baseline 10% tariff took effect in April.

• CPI inflation measured 2.3% in April. That figure had accelerated to 3% as of September, and estimates from the Federal Reserve Bank of Cleveland put inflation at 3% in October and November.

• The U.S. economy added an average of 123,000 jobs per month between January and April. That figure fell to 39,000 between May and September, the lowest five-month average since 2010, excluding the pandemic.

• Unemployment measured 4.2% in April. That figure hit 4.4% in September, the highest level in four years.

Wall Street expects substantial upside in the stock market in the next 12 months. But the combination of a weak jobs market and rising prices has dragged consumer sentiment to a near-record low. That could spell trouble for the stock market.

Consumer sentiment is very close to a record low

The University of Michigan interviews about 1,000 households each month. Consumers answer questions about personal finance, business conditions, and buying conditions, which are compiled to form the Consumer Sentiment Index. In November, the index measured 51, the second lowest reading in history (monthly surveys began in 1978). The only worse reading was 50.3 in June 2022.

However, the Consumer Sentiment Index averaged 58.7 through the first 11 months of the year. That puts 2025 on course to be the worst year on record. The next closest was 2022, when the Consumer Sentiment Index averaged 59 as inflation reached a four-decade high because of fallout from the pandemic.

Consumers are specifically worried about rising prices. Year-ahead inflation expectations measured 4.5%, implying a material increase from 3% in September. "Consumers remain frustrated about the persistence of high prices and weakening incomes," said Joanne Hsu, director of the Surveys of Consumers at the University of Michigan.

That is bad news for the economy. Consumer spending, which accounts for two-thirds of GDP, is the primary engine of economic expansion. And widespread pessimism portends lower spending in the months ahead. That, in turn, may cause Wall Street analysts to lower forward earnings estimates.

Wall Street expects the S&P 500 to soar 20% over the next 12 months

By aggregating the individual forecasts on every stock in the S&P 500, FactSet Research builds a "bottom-up" forecast for the entire index. Using that methodology, the S&P 500 has a 12-month target price of 7,928, which implies 20% upside from its current level of 6,603. But that estimate leaves considerable room for downside.

The S&P 500 has fallen more than 4% from its record high as investors have become more concerned about economic headwinds and elevated valuations. I've already discussed how economic headwinds have dragged consumer sentiment to a near-record low. But the S&P 500 still trades at 21.5 times forward earnings, which is a premium to the 10-year average of 18.7 times forward earnings.

That does not mean a stock market correction is imminent. Valuation is a poor predictor of near-term changes. Economist John Maynard Keynes once explained, "Markets can remain irrational longer than you can remain solvent." That means betting on short-term changes is dangerous even if you are fundamentally correct, because stocks trade on momentum.

However, investors have become less optimistic in recent months. For the week ended Oct. 8, the American Association of Individual Investors reports bullish sentiment was 45.9%, meaning 45.9% of survey participants expected stocks to increase over the next six months. That figure has since fallen to 32.6%.

If fallout from Trump's tariffs leads to downward revisions in forward earnings estimates, the current bull market could come to an end. Investors should hope Wall Street's optimism proves correct, but they should mentally prepare for a less rosy outcome. Now is a good time to focus a little less on buying stocks and a little more on building a cash position.

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Trevor Jennewine has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends FactSet Research Systems. The Motley Fool has a disclosure policy.

Fed Chair Jerome Powell Warned Investors About the Stock Market -- President Trump's Tariffs Make the Warning More Dire was originally published by The Motley Fool