Tariffs and Elevated Valuations Create a Perfect Storm for Stock Market Risk

Economic Deterioration Contradicts Bullish Market Forecasts

The U.S. economy has weakened substantially since tariffs were introduced in April. Employment growth collapsed from an average of 123,000 jobs monthly (January-April) to just 39,000 (May-September)—the lowest five-month average since 2010, outside pandemic disruptions. Unemployment climbed from 4.2% in April to 4.4% by September, reaching its highest level in four years. Meanwhile, inflation accelerated sharply: CPI moved from 2.3% in April to 3% by September, with Federal Reserve Bank of Cleveland estimates holding inflation steady at 3% through November.

Despite these warning signs, Wall Street remains bullish. Analyst consensus projects the S&P 500 will reach 7,928 within 12 months, implying 20% upside from current levels near 6,603. Yet this forecast appears disconnected from economic reality. The S&P 500 trades at 21.5 times forward earnings—substantially above the 10-year historical average of 18.7—signaling stretched valuations in an environment of economic fragility.

Consumer Sentiment Reaches Crisis Levels

The University of Michigan’s Consumer Sentiment Index hit 51 in November, marking the second-lowest reading since monthly surveys began in 1978 (only June 2022’s 50.3 was worse). More alarming, 2025 is tracking toward the lowest annual average on record at 58.7 through November, surpassing even 2022’s 59 average—a year plagued by pandemic-driven inflation at 40-year highs.

The culprit is clear: consumers perceive prices as persistently high while incomes weaken. Year-ahead inflation expectations rose to 4.5% from 3% in September. “Consumers remain frustrated about the persistence of high prices and weakening incomes,” noted Joanne Hsu, director of the Surveys of Consumers at the University of Michigan. This pessimism threatens economic expansion, since consumer spending drives two-thirds of GDP. Widespread pessimism typically precedes reduced spending, which eventually pressures corporate earnings estimates downward.

Market Momentum Masks Underlying Vulnerabilities

Federal Reserve Chair Jerome Powell cautioned in September that “equity prices are fairly highly valued,” yet this observation has proven prescient rather than alarmist. The S&P 500 has already declined more than 4% from record highs as investor concerns about valuations and economic headwinds intensify.

Importantly, valuation alone is a poor short-term predictor. Economist John Maynard Keynes once observed, “Markets can remain irrational longer than you can remain solvent”—a principle that appears in various economics books exploring market psychology and behavioral finance. This means stock prices trade on momentum rather than fundamentals, making near-term bets inherently risky regardless of analytical accuracy.

Evidence of shifting sentiment appears in bullish investor positioning. In early October, 45.9% of individual investors expected stocks to rise over the next six months. That figure has collapsed to 32.6%, reflecting a dramatic loss of confidence. Should tariff-driven earnings revisions occur, the current bull market could reverse sharply.

The Case for Caution

Wall Street’s 20% upside target may materialize, but current conditions suggest meaningful downside risk. Investors face a choice between chasing optimistic consensus or heeding the accumulating warning signals: elevated valuations, deteriorating employment, rising inflation expectations, and consumer sentiment near record lows.

While short-term predictions remain speculative, prudent strategy involves rebalancing portfolios toward cash positions rather than aggressively accumulating equities at stretched valuations.