Will President-elect Donald Trump's plan to implement tariffs cause stocks to drop? Here is what history tells us.

A study from the Federal Reserve Bank of New York finds a worrying correlation between stock performance and the implementation of tariffs during Trump's first term.

In less than four weeks, President-elect Donald Trump will be sworn in as the 47th president and become the second U.S. leader to serve non-consecutive terms. However, Wall Street decided to kick off the party a little early.

Since Election Day, the iconic Dow Jones Industrial Average (^DJI 0.91%), the benchmark S&P 500 (^GSPC 1.10%), and the growth-stock-dependent Nasdaq Composite (^IXIC 1 .35%) all hit record closing highs. It's a continuation of the robust gains that Wall Street's major indexes enjoyed during Trump's first term. Between January 20, 2017 and January 20, 2021, the Dow Jones, S&P 500 and Nasdaq Composite rose 57%, 70% and 142%, respectively.

But to quote Wall Street's favorite warning: “Past performance is no guarantee of future results.”

Although stocks have thrived with Trump in the Oval Office, there is genuine concern that his desire to implement tariffs on day one could hurt American businesses and cause the stock market to plummet. From what history tells us, this is not outside the realm of possibility.

Former President and President-elect Donald Trump delivers remarks. Image Source: Official White House Photo by Andrea Hanks.

Analysis: Previous Trump tariffs had a deleterious effect on US stocks

Last month, President-elect Trump outlined plans to impose 25 percent tariffs on imports from his direct neighbors Canada and Mexico, as well as 35 percent tariffs on goods imported from China, the world's second largest economy.

The overall goal of tariffs is to make products made in the United States more competitive with those imported from outside our borders. They also aim to encourage multinational companies to manufacture their products for the United States within our borders.

But according to an analysis by Liberty Street Economics, which publishes a study for the Federal Reserve Bank of New York, the tariffs imposed by Trump have already had a decisive negative impact on American stocks exposed to countries targeted by these tariffs.

The four authors of Do Import Tariffs Protect US Firms? It is important to distinguish between the impacts of customs duties on outputs and those on inputs. An exit tariff is a cost added to the final price of a good, such as a car imported into the country. At the same time, a tariff on inputs would affect the cost of producing a final good (for example, higher costs for imported steel). The authors note that higher tariffs on inputs make it difficult for U.S. manufacturers to compete on price with foreign companies.

The authors also examined the stock returns of all publicly traded U.S. companies on the day Trump announced the tariffs in 2018 and 2019. They found a clear negative movement in stock prices on the days the tariffs were announced, this effect being more pronounced on companies that were exposed to China.

Additionally, the authors noted a correlation between companies that performed poorly on tariff announcement days and “future actual results.” Specifically, these companies experienced declines in profits, employment, sales and labor productivity between 2019 and 2021, according to the authors' calculations.

In other words, history suggests that tariffs implemented on the first day of Donald Trump's second term may be a downward catalyst for the Dow Jones, S&P 500 and Nasdaq Composite.

This may be Wall Street's biggest concern — and it has nothing to do with President-elect Trump.

Unfortunately, the story presents a double whammy for investors. Although comparing historical stock performance on tariff announcement days during Trump's first term provides a limited data set, one of Wall Street's primary valuation metrics, which can be backtested over 153 years , offers plenty of reasons to worry.

Many investors are likely familiar with the price-to-earnings (P/E) ratio, which divides a publicly traded company's stock price into its trailing 12-month earnings per share (EPS). The traditional P/E ratio is a fairly effective valuation tool that helps investors determine whether a stock is cheap or expensive relative to its peers and general market indices.

The downside of the P/E ratio is that it can be easily disrupted by shock events. For example, the lockdowns that occurred at the start of the COVID-19 pandemic made trailing 12-month EPS relatively useless for most companies for about a year.

This is where the Shiller P/E ratio of the S&P 500, also known as the cyclically adjusted P/E ratio (CAPE ratio), can come in handy.

S&P 500 Shiller CAPE ratio data by YCharts.

The Shiller P/E ratio is based on the inflation-adjusted average EPS of the preceding 10 years. Examining a decade of inflation-adjusted earnings data makes shock events a moot point when assessing the valuation of stocks as a whole.

As of the close on December 20, the Shiller P/E for the S&P 500 stood at 37.68, more than double its 153-year average of 17.19. But what's more concerning is how the stock market reacted after previous instances where the Shiller P/E rose above 30.

Since January 1871, there have only been six instances where the S&P 500's Shiller P/E has reached a high of 30 during a bull rally, including today. Each previous event was ultimately followed by a 20% to 89% decline in the S&P 500, Dow Jones Industrial Average, and/or Nasdaq Composite.

To be clear, Shiller's P/E gives us no indication of when stock market declines will begin. Sometimes stocks extended their valuations for a few weeks before falling, such as during the two-month period before the Great Depression began in 1929. During this time, the Shiller P/E exceeded 30 for four years before the Great Depression began. bursting of the Internet bubble. . Still, this historic valuation metric suggests stocks can plunge — and it wouldn't have made any difference to which presidential candidate won in November.

Image source: Getty Images.

History also strongly favors long-term investors (regardless of president)

However, the story can also be a beacon of hope and inspiration, depending on your investment horizon.

Although investors prefer to avoid stock market corrections, bear markets and crashes, they are ultimately a normal and inevitable part of the investment cycle. But what's important to note is that the ups and downs associated with investing are not linear.

For example, analysts at Bespoke Investment Group calculated the average calendar day duration of S&P 500 bull and bear markets since the start of the Great Depression and found night-and-day differences between the two.

For one, the 27 S&P 500 bear markets between September 1929 and June 2023 lasted an average of only 286 calendar days (about 9.5 months), with the longest bear market lasting 630 calendar days. On the other side of the coin, the typical S&P 500 bull market lasted 1,011 calendar days over the 94 years examined. Additionally, 14 of the 27 bull markets (if you include and extrapolate the current bull market to the present day) last longer than the longest bear market.

^SPX data by YCharts. YCharts S&P 500 return data begins in 1950.

An analysis from Crestmont Research looked even further at stock performance over long periods of time and came to an even more encouraging conclusion.

Crestmont calculated the 20-year rolling total returns (including dividends) of the S&P 500 since the start of the 20th century. Even though the S&P did not officially exist until 1923, researchers were able to track the performance of its components in other indexes to satisfy its back-test through 1900. This 20-year timeline produced 105 periods end (1919 to 2023).

What Crestmont's annually updated data set shows is that all 105 rolling 20-year periods would have generated a positive total return. Hypothetically speaking, if you had purchased an S&P 500 index fund just before the start of the Great Depression in 1929, or before Black Monday in 1987, and held that stake for 20 years, you would still have earned money.

Crestmont Research's dataset also conclusively shows that the stock market can make patient investors rich, regardless of which political party is in power. No matter how you arrange the pieces of the political puzzle, total returns over 20 years have always been decidedly positive.

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