Beware the Tariff Trap: Why the S&P 500 Rally May Be Overcooked

The S&P 500 has surged 12% since April, buoyed by hopes that trade tensions will ease and inflation has peaked. But beneath the surface, a growing number of skeptics—including veteran investor Doug Kass—argue that the rally is built on sand. With tariffs still exacting a toll on corporate margins, and companies' ability to absorb costs nearing its limits, the foundation of this rally may crumble sooner than markets expect.

The Hidden Cost of Tariffs: Margin Squeeze Ahead

Kass, a long-time critic of market complacency, has zeroed in on a critical contradiction: while companies have kept prices stable so far, they are doing so by absorbing tariff costs themselves. A Wall Street Journal analysis of 10,000 everyday items sold by Walmart (WMT), Target (TGT), and Amazon (AMZN) found average prices unchanged since April—but only because retailers pressured suppliers to absorb cost hikes or delayed shipments from China.

This strategy cannot last. As inventory stockpiled before April's “Liberation Day” tariff threats dwindles, companies will face a stark choice: pass costs to consumers, risking sales, or cut margins. Kass warns that the latter is already happening. “The S&P 500's rally assumes earnings growth will accelerate, but margins are under siege,” he says. With core inflation (excluding energy) still stuck at 2.8%, the Fed's pause on rate cuts leaves little room for error.

Why the CPI Dip Won't Last

The May CPI report, which showed a 0.1% monthly rise, has been hailed as proof inflation is tamed. Kass disagrees. He points out that the data still reflects pre-tariff inventory, and once that's exhausted, price hikes will surface. “This is a temporary reprieve,” he says. “When companies can't delay anymore, the CPI will jump—and so will interest rates.”

The automotive sector offers a microcosm of this tension. General Motors (GM) delayed its investor call to assess tariff changes, while Trump's retroactive tariff rebates for automakers highlight how unstable the environment remains. Even if policies ease, the damage is done: small businesses, which account for nearly half of U.S. employment, have already halted hiring and capital spending due to tariff uncertainty.

The “TACO” Rally: Built on Sand

Kass dismisses the current rally as a “TACOs” trade—“Trump Always Chickens Out”—where markets bet on temporary tariff pauses rather than structural solutions. The S&P 500's price-to-earnings ratio now sits at 22x trailing earnings, above its 10-year average of 18x. “This optimism assumes companies can keep absorbing costs while tariffs stay high,” he says. “But if earnings disappoint, the correction could be severe.”

Investment Strategy: Play Defense, Not Offense

Given the risks, investors should avoid overpaying for cyclical sectors most exposed to tariffs and inflation. Consumer discretionary stocks (WMT, TGT) and industrials (GM) are particularly vulnerable. Instead, consider:

1. Defensive Sectors: Utilities (DUK, XLE) and healthcare (JNJ, ABT) have stable cash flows and minimal exposure to trade wars.
2. Domestic Tech: Firms with strong domestic supply chains, like Microsoft (MSFT) or Adobe (ADBE), face less tariff risk.
3. Shorts on Overbought Equities: Overvalued retailers or industrials could face sharp corrections if margins compress.

The Elephant in the Room: Structural Risks

Even if tariffs ease, deeper issues linger. The U.S. deficit is widening as fiscal stimulus and trade deficits collide, while geopolitical polarization fuels market instability. Kass warns that “the Fed's hands are tied—it can't cut rates further without risking inflation, and tariffs won't budge without a China deal that's nowhere in sight.”

Conclusion: Time to Trim Risk

The S&P 500's rally reflects hope, not reality. As companies face an inflection point in managing tariff costs, investors should prioritize capital preservation. Until there's concrete evidence of margin resilience or tariff relief, the best offense is a good defense—diversify, hedge, and avoid overvalued stocks. The market's optimism may yet prove misplaced, and when reality sets in, the downside could be steep.