Wall Street Loves Donald Trump, but This Inherited Risk Can Be the Stock Market's Undoing

As President-elect Donald Trump prepares to take office for his second term, Wall Street is buzzing with optimism. The stock market has rallied hard in response to his election victory, with investors hoping for a pro-business environment and a continuation of the strong economic growth seen during his first term. However, there is one significant risk that could derail the stock market's rally: the high valuation of the S&P 500.



The S&P 500 is currently trading at a forward price-to-earnings (PE) ratio of 21.6, which is significantly higher than the five-year average of 19.7 and the 10-year average of 18.2. This high valuation implies below-average returns in the coming years. In October 2024, Torsten Slok, chief economist at Apollo Global Management, wrote that the current forward PE ratio at almost 22 implies a 3% annualized return over the coming three years.

While Trump's first presidency was marked by extraordinary stock market returns, the current valuation suggests that investors should temper their expectations for future returns. The high valuation of the S&P 500 is a double-edged sword. On one hand, it reflects the strong performance of the U.S. economy and the optimism surrounding Trump's pro-growth agenda. On the other hand, it leaves the market vulnerable to a significant correction if investors' expectations are not met.

To mitigate this risk, investors can take several steps. First, they can stay invested in the market but build an above-average cash position. This will allow them to take advantage of any market declines that may occur. Second, investors can diversify their portfolios to include companies with less exposure to international trade and labor-intensive industries. This will help protect against potential risks associated with Trump's policy proposals, such as tariffs and immigration reform.

In conclusion, while Wall Street is optimistic about a Trump presidency, the high valuation of the S&P 500 poses a significant risk to the stock market's rally. Investors should be aware of this risk and take steps to mitigate it by staying invested, building an above-average cash position, and diversifying their portfolios. By doing so, investors can better navigate the current political climate and make more informed investment decisions.