Introduction
In a recent campaign-style speech, U.S. President Donald Trump boasted that “the only thing really going up, and bigly, is the stock market and your 401(k) plans.” He’s right; all major U.S. stock market indices recorded double-digit percentage gains last year. However, midterm elections in November are still far away, and a market correction could turn Trump’s economic pride into a liability.
Market Correction Possibility
Unfortunately for Trump, a market correction (a 10-20% drop) seems very likely this year. The market reflects unusually high optimism, making stocks vulnerable to a significant downturn if an economic setback occurs—which could introduce numerous “known unknowns,” be they economic or political, before the midterm elections.
Current Market Valuation
The current valuation of stocks is more than double their long-term average based on the cyclically adjusted price-to-earnings ratio, nearly reaching its pre-dot-com bubble peak in 2001. Moreover, the Buffett indicator—the ratio of total U.S. stock market capitalization to U.S. GDP—shows the market trading at historical highs, 50% above its 2008 peak.
Fund Manager Sentiment
Another measure of optimism is the current exuberance among fund managers. According to Bank of America, these influential voices are more ebullient than at any time in the past three years, with cash reserves plummeting to their lowest levels ever recorded. This sentiment—and the bets stemming from it—appears to prepare the market for a substantial drop should the economy falter in the coming months.
Risks to the Market
Unsustainable Public Finances and Fed Independence
The country’s unsustainable public finances, combined with Trump’s threat to the Federal Reserve’s independence, could bring back bond market vigilantes and a rise in long-term interest rates. This risk is exacerbated by the nation’s heavy reliance on foreigners to finance its $2 trillion annual budget deficit. If foreigners perceive the U.S. government attempting to inflate its debt, they will demand higher interest payments on Treasury bonds, increasing the cost of mortgages, auto loans, and other common forms of borrowing.
AI Bubble Risk
Another internal risk is the AI bubble, which could burst or deflate at any moment. This risk is particularly serious given that half of U.S. GDP growth is driven by AI-related investments. The bursting of the AI bubble would negatively impact the stock prices of the “Seven Magnificent” (Alphabet, Amazon, Apple, Meta, Microsoft, NVIDIA, and Tesla), whose combined valuation accounts for around 35% of the S&P 500 total. Oracle, whose stock valuation dropped 30% in the last quarter, could be an early warning sign.
Economic Shocks Abroad
The U.S. stock market could also be shaken by economic setbacks abroad. One such shock could come from China, which still over-relies on an investment and export-driven model to boost its economy. With China’s trade surplus now exceeding $1 trillion, it’s more likely that U.S. and European protectionism will increase, causing further disruption to the international trade system.
Another shock could originate from Japan, where Prime Minister Sanae Takaichi’s irresponsible fiscal policy has raised fears of a “Liz Truss moment” that could lead to a sharp rise in Japanese government bond yields, similar to what happened in the UK in autumn 2022. If this occurred, we might witness a disruptive unwinding of the Japanese carry trade (borrowing at lower interest rates in one country to invest in assets in another) and the repatriation of Japanese capital supporting U.S. financial markets.
Geopolitical Events
Unexpected or underestimated geopolitical events can alter financial markets, as demonstrated by the U.S. military operation against Venezuela. Even before Trump announced that the U.S. planned to “steer” Venezuela towards an “appropriate transition,” China was conducting military drills near Taiwan, and Russia delayed reaching a peace agreement with Ukraine. China might attempt to capitalize on this opportunity to regain control over Taiwan, while Russia could become bolder and demand even more territorial concessions from Ukraine. Any possibility of conflict over Taiwan should be a cause for serious concern, given that the country supplies more than half of the world’s semiconductors.
Key Questions and Answers
- What is a market correction? A market correction refers to a decline in the value of securities, typically by 10-20%, following a period of significant growth.
- Why is the current market valuation considered high? The cyclically adjusted price-to-earnings ratio is more than double its long-term average, and the Buffett indicator shows the market trading at historical highs, 50% above its 2008 peak.
- What are the risks to the U.S. economy? Unsustainable public finances, threats to the Federal Reserve’s independence, the AI bubble risk, and potential economic shocks abroad pose significant challenges to the U.S. economy.
Author: Desmond Lachman, Principal Research Fellow at the American Enterprise Institute, was Deputy Director of Policy and Review Department at the International Monetary Fund and Chief Economist for Emerging Markets at Salomon Smith Barney.
Copyright: Project Syndicate, 1995 – 2026 www.project-syndicate.org
