If you’re someone with a big chunk of money in the stock market right now, you’re probably pretty happy with the state of your portfolio.
At the start of the year, a lot of people were worried that 2025 would be a rocky year for stocks given President Trump’s plan to implement strict tariff policies.
Those policies have since driven costs upward for consumers and created an unquestionable air of economic uncertainty. Consumer confidence is down, and the U.S. unemployment rate just reached its highest level in years.
Despite all of that, the stock market has soared. The S&P 500 index, which is typically considered a benchmark for the performance of the market as a whole, is up about 16% this year.
But the news isn’t all good. A new study by the Federal Reserve suggests that tariffs will lead to a near-term slowdown in economic growth. That could prove problematic given that the S&P 500 now trades at one of its highest valuations in decades.
A widening gap: market gains and a weakening economy
The stock market and U.S. economy don’t always follow the same pattern. It’s possible for economic conditions to sour while stock values remain strong.
Still, investors shouldn’t get too comfortable with the fact that the S&P 500 is trading at above 23 times forward earnings, markings one of the index’s most expensive valuations in decades.
When stocks are overvalued, it tends to signify that the market may be overdue for a correction. That itself shouldn’t sound alarms, since stock market corrections are fairly common.
What’s more concerning is that the stock market seems so heavily overvalued at a time when economic conditions seem to be headed in the wrong direction. This means that investors may not just be in for a market correction in the near term. Rather, they could be looking at a more pronounced dip that doesn’t resolve quickly like some market corrections do.
Fed Study: Tariffs will raise unemployment and halt growth
When investors don’t feel confident in the economy, they can sometimes sell off assets to conserve cash. That alone could cause a stock market decline. Throw in the fact that the S&P 500 is heavily overvalued, and investors could be in for a rocky year.
Of course, it’s not a given that 2026 will mark a notable economic slowdown. But a recent Federal Reserve Bank of San Francisco working paper that analyzed 150 years of data found that tariffs are likely to raise unemployment, thereby halting economic activity and slowing GDP growth in the near term.
If economic growth slows, earnings may increase at a slower pace, which is bad news for investors.
Of course, earnings aren’t the only thing that influences stock values. But if investors aren’t feeling confident in the economy, they may be quick to dump stocks they feel are overvalued. The result? A very rocky market.
Market risk abounds
When stock values are so artificially elevated, they become hard to sustain under the best economic conditions. The S&P 500’s current valuation is so high it’s historically rare. That, combined with a potential economic slowdown, creates significant market risk in the near term.
What’s effectively happening with the stock market today is that investors are paying a lot of money for expected future earnings. This makes the market more suspectable to a sharp decline if economic growth slows or upcoming earnings disappoint investors.
Of course, this isn’t the first time the S&P 500’s valuation has been so remarkably elevated. But in the not-so-distant past, we’ve seen this happen before, and the results weren’t good.
In the late 1990s, the S&P 500 was similarly overvalued during the famous dot-com bubble. Once that bubble burst, the market crashed hard.
More recently, the S&P 500 had a highly elevated valuation in the months leading up the COVID-19 outbreak. It’s fair to say that the pandemic-fueled bear market was fairly short-lived. But it shook investors up nonetheless.
This isn’t to say that now’s the time for investors to dump their stocks. But it is a time to recognize that the market could be headed for a downturn. And if economic conditions worsen in 2026, that downturn could happen soon.
So what should you do? If you’re many years away from tapping your portfolio, maybe nothing. If you have a robust emergency fund and a diversified mix of assets, you may be in a strong position to ride out a near-term market crash.
If you’re near or in retirement, now’s the time to consider unloading a bit of risk. And also, make sure you have enough cash on hand to cover at least two years’ worth of living expenses, in case the market undergoes a prolonged slump.
The more prepared you are for a potential near-term decline in stock values, the easier it should be to weather whatever storm ensues.