For more than two years, Wall Street's bull market rally hasn't disappointed. Last year, the iconic Dow Jones Industrial Average(DJINDICES: ^DJI), benchmark S&P 500(SNPINDEX: ^GSPC), and growth stock-propelled Nasdaq Composite(NASDAQINDEX: ^IXIC) rose by 13%, 23%, and 29%, respectively, with all three hitting numerous record-closing highs.
Catalysts haven't been hard to come by, with excitement surrounding artificial intelligence (AI), stock-split euphoria, a sizable decline in the prevailing rate of inflation, and better-than-anticipated corporate earnings all doing their part.
However, the stock market shifted into a higher gear in November after Donald Trump emerged as the victor on election night. While it's crystal clear that Wall Street loves President Trump, an inherited risk threatens to send the Dow Jones, S&P 500, and Nasdaq Composite tumbling.
President Trump delivering remarks. Image source: Official White House Photo by Joyce N. Boghosian, courtesy of the National Archives.
Wall Street rallies around Trump 2.0
Past performance is one of the reasons the stock market responded so positively to Trump's return. During the president's first term in office, the Dow Jones Industrial Average, S&P 500, and Nasdaq Composite soared by 57%, 70%, and 142%, respectively. While there's no guarantee Trump's second term in office will yield similar returns, investors are clearly hoping for a repeat performance.
Select policy proposals by President Trump and his administration also have investors intrigued. For instance, Trump's return to the White House removes any possibility of the peak marginal corporate income tax rate climbing. In fact, it might even lead to a further reduction in the peak corporate income tax rate.
In December 2017, Trump signed his flagship Tax Cuts and Jobs Act (TCJA) into law. The TCJA reduced personal income tax rates for most Americans -- these changes will sunset on Dec. 31, 2025 -- and permanently lowered the peak marginal corporate income tax rate from 35% to 21%. The president is tinkering with the idea of reducing this peak rate to 15% for companies that manufacture their products in the U.S.
Lower corporate income tax rates appear to have played a key role in lifting share repurchase activity. Between 2011 and 2017, S&P 500 companies collectively bought back $100 billion to $150 billion worth of their stock each quarter. But after the TCJA went into effect, S&P 500 companies were buying $200 billion to $250 billion of their common stock per quarter. Buybacks can increase a company's earnings per share and make its stock more fundamentally attractive to value-focused investors.
Deregulation should be a key theme of the Trump administration, as well. Fostering an environment with less complex oversight and regulations should encourage an uptick in merger and acquisition activity.
President Trump inherited the priciest stock market in 154 years
Though there are plenty of reasons for investors to be excited about Trump 2.0, no amount of policy maneuvering can hide the fact that Donald Trump just inherited the priciest stock market in 154 years.
Admittedly, "value" is a subjective term that can vary from person to person. What one investor finds pricey might stand out as a phenomenal bargain to another investor. But based on a time-tested valuation tool, Wall Street is in dangerous territory.
Most investors tend to rely on the price-to-earnings (P/E) ratio when valuing stocks. This measure, which divides a company's share price into its trailing-12-month earnings per share (EPS), works great for mature businesses but can get tripped up by growth stocks and during shock events. This is where the S&P 500's Shiller P/E Ratio, which is also known as the cyclically adjusted P/E Ratio (CAPE Ratio), can be valuable.
The Shiller P/E is based on average inflation-adjusted EPS over the previous 10 years. By examining a decade's worth of earnings history, it virtually eliminates the skew factor of shock events.
As of the closing bell on Jan. 30, the S&P 500's Shiller P/E stood at 38.28. This is within striking distance of its highest reading during the current bull market (38.89) and is more than double its average reading of 17.2 dating back to January 1871. More importantly, it's the highest the Shiller P/E has been for an incoming president when back-tested 154 years.
Including the present, there have only been six instances when the S&P 500's Shiller P/E surpassed 30 during a bull market and stayed above that level for at least two months. Following each of the prior five occurrences, the Dow Jones, S&P 500, and/or Nasdaq Composite eventually (key word!) lost between 20% and 89% of their value.
While the Shiller P/E isn't a timing tool -- stock valuations can remain at a premium for weeks, months, or even a few years -- it does have a flawless track record of foreshadowing downside for the stock market.
Regardless of which presidential candidate won the November election, they would have inherited this risk.
Image source: Getty Images.
Time is Wall Street's universal healer and investors' greatest ally
Based solely on what 154 years of back-tested valuation data tells us, stocks could noticeably underperform during Donald Trump's second term in office. Though this may not be what investors want to hear, it's not all bad news -- especially for investors with time on their side.
Both the U.S. economy and stock market are cyclical. This is to say that both navigate their way through periods of expansion and decline. But what time and perspective demonstrate is that these cycles are far from mirror images of each other.
As an example, there have been a dozen U.S. recessions since the end of World War II. Three-quarters of these recessions resolved in less than 12 months, with the remaining three failing to surpass 18 months in length. In comparison, two periods of economic growth topped the 10-year mark, with most expansions enduring for multiple years.
This nonlinearity, which is highly favorable to optimistic, long-term-minded investors, can be seen on Wall Street, as well.
The data set above was published by Bespoke Investment Group on social media platform X in June 2023 shortly after the S&P 500 was confirmed to be in a new bull market. It depicts the calendar-day length of every S&P 500 bull and bear market since the start of the Great Depression in September 1929.
What Bespoke found was a night-and-day difference between bear and bull markets on Wall Street. Whereas the typical S&P 500 bear market resolved in 286 calendar days (approximately 9.5 months), the average S&P 500 bull market lasted 1,011 calendar days, or around two years and nine months.
Furthermore, the lengthiest S&P 500 bear market on record stuck around for 630 calendar days in the mid-1970s. Out of the 27 bull markets over the last 95 years, more than half, including the current bull market, have endured longer.
Regardless of who's president, which political party is in power, or what valuation tools foreshadow for Wall Street, time has been a universal healer for the stock market and is, unquestionably, the greatest ally investors have in their corner.
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Sean Williams has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
