With the U.S. stock market at record highs following the 2024 elections, many investors who are enthusiastic about Donald Trump’s tax and regulatory policies are content to ride the bull wave. My take, however, is that people should consider hedging some of their positions in light of a growing number of risks. There are various ways to do so, which will depend on individual circumstances.
One reason for hedging is that U.S. stock market valuations are very high. This is especially so for a metric developed by Nobel Laureate Robert Schiller, who called both the tech and housing bubbles.
The cyclically adjusted price/earnings (CAPE) multiple that Shiller constructed corrects for market moves within an economic cycle by comparing average inflation-adjusted earnings over the previous decade. The calculation also provides a long-term perspective as it dates back to 1881. John Authers of Bloomberg points out that using this metric, only one presidential election has previously taken place when the stock market was as expensive as today. It was during the peak of the tech bubble in 2000 (see chart below).
The Shiller CAPE Multiple: Only 2000 Was More Expensive
By itself, this does not mean the stock market is about to crash. But there are other considerations that add to the risk of a market pullback. One is that S&P 500 returns have been dominated by the so-called “Magnificent 7” stocks, which account for about 30% of market capitalization and have multiples that are well above the average for the index.
A second consideration is that bonds are becoming attractive relative to stocks for the first time since the 2008 Financial Crisis as measured by the earnings yield gap versus 10-year Treasuries (see chart below).
The Stock Market No Longer Is Cheap Relative to Bonds
This measure is computed as the earnings yield on the S&P 500 index (the inverse of the one-year forward market multiple) minus the yield on 10-year Treasuries. It had been positive for well over a decade because bond yields were unusually low. However, it is now flat because bond yields have risen by about 80 basis points since the Federal Reserve began easing monetary policy at the September FOMC meeting.
The backup in yields reflects stronger-than-expected economic activity and growing concern about Federal debt held by the public that has ballooned by $15 trillion over the past eight years. Looking ahead, the combination of tax cuts and tariff increases Donald Trump is contemplating could widen the federal budget deficit by $7.5 trillion or more over the next decade according to the Committee for a Responsible Federal Budget.
Some market technicians believe that if the 10-year Treasury yield reaches the 5% threshold, investors will begin making a tactical shift out of stocks and into bonds.
The third consideration, which poses the biggest risk for a full blown market sell-off, is that Trump could follow through on his pledge to raise tariffs on goods imported from China by as much as 60% and those on other imports by 10%-20%. During the trade war from mid-2018 to mid-2019, the S&P 500 sold off at one point by 15% from peak trough. The sell-off could be bigger this time, because both valuations and prospective tariff hikes are greater.
The main uncertainty is whether Trump will move boldly or incrementally in raising tariffs.
Robert Lighthizer, a hardliner on tariffs who served as U.S. Trade Representative in Trump’s first term, contends the administration will proceed much more quickly this time. By comparison, Scott Bessent, a front runner to become Treasury Secretary, believes tariffs should be implemented in stages as a negotiating tactic with trading partners. However, recent press reports indicate he could lose out as the nominee because his views on tariffs are pragmatic. If Trump opts for a hardline approach, financial markets are likely to turn volatile at some point.
There are various ways investors can protect themselves depending on their circumstances. The most straight-forward way is to lighten equity positions and build up cash holdings over time.
This is the strategy Warren Buffet has been pursuing. In its third quarter report, Berkshire Hathaway said it sold about 100 million of its Apple shares over the summer, and it had sold more than 600 million shares for the entire year. Meanwhile, Berkshire has boosted cash to a record $325 billion, because Buffett thinks stocks are trading considerably above their intrinsic value and he is building a war chest to deploy when prices are lower.
The main deterrent for individual investors is they could incur sizable capital gains taxes by unloading stocks that have performed very well. If so, one way to lessen the tax consequences would be to gift those stocks.
Another tactic is to buy puts on the stock market or individual stocks to limit the downside risk. However, people could lose all of their premium and not benefit if the respective stocks do not sell off in a timely manner. One way to lessen the cost would be to pursue a buy-write or covered call strategy, in which an investor sells some of the market upside on a stock to pay for downside protection.
Finally, one strategy to consider for those who are concerned about a full-blown market crash is to buy gold. Many savvy investors believe gold offers the best protection during times of extreme uncertainty and that it is preferable to holding U.S. Treasuries or the dollar if there is a crisis of confidence.
The caveat is that gold has increased by more than 50% over the past two years, and it is currently trading at an all-time high of nearly $2,570 per ounce. Weighing this, I believe buying long-dated U.S. Treasuries is preferable to buying gold at this time.