Stock markets regularly go to irrational extremes, and their volatility has caused economic hardship and financial pain. Now, jubilant investors are pushing our market to historic highs despite President Trump’s tariffs and tax and spending policies that will increase the level of unsustainable budget deficits.
No one can know for sure where the stock market will go next. But there are worrisome signs that investor optimism may have gotten out of hand. The recent exuberance of investors raises the question of whether they are making the same mistakes they made in the past — errors that could prove very costly down the line. If history is repeating itself, what can we do to protect our financial futures?
In the stock market bubble of the late 1990s, investors believed that the internet would usher in a golden period of extraordinary economic growth — until they didn’t, sparking a recession and a roughly 40 percent decline in the S&P 500 between 2000 and 2002. Less than a decade later, a housing bubble led to the worldwide financial crisis and the deepest recession since the 1930s. The S&P 500 lost roughly half its value. The financial wreckage to individuals’ retirement savings was so pervasive that some worried whether they ought to own equities at all.
This past spring, the stock market appeared to be in free fall as investors worried that Mr. Trump’s threatened tariffs, some almost as high as 150 percent, and future tax policy would crater the economy. The S&P 500 stock index dropped by about 12 percent in a single week following the April 2 “Liberation Day” tariff announcements.
But just as quickly, the uncertainty seemed to disappear; the tariffs were delayed, negotiations were offered and on April 9, the S&P 500 had its best day in almost two decades. The market continued to soar as the “big, beautiful” tax bill was enacted and tariff deals were announced with several major trading partners.
These days, stock market valuations (such as the multiple of stock prices to average corporate earnings) are at one of the highest levels in its 230-year history when normalized. Not only have investors come to believe that an “all clear” signal has been announced, many have also embraced the idea that the artificial intelligence boom will turn out to be far more important than the internet and usher in a new golden age of prosperity. In July, the chipmaker Nvidia, the exemplar of the A.I. revolution, rose to a record market valuation of over $4 trillion. Only in the late 1990s and early 2000s was the tech market more richly valued, peaking in March 2000 — by October 2002, it had cratered by almost half.
I worry that investors may, as they have at times in the past, be misreading the current situation. The market is ignoring several risks that normally could be expected to restrain stock prices.
We still do not know what the final tariff regime will be. A “permanent” level of tariffs of 15 percent or more is still considerably higher than recent levels, and there is no certainty regarding their ultimate unhealthy effects on inflation and economic growth. Tariffs lead to higher prices unless they are totally absorbed by business, effectively shrinking their profit margins. Tariffs also act as a tax on consumers, causing them to spend less on goods and services. Thus, tariffs worsen inflation while simultaneously suppressing economic activity.
Mr. Trump’s policy bill has been no help in resolving our unsustainable federal budget deficit. We are on track to run unprecedented government deficits over the next several years, and our national debt and related interest payments will rise to unsupportable levels. We do not know when the next financial crisis will occur, but if nothing is done to rein in the deficit, a crisis is inevitable. Yet despite the presence of all these risks, stock market valuations are at one of their highest levels in history.
So what should ordinary Americans do? Is this the time to slash the amount of common stock in their retirement portfolios? Despite all the legitimate worries, my answer is no. Trying to invest your money by guessing exactly when stocks may rise or fall all but invariably leads to poor results.
To time the market successfully, you have to make two correct decisions: when to get out and when to get back in. No one can do that consistently. In fact, studies by Dalbar and Wealthfront (where I am chief investment officer) indicate that investors who try have significantly lower long-run returns. In fact, an investor who bought a U.S. stock index fund the day after Alan Greenspan suggested that the stock market had “irrational exuberance” in December 1996 earned an average rate of return of almost 10 percent per year over the next 20 years, assuming they reinvested dividends. The lesson is clear. Market timing can ruin a well thought out investment plan. Just because the market is bipolar doesn’t mean you should be too.
There are actions investors should take. If you are retired, and need money soon, you should invest it in safe short-term bonds. Suppose you are in your late 50s, and your retirement fund is well balanced, for example, at 60 percent stocks and 40 percent bonds. Check to see if the recent rise in stock prices has increased your equity position, perhaps to around 75 percent. If so, sell enough stock to get back to the preferred 60/40 allocation suitable for your age and risk tolerance. Periodic rebalancing is always sensible and gives you the best chance to buy low and sell high. Otherwise, you will simply be letting your emotions rule your trades. And make sure that the proportion of stocks in your retirement portfolio allows you to sleep well at night. Finally, broad diversification including equities from foreign countries is likely to reduce risk.
For young investors just starting to build a retirement fund, a portfolio heavily weighted with stocks is appropriate. Equities are likely to provide the most generous long-run returns and the most effective way to build wealth. Investments made when markets are unusually high may turn out to produce relatively low returns. But a regular savings program will enable you to buy more shares when prices are low and future returns are high.
Consistent saving and investing is particularly effective when markets are very volatile. And even if our worries today seem unsurmountable, we generally find a way to muddle through. As an old saying — apocryphally attributed to Winston Churchill — goes: Americans can always be trusted to do the right thing once all other possibilities have been exhausted.
Burton G. Malkiel is professor emeritus of economics at Princeton University and the author of “A Random Walk Down Wall Street.”
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