Trump’s second term requires a new strategy for traders in times of market uncertainty

The Unstable Approach of Donald Trump to His Iconic Myths Shook Markets Last Week

Traders trying to position themselves in the market to navigate this ongoing uncertainty are recalling the strategy from his first term. What hasn’t changed is Trump’s strategy of promising aggressive tariffs on trading partners and then quickly backing down, either postponing or completely canceling them. What has changed is essentially everything else.

The Wider Impact of Proposed Tariffs and the Changed Environment

To start, the tariffs he proposed will affect a broader range of goods than during his first term. But more importantly, traders are in a completely different environment. Volatility is higher. The S&P 500 is in an extremely strong uptrend — a 53% combined rise in 2023 and 2024, pushing valuations to high bullish levels. Compare this with 2017, when the S&P saw a combined rise of only 8.7% in the previous two years when Trump took office.

For Tim Hayes, Chief Global Investment Strategist at Ned Davis Research, this means a defensive approach to asset allocation. He said the firm’s investment model will likely recommend reducing exposure to equities “if tariffs lead to a trade war, increasing bond yields, worsening the macroeconomic environment, and causing a pullback” in the tech sector and U.S. markets as a whole.

Higher Inflation, Higher Interest Rates, and Larger Federal Deficits

Caution underscores how significantly the macroeconomic backdrop has changed. Inflation is higher. Interest rates are significantly higher. And the federal deficit is a much larger problem than it was eight years ago. Taken together, these factors make stock market prospects considerably more uncertain, even as the economy continues to grow.

“We are in an environment of really high expectations in the third year of a bull market, whereas in 2017 we were coming out of a bear market,” said Todd Son, ETF and Technical Strategist at Strategas Securities LLC. “When there’s any form of instability, any catalyst can shake the markets.”

Historical Metrics Pointing to Below-Average Future Stock Returns

According to one measure, traders’ expectations for the stock market have never been so high at the start of a presidential term. The cyclically adjusted price-to-earnings ratio, better known as the CAPE ratio, reached nearly 38 at the end of January — an “extremely high” level, according to Charlie Bilello, Chief Market Strategist at Creative Planning.

“Historically, this has meant below-average future stock returns when forecasting the next 10 years,” he added.

Market positioning tells a similar story. The equity risk premium (ERP) — a measure of the difference between expected equity returns and bond returns — is deeply in negative territory, something that hasn’t happened since the early 2000s.

Whether this is a negative signal for stock prices depends on the economic cycle. A lower value might indicate corporate earnings will rise. Or it might mean that stocks are becoming too expensive and are well above their true value.

Q4 Earnings Season Reveals Troubling Trends

However, the fourth-quarter earnings season so far shows a worrying trend. Fewer American companies are beating earnings forecasts, the tariff issue dominates earnings conference calls, and 2025 projections are already starting to face negative revisions.

Shares of General Motors Co. plunged after the automaker posted results, sparking concerns about the impact of tariffs on profits this year. Industrial giant Caterpillar Inc., considered a barometer for trade tensions, warned that revenues would be lower due to pressure on demand, and higher prices for the heavy machinery it sells would only exacerbate the situation.

Seeking Opportunities in Niche Sectors

Meanwhile, some traders are looking for opportunities in niche areas of the stock market, where valuations are more reasonable and historical patterns are more favorable.

Scott Welch, Chief Investment Officer at Certuity, is redirecting funds to a somewhat forgotten segment of the market that typically performs well when the Federal Reserve cuts interest rates: mid-cap companies.

“Mega-companies in the tech sector are priced for perfection, so it wouldn’t take much for them to get shaken up,” Welch said in an interview. “They’ve recovered because they have strong profits and cash flows. But nothing lasts forever.”

The Impact of Macro Risks on Market Behavior

Big macroeconomic risks, like Trump’s tariffs, often cause the stock market to move as a unified organism. In fact, in 2018, stock prices became highly correlated when trade tensions with China intensified, and uncertainty surrounding the Federal Reserve’s monetary policy weighed on stocks overall. The Chicago Board Options Exchange’s three-month implied correlation index surged during that period, and the S&P 500 posted its worst annual decline since the global financial crisis.

Current Market Conditions Show Low Correlation Between Stocks

Currently, this correlation index is close to record lows, meaning stocks are not moving in unison. Typically, this is a healthy sign for markets, as it indicates that company-specific fundamentals are having more influence than macroeconomic factors. The downside, however, is that it encourages investors to take on more risk.

Investors Watch for Political Clarity on Trade Policies

Ultimately, the biggest challenge for investors in this situation is deciphering the political winds and understanding which direction Trump’s administration will take regarding tariffs and trade policy. The lack of clarity is causing many professionals on Wall Street to closely monitor the situation but take no action for now.

“We always tell investors not to focus too much on politics because it rarely has an immediate impact on stocks,” said Mark Newton, Head of Technical Strategy at Fundstrat. “Every year has its scary factors that investors need to worry about, but overall, the stock market has been resilient.”