Ordinary Correction

by: Kenneth J. Entenmann CFA®, March 18, 2025

The financial markets popped after the election results last November. President Trump was elected to a second term on a platform highlighted by trade reform/tariffs and lower government spending. Indeed, the markets rose nicely in anticipation of better trade, lower taxes and less regulation. Until three weeks ago! Apparently, the equity markets are shocked, shocked, to see that Trump 2.0 is instituting tariffs and aggressively downsizing the federal government and its programs. Over the last month, the S&P 500 index dropped 7.98%. It is now down 4.33% for the 2025.

Of course, when the markets are rising rapidly, like they did in 2023 and 2024, investors cheer and congratulate themselves for their brilliant investment skills. When markets decline, particularly as quickly as this correction has unfolded, there must be a reason for the decline. It couldn’t possibly be the investor’s fault! The financial media fuels the finger pointing with a relentless stream of negative headlines. The media has declared that tariffs and DOGE are the culprits. Convenient. I say not so fast!

In our last blog, we discussed the potential impact of tariffs. The announcement of Trump 2.0 tariffs started in earnest 3 weeks ago. They have come fast and furious, have been through several on-again, off-again events. There have been tariffs on top of tariffs. As expected, our trade partners have begun to retaliate, and some have been withdrawn and reinstated. In short, it has been chaotic! The “uncertainty” spooked investors. Consumer confidence has swooned. CEOs are complaining; they acknowledge that the trade playing field is not level and support President Trump’s efforts to improve the global trade environment. They support tariffs…if they are “targeted.” That is code for tariff every industry except mine! Yes, economists hate tariffs. The question is, in a lop-sided trade world, what is the alternative? There appears to be few alternatives in the offering! To be clear, tariffs have the potential to slow economic growth and raise inflation. But the likely impact, as detailed in the previous blog, is modest and certainly manageable for a $28 trillion economy. The torrent of negative news regarding tariffs simply does not meet the potential economic impact of tariffs. Certainly, the chaotic tariff roll out is contributing to the market sell-off, but it is a convenient excuse for the recent sell-off.

Similarly, the DOGE (Department of Government Efficiency), led by the chain saw yielding Elon Musk, claims to have identified $115 billion (as of March 13) in spending cuts to our Federal government. There is a general agreement that our government is bloated and in need of rightsizing. It is the process that concerns everyone. Too fast, too broad they claim. We need to take a slow, methodical, surgical scalpel approach. OK, please show me when that has ever occurred? Government spending has grown exponentially since 1960 with every possible iteration of political control. Nonetheless, the spending cut back is being blamed for the market sell-off. Good excuse, but immaterial to the economy. $115 billion in spending cuts on a government budget of $6.7 trillion, with a $2 trillion deficit, $36 trillion in debt and $1 trillion in interest expense… is a rounding error! Indeed, as mentioned in this blog over the years, it will be very difficult to reset government spending without taking on the entitlement programs (Social Security, Medicaid, Medicare). Even President Trump has vowed not to touch them. As such, I doubt DOGE will have a major impact on spending and clearly will not have a significant impact on our economy or the financial markets.

While tariffs and DOGE are taking the blame for the recent sell-off, I believe it is simply a run of the mill, plain vanilla valuation correction. This blog has been imploring investors to “manage their expectations.” After two consecutive years of 20%+ S&P 500 returns, we cautioned that markets do not grow to the sky. The S&P 500 price earnings ratio, at 24 times earnings, has traded nearly one standard deviation above its historic average of 18, i.e. the market was expensive. Clearly, markets can remain expensive for long periods of time and that has been the case for two years. However, history demonstrates that when valuations are high, prospective returns are poor. Also, the market has been dangerously concentrated in the “Magnificent Seven” tech sector. These stocks represented nearly 40% of the total market capitalization and were richly priced. The Artificial Intelligence mania that drove the prices of these companies was dented last month when the Chinese AI model Deep Seek was introduced. Deep Seek was very effective, used fewer semiconductor chips and less energy and was significantly less costly. It is impossible to time when a correction will occur or what the catalyst will be. While the headlines would suggest that tariffs and DOGE are the cause, I would suggest that Deep Seek was the catalyst for the tech led sell-off.

Most importantly, it is difficult to believe that the Fed will be cutting interest rates any time soon. Today, the Fed kept rates unchanged and cited concerns for higher unemployment and higher inflation. That would be called Stagflation! But with the most recent employment data demonstrating strength, inflation still well above the Fed’s target and pressure on prices due to potential tariffs, the Fed is stuck between a rock and a hard place. Until the hard data weakens, the Fed will likely to remain on hold for the foreseeable future.

Whether we like it or not, the correction has happened. The “cause” is debatable but immaterial. When evaluating stock prices, there are three primary factors; interest rates, earnings and the price paid for those earnings (P/E). In general, lower interest rates are better for stocks. Interest rates have declined modestly this year, and it is highly unlikely that rates will rise this year. So, interest rates were not the correction catalyst. The S&P 500 has been projected to earn $270 in 2025. That estimate has not budged in this correction. At least not yet! A decline in the $270 estimate is something to watch if there is going to be continued weakness. But so far, it has been stable and therefore not the cause of our correction. That leaves the price investors are willing to pay for that $270. At its recent high price of $6147 on Feb. 19, the S&P 500 traded at 23x earnings. Today, it trades at 20x earnings. It has been a market valuation correction, led by highly valued, dare we say, overpriced, AI mania Tech stocks. In short, a dull, boring, painful, ordinary correction. Ignore the noise (and there is lots of it!), stay diversified and remain invested!