Spotting Clouds in a Carefree Summer Market

On a sunny summer’s day, you might think of going to the beach. Or you might list the things that ought to be worrying investors, and mostly aren’t. Your scribe chose the latter, as regular readers might expect.

The list of what is actually giving investors pause is remarkably short, itself a reason for concern. If stocks climb a wall of worry, they may be approaching the top—and the nasty slide down the slope of hope.

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What should be concerning them divides into three: the economy, stock valuations and politics.

The economic outlook boils down to one neat question: Will the president’s hike in tariffs to their highest since the Smoot-Hawley Tariff Act in the 1930s matter? Investors have swung in their answer. They initially treated the “Liberation Day” tariffs as a disaster for growth and inflation, before concluding that the tariffs at the mostly lower rates eventually imposed don’t much matter—in large part because the feared effects have barely shown up in the data.

Futures traders now think a Federal Reserve rate cut is a slam dunk next month, something usually good for stocks when it isn’t due to weaker growth.

Yet take off the rose-tinted sunglasses and there’s a risk that the markets are ignoring. Far from coming down, core inflation excluding volatile energy and food rose last month to the highest level since President Trump’s inauguration. Other measures that try to tease out the trend also point to an inflation issue, albeit nothing like the spike after the Biden administration’s Covid-19 stimulus.

Take the Atlanta Fed’s gauge of hard-to-change, or “sticky,” prices and the Cleveland Fed’s measure of the median item in the basket of items used to measure inflation. As of last month, both metrics were rising at an annual rate of well above 3%. Wholesale prices jumped last month by the most in three years, suggesting that tariff effects are working their way through the supply chain and will eventually push up inflation. Maybe tariffs are just taking longer than expected to hit.

The jobs market is also concerning. Private-sector job creation has stalled, with the report showing this infuriating the president so much he fired the head of the Bureau of Labor Statistics, which also produces the inflation figures.

A move toward mild stagflation, or weaker growth and higher inflation, is far from certain. But the data suggest it is absolutely a risk, and it is even visible in Wall Street earnings forecasts, if you squint. It just doesn’t show up in stock prices.

The consensus for S&P 500 earnings in 12 months is 6% higher than at the start of the year, which—if believed—would justify rising stocks. But earnings upgrades have been heavily skewed toward three successful sectors: tech, communication services (where Meta and Alphabet sit) and financials. Four out of 11 sectors—energy, materials, healthcare and consumer staples—have been downgraded this year, and another two are barely changed.

One plausible explanation: The artificial-intelligence boom and data-center construction is hiding pain in other areas. That’s not a great foundation for record-high stocks.

Stress-screen factor: 30.

Valuations show no worry at all. Stocks’ price-to-earnings ratio, using forecast profits for the next 12 months, last month hit 22.5. That is the highest in data since 1985 apart from during the dot-com bubble of 1999-2000 and the SPAC/cannabis/clean-tech bubble of 2020-21.

This valuation gauge is down a bit this month because analysts have upgraded their profit forecasts by the most in more than a year, but is still extraordinarily high. Lofty valuations also show up in gauges such as the Shiller P/E, and ratios of prices to free cash flow and to book value.

The good news is that high valuations are no barrier to short-term performance. But they show marked optimism about future profits, raising the risk of disappointment and low long-term returns, especially if the economy or AI fail to fulfill hopes.

The bad news is that the high valuations are combined with profit margins expected to hit a new high for listed companies in data going back to 2002. Investors expect the best of all possible worlds.

Stress-screen factor: 50.

Politics suggest we may not get the best of all possible worlds. Sure, tariffs turned out less bad than feared. Even if the most extreme claims of Democrats that democracy is dying turned out to be right, investors have long been able to make good returns from stocks in autocracies, so long as the autocrat doesn’t fall foul of more-powerful countries.

But the president’s firing of the BLS head and attacks on the Federal Reserve mean the U.S. is less likely to get decent data on its most important statistics or nonpolitical interest-rate setting.

The risk shows up in long-run inflation expectations, measured as the gap between standard Treasury yields and those on Treasury inflation-protected securities for the five years starting in five years’ time. These jump every time Trump wades in—but not that severely. Investors are alert to the danger, but still expect Trump to leave a functioning system in place.

The danger to investors is that the Fed loses its independence. If that happened, even if Trump set rates exactly right, Treasurys would be likely to attract a political risk premium, with knock-on effects on financing costs across the economy.

Stress-screen factor: Unknown, between 0 and Argentina.

All these are merely risks, and everything could work out fine. Maybe I’m the guy on the beach sitting in the shade complaining about the heat. But when obvious dangers are ignored, it isn’t usually a good time to invest for the long run.

Write to James Mackintosh at james.mackintosh@wsj.com