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Trump's policies could lead to a big market drop, Jeremy Siegel warns

U.S. markets are notching fresh new record highs this year, but several factors could pose big threats to the rally, according to the Wharton finance professor Jeremy Siegel.

"I think the biggest risk to the rally is that we're going to see a protectionist movement … throwing tariffs on, and then retaliation [from abroad]," Siegel said in a recent interview on CNBC's "Trading Nation."

Siegel said a potential trade war could drag the Dow industrials down to 18,000, implying a 12 percent drop from current levels.

"It has to be recognized as a risk to the market," Siegel said, although he is maintaining his long-held bullish stance.

President Donald Trump has made clear that he is pursuing an "America first" approach on the economy, vowing to restore jobs that moved abroad and reworking trade agreements.

Investors rank protectionism as the biggest risk to the bull market, according to Bank of America Merrill Lynch's February Fund Manager Survey, published Tuesday. Protectionism was followed by higher interest rates, what the survey categorizes as a "financial event" and weaker earnings.

A trade war was found to be the second-largest tail risk to investors, preceded by political elections in Europe raising "disintegration risk." A tail risk is perceived to be an event that has a small likelihood of happening.

"I think Donald Trump is the avatar of tail risk. He is personally the expression of possible disparate extreme outcomes. Things could be, as he might say, great. They could be really nice or not," Jim Grant, founder of Grant's Interest Rate Observer, said on CNBC's "Squawk Box" in a wide-ranging interview in January.

Lingering fears of the way Trump might handle a foreign crisis are at play, too, Siegel said.

"If [Russian President Vladimir Putin] makes some moves toward the Baltic states or more aggressively in Ukraine, … if China makes some moves, you know, Trump is more unpredictable. And that unpredictability is a negative for the market," Siegel said.

The thought of global trade shrinking is "scary," he added, and that could stand in the way of the market logging further gains. The S&P 500, Dow Jones industrial average and Nasdaq composite, respectively, are up 4 percent, nearly 4 percent and a little over 7 percent year to date.

The major indexes could see further upside if some of Trump's promised policies — like corporate tax cuts and fewer regulations in the financial industry — are implemented, Siegel said.

"That in and of itself, I think, is worth, certainly, as I said, 22,000 on the Dow, or maybe even higher. Whether it's going to get there or not is that lingering fear on those negatives that accompany the Trump presidency," he said.

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Trading Nation is a multimedia financial news program that shows investors and traders how to use the news of the day to their advantage. This is where experts from across the financial world – including macro strategists, technical analysts, stock-pickers, and traders who specialize in options, currencies, and fixed income – come together to find the best ways to capitalize on recent developments in the market. Trading Nation: Where headlines become opportunities.

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Brian Sullivan is co-anchor of CNBC's "Power Lunch" (M-F,1PM-3PM ET), one of the network's longest running programs, as well as the host of the daily investing program "Trading Nation." He is also a frequent guest on MSNBC's "Morning Joe" and other NBC properties.

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