The markets have woken up to two facts: The odds of a tariff increase on Friday are much higher than the market had estimated and stocks will be dramatically overvalued if this happens.
The market is just off historic highs amid positive sentiment around four factors: the Fed pivot, a trade deal getting done, China's stimulus program that is creating the perception China's economy is bottoming, and a strong U.S. economy.
Higher tariffs and the absence of a trade deal will force investors to lower estimates for global GDP, global earnings growth and the earnings multiple associated with higher growth. This is why stocks like Molson Coors, Conagra Brands, Colgate-Palmolive and Kraft Heinz — all of which have little or no direct revenue exposure to China — are dropping along with those that do, like semiconductors, industrials and retailers.
Lower global growth impacts the value of all companies.
"This is a much broader deal than just who has revenue exposure to China, or who imports from China," said Art Cashin, UBS' floor director at the New York Stock Exchange.
A lower multiple is a particular problem. Large indexes like the S&P 500 trade off a multiple of forward earnings expectations.
The market will assign a higher multiple to the markets if global growth and earnings are expanding. It will assign a lower multiple if growth and earnings are contracting.
A typical multiple for the S&P 500 is 15 to 16 times forward earnings (the next four quarters). Refinitiv estimates the S&P will earn $171 per share in the next four quarters.
With the S&P at 2,940 a few days ago, the index was trading at a historically high multiple of about 17.2 (2,940/$171 = 17.2) at the start of May because of the Fed pivot to lower rates, a bottom in China's economy and the prospect of a trade deal getting done — all positives.
With no trade deal, and much higher tariffs, global growth will clearly be lower and the markets are assigning a lower multiple to the markets, but how much is still not clear. If the S&P gets assigned a more reasonable multiple of 15.5 (roughly the historic average), the S&P could quickly drop to the 2,650 range (2,650/$171 = 15.5).
And what about that amazing rally, when the Dow rose 165 points in the last 15 minutes of trading Tuesday?
"Be wary of overnight tweets," Cashin quipped, implying that President Donald Trump could just as easily issue a tweet that would move the market again.