With the S&P 500 trading more than a third above its 10-year average for expected profits, and high-risk shares leading the benchmark’s charge to new highs, the US stock market looks more vulnerable than ever. The combination of overvaluation, economic vulnerability and the current downward trend in long-term returns should matter to everyone, even investors in it for the long haul.  This month poses a critical test for the rally’s sustainability.

Here’s one way to think about where things stand:

1. Historically, long-term US equity returns have moved in long waves from overvaluation to undervaluation. Right now, returns are coming down from a peak seen in the early stages of the pandemic. For this I’m looking at 10-year inflation- adjusted returns for the S&P 500, not including dividends.
2. The downward pull of long-term returns is a threat, then, even to buy-the-dip style long-term investors, especially given where US equity values are now as a multiple of yearly earnings.
3. In the past, that threat has been potent really only as a result of recessions. We may be able to give the all-clear signal on that front this month, which should allow investors to breathe easier. 
4. Tariffs do present a potential shock, given poor employment data, that could lead to recession. How President Donald Trump handles his coming tariff deadline will help determine whether we get the all-clear.

Long-term returns have been stalled for three years

Let’s start with this chart that I’ve used a few times. It shows how the S&P 500 has fared over the decades, adjusting for inflation.

We’ve basically stalled at levels around 100% since the Fed started raising the fed funds rate in 2022. Unlike other return super-cycles, we did have a second top in 2021 after the initial mean reversion began in 2019. But that’s a unique outcome of pandemic stimulus. Overall, we’re following the pattern of other cycles that go from very high returns to low and even negative long-term returns.

What this chart says is that we’re potentially on the cusp of entering a period where equity returns in the US are average or terrible for years to come. And what we’ve seen in past episodes like this is that the trigger for that final slide is a recession. Think the recession of 1970 or the Great Financial Crisis.

The reason is that if you combine overvaluation and a waning return in the equity super-cycle with a recession trigger, you get a big downdraft in stock-market valuations —  losses that even long-term investors can’t recoup. Baby Boomers found that out the hard way after the collapse of the tech bubble in 2001 popped that super-cycle. The Great Financial Crisis in 2008 catalyzed a wash-out in 10-year inflation-adjusted returns, which remained below long-term averages for the better part of a decade. Combined with the slump in house prices, that was a catastrophic loss of US household wealth.

By the numbers

Trump needs to be careful

All of this matters because my read of the recent economic data suggest this is a make-or-break period for the US economy. With companies already on alert from tariff-induced margin pressure, any further slowing in consumer spending will cause them to start reducing capital investment and laying off more workers. Here are a few data points.

• Initial jobless claims filed when people are laid off have spiked from a seasonally adjusted four-week average low of 212,500 per week to 245,000 in the most recent data. This isn’t an increase in part-time work or a diminution in temp workers, trends that are canaries in the coal mine for a softening labor market. We’re talking about actual layoffs. Continuing claims are at their highest levels since the end of 2021.
• Private payrolls administrator ADP showed that the private sector lost 33,000 jobs in June. While ADP and the official jobs report don’t match month to month, they do move in sync. And a decline in payroll growth into outright losses of jobs is what you typically see in the run-up to recession. 
• The 12-month increase in non-farm payrolls through May is about 1.7 million, down from 2.2 million in May 2024, and 3.7 million in May 2023. That decline to a 1.1% increase in non-farm payrolls is consistent with the run-up to a recession. For example, in past pre-pandemic cycles the economy only created fewer jobs in July 2007 (five months before a recession), in March 2001 (the month recession began), and in September 1990 (two months after recession began).

Overall, I reckon the Federal Reserve would normally be cutting here given that backdrop, simply because monetary policy acts with a lag and these are numbers that give the central bank very little time to counteract the already-apparent slowing. But of course, the threat of tariffs and the associated inflation means the Fed has stopped cutting rates. Fed Chair Jerome Powell said this week that it’s prudent to wait to assess the impact of tariffs.

That means Trump has to be very careful regarding next week’s tariff deadline. Any negative shock could galvanize firms to make the type of moves that will seed a US recession.

The coming jobs report is critical given the ADP miss. If Thursday’s data are bad enough, it could get markets to price in even odds of a Fed rate cut this month. And that might just be enough to move the Fed into action if the data deteriorate from here.

On a week-to-week basis then, the Fed will be watching jobless claims. If initial claims stay around 245,000, even with even odds of a rate reduction priced in, they may just take a pass on cutting this month.

But a lot of this depends on what Trump does with the tariff deadline, what the inflation implications are, what firms say in their earnings calls about inflation and how markets react. I’ll also be watching how well Amazon.com Inc. does with its July 8-11 Prime Day. Amazon is now a consumer bellwether, and this Prime Day is longer than usual, so it will be a better gauge of whether demand remains high after the tariff-induced panic shopping earlier this year.

I’m likely to pause my recession watch if Trump doesn’t escalate the tariff war and jobless claims stall at these levels. Government deficits of 6% or 7% of GDP, the resilience of upper-income household spending and the promise of $6000 in savings for that group in Trump’s tax-cut bill should be enough for the market to pass this critical test. But if Trump surprises on levies or if jobless claims rise to 260,000 a week, it will be game over for this economic expansion and bull market.

Things on my radar

• The housing market is a big drag on growth right now.
• Car sales are another drag due to tariff-induced panic buying
• The company using millions of AMEX points to pay a $11,000 bill is an avatar for the dilemmas small business face with tariffs
• Strategy (formerly MicroStrategy) is booking a $14 billion bitcoin windfall as profit. Is this a contrarian signal?

Like getting The Everything Risk? Check out these newsletters:

• Markets Daily for what’s moving in stocks, bonds, FX and commodities
• Odd Lots for Joe Weisenthal and Tracy Alloway’s newsletter on the newest market crazes
• Economics Daily for what the changing landscape means for policymakers, investors and you
• CFO Briefing for what finance leaders need to know

You have exclusive access to other subscriber-only newsletters. Explore all newsletters here to get most out of your Bloomberg subscription.