Recent tariff talks have spooked the financial markets, sending stock prices lower. In this post, we’ll look at how tariffs work, why they exist, what has happened recently, and what we might expect in the near term.

How They Work and Why They Exist

Tariffs are a tax added to the price of goods. To explain, let’s assume a U.S.-based company manufactures refrigerators and sells them for $1,000. If a Chinese-based company can produce refrigerators with the same quality and features at a lower cost, and sell them in the U.S. market for $800, the Chinese company should capture a larger share of the market. This would cause the U.S. company to lose sales and perhaps reduce its workforce.

To combat this, the U.S. government could impose a 25% tariff on refrigerators imported from China. This would make the price of the Chinese refrigerators the same as those made in the U.S.A. (ex: Step 1: $800 x 25% = $200; Step 2: $800 + $200 = $1,000). Because this tariff would reduce the number of Chinese refrigerators sold, China might impose a high tariff on automobiles imported from the U.S. This would reduce exports (sales) for U.S. auto manufacturers. Then the U.S. might impose additional tariffs on other Chinese imports, and eventually, we have a trade war. An imbalanced trade policy can stifle economic growth in the country that has negotiated the worse deal.

Regulations, Taxes and Tariffs

Due to the 2008 Great Recession, the Obama administration and Congress added a host of new regulations and the regulatory environment became quite burdensome to U.S. businesses. In addition, the extremely onerous and lengthy legislation, known as Obamacare, compounded an already difficult situation. Businesses were so concerned, in fact, that they amassed historically high levels of cash rather than invest it.

These and other factors made the economic recovery from the post-2008 recession the slowest in modern history. When Trump was elected, investors expected, and received a business-friendly administration. First, Washington relaxed regulations. Then, the President and Congress cut taxes. So far, so good. But stocks became overvalued as the economy failed to grow at the same rate as stock prices.

During the campaign, President Trump frequently mentioned our “terrible” trade deals. With regulations and taxes behind us, trade has become the next frontier. Unfortunately, Trumps recent tariff tirade has made investors nervous, fearing a trade war, and causing an increase in selling pressure. The past few weeks have not been kind to stock investors. Last week, the Dow fell 724.42 points on Thursday, followed by another drop of 424.69 points on Friday.

To illustrate how rare a loss of this magnitude is, consider this. From October 1, 1928, to March 23, 2018, there were 22,474 total trading days. During this period, the Dow lost more than 2.0% in only 477 days, which equates to 3.16% of all trading days. Such large losses are indeed rare. On the bright side, even with the recent and significant losses as of this past Friday’s close, the DJIA is still over 28% higher than it was on election day in 2016. The bad news? It is still 39.2% overvalued as of Thursday, March 22, 2018.

Summary

U.S. economic fundamentals are strong, but stocks remain overvalued, and Trump’s tariffs are still causing concern. Once the tariff talk subsides, fear should decrease, and stocks could begin another ascent. More importantly, how far will stock prices fall before the tariff subject is resolved? Remember, they are still quite overvalued. We’ll have to wait and see.