By Jacob Sonenshine

The stock market's mild drop could easily turn into a larger decline. Truist Wealth Management's co-chief investment officer, Keith Lerner, downgraded equities to Neutral from Attractive.

The S&P 500 is down just over 2% to about 6000 from the record close of 6144 it hit earlier this month. That might appear to be an innocuous decline, but it is the result of a weakening economic picture. Combined with the fact that the index is still trading expensively, that sets it up for more losses.

"We have seen modest deterioration in earnings, technical, and economic trends that warrants a more neutral equity posture and slightly higher cash," Lerner wrote on Monday. He also raised his call on the market for cash and short-term fixed-income investments, where yields are around 4%, to Neutral from Less Attractive.

The U.S. Citi Economic Surprise Index, which tracks the difference between economic data and expectations, has fallen to its lowest level in almost six months. The index rises when the surprises are favorably, so the decline means the data are showing a less robust U.S. economy than expected.

Gross domestic product still grew 2.3% in the fourth quarter, but consumers are becoming choosier about where to spend their money because interest rates remain high. Home sales have been weak for years because higher prices and interest rates are forcing would-be purchasers to walk away. Sales of related goods have taken a hit too. Manufacturing activity remains under pressure.

That continuing weakness -- and recent disappointments on economic data -- leave the market wondering how much worse things could get. President Donald Trump's policies are adding to the concerns.

He has prioritized placing tariffs on potentially hundreds of billions of dollars of goods coming in from China, Mexico and Canada. That would raise import costs, forcing companies to lift prices and putting even more pressure on consumer demand. That upward pressure on prices would add to inflation, potentially preventing the Federal Reserve from cutting interest rates this year.

Economists say the tariffs, likely affecting goods valued at ]1% to 2% of total annual U.S. economic output, could mildly reduce economic growth.

This is already causing the market to worry that companies are pulling back on capital spending, preferring not to overinvest in case demand for their goods and services weakens. Year-over-year growth in capital expenditures for equipment fell to 3% in early 2025 from mid-single digits early last year, while investment in structures has fallen to flat year over year, according to Ironsides Macroeconomics.

The data have "pointed to a cooling in the post-election business confidence, perhaps due to trade policy uncertainty," Barry Knapp, Ironsides' director of research, wrote on Saturday.

Many companies' financial outlooks for this year have disappointed. Walmart's forecast for sales growth this year, issued last week, suggested a deceleration relative to the fourth-quarter number.

TJX Cos. told investors to expect 2.5% growth in same-store sales this year, compared with the 3.4% analysts expected, hurting the outlook for pretax profit margins. Although management said TJX may perform better than it has forecast, its guidance for earnings was 10% below analysts' previous estimates. Telsey Advisory Group analyst Dana Telsey said in a research note that the guidance "reflects conservatism," which is no surprise given all of the current economic challenges.

Analysts are already reducing their forecasts for profits. Aggregate earnings estimates for S&P 500 companies for the coming 12 months have dropped about 1% since the start of the year, according to FactSet.

The index trades at 22 times the earnings expected for the coming 12 months, near the high end of its range for the past four years, so there is plenty of room for it to fall. Expectations that earnings will grow briskly make the potential return in equities look attractive, but if earnings disappoint, the market would have nowhere to go but lower.

As Lerner pointed out, "the flatlining of earnings is occurring at a time when the S&P 500 trades at the top-end of its valuation range."

That is why the market has just begun to crack. Any one of a number of factors could send it tumbling. First-quarter earnings reports and company outlooks could do it, though they won't roll in for several weeks. More weakness in economic data could also spark selling. Confirmation from Trump on the extent and timing of tariffs could also hurt, especially because the Fed's coming interest-rate announcements may indicate that rates could stay higher for longer.

While investors who have been in the market for a long time can ride out some near-term weakness, buying new shares today isn't the best idea.

Write to Jacob Sonenshine at jacob.sonenshine@barrons.com

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February 26, 2025 13:20 ET (18:20 GMT)

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