Stocks risk 'Wile E. Coyote' moment

Everyone thought tariffs would send the U.S. economy spiraling into stagflation or recession earlier this year, causing a sharp drop in the stock market. However, optimism has instead sent markets to all-time highs on hopes that the tariffs won't hurt companies as much as initially feared.

That may be true, but not everyone is convinced that it will be roses and daisies for investors from here.

Nobel-prize-winning Paul Krugman delivered worrisome words this week on the outlook for the economy and stock prices, suggesting we're on the precipice of a “Wile E. Coyote” moment.

Krugman won the Nobel Prize for his work on trade theory, so he knows a thing or two about global trade decisions and the economy, making his opinion worth considering.

Krugman on stock market complacency

The S&P 500's 30% rally since President Donald Trump paused most reciprocal tariffs in April has been impressive.

The stock market has climbed a wall of worry despite the pause ending in August, leading to record closes for the S&P 500 and the Dow Jones Industrial Average.

Those gains have surprised many, given that tariffs are considered inflationary and a drag on corporate profit margins.

President Trump's war of words with the Federal Reserve to persuade it to lower interest rates has ratcheted up to reshaping its membership, casting doubt on its role as an independent body.

However, in a recent Substack, Paul Krugman suggests that “business as usual” complacency is the major reason the stock market is shrugging off economic threats:

“My read of economic and financial history is that market pricing almost never takes into account the possibility of huge, disruptive events, even when the strong possibility of such events should be obvious. The usual pattern, instead, is one of market complacency until the last possible moment. That is, markets act as if everything is normal until it‘s blindingly obvious that it isn’t.”

Krugman maintains that people don't change their behavior until forced, suggesting that extrapolating business as usual may not be a wise choice.

“If the conventional wisdom is that economic conditions will remain more or less normal despite highly abnormal policy, markets will remain calm until the illusion of normality becomes unsustainable.”

Krugman warns of “Wile E. Coyote” moment

The risks to the economy from President Trump's attempt to cudgel the Fed to deviate from its mandate of balancing inflation and unemployment risks based on data, rather than politics, shouldn't be ignored, suggests Krugman.

“Market prices may 'change violently.' The current technical term for this phenomenon is a 'Wile E. Coyote moment' — the moment when the cartoon character, having run several steps off the edge of a cliff, looks down and realizes that theres nothing supporting him. Only then, according to the laws of cartoon physics, does he fall,” wrote Krugman.

Krugman compares the current environment to the housing bubble, pointing out that markets didn't truly react to the risks until well after home valuations shot to extremes in 2005 compared to average rents.

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“One could try to rationalize the extremely high prices of houses relative to rents in 2006. But an honest assessment would at least have reflected the serious possibility — not the certainty — that there was a bubble,” wrote Krugman.

Of course, markets, as the Wall Street adage goes, can remain “irrational longer than you remain solvent,” so there's no telling for certain what's next for the market.

Nevertheless, Krugman doesn't lay out a bullish message.

“The absence of a strong reaction to Trump‘s assault on the Fed isn’t a sign that everything is OK. We are, in fact, looking at a policy disaster in the making. But markets probably wont react strongly until the disaster is already upon us,” concludes Krugman.