A Stock Market Alarm Is Sounding for the Third Time in 20 Years. History Says This Will Happen Next.

The S&P 500 (SNPINDEX: ^GSPC) briefly fell into correction territory in March. The index has since bounced back to a small degree but remains more than 8% below the record high it reached in February. However, an economic warning bell seen during just two periods in the last 20 years may signal more trouble on the horizon.

As of March 18, data from the Federal Reserve Bank of Atlanta shows that U.S. gross domestic product is on pace to decline an annualized 1.8% in the first quarter of 2025. That would be the worst economic contraction since the second quarter of 2020. Historically, the S&P 500 has performed poorly during periods of economic contraction.

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Here are the important details.

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History says the S&P 500 could decline sharply if GDP contracts in the first quarter

Gross domestic product (GDP) measures the size of an economy. It's calculated as the sum of four numbers: consumer spending, business spending, government spending, and net exports. In the U.S., quarterly GDP has declined during just two periods in the last 20 years, as detailed below:

• 2008-2009: GDP declined 2.5% in Q4 2008 and remained negative through Q3 2009 as the housing market collapsed and borrowers defaulted on subprime mortgages. Those events led to the Great Recession.
• 2020: GDP declined 7.5% in Q2 2020 and remained negative through Q4 2020 as the COVID-19 pandemic forced business closures and social distancing that disrupted supply chains around the world. Those events led to brief recession.

The events listed above correlated with sharp declines in the S&P 500, which is commonly regarded as the best gauge for the overall U.S. stock market. Specifically, the S&P 500 fell 56% from its high during the Great Recession, and the benchmark index fell 33% during the early days of the COVID-19 pandemic.

As mentioned, data from the Federal Reserve Bank of Atlanta shows GDP is on track to fall at an annualized rate of 1.8% in the first quarter of 2025, but that number isn't yet finalized. The first quarter doesn't end until March 31, and the Bureau of Economic analysis won't publish a finalized number until April 30.

Weakening consumer sentiment and a soaring trade deficit are weighing on the economy

Consumer spending, which accounts for two-thirds of GDP, rose 4.2% in the fourth quarter, but growth is on track to decelerate to 0.4% in the first quarter amid concerns about inflation and tariffs. Consumer spending in January unexpectedly fell, the first month-on-month decline in two years. And consumer sentiment in February reached its lowest level since November 2022.

Additionally, while the Trump administration's trade policy aims to correct the long-standing trade deficit -- U.S. imports have consistently exceeded exports since 1975 -- tariffs have so far had the opposite impact. The trade deficit in January hit a record high as businesses stockpiled inventory. That means U.S. imports exceeded exports by the largest margin in history. That's the primary reason GDP is on pace to decline in the first quarter.

However, tariffs could send the S&P 500 lower in the months ahead, even if the U.S economy avoids a first-quarter contraction. Goldman Sachs strategists recently wrote, "Tariffs on autos, critical imports, and reciprocal tariffs could raise the effective rate to about 10%, which is five times the increase in the first Trump administration."

Tariffs imposed during the first Trump administration contributed to a 19.8% decline in the S&P 500 during a three-month period in late 2018. If the second Trump administration forges ahead with more aggressive trade policy, the impact on the stock market could be correspondingly larger.

Here's the bottom line: Trade tensions and economic uncertainty make the current market environment risky, so investors should proceed with caution. That doesn't mean avoiding stocks altogether, but it does mean limiting purchases to high-conviction ideas and only buying stocks that trade at reasonable valuations.

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Trevor Jennewine has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Goldman Sachs Group. The Motley Fool has a disclosure policy.