Market Update

The S&P 500 and Nasdaq Composite achieved double-digit gains for the third consecutive year in 2025. The Federal Reserve’s rate reduction in December indicated a preference for prioritizing economic growth and a robust labor market over inflation containment. The Federal Reserve FOMC committee is signaling fewer if any rate cuts ahead – maybe in June with new Fed Chairman. A measured and gradual Fed easing cycle, as opposed to aggressive rate cuts, is generally considered positive for equity markets.

Currently, the Federal Reserve is in an easing phase. Historically, rate cuts have resulted in a positively sloped yield curve, which is typically correlated with periods of economic expansion and bullish market conditions. Sectors sensitive to economic fluctuations often demonstrate accelerated performance in such environments. The outlook for the coming year is optimistic, supported by government stimulus initiatives that are expected to enhance spending, continuing declines in interest rates, and sustained growth in artificial intelligence investment driving overall economic advancement. Inflationary pressures are subsiding, and the labor market remains stable from an economic standpoint.

Earnings projections have been revised upward for the remainder of this year and the following year. Corporate profits serve as a leading indicator, preceding other fundamentals such as employment, which tends to lag, and economic fundamentals that are often anticipated by stock market movements. Historically, stronger profit growth has contributed to higher equity prices and fostered a wealth effect through increased consumer spending, which remains the primary driver of the U.S. economy.

Earnings Picture

Consensus among analysts points to improving earnings prospects, driven mainly by lower interest rates, government stimulus measures, and a series of trade agreements that have alleviated policy concerns. Importantly, advances in artificial intelligence are sparking demand for computer chips, data centers, and a range of equipment necessary to develop AI infrastructure, further energizing earnings growth.

Earnings growth, not valuation expansion has fueled stock performance, which is anticipated to persist and extend beyond the Magnificent 7 stocks. Analysts forecast that these seven companies will see their earnings increase by 22.7% in 2026, while the remaining 493 companies in the S&P 500 are expected to achieve 12.5% growth according to FactSet. The Technology sector stands out, projected to deliver the highest earnings and revenue growth rates—surpassing the average growth seen over the past decade. Additionally, the U.S. dollar experienced its worst annual decline since 2017, which benefits Technology firms and multinational corporations by boosting sales abroad.

Several factors are underpinning this earnings momentum, including stronger employment figures, improving affordability, and the economic stimulus from the One Big Beautiful Bill. The One Big Beautiful Bill introduces further tax reductions for households and businesses, encouraging greater spending. Capital expenditures by companies should remain strong, aided by beneficial depreciation write-offs. As a result, businesses and consumers are becoming financially healthier this year.

Nominal GDP growth is estimated to reach up to 7% in 2026, a level typically linked to accelerating corporate earnings. Reduced policy uncertainty is expected to bolster business confidence, contributing to profit increases worldwide.

Valuation Snapshot

By several metrics, U.S. equities are currently trading at elevated valuations. The forward P/E ratio for the S&P 500 Index stands at 22.2, exceeding its 10-year average of 18.8. Elevated valuations suggest that future returns may be subdued unless earnings growth surpasses expectations. However, as a tool for market timing over the intermediate term, valuation alone is not reliable. Investors may reasonably choose to purchase stocks at higher valuations in an environment of easing monetary policy and record corporate profits. Nonetheless, lofty valuations raise the threshold for companies to outperform earnings forecasts, and as earnings growth decelerates, corrections among richly valued stocks can occur.

Presently, the stock market does not exhibit characteristics of a speculative bubble, nor do the so-called "Magnificent Seven" stocks. Current valuation levels are not comparable to those observed in previous bubbles, such as the Dot.com era.

Despite ongoing concerns, tariffs have not adversely affected corporate profitability. In fact, the S&P 500 has reported net profit margins above its five-year average for the fourth quarter, and analysts project even higher margins by 2026 based on FACTSET data. Large-cap equities are posting record-high margins, excluding the peak observed during the post-COVID period. These robust margins provide fundamental support for elevated equity valuations.

Looking Forward

Looking forward, I remain optimistic about the year ahead despite ongoing geopolitical uncertainties, as strong fundamentals outweigh external noise. Economic growth is solid, productivity continues to improve, inflation remains under control, and market leadership is expanding beyond its recent narrow base. While policy and geopolitical concerns will persist, both the economy and markets are on a positive path.

Investment in AI continues to be strong and is expected to drive productivity improvements first at large firms, eventually benefiting smaller companies in future years. Historically, when productivity rises, equity markets tend to perform well—even if the leading stocks change. Increased productivity also tends to lower inflation, supporting real economic growth without requiring tighter monetary policy from the Federal Reserve.

The broadening of markets is encouraging for investors, with the U.S. market entering 2026 on solid ground, fueled by robust profit growth that's expected to persist. Factors like potential tax cuts and interest rate reductions could further benefit businesses and consumers.

The bottom-up target price for the S&P 500 stands at 8084, representing a 16.4% increase from the closing level of 6944. However, it's worth noting that analysts have typically overestimated the index's closing price by about 6%, which would suggest an anticipated rise of about 9% to 7,569. This year could see actual earnings surpass estimates, given that nominal GDP is trending towards 7%, and earnings growth appears strongly supported by overall economic momentum and consumer spending, aided by the "One Big Beautiful Bill" stimulus package.

What else? Equity returns may be more modest based on historical performance patterns in the fourth year of a bull market. Additionally, mid-term election years usually bring greater volatility, which often subsides after Election Day and can be followed by a year-end rally. Moreover, the S&P 500's valuation is near the upper end of its historical range, suggesting possible increased volatility in 2026 and potentially lower returns going forward. Although the S&P Forward P/E ratio is historically high at 22, this reflects equally high profit margins. High valuations aren't deterring investors from investing in companies delivering exceptional profits, as I strongly believe in the AI revolution's capacity to sustain profitability and improve productivity. Even so, it’s normal for markets to pullback and correct each year. This year should be no different. Expect a couple of pullbacks and maybe a correction before election day.

Risks to Watch

Although the short- to mid-term outlook for stocks seems positive overall, elevated geopolitical risks—such as the threat of regional conflicts, renewed trade disputes, slower-than-expected productivity growth, and a shift away from accommodative monetary policy—could jeopardize the ongoing bull market. While inflation, long-term Treasury yields, and US debt and deficits are not immediate concerns, they would present significant risks for the economy and markets if they worsen. Any early signs of trouble are likely to appear in the Treasury market.

A word of caution, past analogies and patterns may not always repeat themselves; future fundamentals may no longer be supportive of markets due to a slew of factors including fiscal, monetary, geopolitical, regulatory, government policies, rising cost of capital, etc. Always expect a few pullbacks of 5-7% in stock market indexes as well as a possible 10-15% correction in any given year as part of a normal equity market. Past performance is no guarantee of future performance.