Stock markets are poised to finish with double-digit gains for the sixth time in seven years. The sole interruption came in 2022 during the inflation-driven decline, leaving many investors with portfolios that have grown substantially.
There's a common saying that anticipation often exceeds reality. While strong market returns are undeniably beneficial for portfolios and financial objectives, they also tend to make investors anxious once achieved. This is particularly true with major indices trading near record highs and valuations nearing levels last seen during the dot-com era.
Throughout 2025, several key issues facing investors reached inflection points. Inflation, though still impacting households, has settled around the 3% level. Tariffs remain elevated compared to historical norms and drove market volatility in 2025, yet they haven't triggered the economic disruption many anticipated. The Federal Reserve has maintained its rate-cutting cycle while the economy has expanded at a solid pace.
Taking a broader view, one of the most valuable insights heading into 2026 is that investors' greatest fears frequently don't materialize. The recession widely anticipated since 2022 never arrived. Historical patterns show that for every genuine market disruption like the 2020 pandemic or 2008 financial crisis, numerous feared "black swans" - unexpected, rare events - fail to occur. The true test for long-term investors isn't forecasting which events will prove significant, but rather maintaining both perspective and discipline regardless of market conditions.
Looking toward 2026, the investment environment offers both promising opportunities and notable challenges. Headlines will likely focus on topics including the midterm election, upcoming Federal Reserve leadership transition, AI's trajectory, mounting concerns about loan performance, U.S. dollar movements, and more. What truly matters isn't whether investors can anticipate every development, but whether portfolios are structured to navigate uncertainty while pursuing long-term growth. The following seven themes can help frame investor thinking about the year ahead.
Multiple asset classes are contributing to portfolio performance heading into 2026
A significant development for investors approaching 2026 is that numerous asset classes are delivering positive portfolio contributions. This contrasts with much of the previous decade when U.S. equities substantially outperformed global markets. Throughout 2025, international equities have exceeded U.S. market performance, with developed market stocks (MSCI EAFE) and emerging market stocks (MSCI EM) each advancing approximately 30% in U.S. dollar terms. Two primary drivers explain this performance: strengthening growth projections across many economies and dollar weakness, which enhances returns for U.S.-based investors.
Fixed income investments are also fulfilling an important stabilizing function within portfolios. The Bloomberg U.S. Aggregate Bond Index has delivered 7% returns year-to-date as the Federal Reserve maintains its rate-cutting trajectory and inflation moderates. Higher-quality bonds have fulfilled their intended purpose by generating income and cushioning stock market volatility during uncertain market periods.
Looking ahead to 2026, this reinforces the value of maintaining balance and diversification. Although reacting to headlines with sudden portfolio adjustments might seem appealing, investors who adhere to their financial plans are positioned to benefit.
Stock market valuations are climbing toward dot-com era peaks
Strong market performance over recent years has pushed stock valuations progressively higher. The S&P 500 currently reflects a price-to-earnings ratio of 22.5x, approaching the record high of 24.5x established during the dot-com bubble. By definition, this indicates investors are paying more for each dollar of anticipated future earnings compared to recent periods.
Concerns about valuations typically arise when they diverge from underlying business fundamentals. During the dot-com bubble, for instance, valuations reached historic extremes far exceeding actual revenues and earnings, as investors favored any company associated with the "new economy." While today's valuations appear expensive due to AI enthusiasm and continued economic expansion, corporate fundamentals remain solid. Earnings have grown at a healthy rate, with consensus estimates from LSEG suggesting this trend could persist.
Understanding what elevated valuations reveal and what they don't is crucial. High valuations don't necessarily signal imminent market declines, as markets can sustain elevated levels for extended timeframes. While some worry about an "AI bubble," not every bubble ends in a dramatic collapse. Some deflate gradually as fundamentals catch up, which distinguishes the dot-com crash of the late 1990s and early 2000s from cloud computing's evolution over the past decade.
Nevertheless, elevated valuations do indicate that future returns may be more moderate, since markets have already incorporated expected growth. This can also heighten market sensitivity to disappointments. Markets in this environment are often described as "priced for perfection," meaning even small earnings misses or weaker economic data can trigger volatility. This suggests that selectivity and maintaining diversified exposure across different market segments - including various asset classes, sectors, sizes, styles, and more - will become increasingly important.
Artificial intelligence is propelling economic expansion and market returns
No single development has captured investor focus quite like AI. Capital spending on AI infrastructure achieved remarkable levels in 2025, with total investment easily reaching trillions of dollars. This encompasses constructing new data centers, acquiring equipment like GPUs, and recruiting AI researchers.
Certain investments involve arrangements that appear circular. For instance, Nvidia invested up to $100 billion in OpenAI, which subsequently purchases millions of Nvidia chips. These interconnected relationships have sparked questions about whether the AI ecosystem can maintain itself if enthusiasm diminishes.
These developments highlight the reality that AI infrastructure requires resources few companies can afford independently. The critical question is whether the technology will ultimately create sufficient value to warrant the massive expenditures. Currently, AI investment represents a substantial contributor to overall economic activity.
Survey data indicates businesses are increasingly incorporating AI into operations. According to the Census Bureau's Business Trend and Outlook Survey, the percentage of businesses reporting AI usage more than doubled from 4% in September 2023 to 10% in September 2025. The share of businesses expecting to use AI within the next six months increased similarly, from 6% to 14% during this period.1 While these figures have jumped significantly, substantial room for growth remains.
For investors, AI represents both opportunity and risk. The Magnificent 7 technology companies continue driving market gains, powered by infrastructure investments and expanding AI adoption. However, this concentration creates exposure. These companies now comprise roughly one-third of the S&P 500, meaning most investors hold significant exposure whether they recognize it or not.
The question isn't whether AI will reshape the economy - that transformation is underway. Rather, it's whether current valuations appropriately reflect realistic timeframes for generating returns on these substantial investments. Historical precedents from the 1860s railroad boom to the 1990s dot-com era demonstrate that transformative technologies often follow comparable patterns: initial doubt, rapid adoption, market excitement, and eventual integration throughout the broader economy.
The important takeaway is that markets frequently overestimate how quickly profits can materialize. In reality, most investors likely hold AI exposure either directly or through major indices, so recognizing this concentration and maintaining an appropriate asset allocation aligned with long-term objectives will be essential in the coming year.
Economic expansion is moderating but remains in positive territory
Economic growth momentum has decelerated but continues exceeding many pessimistic projections. U.S. GDP experienced a minor negative contraction during the first quarter of 2025, but recovered swiftly as tariff-related uncertainty subsided. The 3.8% second-quarter growth rate not only surpassed expectations but ranks among the strongest quarterly readings in years.
Regarding global GDP, the International Monetary Fund forecasts growth could moderate slightly from 3.2% in 2024 to 3.1% in 2026. Advanced economies are projected to expand around 1.5%, while emerging markets are expected to sustain growth above 4%.2
Despite positive aggregate figures, economic expansion has been uneven across income groups and sectors. This phenomenon is frequently described as a "two-speed" or "K-shaped" economy, where some segments flourish while others face challenges.
In the current environment, this divergence stems primarily from technology trends, as those positioned to capitalize on AI growth may experience stronger employment prospects than those in traditional industries. However, factors beyond AI matter, including consumer debt, auto loan delinquencies, and other financial pressures that influence whether individuals benefit from economic expansion.
Regarding longer-term economic prospects, perhaps the most significant question is whether productivity will accelerate due to recent technological progress. Productivity measures worker output, both quality and quantity, within a given timeframe. Historically, improved equipment, training, and education have driven productivity gains, which fuel genuine economic growth.
As illustrated in the chart, productivity growth averaged just 1.2% annually during the 2010s. The promise of AI and emerging technologies is enhanced worker output. However, this transformation typically unfolds more slowly than anticipated and won't necessarily benefit all workers equally. For investors, the potential for improved productivity means profit margins could strengthen, supporting both the broader economy and investment portfolios.
Tariff implications remain unclear
Although tariffs primarily drove stock market fluctuations in 2025, their economic consequences have been mixed. One continuing puzzle is how minimal the immediate tariff impact has been on inflation and growth. Despite tariff costs rising tenfold compared to prior-year averages, measures like the Consumer Price Index have increased only marginally.
Several explanations exist for why tariffs haven't produced their expected effects. First, numerous announced tariffs were promptly paused or reduced. Second, many businesses absorbed initial tariff costs by maintaining stable prices and importing goods before tariff implementation. Finally, robust consumer spending, fiscal stimulus, and strong AI-sector growth helped counterbalance any negative growth impact. Additionally, the Supreme Court may rule in 2026 on the legality of the economic rationale used for these tariffs.
For long-term investors, these recent developments, combined with the initial 2018 trade negotiations, demonstrate that tariffs remain part of the government's policy toolkit. Rather than viewing tariffs as a fundamental shift in global order, they instead represent instruments for advancing broader policy objectives. While tariffs aren't disappearing, their influence on daily market movements could diminish.
Midterm election and federal debt will dominate 2026 discussions
Beyond trade policy changes, 2025 witnessed a historic 43-day government shutdown and persistent concerns regarding budget deficit size. Simultaneously, the recently enacted One Big Beautiful Bill Act (OBBBA) tax legislation has provided greater clarity for investors and taxpayers.
The new year begins with additional Washington uncertainty as the short-term funding bill expires at January's end. This creates potential for another negotiation cycle that could produce another government shutdown. Subsequently, some investors anticipate households and businesses will benefit from larger tax refunds due to OBBBA provisions including full research and development expensing.
Further ahead, investor attention will likely shift toward the midterm election and its potential implications for tariffs, regulation, government spending, and other policies. The chart demonstrates that midterm election years have historically produced healthy returns, averaging 8.6% since 1933, though slightly trailing non-election and presidential election years.
Nevertheless, the expanding national debt remains many investors' primary concern. The reality is that the historically elevated national debt, currently hovering around 120% of GDP for total debt, or exceeding $36 trillion, is unlikely to be resolved soon. The OBBBA is estimated to potentially increase national debt by over $4 trillion within the next decade. Currently, the national debt represents over $106,000 per American.
For long-term investors, recognizing what we can and cannot control is essential. The national debt has presented challenges for decades, yet making investment decisions based solely on these concerns would have resulted in suboptimal portfolio positioning. While U.S. federal debt sustainability may influence economic growth and interest rates, history demonstrates this shouldn't primarily drive portfolio decisions.
Instead, what investors can control immediately is understanding key tax legislation changes and their long-term planning implications. These include permanent lower tax rates from the Tax Cuts and Jobs Act, sustained higher estate tax exemption levels, increased SALT deduction caps, and numerous other provisions. Now represents an ideal time to review tax strategies ensuring full advantage of these new regulations.
Federal Reserve policy will continue supporting economic conditions
The Fed resumed rate cuts in September following an earlier pause. Entering 2026, monetary policy direction may become less predictable. This reflects the fact that runaway inflation risk may no longer be the primary consideration as labor market weakening has gained importance. This environment requires policy rate adjustments rather than the dramatic shifts witnessed in 2022.
An additional complication involves Fed Chair Jerome Powell's term ending on May 15, 2026, opening the door for new Fed leadership. The White House is expected to name a successor who may support additional rate reductions aligned with the administration's economic agenda favoring lower interest rates.
The chart illustrates that economic performance has been solid across Fed Chairs appointed by both parties. It's worth noting the Fed only influences the "short end" of the yield curve, meaning interest rates closely tied to the federal funds rate. Long-term interest rates depend on numerous other factors including economic growth, inflation, and productivity. Rather than tracking the Fed's every action and analyzing every statement, investors should maintain focus on these longer-term trends to understand their impact on interest rates and bonds.
Keeping perspective throughout 2026
Entering 2026, investors confront a familiar challenge: balancing worries with the historical reality that markets have consistently rewarded patient, disciplined investors across time. The list of potential concerns remains constant, yet history indicates that for every crisis disrupting markets, many more feared events never occur. What distinguishes successful long-term investors isn't predicting which concerns prove most significant, but maintaining balance throughout all market cycle phases.
The bottom line? Strong market returns have been delivered, but elevated valuations combined with moderating global growth point toward more modest 2026 expectations. Rather than trying to time markets based on any single concern, investors should prioritize maintaining balanced portfolios structured for multiple potential outcomes.
References
- https://www.census.gov/hfp/btos/data_downloads
- https://www.imf.org/en/publications/weo/issues/2025/10/14/world-economic-outlook-october-2025
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