BY: Jim McElroy

The Beginning of the End … of 2026

It’s a little early to write a postmortem on 2026—after all, there are three months left before we can ring in 2027—but it’s already been a momentous year.  On the plus side, the stock market, as represented by the S&P 500, grew 11.8% for the first three quarters of the year. And yes, this includes the 7% drop in price during the first quarter.  Much of this is due to the dominant percentage (c. 40%) that Information Technology represents in the index, as well as the seemingly insatiable enthusiasm for Artificial Intelligence and everything associated with it.  What makes this stock performance particularly interesting is that it has occurred against a backdrop of what one would normally call disastrous news.

Let’s not forget that since the end of February of this year, the U.S. has been engaged in a costly and so far unsuccessful war with Iran, that energy prices have moved up to levels not seen in over five years (a high of $114 per barrel for West Texas Intermediate crude), that inflation is well above the Federal Reserve’s 2% target (PCE of 3.6%), and that the Fed, after two years of lowering its target rate for Federal Funds, has begun lifting it with an initial shift from 3.75% to 4%.  The current yield on the 10-year U.S. Treasury Note is at its highest level in almost twenty years.  Looking ahead, the next biennial exchange of skilled prevaricators—i.e., the November mid-term elections—presents another order of uncertainty, especially when one considers the presence of avowed socialists in a swath of congressional and state elections.  And, if that weren’t enough to frighten investors, we now have leaders in the AI industry warning that there is a significant probability of an AI apocalypse within the next 10 years that could wipe out the entire human race.  Many investors, had they known what the economy would be facing in the first nine months of 2026, might well have sold all their stocks and bonds and invested in cash.  On the other hand, those same investors, who now face more of the same—a seemingly winless war, accelerating inflation, a decidedly hawkish Federal Reserve and even higher interest rates—still keep buying stocks.  Why does this happen?

There are almost as many mathematical formulas for assessing the justifiable prices for equities as there are business schools on the North American continent.  Most, if not all, rely on estimates/guesses for two variables: expected growth in earnings and the risk premium one demands for the uncertainty of this expected growth.  The data for expected growth in earnings is provided by corporate spokesmen, equity analysts, barbers, fortune tellers, etc.  The risk premium is derived from the yield on so-called risk-free investments (e.g., 10-year U.S. Treasury Bonds) plus four or five extra percentage points for added uncertainty.  In very simple terms, equity prices react positively when growth expectations increase and negatively when risk premiums increase, primarily due to increases in the yield on U.S. Treasuries.  There’s an old saying, attributable to Warren Buffett, about buying stocks: “Price is what you pay, value is what you get.”  It’s not surprising that many investors transform this statement to mean that the value they perceive justifies the price that they will pay.  In today’s stock market, there appears to be a belief that future growth in earnings will outstrip current and future increases in interest rates.  And so far, the growth believers have been right.

As we mentioned earlier, much of the enthusiasm in the stock market is due to excitement over Artificial Intelligence.  Despite references to Skynet of “Terminator” fame and the apparent unpopularity of AI data centers, the development and build-out of AI appears to be a major source of U.S. economic growth.  The Wall Street Journal reports that recent employee hiring increased in August, that layoffs remained low and that, due to new orders, manufacturing and service activity reached their highest levels since the 2021–2022 period.  All this supports the growth case.  However, the Fed’s dedication to bringing inflation down to 2% (currently 3.6%) by raising interest rates could easily frustrate this growth argument.

The Fed’s job has always been difficult: the twin goals of maintaining both full employment and stable prices are, at their extremes, contradictory.  Tilting too much in one direction can lead to hyperinflation; too much in the other can lead to another great depression.  Today’s situation is particularly difficult for the Fed because much of the inflation it apprehends is out of its control.  Instead of facing price pressures from an overheated domestic economy, the Fed finds itself confronting a global crisis in energy supplies. The war in the Middle East has driven gasoline and diesel prices to excessive levels, which in turn has added to price increases for (and from) producers and consumers.  The Fed’s preferred gauge of inflation, the Personal Consumption Expenditures Price Index (PCE), limits itself to consumer goods and services and excludes food and energy from its calculation due to their high price volatility.  Eventually, however, the sustained effects of food and energy inflation do appear in the PCE index (think of Amazon deliveries or shipping costs for home improvement purchases).  We should expect higher inflation and higher “corrective” interest rates over the next few months.

Will higher interest rates derail the bull market in stocks that began almost four years ago and more than doubled since the S&P 500 bear market low of October 17, 2022?  So far, the market has shrugged off the more aggressive stance of the Federal Reserve, presumably under the belief that the growth promise of AI will dwarf the slowing effects of 0.25% rate hikes.  The promise of AI is no doubt world-changing: it is possible that it can usher in a new era of unprecedented growth and inflation-proof efficiency.  It has already produced jaw-dropping wonders of inventiveness and effectiveness.  But, for now, it’s still mostly a promise.  Higher interest rates are also only a promise, but still a promise of something we have seen before.  At least in the short term, or until the machines take over, we recommend caution.

Summary Q3 2026:

• So far, in 2026, the S&P 500 has grown 12.5%
• This growth has occurred in spite of very disheartening news. Why?
• Stock prices are pushed upward by growth expectations and downward by increases in the risk premium.
• The Fed is determined to push inflation lower by raising the risk-free interest rate.
• We recommend caution.

Not Investment Advice or an Offer
This information is intended to assist investors. The information does not constitute investment advice or an offer to invest or to provide management services. It is not our intention to state, indicate, or imply in any manner that current or past results are indicative of future results or expectations. As with all investments, there are associated risks and you could lose money investing.