As the U.S. stock market, represented by the S&P 500, wraps up another strong year, it boasts an impressive gain of over 17 percent with just a few trading days left in 2025. Once again, those who have adopted a buy-and-hold strategy with index funds are enjoying the fruits of their unwavering investment discipline.
While it’s certainly gratifying for these investors, a bull market often encourages a lack of critical thinking regarding potential risks. Riding the index’s upward trajectory may feel exhilarating, but it is essential to evaluate the underlying risks and maintain a balanced portfolio—especially now. The outlook for 2026 may not be as rosy for those who have bet everything on continued market growth.
Uncomfortably so, we are faced with a market that appears, almost universally, to be priced for perfection—a level that history shows is notoriously difficult to maintain.
Although fundamentals might seem tedious and irrelevant after such a lengthy bull run, neglecting them can lead to significant repercussions. Typically, they may fade into the background for a while, yet they are always present, waiting for the opportune moment to re-emerge when least expected.
As we enter 2026, it is crucial for investors to stay alert. This is no moment for complacency, as investment fundamentals tend to resurface at the most inopportune times—precisely when everyone anticipates further stock price increases.
If the S&P 500 concludes December in positive territory, as it seems likely it will, it will have marked an 8-month streak of gains. This would be the longest positive stretch since the ten-month run that ended in January 2018.
Yet, it is critical to recognize that winning streaks inevitably come to an end. Current momentum may continue for another month or two, but it is clear that this one is approaching its conclusion.
The Ghost of 1999
Major banks such as Morgan Stanley, JPMorgan Chase, and UBS project that the S&P 500 will rise by 10 to 15 percent in 2026, while Bank of America offers a more conservative forecast of around 5 percent. The prevailing sentiment is that factors such as Federal Reserve rate cuts, productivity gains from artificial intelligence (AI), and supportive regulatory and tax environments will propel the index higher.
However, these expectations overlook fundamental market realities. While such assumptions may have been beneficial over the past three years, they are likely to be challenged in 2026 as basic market fundamentals make their presence felt.
To grasp why bearish outlooks prevail, one needs to consider the Shiller PE Ratio, or Cyclically Adjusted Price Earnings (CAPE) ratio. Unlike the standard P/E ratio that only reflects the past year’s earnings, Professor Robert Shiller’s measure averages the last ten years of earnings while adjusting for inflation. It’s akin to assessing someone’s overall health over a decade instead of merely relying on how they felt after a good night’s sleep.
Currently, the Shiller PE is over 40, significantly higher than the historical average of approximately 17. This means we are currently 135 percent above the long-term trend. The only other instance of such a high reading occurred in December 1999, just before the dot-com bubble burst. The outcome of that scenario is well known.
When the Shiller PE reaches these elevated levels, the market essentially anticipates a decade of unprecedented economic prosperity. If reality falls short—say, it only experiences moderate growth—stock prices must decline or stagnate for earnings to catch up with inflated valuations.
Most likely, we will witness a sharp decline in stock prices as they align with earnings.
Big Problems
Presently, the stock market is buoyed by unrealistic optimism. There exists an unfounded belief that AI will drastically enhance productivity, keeping profit margins at historic highs indefinitely. Thus far, AI has not lived up to its promise of delivering substantial productivity increases and soaring revenues. What happens if AI turns out to be a capital-consuming illusion?
Investors are also counting on cuts to the Federal Reserve’s interest rates to maintain credit flow and further inflate stock prices. Consumer price inflation is well above reported figures, raising the specter of another significant breakout—similar to what occurred in 2022—being quite possible.
How long can the Federal Reserve maintain lower rates and stimulate the economy before facing another surge in consumer price inflation? If prices rise again, the Fed will have to choose between sustaining an asset bubble or mitigating a currency crisis.
Moreover, expectations are that corporate earnings will continue to grow, with estimates projecting double-digit growth for 2026. However, many of these forecasts project recent trends into the future. What if businesses fail to meet these optimistic expectations?
Adding to the worries is the issue of market concentration. The top ten stocks currently account for about 40 percent of the S&P 500 index. During the height of the dot-com bubble, the top 10 stocks only represented about 29 percent.
Many index fund investors believe they are diversified, yet they are unknowingly placing their bets on a limited number of tech companies to consistently perform exceptionally well. When 10 stocks account for nearly half of the index, significant issues are inevitable.
History indicates that such extreme market concentration often precedes sharp corrections.
Why Market Fundamentals Always Win in the End
“Markets can remain irrational longer than you can stay solvent.” This famous quote from John Maynard Keynes resonates for many investors.
Ultimately, the laws of mathematics remain unchallenged. Market fundamentals will inevitably reassert themselves through a process known as mean reversion. The stock market can exceed or dip below its average for an extended period, but it must always return to its baseline eventually.
Several catalysts can trigger a market’s upward trajectory to reverse. For instance, while 10-year Treasury yields remain above 4 percent, they compete for investor attention. Why invest in a technology stock with a 40 P/E ratio when one can secure a guaranteed 4 percent from the government?
What if a company misses earnings estimates? Elevated valuations leave little room for unexpected outcomes. If a popular tech company announces 12 percent growth instead of the anticipated 15 percent, its stock will likely take a steep decline.
Numerous factors could prompt a bear market. The key takeaway is that when the Shiller PE is at extremes (as it is now), the subsequent ten years of returns are typically flat or negative in real terms. The current risk-reward equation for owning stocks is strikingly unfavorable.
You don’t have to be overly pessimistic to recognize that the math simply doesn’t add up. Fundamentals are not merely theories or ideas; they represent a natural law—akin to gravity—that holds the financial realm together.
While markets can soar far above the underlying economy for a period, gravity ultimately prevails. You can take that to the bank.
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Sincerely,
MN Gordon
for Economic Prism
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