By Paul R. La Monica
The big debate for 2026 is whether artificial intelligence will keep the markets happy. We can't settle that question, but we do see bargains below the AI surface and building blocks for another good year for stocks and bonds.
Adding to 2025's market performance might seem like a tall order. The S&P 500 index is on track to gain more than 17%, following up on two years of returns above 20%. International markets like Europe and China are cruising, up 30%. Even more dazzling have been gold and silver, up 60% and 100%, respectively.
What's next for markets hinges on a confluence of factors, including U.S. economic growth, Federal Reserve interest-rate cuts, and the mercurial policies of President Donald Trump. None are sure bets. And there's a bear case that valuations are stretched, leaving scant margin for error if companies don't hit Wall Street's forecasts for profit growth -- estimated at 14% for the S&P 500 in 2026, according to consensus estimates.
The bearish narrative has holes, though. Fiscal and monetary policy is becoming more supportive, including slightly lower interest rates and an economic tailwind from the Republicans' One Big Beautiful Bill Act. Federal Reserve officials see inflation easing a bit and economic growth picking up next year to 2.3% from an estimated 1.7% in 2025.
Analysts have raised S&P 500 profit estimates lately -- bumping year-over-year growth for the fourth quarter from 7.7% to 8.2%, according to strategist Ed Yardeni. That's a sign of confidence that companies are working through tariffs and other economic headwinds.
Another positive: The bull market is spreading beyond Big Tech. While tech is still the standout, sectors like industrials, financials, and healthcare are putting in solid gains of 10% to 20%. Small-caps and value are up a respectable 14%.
"I know there are some concerns about valuations, but the macro backdrop is supportive of equities. The U.S. economy is showing resilience," says Brian Levitt, chief global market strategist with Invesco. "Oil prices are still low, bond yields are low, and the Fed is looking to lower rates. That's favorable for stocks."
Much of Wall Street sees the S&P 500 notching another good year. Stocks tend to follow the path of corporate profits. If companies can meet or beat Wall Street's target for 14% earnings growth, stocks can keep rising. Goldman Sachs strategists see the S&P 500 at 7600 by the end of next year. Morgan Stanley has a 7800 target.
Yardeni, a longtime bull and head of Yardeni Research, sees 7700 within reach. He expects earnings for the S&P 500 to rise 15% and stocks to trade for nearly 25 times year-ahead profits forecasts, up from 22 now. "Our base-case outlook calls for a continuation of the Roaring 2020s scenario next year, with ongoing productivity gains that fuel a robust economy, which propels earnings and the stock market higher," Yardeni wrote in his 2026 outlook.
Much will depend on AI continuing to fuel trillions in capital expenditures. Despite some jitters in the market over whether a slowdown is coming, bulls argue the cycle is still far from peaking. Research firm Gartner predicted in a report in September that global AI spending will top $2 trillion in 2026 following expenditures of nearly $1.5 trillion this year.
That doesn't mean it will be smooth sailing for AI, as Oracle's results demonstrated. As companies like Meta Platforms, Alphabet, and Microsoft plow billions into AI development -- building data centers, apps, and new products -- investors may start to cast doubt on whether all that capital investment will yield tangible results.
Lofty multiples make the stocks susceptible to sharp reversals. The Magnificent Seven stocks -- a proxy for AI and tech -- go for an average 31 times earnings, about 40% above the S&P 500's multiple of 22.
Some strategists say it would be wise to branch out from the tech-heavy S&P 500, which is roughly 40% in the Magnificent Seven and Broadcom. "While we continue to believe in the AI story, investors should avoid overconcentration on AI risk," says Stephen Dover, chief market strategist with Franklin Templeton.
Looking Beyond AI
One way to hedge your bets: Shift from the AI arms dealers to the adopters -- companies in retail, financial services, and other parts of the economy. "The AI rally is going to evolve as more companies see productivity enhancements and efficiencies," says Joseph Amato, president and chief investment officer with Neuberger Berman.
Large companies like Walmart say they're getting an AI bump. "We're using AI across the organization to manage cost effectively and to accelerate our growth," said Walmart Chief Financial Officer John David Rainey on the company's earnings call in November.
Beyond AI, other tailwinds could keep the market aloft. Earnings estimates have been rising in areas like financials, utilities, and communication services. Estimates are also improving down the food chain to small- and mid-cap stocks. Earnings for the equal-weight S&P 500 are forecast to rise 11% in 2026 following 7% growth in 2025.
"The earnings backdrop should improve for a broader set of industries. There could be a pretty healthy move, for not just the megacaps," says Kevin Gordon, head of macro research and strategy for the Schwab Center for Financial Research.
The market isn't as pricey below the megacap surface. The Invesco S&P 500 Equal Weight exchange-traded fund goes for 17 times earnings. The S&P SPDR Small Cap 600 ETF has a forward price/earnings ratio of 15. Both ETFs have trailed behind the S&P 500 for years but can help diversify exposure to the tech-heavy megacap index.
Small-caps, in particular, look healthier. Consensus estimates call for nearly 17% earnings growth for the S&P SmallCap 600 in 2026, up from 13.5% in 2025.
Small-caps tend to get a tailwind from Fed rate cuts. The Russell 2000 index of small companies is beating the S&P 500 over the past six months as investors anticipate lower rates. We would suggest investing in the S&P 600 ETF, since it has higher profit criteria than funds tracking the Russell 2000.
"There is a lot of rhetoric about small-caps being dead. But it's not the case that the sequoias always outgrow the saplings," says Chris Tessin, founder of Acuitas Investments, a firm specializing in small-caps.
Three other sectors to consider are financials, utilities, and healthcare. David Bianco, chief investment officer for the Americas at DWS, favors those sectors partly as a bulwark against a slowdown in AI spending. "Concerns about China and others catching up or leapfrogging the U.S. in AI is something to keep in mind," he says.
For value investors, there are also plenty of stocks with reasonable multiples. Max Wasserman, co-founder and senior portfolio manager at Miramar Capital, favors companies like Home Depot and McDonald's on the consumer side, as well as industrial firm Waste Management, pipeline operator Oneok, and financials Visa and CME.
"Investors will rotate back to value sectors and look for steady earnings. We're looking for companies that haven't participated as much in the rally," he says.
A simple way to capture the value theme is with an exchange-traded fund targeting the market's cheaper stocks. The Vanguard Value ETF, for instance, holds stocks such as JPMorgan Chase, Berkshire Hathaway, Exxon Mobil, and Johnson & Johnson. It's up 15% this year and trades more cheaply than the S&P 500 at about 20 times earnings, with a 2.1% dividend yield.
Does all of this mean it will be clear sailing for stocks in 2026? Hardly.
Bears argue that Trump's tariffs are just beginning to bite while U.S. consumers look stretched on housing and other affordability issues. Stalling economic growth would make it tougher for companies to hit earnings targets. Bulls say stocks can overcome this "wall of worry," but with the S&P 500 up a cumulative 75% over the past three years, it's getting tougher to push ever higher.
Perhaps the biggest risk for stocks is simply that they're pricey. The U.S. market is trading above the 90th percentile historically on measures like the cyclically adjusted P/E ratio. Steep valuations in tech account for today's high valuations, and bulls say they're warranted by the sector's tremendous growth and margins.
Yet rarely in history has the market been able to maintain such valuations, and rarely have bull markets extended as long as this one without a 10% correction or deeper pullback (excluding the panic over Trump's tariffs in early 2025).
Valuations are a major concern, says Chris Hyzy, chief investment officer at Merrill and Bank of America Private Bank. BofA is one of the few Wall Street firms that doesn't see much juice in the market. The bank's target for the S&P is 7100 by the end of 2026, up just 4% from recent levels.
"The biggest risk is a negative growth shock that could hit the labor market," he says. "There could be big buying opportunities when volatility picks up," he adds.
International Stocks, Gold, and Bonds
If 2025 taught investors anything, it's that the American stock market isn't the only option. After a strong year for international stocks, Franklin Templeton's Dover favors Japan and emerging markets as relatively inexpensive bets.
Kristina Hooper, chief market strategist with investment firm Man Group, favors European equities. European economies are getting a boost from military spending and fiscal stimulus, she says. European stocks also have high dividend yields and are still cheaper than U.S. counterparts.
A low-cost way to get exposure would be the iShares Core MSCI Europe ETF. It trades around 14.5 times 2026 earnings estimates and yields just under 3%.
Gold is tougher now that it has gained so much. "Gold has moved from a classic risk-off position to more of a momentum FOMO [fear of missing out] trade. It's a mini version of large-cap tech," says Julia Hermann, global market strategist with New York Life Investments. She says it's difficult to make the case for buying more gold at these prices.
Other experts argue that gold and other precious metals still deserve a place in investors' portfolios. Rick Ratkowski, director of investment strategies with NISA Investment Advisors, recommends a roughly 5% position. The SPDR Gold Shares ETF is a good option.
Bonds are in a tricky spot. Fed rate cuts should be a tailwind for yields to come down at the short end of the curve. But long-term bonds trade on inflation expectations, which remain above the Fed's 2% target, and yields have increased slightly as the Fed has cut rates by 0.75 percentage points since September. Unless inflation falls sharply or the economy goes into a tailspin, the 10-year Treasury yield could stay in a range of 4.25% to 4.5%, according to Invesco's Levitt.
Investors can still pick up attractive yields, especially in corporate credit, where yields tend to be higher than in Treasuries and other government debt. "There are solid investment-grade credits yielding 5.25%," says Elliot Dornbusch, CEO and chief investment officer with CV Advisors.
Two low-cost bond ETFs to consider: The iShares 5-10 Year Investment Grade Corporate Bond focuses on intermediate-term debt. It yields 4.2% and is up 9% this year on a total return basis. Vanguard Short-Term Corporate Bond sticks with short-term debt, posing less risk if interest rates move up again. It yields 4.3% and is ahead 6% this year.
Bonds can help cushion your portfolio if stocks take a dive. There's also a good case for money-market funds, which should yield more than 3% in 2026 even if the Fed cuts rates mildly. Keeping some dry powder may come in handy if the markets pull back temporarily while continuing to push higher in the long term.
Write to Paul R. La Monica at paul.lamonica@barrons.com
This content was created by Barron's, which is operated by Dow Jones & Co. Barron's is published independently from Dow Jones Newswires and The Wall Street Journal.
(END) Dow Jones Newswires
December 12, 2025 02:00 ET (07:00 GMT)
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