The S&P 500 faces heightened volatility due to escalating conflict in Iran and turbulence in energy markets, with downside risks not yet fully eliminated. Although U.S. markets have demonstrated resilience, surging credit stress indicators and demand for hedges suggest a shift towards defensive strategies and growing concerns that a financial crisis could deepen. Persistent energy shocks and the potential for stagflation may force the Federal Reserve to reconsider its interest rate policy, particularly if oil prices could potentially surge to $200 per barrel and disputes over the Strait of Hormuz continue. Analysis indicates the market is at an inflection point: stabilization could form a medium-term bottom, but prolonged conflict risks triggering further declines, especially with current market valuations as high as 20 times expected earnings.
The conflict, which began on February 28th, is now in its fourth week with no clear end in sight. Despite claims by U.S. and Israeli forces of significant damage to Iranian military capabilities, the situation remains deadlocked. Just last weekend, Iran came close to attacking the joint U.S.-UK military base on Diego Garcia. Reports indicate the attack involved medium-range ballistic missiles, challenging conventional market assumptions about the sophistication of Iran's missile arsenal. While the attack ultimately failed to achieve its intended impact, it reinforced the view that Iran has the capacity for significant escalation and remains a major threat to U.S. forces, tempering optimism from the White House and U.S. Central Command.
The threat is no longer confined to the Middle East, raising concerns that Europe could also face potential attacks from Iran. As the conflict enters its fourth week, the uncertainty threatening U.S. and global markets appears to be reaching a critical point. While U.S. equities have outperformed global markets, demonstrating investor confidence in their resilience, the narrative of "going global" or "selling U.S. assets" has been upended. This has negatively impacted non-U.S. stock markets, causing significant losses for investors who adopted that strategy earlier in the year.
Given U.S. energy independence—the nation is a net energy exporter—global investors are now pricing expectations of a prolonged conflict into stock prices. Attacks by Israel and Iran on Middle Eastern energy infrastructure, such as the recent disruption to liquefied natural gas production in Qatar which may be halted for up to five years, have significant implications for countries heavily reliant on energy imports. However, resilience does not equate to immunity for the U.S. economy, which is why the S&P 500 and Dow Jones indices are still testing their November lows this week.
Furthermore, the specific patterns of decline—an inverted U-shape for the S&P 500 and an inverted V-shape for the Dow Jones—coupled with rapidly spreading concern into U.S. markets, has prompted a scramble for hedging instruments. Demand for hedges remains extremely high, with VIX short positions being squeezed out and turning net long, while short equity positions have surged.
Potential future impacts of the Iran conflict on U.S. stocks include continued downside volatility. Credit market indicators show a sharp rise in credit stress, and historical back-testing suggests current conditions are unfavorable. This supports the view that investors are not only adopting more conservative strategies but also fearing a potential credit collapse that could trigger a deeper financial crisis. Given the current energy shock is primarily a supply chain issue, the Federal Reserve's ability to respond effectively may be limited.
Last week's spike in energy prices, which nearly retested early March highs before retreating, caused investors to scale back expectations for interest rate cuts within the next 12 months. This has weakened the dovish stance that had supported high valuations, a trend that could persist if the Strait of Hormuz impasse continues. While recent reports suggest more nations could take active measures to ensure safe passage through the strait, critical questions regarding the form and timing of such actions remain unanswered and require urgent attention.
The market appears uncertain if it is prepared for further prolonged delays. The threat of high energy prices, including potential further increases in energy product costs, could reverse the relatively mild economic forecasts for early 2026 and potentially lead to a recession. Consequently, the most severe negative impacts of the Iran conflict might not materialize for several more weeks. A more severe bear market cannot be ruled out if investors begin to anticipate a stagflationary scenario reminiscent of the 1970s.
Compounding the issue, without regaining control of the Strait of Hormuz, a clear exit strategy for the U.S. administration is difficult to envision. With no signs of internal uprising in Iran or dissent within the Islamic Revolutionary Guard Corps, the Iranian regime is likely to adopt a highly rigid strategy. Having endured sustained strikes from the U.S. and Israel, their determination to persist, viewing regime survival as a hard-won victory, may be strengthened. If the U.S. seeks an exit without fully reclaiming control of the strait from Iran, it risks a protracted geopolitical quagmire, with Iran, as the de facto gatekeeper of the narrow waterway, holding significant leverage. This would undoubtedly worsen the global situation and significantly heighten the risk of regional escalation as the U.S. weighs stronger intervention to reclaim the strait.
In other words, a "declare victory and leave" exit strategy now appears unviable. U.S. partners in the Middle East, who likely expect the U.S. to see the situation through, would not welcome such an approach. This context helps explain the fairly rapid sell-off in the S&P 500, exhibiting an inverted U-shaped pattern that signifies a retest of the late-November lows and marks a significant rotation from growth to value stocks.
Compared to another event-driven market crash in April 2025 triggered by the "Liberation Day" announcement, the current decline has been less severe, partly due to the administration's subsequent rapid de-escalation which helped markets rebound quickly towards the 50-week moving average. Currently, this is the first time since then that U.S. stocks are retesting that key level while simultaneously confronting bear market and recession concerns. The absence of a bullish reversal signal indicates investors are not yet actively buying the dip, but the potential for a reversal anchored above the rising 50-week moving average remains.
If the market perceives recent declines as having largely priced in the worst-case scenarios from energy markets and stagflation fears, a reversal could begin to emerge in the coming weeks. However, in the absence of constructive developments, or if the market concludes that ending the crisis requires a longer, more protracted, or bloodier U.S. ground campaign to reclaim the Strait of Hormuz (thus prolonging its blockage), investors might even begin to price in potential interest rate *hikes*. The Fed could be forced to combat inflationary pressures from oil near $200 and the accompanying economic slowdown. Given the relatively strong state of the U.S. stock market and economy heading into early 2026, this represents one of the worst potential outcomes of the Iran conflict.
Furthermore, with anticipated capital expenditure in the AI sector nearing $700 billion by 2026, the market might have to accept delays. Hyperscale data center operators could start factoring concerning energy costs into their plans, potentially pausing some projects until the evolving conflict reaches a clearer resolution—a timeline that remains highly uncertain. Therefore, the market is indeed at a critical juncture, a fact reflected in the price action. While a bottom may be forming, the signals are not yet definitive, and the market requires clearer confirmation. Should the situation fail to improve, the S&P 500 could experience more sustained declines, especially given its current price-to-earnings ratio of 20, which is significantly above the historical median of 15. If the impact on corporate earnings proves persistent over several quarters rather than temporary, the current trend of rising earnings estimates might even need to be revised downward.
