The S&P 500 is currently hovering near all-time highs, reflecting a significant 17% gain in 2025, positioning the index for a third consecutive year of double-digit gains. As we approach the new year, questions arise about the sustainability of this remarkable rally.
Artificial intelligence has been one of the pivotal themes driving the stock market in 2025, alongside growth in the technology, energy, and industrials sectors. However, investor sentiment regarding President Donald Trump’s tariff strategies has also played a crucial role in shaping market performance.
With 2026 on the horizon, market participants are keen to analyze metrics that could indicate the S&P 500’s trajectory going forward. Currently, the index boasts a forward price-to-earnings (P/E) ratio of 21.8, which exceeds both its five-year and ten-year averages by notable margins. Historical comparisons reveal that similar valuation levels were observed during the COVID-19 pandemic and at the peak of the dot-com bubble, periods that ultimately led to sharp declines in the index.
Another vital measure is the Shiller CAPE ratio, which currently sits at 40.7. This figure has approached these levels only once before, during the internet boom of 2000, raising concerns about the current rally’s sustainability.
In light of rising inflation over the past few years, which peaked at 9.1% in 2022, Trump’s administration shifted the focus to tariffs as a solution. Announced earlier in 2025, these tariffs aimed to alleviate inflationary pressures. While inflation has eased somewhat, the Federal Reserve’s analysis offers a more complex perspective. The Fed’s report from November highlighted that tariffs can be inflationary, increasing the cost of imported goods and potentially leading to reduced consumer spending. Lower spending slows economic growth, exerting downward pressure on inflation.
Moreover, this scenario poses risks to the labor market, as businesses facing tighter margins and declining sales often resort to layoffs, which has been reflected in the uptick of the unemployment rate to 4.6%, the highest since 2021.
In the long run, tariffs may incite businesses to reorganize their supply chains, eventually allowing them to regain pricing power, which could lead to a resurgence in inflation. Thus, while tariffs may contribute to short-term disinflation, they could reinforce higher costs in the broader economy over time.
Considering these factors, many analysts are raising alarms about potential market overvaluation and the likelihood of a correction in 2026. Historical data supports the notion that stocks often face downturns after periods of significant gains. Furthermore, indications point toward the possibility of rising inflation rates, which may further strain consumers and investors alike.
In light of these developments, it may be prudent for investors to reassess their portfolios, particularly reducing exposure to volatile stocks and focusing on durable businesses that can withstand various economic cycles. Holding cash reserves is also advisable, positioning investors to take advantage of opportunities during potential market dips in the coming year.
