A Stock Market Priced for Perfection Can Still Have a Very Good Year

Traders at the New York Stock Exchange on Christmas week. (Michael Nagle/Bloomberg)

Christmas week sparked a Santa Claus rally, but a stock market that’s posted three straight years of above-average gains will have to wrestle with a simple fact of life—it’s incredibly hard to stay perfect.

The setup, of course, suggests otherwise. After a muted beginning to December, the S&P 500 index was up 1.4% this week, crossing 7000 for the first time ever, while the Dow Jones Industrial Average advanced 1.1% and the Nasdaq Composite gained 1.3%, helped by rekindled interest in the Magnificent Seven. What’s more, the Cboe Volatility Index, or VIX, closed at 13.47 on Wednesday, its first foray below 14 in more than a year.

Created with Highcharts 9.0.1Market SnapshotSource: FactSet

Created with Highcharts 9.0.1State Street Financial Select Sector SPDR ETFS&P 500 IndexNASDAQ Composite IndexDow Jones Industrial AverageDec. 22Dec. 2600.51.01.52.0%

Profits should cooperate. The S&P 500 is expected to grow earnings by 15% in 2026, per FactSet, while net profit margins are forecast to hit 13.9%, the highest since FactSet began tracking the metric in 2008. Meanwhile, economic growth forecasts are moving higher after a stellar third-quarter gross-domestic-product reading, inflation isn’t expected to be a problem, and the labor market should be able to hold on.

Look closer at this past week’s action, however, and the flaws with this argument reveal themselves. While it was comforting to see all of the Mag Seven stocks plus Broadcom rise this past week, any hint that artificial-intelligence spending has become overzealous or that funding will fall through could cause the group to slip again. Keep an eye on Oracle, whose stock has gained 10% this week but is still down more than 35% over the past three months, for signs of renewed trouble.

And then there’s the economy. While the GDP reading released on Dec. 23 showed the U.S. expanding at the fastest level in two years, it also raised concerns about inflation and whether the Federal Reserve would be able to deliver more rate cuts in 2026. Broader stock indexes briefly slipped as a result, while Treasury yields rose and energy stocks and gold, which are particularly sensitive to rising prices, moved higher.

“Inflation is just not dead and gone,” says Richard Bernstein Advisors CEO Richard Bernstein. “I think the Fed is going to be a little more constrained in terms of their ability to cut rates and cut rates as quickly or as meaningfully as people think right now.”

A continued rise in Treasury yields could also cause issues, notes Piper Sandler Chief Investment Strategist Michael Kantrowitz. Since 2023, a rise above 4.25% in the 10-year Treasury yield has coincided with weaker equity returns and a doubling in realized equity volatility, he says. The 10-year closed as high as 4.17% this past week before trading at a recent 4.13%.

But there’s a line in the sand on the downside—a line drawn with employment data. If the labor market continues to slow, the Fed might still decide to cut interest rates, providing a boost to stocks, though too much weakening in the jobs market wouldn’t be a welcome sign. The AI trade, too, may find a comfortable ground between too hot and too cold, one that allows the market to continue its winning ways.

That presents a narrow tightrope for markets to keep the rally going in 2026 once again. Still, as the past three years have shown, it doesn’t have to be perfect.

Write to Josh Schafer at josh.schafer@barrons.com. Follow him on X and subscribe to his Substack Searching for Signals with Barron’s.