3rd Quarter 2026: Market and Economy

The S&P 500 is up 86% over the last three years; surely that can’t continue! Inflation is going to cut into profits! High interest rates are going to halt the economy! The AI bubble is about to burst!

That’s how it felt when we started 2026. Add in conflict in the Middle East that spiked oil prices and there are plenty of reasons for stocks to fall. And yet, here we are looking to close out what has been another good year for investors.

The third quarter wasn’t particularly strong for stocks, but they held up well despite higher energy costs, a Fed rate hike, and yoyoing sentiment on AI. The S&P 500 added another 2% and is now up nearly 13% for 2026, which means stocks have more than doubled since the start of 2023.

We’re happy with the growth our clients’ portfolios have earned. I say “earned” intentionally. Successful investing is never passive. The best returns come to those willing to stay the course through all the uncertainty.

Diversification has been important in 2026 as leadership has frequently shifted from one area of the market to another. Despite very different returns this quarter, large-cap, mid-cap, small-cap, and international stocks all have surprisingly similar returns for the year.

Well-Earned Returns

I started this commentary with several of the most frequently mentioned concerns. So, do stock fundamentals support the continued bull market? The good news is that for now, earnings growth has been spectacular. S&P 500 earnings in the second quarter of 2026 were 52% higher than a year ago. Analysts expect year-over-year earnings to be 29% higher in the third quarter and are now projecting 32% earnings growth for all of 2026, according to FactSet.

So, while stock returns have been solid this year, profit growth has been even better. That means stocks have given us a nice return and gotten cheaper. On December 31, 2025, every $1 of S&P 500 profits cost $22.30 to buy. Today, $1 of profits cost $19.30. That’s a 15% discount. It’s not often that we see account values rise and valuations fall at the same time. Looking forward, strong earnings growth helps show a pathway for stock prices to continue to rise.

Please don’t hear what I’m not saying. That doesn’t mean stocks are necessarily cheap. Valuations are still above the average compared to the past 30 years. What we can say is that stock prices are less expensive on an earnings basis than where they started the year.

Looking ahead, the engine driving this spectacular profit growth is also the biggest risk to future earnings. Much of the growth continues to be powered by the AI buildout which permeates several industries from mega-cap technology companies to electric utilities, construction, and basic material suppliers.

Hard-Earned Interest

While stocks continue to do well in 2026, bonds have had a rough go of it. Even with the interest they have paid, taxable bonds are down 2.9% for the year and municipal bonds have fared even worse, losing 4.2% after a rough third quarter. Zooming out doesn’t look much better. Going back to the start of 2022, bond returns have been negative as stocks have risen.

But it isn’t all bad news. Bond prices and interest rates move like a seesaw. When one goes up, the other goes down. If new bonds are paying a higher interest rate, the price of older bonds fall to match the new rates. No one would want to buy a bond issued five years ago paying 3% if they can make 5% from a new issue.

There are two main forces pushing interest rates higher right now. The first is one we have talked a lot about over the past several years. Inflation remains stubbornly above the Federal Reserve’s 2% target. The most recent CPI inflation report for August showed prices rose 3.4% overall over the past year.

The Fed is taking action, recently raising its Fed Funds rate by 0.25%. The thought is that higher borrowing costs will convince people and businesses to cut back on spending, which will lower demand and slow the pace of rising prices. Now 0.25% is not a big jump, but it is the first rate hike in three years and more importantly, it signals that the Fed doesn’t think inflation will come down on its own any time soon. That pushes interest rates up for borrowers and for most of the bonds you own.

Second, borrowers are facing new competition. Building out AI infrastructure (think: data centers) is really, really expensive. In June, JPMorgan Chase estimated $4.1 trillion in debt for AI projects will be needed through 2030. And that could be an underestimate. AI projects are now competing with governments and corporations for capital, giving bond investors more negotiating power to demand higher yields.

Combine these two forces and you can see why interest rates have been steadily rising this year and why the yield on 10-year Treasury bonds is at the highest level since 2007. Unfortunately, that also means bond prices are trading at their lowest level in nearly 20 years as well.

We never like to see the value of anything we own fall but at least with bonds, there is a silver lining. The outlook for bonds going forward looks better than it has in a long time because bonds are paying more. For much of the 2010s, bond portfolios offered investors very little income. Today, a diversified portfolio of taxable bonds can yield 5% or more, meaning investors are finally earning a meaningful amount to lend their money. When we are taking gains off the table from the rising stock market, those proceeds are being put into bonds that now will continue to add to the portfolio’s growth.

I can also tell you that we aren’t taking extra risks to eke out higher yields. There are a lot of risky AI projects offering higher yields that are attracting a lot of money. We don’t pretend to know which ones will work out and which ones will be total losses, and so we are avoiding making big investments at the riskier end of the curve.

Investing in Imperfect Markets

Every generation seems to think they are living through uniquely difficult times. The same could be said for most investors. Things are always clear in hindsight but not so much when you’re looking forward. There are still plenty of reasons stocks can fall: inflation, war, or a bursting bubble. An approaching midterm election will soon add another layer of uncertainty.

Any and all of those reasons could contribute to the next bear market. And we will certainly have another bear market. It could start next month or in another five years. The spark that initially sends stocks lower is almost always something experts and pundits didn’t see coming and each bear market’s duration is almost just as unknowable. It could last weeks, like we saw in 2020, or years, like what followed the dot-com bust.

The great returns the market has given us in recent years weren’t earned because conditions were perfect. In fact, conditions never were. That will remain true in the years ahead. That’s why it requires a portfolio built for uncertainty. The good news today is that a diversified portfolio has continued to grow, and higher bond yields are creating opportunities that haven’t existed for a long time, which helps offset some of the uncertainty of future stock returns.

This information is believed to be accurate at the time of publication but should not be used as specific investment or tax advice as opinions and legislation are subject to change. You should always consult your tax professional or other advisors before acting on the ideas presented here.