Capital Economics predicts the S&P 500 stock market rally will continue through 2026 before experiencing a significant correction in 2027, according to recent client notes from the research firm. The firm forecasts the benchmark index could climb as high as 8,000 in 2026 before retreating to 7,000 the following year, representing a decline of approximately 13% to what it describes as a more normal level.
Economists Jennifer McKeown and William Jackson wrote on Monday that a plausible scenario involves the stock market collapsing under its own weight as investors reassess stretched valuations for major technology firms. However, they noted that investors would still maintain belief in artificial intelligence’s long-term benefits for the broader economy. In the worst-case scenario, the firm warned that a correction of as much as 30% remains possible.
Stretched Valuations Present Primary Risk
According to Capital Economics, current stock market valuations are elevated but not yet excessive given strong corporate earnings. Thomas Mathews, the head of markets at the firm, noted that technology stocks in particular have reached pricey levels and could continue climbing higher. The price-to-forward 12-month earnings ratio in the US tech sector briefly reached its highest level since the dot-com bubble last year before easing.
Mathews suggested that investor enthusiasm for artificial intelligence could push valuations beyond sustainable long-term levels. Additionally, he observed that as the rally progresses, rising valuations appear more likely than not. The firm emphasized that while current metrics remain within reasonable bounds, the trajectory points toward potential overextension.
Tech Earnings Growth Faces Concentration Risk
While the earnings backdrop remains positive overall, Capital Economics identified a key vulnerability in the concentration of growth within the technology sector. The firm noted that earnings growth in the S&P 500 has been largely driven by tech companies, creating dependency on a narrow segment of the market.
Mathews speculated that a bubble could emerge in earnings expectations rather than valuations themselves. Meanwhile, he acknowledged that rapid earnings growth at tech companies will eventually moderate, even if that slowdown does not materialize this year. This concentration represents a significant structural risk to the ongoing stock market rally.
Economic Slowdown Could Derail Rally
The artificial intelligence-fueled rally faces potential disruption if the US economy experiences meaningful deceleration, according to Mathews. However, he observed that economic growth currently appears healthy and the risk of recession seems remote. Nevertheless, any significant economic weakness could undermine the conditions supporting elevated stock prices.
AI Demand and Chinese Competition Pose Threats
Capital Economics highlighted risks that artificial intelligence may not deliver returns matching investor expectations or that China could advance ahead of the United States on the technology frontier. Mathews pointed to persistent concerns about AI capital expenditures, an issue that has triggered multiple market sell-offs over the past year.
In contrast, concerns about Chinese AI innovations like DeepSeek sparked a steep sell-off in early 2025. Mathews acknowledged that Chinese competition poses a significant threat to major US tech companies at face value. However, he cited factors including US companies’ hardware advantages that could provide protection for the tech sector.
Geopolitical Tensions Add Uncertainty
Markets have already experienced volatility this year from geopolitical tensions, with the firm noting recent disruptions stemming from President Donald Trump’s threats regarding Greenland. Europe represents approximately 40% of revenue for US tech firms, making geopolitical conflicts with allies and partners particularly consequential, according to Capital Economics’ analysis.
The firm’s analysts indicated that for geopolitical risks to have lasting effects on the AI rally, they would need to significantly impact the US economy or tech company earnings through alternative channels. The timeline for any potential stock market correction remains uncertain, with Capital Economics maintaining that multiple risk factors would need to converge to trigger the anticipated decline in 2027.
