The tech sector’s free cash flow margin, near 20%, is more than double its late 1990s level, underscoring both robust profitability and the capacity to self-fund AI investment.
Despite a tempestuous start, U.S. equities are on track to notch a third consecutive year of double-digit gains – the third instance since the Great Financial Crisis (GFC). Given this heady run, investors are grappling with three central questions for 2026:
- Are stocks too expensive? Valuations are undoubtedly rich, but there are some compelling justifications. First and foremost, profit growth has been impressive, tracking for four consecutive quarters of double-digit earnings growth. Earnings also comprise the largest contribution to total returns in the United States compared to its global counterparts on an absolute and relative basis. This resilience in valuations and profits comes with policy rates above 4% for the last three years, a softer consumer, less fiscal stimulus and few cyclical tailwinds. In addition, structural factors, like shifting index composition from value to growth, may also warrant higher valuations.
- Can earnings remain this robust? Profit growth is poised to continue its remarkable run, although expectations may be a tad optimistic, hinging on tech and taxes. S&P 500 earnings are expected to grow 11% in 2025 and another 13% in 2026. Magnificent 7 earnings growth may decelerate slightly to 20%, while the rest of the index is expected to grow 11%, contributing 64% of overall profit growth. However, this “broadening out” has thus far failed to materialize, and 2026 Mag 7 earnings estimates have been revised up by 3.4% vs. -1.2% for the S&P 493 since the start of the year. Additionally, estimates call for earnings growth to accelerate in 2H26 without any clear catalyst.
Provisions from the OBBBA around capex and R&D expensing and bonus depreciation could postpone certain tax liabilities, improving free cash flow for R&D-intensive (tech, health care) and capital-intensive (industrials, energy) companies. However, if companies increase investment, this effect would be neutralized. Finally, consumer sectors may benefit from a consumption boost from tax refunds, but that could be offset by tariff costs hitting already slim margins. - Is AI a bubble? Unlike past episodes of speculative excess, today’s AI cycle is being largely financed by profitable, cash-rich firms and underpinned by robust demand. The tech sector’s free cash flow margin, near 20%, is more than double its late 1990s level, underscoring both robust profitability and the capacity to self-fund AI investment. AI spending is also translating into monetized demand for AI hardware, cloud services and software, helping justify continued investment. Indeed, bubbles burst into nothing, but the AI theme is building real infrastructure to meet growing demand.
Still, markets are struggling to price a technology that is advancing at exponential speed. Earnings growth has been extraordinary, but expectations have risen even more so. Tech sectors have accounted for 36% of S&P 500 earnings and 56% of the index’s capital spending growth over the last 12 months, leaving markets vulnerable to any missteps, such as a slowdown in business adoption, power constraints or faster-than-expected hardware obsolescence. The stakes are high, and visibility into the ultimate winners limited, but this looks less like a bubble and more like the tumultuous beginnings of a structural transition.
Whether bubble or boom in valuations, profits or innovation, selectivity and balance are critical for portfolios. Within growth, the tech sectors have obvious appeal given their exemplary profits, while consumer discretionary has lagged this year, beleaguered by tariff pressures, a softening consumer and a relatively weak showing from the sector’s Mag 7 names. Within AI, beneficiaries should continue to broaden out from the innovators (tech) to the enablers (industrials, utilities) and the adopters (financials, health care). Traditional value sectors like energy and consumer staples may continue to struggle due to low oil prices and a deteriorating low-end consumer, while financials boast resilient earnings and differentiated catalysts like deregulation and yield curve steepening.
While markets appear undeterred, even with solid fundamentals markets can correct, investors should be prepared for both success and setbacks.