The S&P 500 and Nasdaq Composite have added 12% in 2026 despite a number of economic headwinds. That puts both indexes on pace for their fourth consecutive year of double-digit gains for the first time since the late 1990s.
However, investors recently got bad news about the economy. Inflation accelerated in September, as President Trump's decision to take military action against Iran continued to pressure energy prices. The Federal Reserve has already raised interest rates once, and further rate hikes are now more likely.
Higher interest rates threaten the stock market in two ways. They make bonds look more attractive relative to stocks, potentially drawing capital away from equities. They also raise borrowing costs for businesses, creating a direct headwind to corporate profit growth.
Accelerating inflation makes further interest rate hikes more likely
Inflation accelerated in September as the Iran war continued to disrupt global oil supplies. The Consumer Price Index (CPI) increased 3.7%, the highest reading since May, topping the consensus estimate of 3.6%, according to the Bureau of Labor Statistics.
Perhaps more concerning, core CPI increased 2.6% in September, the highest level since June. Core CPI measures underlying inflation by excluding volatile food and energy prices. The acceleration suggests that elevated energy prices are bleeding into other areas of the economy by raising manufacturing and transportation costs.
Federal Reserve Chairman Kevin Warsh has vowed on multiple occasions to restore price stability by returning inflation to its 2% target, a level last seen more than five years ago. The Federal Open Market Committee (FOMC) raised its benchmark interest rate by a quarter percentage point in September, and the latest inflation data makes further rate hikes more likely.
History says the stock market is headed for correction territory
Indeed, CME Group's FedWatch tool shows the most likely outcome is a second quarter-point rate hike at the December meeting, followed by a third quarter-point rate hike at the March meeting. That would bring the target range on the federal funds rate to 4.25% to 4.5%, a level last seen in August 2025.
That represents a dramatic change from January. When the year started, CME Group's FedWatch tool indicated that investors anticipated two quarter-point rate cuts in 2026. But inflationary pressure from President Trump's tariffs and military action in Iran have already led to one rate hike and more could follow in the coming months.
So what? Warren Buffett has often argued that interest rates are the most important factor in determining stock valuations. He once compared interest rates to gravity, explaining that higher rates put downward pressure on prices, while lower rates support higher valuations.
The Federal Reserve has initiated three rate-hike cycles in the last quarter-century, and the stock market has typically performed poorly in the aftermath. Following the first hike, the S&P 500 and Nasdaq Composite dropped by an average of 10% and 12%, respectively, at some point during the next three months. In other words, new rate-hike cycles -- like the one that started in September -- have frequently correlated with stock market corrections.
Investors should focus on long-term opportunities rather than short-term uncertainty
Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management, believes the stock market could move higher in the coming months. She writes, "The bull case remains intact, supported by strong earnings, accelerating investment in artificial intelligence, and a market that is less dependent on mega-cap technology leaders."
However, Shalett also identified several headwinds that could, under the right conditions, bring the bull market to an end. "Higher bond yields, elevated oil prices, policy uncertainty, and strain among lower-income consumers could test the ally as we move toward 2027."
Against that backdrop, investors should be cautiously optimistic. They should focus on high-quality stocks with strong fundamentals and reasonable valuations, while mentally preparing for a potential decline. But history says a decline would come with a silver lining. The S&P 500 has recovered from every past drawdown, meaning dips have always been buying opportunities.
