Stock Market Could Face a Significant Downturn in 2026—Here's What the Fed Isn't Saying

The Valuation Red Flag Nobody Wants to Talk About

The S&P 500 has delivered impressive returns lately—16% in 2025 alone, marking the third straight year of double-digit gains. But beneath this bullish facade lurks a troubling reality: the stock market is reaching price levels that have historically preceded sharp corrections.

Federal Reserve Chair Jerome Powell didn’t mince words back in September, stating that “by many measures, equity prices are fairly highly valued.” Since then, the situation has only intensified. The index now sports a forward price-to-earnings (PE) ratio of 22.2 times—a valuation that sits well above the 10-year average of 18.7.

Here’s what makes this concerning: Throughout modern market history, the S&P 500 has only breached the 22x forward earnings threshold three times. Every single instance ended badly.

When Rich Valuations Meet Market Reality: Three Historical Lessons

The Dot-Com Reckoning (Late 1990s) Investors threw caution to the wind, bidding up internet stocks to astronomical prices. The S&P 500’s forward PE ratio soared past 22. The consequence was brutal—a 49% crash by October 2002.

The COVID Era Miscalculation (2021) Markets misjudged the inflationary impact of pandemic stimulus and supply chain chaos. The S&P 500 hit 22x forward earnings. By October 2022, the index had plummeted 25% from its peak.

The Trump Trade Effect (2024) Optimism about pro-business policies sent valuations soaring above 22x forward earnings. But tariff uncertainties and geopolitical tensions created volatility—resulting in a 19% decline by April 2025.

The pattern is clear: a PE ratio above 22 doesn’t guarantee an immediate stock market crash, but the S&P 500 has consistently experienced significant declines within a reasonable timeframe after reaching such extremes.

Midterm Elections: A Historical Headwind for Equities

Adding fuel to this fire is the 2026 midterm election cycle. History reveals an uncomfortable truth about how markets behave during these political inflection points.

Since 1957, the S&P 500 has endured 17 midterm election years. During these periods, average returns have been a meager 1% (excluding dividends)—dramatically underperforming the market’s typical 9% annual return. The situation deteriorates further when a sitting president’s party faces midterms: the index has averaged a 7% decline.

Why? Midterms create policy uncertainty. The sitting president’s party traditionally loses Congressional seats, raising questions about the administration’s legislative agenda. Investors respond to this uncertainty by rotating away from equities, creating downward pressure.

However, there’s a silver lining. Research from Carson Investment Research shows that the six months immediately following midterm elections (November through April) have historically been the strongest period of the four-year presidential cycle, with average returns reaching 14%. Once political clouds clear, the rally often resumes.

What the Federal Reserve Really Thinks

Powell isn’t alone in flagging this risk. During October’s FOMC meeting, officials noted “stretched asset valuations” across financial markets, with several highlighting “the possibility of a disorderly fall in equity prices.”

Fed Governor Lisa Cook added her voice in November: “Currently, my impression is that there is an increased likelihood of outsized asset price declines.” The Fed’s Financial Stability Report reinforced this message, warning that the S&P 500’s forward PE ratio stands “close to the upper end of its historical range.”

The central bank is essentially sounding an alarm that few investors seem willing to heed.

Connecting the Dots: Why 2026 Could Be Treacherous

When you layer today’s expensive stock market valuation on top of midterm election year headwinds, the case for caution becomes compelling. While the stock market crash scenario isn’t certain, the confluence of these factors creates a meaningful risk environment for 2026.

That said, market timing remains notoriously difficult. The key for investors is acknowledging that elevated valuations combined with political uncertainty create conditions where patience and defensive positioning may be prudent strategies—at least until the post-election clarity materializes.