Analysis-AI spending, strong corporate profits, Fed rate cuts seen as key to 2026 stock market?

By Lewis Krauskopf

NEW YORK, Dec 24 (Reuters) - The U.S. stock market is closing the books on a third straight year of double-digit percentage gains. A fourth stellar year in 2026 may be a tall order, requiring strong earnings, a dovish Federal Reserve and strong artificial intelligence spending.

The bull market for U.S. stocks that started in October 2022 has been propelled by AI optimism, interest rate cuts and the economy continuing to grow despite fears of a recession. The gains were achieved during a rollercoaster year which saw shares dive?after the Trump administration unveiled bigger-than-expected tariffs in April. The benchmark S&P 500 is now up over 17% ?in 2025 with a few trading days left, after rising 23% in 2024 and 24% in 2023.

For another year of strong double-digit percentage returns, markets need "everything firing on all cylinders," said Sam Stovall, chief investment strategist at CFRA.?

"A lot of headwinds indicate to me ?that while we could end up with a surprisingly good year, I don't think it will be another great year," said Stovall, who has a year-end 2026 price target ?of 7,400 which would be up about 7% from current levels.

Many market strategists foresee a strong 2026, with some S&P 500 targets ?equating to over 10% gains, including Deutsche Bank's ?target of 8,000, which is roughly 16% higher for the index.

WILL EARNINGS AND AI PROVIDE A LIFT?

Stock bulls point to the upbeat outlook for U.S. corporate profits. Earnings among S&P 500 companies are projected up over 15% in 2026, on the ?back of a solid 13% rise in 2025, according to Tajinder Dhillon, head of earnings research ?at LSEG.?

Earnings growth is expected to be driven by a broader swath of companies, as fiscal stimulus and easier monetary policy help shore up the economy and consumer spending, rather than confined to a small group of tech and tech-related behemoths. Those megacap companies, which include Nvidia, Apple and Amazon and are ?known as the "Magnificent Seven", posted 37% profit growth in 2024 compared to 7% for the ?rest of the S&P ?500, according to LSEG's Dhillon.

In 2026, that gap is poised to narrow significantly: the Mag 7 are expected to have earnings growth of 23% against 13% for the rest of the index.

"An improvement in earnings growth for many of the 493 other stocks in the S&P 500 -- and we've seen some of that already -- ?that certainly would help the stock market get to double-digit returns next year," said Kristina Hooper, chief market strategist at Man Group.

Profit growth will be critical because stock valuations will be hard-pressed to expand beyond lofty levels, investors said.

One boost to valuations has been excitement over AI, including massive spending for infrastructure and expected voracious demand for its application. Recently, questions about the returns from the capital spending dented tech and other AI-linked shares, and will likely remain a critical theme in 2026.

"If companies start to pull back on the capex that they have already guided to and the market loses confidence in the returns that the AI investment will generate...you're probably looking at more of a flat or even a modestly down year," said Jeff Buchbinder, ?chief equity strategist for ?LPL Financial.

DOVISH FED, MIXED HISTORICAL SIGNALS AND WILDCARDS

Another critical factor for a strong stock market year, investors said, is the economy softening enough to pave the way for calming inflation and more rate cuts, but not so much that it falls into a recession. Fed funds futures indicate investors expect at least two more ?quarter-point reductions in 2026 following 175 basis points of cuts in 2024 and 2025.

"Probably the biggest driver I'd be looking for is the Fed maintaining a dovish stance," said?Yung-Yu Ma, chief investment strategist at PNC Financial Services Group.

Investors are watching President Donald Trump's choice of a Fed chair, expected early in 2026, as a sign the central bank will be more dovish but are concerned about its independence being tested.

Historical data yields a mixed story about potential returns in 2026. On the plus side, of seven bull markets that made it to year four since 1950, the fourth year has averaged a gain of 12.8%, posting positive performance for the year in six of seven occasions, according to LPL Research.

However, U.S. midterm election years, when the election of a new Congress injects uncertainty about the makeup of the federal government, tend to ?be subpar. The S&P 500 is up just 3.8% on average in midterm years, compared to an average 11% during the other three years of a presidential term, according to CFRA's Stovall.

There are also a host of possible wildcards. For example, while tariffs receded as the dominant market issue after driving extreme volatility in early 2025, the relationship between the U.S. and China, the world's two largest economies, could sway stocks in 2026, said PNC's Ma.

"There's actually a ?possibility for a breakthrough between the U.S. and China that could be a positive catalyst that is not baked into expectations," he said.

?

(Reporting by Lewis Krauskopf; editing by Megan Davies and Anna Driver)