The Bull Market's Final Gasp: Policy Support Meets Fragile Foundations

The bull market's fourth consecutive year of gains is being driven by a powerful, if fragile, dual engine. On one side, the fundamentals appear solid. Goldman Sachs Research forecasts the S&P 500 to produce a 12% total return in 2026, with earnings per share (EPS) to increase 12% this year. This rally is supported by a resilient economy and the expectation of continued Federal Reserve easing. Yet, this optimistic setup is built on a foundation of historically high valuations and extreme market concentration, creating a central tension that will define the year ahead.

The policy tailwind is clear. The expectation of a fed funds rate will fall from its current range is already reflected in current valuations, providing a supportive backdrop for equities. At the same time, the earnings engine is firing. Double-digit earnings growth is "providing the fundamental base for a continued bull market," driven by healthy economic growth, corporate profit strength, and an emerging productivity boost from AI adoption. This combination of steady growth and easing policy forms the core of the bullish case.

But the market's elevated price tag introduces significant vulnerability. The S&P 500 trades at a forward price-to-earnings (P/E) ratio of 22x, matching the peak multiple of 2021 and approaching the record high of 2000. More critically, the market's capitalization is the most concentrated on record, with the top tech stocks accounting for a dominant share of returns. This concentration has been a clear positive, but it also embeds substantial idiosyncratic risk, making the entire index overly dependent on the continued strength of a handful of companies.

This fragility is hinted at by a leading indicator. The Conference Board's Leading Economic Index declined again in September, marking a second consecutive monthly drop. The index fell by 0.3% last month, with weakening expectations from consumers and businesses leading the contraction. While stock prices themselves contributed positively to the index, the broader signal points to slowing economic activity at the end of 2025 and into early 2026. This potential near-term weakness directly challenges the growth narrative underpinning the bull market's lofty valuations.

The setup, therefore, is one of powerful momentum meeting a high-wire act. The dual engine of policy easing and resilient earnings is keeping the rally alive, but the market's record-high concentration and stretched valuations mean any stumble in the economic outlook could amplify downside risk. The coming year will test whether the fundamental growth is broad and durable enough to justify the price.

The Fragile Engine: Labor Market Divergence

The bull market's foundation rests on a resilient economy, but its engine is showing signs of uneven wear. While the headline unemployment rate has held steady, the underlying data reveals a labor market in a state of balanced slowdown, masking deeper sectoral fragility. Job growth has slowed notably from mid-2024 to mid-2025, a trend that typically signals rising unemployment. Yet the rate changed relatively little over that period. This apparent stability is explained by a joint stepdown in both labor demand and labor supply, where the decline in payroll employment has been matched by a similar slowdown in labor force growth. In other words, the economy is creating fewer jobs at the same time fewer people are entering or re-entering the workforce.

This balanced picture, however, is deceptive. It masks a severe concentration of hiring. The vast majority of job growth in the first half of 2025 has been limited to a single industry-education and health services-with other broad sectors contracting or showing almost no growth. This divergence suggests the labor market is not weakening uniformly but is instead stagnating across the board, with only one sector providing a narrow source of expansion. Furthermore, declining rates of labor force participation play a significant role in the slowing of labor force growth. Since participation tends to respond to the cyclical strength of the labor market, this trend points to a weakening environment for workers more broadly.

The implications for the economic and market outlook are significant. A labor market that is slowing in both demand and supply may explain the stable unemployment rate, but it also suggests underlying fragility. This stagnation in job creation and workforce expansion could pressure consumer spending, as fewer new jobs mean less income growth for households. For corporations, it may signal a tighter labor market for the sectors that are still hiring, potentially putting upward pressure on wages and margins. This directly challenges the pillar of resilient corporate earnings that supports the bull market.

The resilience of the economy and corporate earnings is a key pillar supporting the bull market, but it faces risks from policy actions like tariffs and pre-election stimulus. As noted, these measures could stoke inflation and put pressure on margins. The labor market's divergence adds another layer of vulnerability. If the concentration in education and health services is not sustainable, or if the broader stagnation deepens, it could accelerate the slowdown in consumer demand that policy actions are designed to counter. The market's high valuations leave little room for error, making the fragility of this economic engine a critical risk to the bull market's trajectory.

Structural Shifts and the AI Premium

The character of the rally is undergoing a subtle but important transformation. While the bull market's engine remains powered by earnings growth, the source of that growth is becoming more selective. Goldman Sachs Research highlights a key structural shift: AI investment is expected to increase this year even as the growth in capex decelerates. This divergence signals that capital is being redeployed, not necessarily expanded. The focus is narrowing from broad investment to targeted spending on new technologies, with AI adoption emerging as a primary driver of corporate profit strength.

This shift has significant implications for market breadth. With valuations high and the market's capitalization the most concentrated on record, the search for returns is likely to extend beyond the traditional tech leaders. The narrative is moving toward a "broadening bull market," where investors look for diversification among styles and sectors to capture gains. This could mean a rising focus on companies outside the technology sector that benefit from new AI capabilities-manufacturers using AI for efficiency, healthcare firms leveraging data analytics, or financial institutions deploying automation. The potential for this broadening is a positive, as it could reduce the index's dependence on a handful of mega-cap stocks and make the rally more resilient.

Yet the effectiveness of this diversification depends on a critical condition: the persistence of earnings growth across different market styles and sectors. The historical appeal of a 60-40 portfolio-60% stocks, 40% bonds-lies in its ability to smooth returns through different economic cycles. But in a high-valuation environment, that diversification benefit may be tested. If the earnings growth that is supposed to drive returns in 2026 fails to materialize broadly, the portfolio's traditional risk-reward profile could break down. The market's high price tag means that any sector-specific weakness could have amplified effects.

The bottom line is that the rally is evolving from a simple story of concentrated tech strength to a more complex tale of selective investment and broadening opportunity. The AI premium is real, but its payoff will be measured not just in stock prices, but in the durability and distribution of corporate profits. For the bull market to sustain its momentum, this new engine must deliver growth that is both strong and widely shared.

Catalysts, Scenarios, and the Path Ahead

The bull market's endurance hinges on a single, critical test: whether projected earnings growth can materialize to justify today's elevated prices. Goldman Sachs Research forecasts 12% earnings per share growth in 2026, a figure that is meant to provide the fundamental base for continued gains. Yet the market trades at a forward P/E of 22x, a multiple that leaves little room for error. The primary catalyst, therefore, is the alignment between this optimistic profit outlook and actual corporate profitability. If earnings meet or exceed expectations, the high valuations can be supported. If they falter, the market's fragile foundation could crack.

This scenario is complicated by a constellation of risks that could pressure margins and disrupt the growth narrative. First, policy actions like tariffs and pre-election stimulus have the potential to stoke inflation, directly threatening corporate profits. Second, the labor market's underlying fragility presents a second front. The sectoral divergence, where job growth is limited to a single industry while other sectors stagnate, could accelerate into broad-based weakness. This would undermine consumer spending and corporate demand, challenging the resilient economic backdrop. Third, the AI investment boom itself carries overheating risks. While Goldman forecasts AI investment to increase even as capex growth decelerates, a misallocation of capital or a sudden cooling in the technology cycle could deflate the productivity premium that is currently boosting earnings.

For investors, the path ahead requires vigilant monitoring of two leading indicators. The first is the Conference Board's Leading Economic Index, which has shown a sustained downturn, falling for two consecutive months. A third straight decline would signal a deepening slowdown in economic expectations, directly threatening the earnings growth forecast. The second is the labor market's sectoral composition. Any broadening of weakness beyond education and health services would confirm the stagnation noted earlier, a red flag for the consumer and corporate earnings outlook.

The bottom line is one of high-stakes calibration. The structural shifts toward AI and a potential broadening of the bull market offer a positive narrative. But they must overcome the headwinds of policy risk, labor market fragility, and a market priced for perfection. The coming months will reveal whether the market's dual engine of policy easing and earnings growth is powerful enough to sustain the rally, or if the fragile foundations will finally give way.