Will market momentum continue in 2026?

By Jim Allworth, Investment Strategist – RBC Dominion Securities

Turning first to the U.S. economy, the consensus estimate for U.S. GDP growth in 2026 currently sits at 2 percent.

In years where U.S. GDP growth has come in somewhere in the 1.1 percent to 2 percent range, the S&P 500 has typically struggled. It has delivered positive returns only 40 percent of the time, and the average return has been a chilly minus 3.4 percent. But when GDP growth has landed in the 2.1 percent to three percent range, the equity picture has brightened considerably, with the S&P 500 delivering positive returns 71 percent of the time and the average return coming in at a healthy 11.6 percent.

How does AI fit into the picture?

AI has been making a very large contribution to index earnings and to GDP growth. Recently, the 10 largest capitalization stocks in the S&P 500—eight of which are AI giants—traded at an average price-to-earnings (P/E) ratio near 30x earnings (vs. a long-term average 20x), while the rest of the index trades at 18.7x (long-term average 16.5x). [The TSX, which has very little if any exposure to the AI build-out, is trading at 19.4X versus a long-term average of 17.3x.] 

We think investors are willing to pay a premium multiple for the AI leaders because of their superior earnings growth and their perceived capability to deliver more in the future. We note that the rest of the market, as well as the TSX, while much cheaper than the mega-cap AI leaders, are expensive relative to their own historical average.

AI is also very important to GDP growth expectations in 2026 and beyond because of the dramatic growth in associated capital spending. The announced 2026 capex budgets for the biggest players add up to over USD$400 billion , although it remains an open question whether there will be sufficient surplus electric power available to run the fast-proliferating data centres.

Canadian equities are dependent on both economies

Whether or not the Canadian economy can avoid recession has to be looked at in conjunction with how the U.S. economy is faring. Big components of Canada’s stock market have a lot riding on the growth trajectory of the U.S. economy. Most Canadian banks and insurers, auto-related businesses, as well as energy, metals, forestry companies and others either have large U.S. operations or sell a significant proportion of their output to U.S.-based customers, or both.

Positive assumptions are not without risks

The consensus street estimate for 2026 S&P 500 price level one year out of about 7,700 if the S&P 500 were to appreciate in line with earnings. That would represent a market gain of about 13 percent from the late December level of 6,900.

However, achieving a 13 percent earnings gain in an economy growing at only 2 to 3 percent will be a tall order. We suspect that analysts believe the earnings of the mega-cap AI stocks will continue to grow rapidly no matter what the economy does, skewing the market P/E multiple higher in the process. This underlines what we think is the biggest risk to an optimistic outlook: any significant derailing of the AI juggernaut, were it to occur.

Source: FactSet; RBC Wealth Management

Position for less, be happy with more

In our view, the conditions necessary for the S&P 500 and the TSX to deliver high-single-digit total returns in 2026 (rather than the 13 percent-plus implied in today’s consensus forecast), are much less demanding and more likely to occur. They would include some slight further moderation in inflation, allowing another cut or two from the Fed (although perhaps not from the Bank of Canada), leaving S&P 500 earnings able to get close enough to the consensus $311 per share estimated for 2026.

As 2026 gets underway, we think portfolios should be invested up to, but not beyond, a predetermined long-term equity exposure with a plan for becoming more defensive when and if needed.

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