Federal Reserve Warns Investors: Potential Stock Market Crash by 2026

Federal Reserve officials have raised concerns about the elevated valuation of the stock market, suggesting potential instability ahead. The S&P 500 index recorded a significant rise of 16% in 2025, marking its third consecutive year of double-digit returns. However, this trend may be at risk of reversing in 2026, particularly given the historical challenges associated with midterm election years.

Concerns Over Elevated Stock Market Valuation

In September, Federal Reserve Chairman Jerome Powell highlighted that “by many measures… equity prices are fairly highly valued.” Since then, the S&P 500’s prices have continued to rise, leading to an increasingly stretched valuation. Currently, the index is one of the most expensive in its history, prompting warnings from various Federal Reserve officials.

Historical Performance Trends During Election Years

Historically, the stock market tends to perform poorly during midterm election years. Since the creation of the S&P 500 in 1957, there have been 17 such election years, with an average return of just 1% (excluding dividends), significantly lower than the long-term average return of 9%.

• The S&P 500 has shown a consistent decline during midterms when new presidents are in office, averaging a drop of 7%.
• This decline is often caused by policy uncertainty, as the president’s party typically loses congressional seats.

Despite these challenges, market conditions tend to improve after midterm elections. Historically, the S&P 500 has recorded an average return of 14% in the six months following these events.

Warnings from Federal Reserve Officials

In addition to Chairman Powell, several Federal Reserve officials have echoed concerns about the stock market’s high valuations. During the October FOMC meeting, minutes revealed discussions about stretched asset valuations. Fed Governor Lisa Cook warned in November about an increased likelihood of significant asset price declines. She referred to the Financial Stability Report, which indicated that the S&P 500’s forward price-to-earnings (P/E) ratio was nearing its historical limit.

Current Market Valuations

As noted by Yardeni Research, the S&P 500’s forward P/E ratio stands at 22.2, considerably above the ten-year average of 18.7. This ratio has surpassed 22 only three times in history, each time proceeding a sharp market decline:

• Dot-com Bubble: The S&P 500’s forward P/E ratio exceeded 22 in the late 1990s, leading to a 49% drop by October 2002.
• COVID-19 Pandemic: A similar ratio was noted in 2021, followed by a 25% decline by October 2022.
• Trump’s Election: The ratio also peaked in 2024, resulting in a 19% drop by April 2025.

Looking Ahead: Potential Challenges for 2026

While a forward P/E ratio above 22 does not guarantee an imminent market crash, historical patterns indicate that the S&P 500 often experiences significant declines after reaching such valuations. Given the added uncertainty surrounding midterm elections, it is reasonable to forecast that the stock market may face challenges in 2026, prompting investors to proceed with caution.