Heading into last year, I predicted that the broader benchmark S&P 500 (^GSPC +0.41%) index would experience a 10% correction at some point in 2025. While I turned out to be correct, I was not nearly aggressive enough in my call, as the S&P 500 fell by nearly 20% in April (and indexes like the Nasdaq Composite (^IXIC +0.90%) fell even further) due to President Donald Trump's surprising tariff announcements, almost entering bear market territory.
However, as most investors know, this didn't last long, as Trump eventually delayed and somewhat eased tariffs, leading to a swift and fervent market rebound. The S&P 500 would ultimately finish the year over 16% higher.
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One of my main arguments for a correction last year was the elevated valuations and the market's fragility. While I didn't see the steep April sell-off coming, I do believe this theory was correct, and that stocks sold off so much in April because, given valuations, it didn't take much to trigger a big decline.
The market remains elevated and has gotten off to an interesting start to the year, with investors rotating out of large artificial intelligence (AI) stocks and into small caps and sectors that have been out of favor. Here's why another 10% correction is likely this year.
The market can still do well in 2026
I'll admit here that while a 10% correction sounds intense, it's not that bold a call, since these kinds of corrections happen quite often. In a 2019 report from Guggenheim, the investment firm pointed out that since 1946 (80 years), there have been 84 declines in the stock market between 5% to 10%. On average, the market recovers in one month from these corrections.
There have also been 29 declines of 10% to 20% in this period, with an average recovery time of four months. Whether it's due to technology or some other factor, the market also seems to react more quickly these days, making these kinds of big moves even more likely.
So I definitely think another correction could be on the way. What triggers it? Well, it's likely some event I am not currently aware of, but if I had to speculate right now, I am most worried about inflation or a more disastrous event in the AI space.
It's still not clear whether Trump's tariffs have fully worked through to consumer prices, and many market strategists are calling for inflation to rise before it dips again toward the end of this year. The longer inflation remains elevated, the more it will drain consumer savings and potentially send the economy into a recession.
While investors have cooled on AI stocks, we still haven't seen a cataclysmic event that could put the sector in serious danger and pause progress, as happened to the internet during the dot-com bubble. Again, it's hard to predict the future, but if a company like OpenAI encounters real struggles, that would impact the entire sector, given that there appears to be a lot of circular financing, where companies like OpenAI and Nvidia are funding their vendors and critical customers.
A correction doesn't mean the market can't finish the year in the green again. There have been several in recent years, and look how well the market has done. But investors should be aware of the potential for volatility.
