Despite a U.S. government shutdown that has delayed crucial economic reports typically guiding trading, the stock market continues its robust ascent, defying expectations. Both the S&P 500 and Dow Jones Industrial Average achieved all-time highs on a recent Friday, signaling a broad rally that extends beyond the usual dominance of Big Tech. While artificial-intelligence powerhouses like Nvidia are still driving growth, the current market surge is remarkably widespread, with almost all sectors experiencing gains. This includes the Russell 2000 index of smaller stocks, which has finally surpassed its prior all-time high after nearly four years. Adding to this unusual confluence of successes, gold also hit a record, and the most popular U.S. bond fund is on track for its best annual performance in at least five years.

Historically, past government shutdowns have had a minimal impact on both the stock market and the broader economy, and Wall Street is betting on a similar outcome this time. Many professional investors remain optimistic, anticipating further market gains even after a significant 35% surge from its low in April. However, this optimistic outlook is predicated on several key factors, and failure to meet these expectations could quickly turn the market's 'pretty picture' into a 'much uglier' scenario.

One of the primary concerns is that stocks are currently deemed expensive. This criticism is easily made given the market's nearly relentless rally since April, which has seen stock prices climb much faster than corporate profits. A measure popularized by Nobel-winning economist Robert Shiller, which considers profits over the preceding 10 years, places the S&P 500 near its most expensive level since the 2000 dot-com bubble. This has led some critics to draw parallels between the current AI bonanza and the dot-com era, which ultimately saw the S&P 500 halve in value. The concern isn't limited to large-cap stocks; Ann Miletti, head of equity investments for Allspring Global Investments, points to the disproportionate rise in speculative stocks, particularly smaller, money-losing companies, which have outperformed their profitable counterparts. While generally optimistic about 2026, Miletti finds these 'little bubbles' concerning, as they typically signal potential issues.

For stock valuations to normalize, either prices must decrease, or corporate profits must significantly increase. This places considerable stakes on the upcoming profit reporting season, where companies like PepsiCo, Delta Air Lines, and JPMorgan Chase are set to announce their summer earnings. Analysts are projecting a collective 8% growth in earnings per share for S&P 500 companies from the previous year, according to FactSet. Companies not only need to meet this target but also provide forecasts for sustained growth through the rest of this year and into the next, all while navigating challenges such as tariffs, persistent inflation, and a volatile economy.

Another crucial expectation driving the market's boom is that the Federal Reserve will deliver a series of interest rate cuts. Lower rates are beneficial for the economy as they reduce borrowing costs for households and companies, stimulating spending. They also make investors more willing to pay higher prices for various assets, including stocks and bonds. Wall Street traders largely anticipate at least three more rate cuts by the Fed by mid-next summer. Fed officials themselves have indicated a likelihood of cuts due to a slowing job market. However, Chair Jerome Powell has cautioned that plans could change rapidly, primarily because inflation remains stubbornly above the Fed's 2% target, and rate cuts could potentially fuel further inflationary pressures. Miletti emphasizes that interest rate expectations are currently 'driving everything,' warning that if the Fed cuts less than anticipated, 'speculative' areas of the market, not based on fundamental strength, 'will have some real problems.'

Finally, the artificial intelligence (AI) boom itself needs to deliver on its promises. Yung-Yu Ma, chief investment strategist at PNC Asset Management Group, believes AI-related stocks are not overly expensive, provided the industry maintains its rapid growth and sales. Hopes for AI are also contributing to suppressed longer-term interest rates and inflation concerns. For the market's current trajectory to be sustainable, AI must significantly boost economic productivity to counteract the inflationary and interest-rate pressures stemming from the substantial global government debt. Ma articulates the high stakes: 'If we do achieve these benefits for companies and for people’s lives, everything can go well for years. I think everyone is tying their fortunes to that ship, whether they realize it or not.'