Three surprises for 2026: The curse of consensus in a market built on uncertainty
“Set your own rules and stick to them; never argue with the market; never make a play you can’t afford; never give way to irrational exuberance. Above all, don’t be a sucker.”
Turning the page on a decade of predicting capital market surprises evokes a sense of nostalgia. In some strange twist of fate, this forecasting business all started in 2016—a year defined by Brexit and Donald Trump’s shocking first presidential election victory. There have been plenty more surprises since then—trade wars, Federal Reserve (Fed) rate-hiking and cutting cycles, a global pandemic, the highest rate of inflation in more than 40 years, Russia’s invasion of Ukraine, the rise of AI, and many others.
Despite the sheer number of surprises over the past decade, predicting them hasn’t become any easier. Perhaps the lesson for investors is to prepare for surprises rather than try to predict them. Yet, as Chief Investment Strategist for State Street Investment Management, I’m still obligated to participate in the annual forecasting ritual.
Markets now process uncertainty differently
Uncertainty has always been part of markets. What’s changed is how it’s processed. Meme stocks, the popularity of Zero Days to Expiration (0DTE) options, and retail investors—who now account for 30% or more of daily US equity trading volume—have transformed the way investors think about markets and prediction.
That evolution is accelerating with the rapid growth of prediction markets. In October, Intercontinental Exchange, owner of the New York Stock Exchange, announced that it would invest up to $2 billion in prediction market darling Polymarket. Robinhood also has become a major partner of and the largest source of trading volume for Kalshi—with users trading through the Robinhood app. And an increasing number of capital markets companies are racing to build or buy their own prediction market capabilities.
Traders—using that definition loosely—can place money on sports, stocks, politics, economics, and everything in between all from the same app, in the palm of their hands. The lines between investing and gambling have never been more blurred.
Why process matters more than predictions
Investment outcomes are always uncertain. But the one thing investors can control is a consistent, disciplined, and repeatable investment process. Over time, a thoughtful approach—combined with a measure of luck—offers the best chance of long-term success.
I’ve applied the same forecasting formula for more than a decade. I focus on unloved assets with compelling valuations, where much of the bad news is already priced in and investor sentiment is decidedly one way.
As I predict three surprises for the 11th consecutive year, the forecasting environment has become more challenging. That’s why I’m going to heed legendary stock-market plunger Jesse Livermore’s advice and stick to my rules. Hopefully, I’m not a sucker.
Over the past 10 years, I’m a respectable 17 for 30, about 57% in accuracy. Although inching closer with each passing year, 30 observations are still too few to determine whether I have any forecasting skill or just dumb luck.
The number 11 is considered lucky and powerful in numerology. Here’s hoping.
My three surprises for 2026 are:
- Small caps beat large caps
- Inflation surprises to the downside
- Health Care outperforms the S&P 500® Index
1. Small caps beat large caps
2. Inflation surprises to the downside
3. Health Care outperforms the S&P 500 Index
1. Small caps beat large caps, David defeats Goliath
In January, US-listed ETFs registered $165 billion of inflows, the most ever for a January and more than the past three Januarys combined. Despite solid outperformance versus large-cap stocks in January, small-cap ETFs suffered $4.7 billion in outflows for the month.1
Although small-cap performance has kept pace with large caps since Liberation Day, investors remain skeptical—withdrawing more than $12 billion from small-cap ETFs over the past 12 months.2 Who can blame them? Small-cap performance has trailed large caps for nine consecutive calendar years, the longest losing streak ever.3
The result is a historically wide valuation gap. Relative to large caps, small caps are cheaper than they’ve been roughly 80% of the time.4 Also, market concentration has intensified—the five largest stocks now have a combined market capitalization more than six times that of the entire small cap universe. At the same time, small caps’ share of total US equity market capitalization has fallen to its lowest level on record.5
Small cap stocks are deeply out of favor. And the combination of weak sentiment, extreme concentration, and discounted relative valuations creates the conditions for a potential positive surprise—particularly if the market narrative begins to broaden beyond the largest names.
How the backdrop for small caps is improving
Market folklore says, “So goes January, so goes the year.” Historically, when small caps outperform large caps in January, they go on to beat them for the full year more than 60% of the time. Portending good fortune, small caps handily outpaced large caps in January.6
Hope and market legend alone do not make an effective investment strategy.
More encouraging is the growing list of fundamental and macroeconomic factors that could help small caps end their nine year losing streak. Tight high yield spreads, a steeper yield curve, and a weaker dollar have been historical tailwinds for small cap performance. At the same time, deregulation combined with rising animal spirits could finally boost sluggish M&A and IPO activity, further flattering small caps’ prospects for 2026.
The One Big Beautiful Bill Act (OBBBA) and Fed rate cuts create a powerful one two punch for small cap companies. For example, the legislation restores the deductibility of interest expense based on EBITDA rather than EBIT and applies the change retroactively to tax years beginning after December 31, 2024. Because small companies typically have nearly double the depreciation and amortization of large companies, they stand to benefit more from the change, improving cash flow and balance sheet flexibility at a critical point in the cycle.
Why rate cuts matter more for small caps
When Fed rate cuts reach 2%—likely to happen soon—small cap companies stand to gain an edge. Small caps carry higher interest expense as a percentage of debt than large caps, making them more sensitive to changes in borrowing costs.
That sensitivity is already showing: interest expense for small companies has been declining and should continue to fall as the Fed extends its rate cutting cycle. Meanwhile, interest expense as a percentage of debt for large companies has seen little-to-no change. Lower interest expense and an improving cost of capital should have a greater positive impact on small cap profitability.
This dynamic is beginning to show up in earnings. For the first time in years, small cap earnings growth is expected to exceed large cap earnings growth in 2026.7 That shift is the single biggest reason small caps have a meaningful opportunity to outperform. In the third quarter, small cap earnings growth surpassed large cap earnings growth for the first time in 13 reporting periods.8 One quarter does not make a trend, but if the earnings advantage persists, small caps could finally gain the upper hand.
That sets the stage for my first surprise of the year: Small caps beat large caps in 2026.
2. Inflation surprises to the downside: Price pressures quietly cool
Many investors see rising inflation as the greater threat to the stock market rally this year, outweighing concerns about slower economic growth. But it’s difficult to envision a serious reacceleration of inflation with tame oil prices, low quit rates in the labor market, and falling rents.
Historically, a pickup in inflation—particularly one reminiscent of the 1970s—often coincides with a spike in oil prices. That backdrop looks unlikely today. In late January, the International Energy Agency (IEA) projected a deep surplus for the global oil market in the first quarter of 2026, with supply exceeding demand by 4.25 million barrels per day.9
Supply has risen faster than demand in part because the Organization of the Petroleum Exporting Countries plus Russia and other allies (OPEC+) began increasing production in April 2025 after years of cuts. Trump administration policy is also prioritizing low oil prices to fight inflation and reduce consumer costs.
Admittedly, oil prices have increased so far this year due to rising tensions between the US and Iran, supply disruption fears from Venezuela, and OPEC+’s decision to pause output increases in the first quarter. But these pressures are likely to be short lived. Geopolitical tensions and supply disruption fears will get resolved while bloated supplies are likely to keep oil prices in check. Without a sustained surge in oil prices, it’s unlikely that inflation will experience a significant increase this year.
From job hopping to job hugging, a labor market cooling signal
The Bureau of Labor Statistics (BLS) tracks labor market separations, including quits, layoffs and discharges, and other separations. Among these, quits—voluntary separations initiated by workers—are particularly informative. A rising quits rate signals that workers are confident in their ability to get a better job and it’s a precursor to wage inflation.
That pressure is notably absent today. In the BLS’ February 5 Job Openings and Labor Turnover Summary (JOLTS) report, quits were unchanged at 3.2 million, with the quits rate holding steady at 2%. Those figures haven’t budged in more than a year. Workers are not voluntarily leaving their jobs.
The labor market has shifted from job hopping to job hugging—the practice of staying in a role longer than usual for comfort or security. According to Monster’s Job Hugging report, nearly half of employed workers say they are currently staying put. And 75% expect to remain in their current job for at least two more years.10
Rising wages are a key ingredient to inflation. But stagnant quits, widespread job hugging, a softening labor market, and growing non-farm productivity suggest wage inflation is restrained.
Rents roll back, CPI lags
Shelter costs, which include rent and owners’ equivalent rent (OER), make up about 35% of the total Consumer Price Index (CPI). As the largest service component of CPI, changes in rent costs have a significant impact on headline inflation.
But OER is widely criticized as a slow moving, lagging indicator that fails to capture real time conditions in the housing market, often keeping reported inflation artificially high.
Real time rent data tell a very different story. Apartment List’s February National Rent Report showed that national median rent fell 0.2% in January, marking the sixth consecutive monthly decline. Rents are down 1.4% year over year and rent growth has been modestly negative for more than two years. The national median rent has now fallen by 6.2% from its 2022 peak.11
Falling rents are likely to begin to show up in CPI and other inflation measures later this year, putting downward pressure on prices.
Goods inflation has a shelf life
Fed Chair Jerome Powell suggested at his January 28 post-FOMC press conference that elevated inflation data largely reflect goods inflation, driven by the effects of tariffs. Powell acknowledged that there continues to be ongoing disinflation in the services sector and that, without the impact from tariffs, core Personal Consumption Expenditures (PCE) inflation is running just a bit above 2%.12
The good news is that the worst effects on inflation from tariffs should begin to roll off in the middle of this year.
Chair Powell went on to say that near-term measures of inflation expectations have declined from last year’s peaks and that most longer-term expectations remain consistent with the Fed’s 2% inflation goal.13
Together, benign oil prices, static voluntary separations, falling rents, improving goods inflation, and anchored expectations point to my second surprise: Inflation surprises to the downside in 2026.
3. Health Care outperforms the S&P 500: The cure for market volatility
The Health Care sector has struggled over the past decade, outperforming the S&P 500 just twice in the past 10 calendar years, in 2018 and 2022.14 Notably, both episodes occurred in years the broader market delivered negative returns for investors—underscoring Health Care’s defensive characteristics. That defensive profile has come at a cost. Health Care’s weight in the S&P 500 peaked at 16% in December 2015. Today, at less than 10%, the sector sits near a 40 year low as a share of total US equity market capitalization.15
Not surprisingly, ETF investors haven’t expressed much enthusiasm for the sector either. Over the past 12 months, Health Care ranks fourth-worst of the 11 economic sectors in terms of flows, taking in a miserly $537 million—well behind Industrials, the leading sector, which gathered $10.6 billion over the same period.16
There’s a lengthy list of ailments plaguing the Health Care’s outlook. Healthcare spending as a share of GDP has stagnated. There is unrelenting pricing pressure on drugs. Higher interest rates have made funding new drug discovery expensive. The OBBBA contained massive cuts to Medicaid spending. The Trump administration is pursuing a most-favored-nation (MFN) drug pricing policy, aiming to cap Medicare drug prices at the lowest levels paid in other developed nations. This would have a significant impact on pharmaceutical companies’ earnings. And biotech stocks face growing competition from cheaper Chinese innovation.
Just what the doctor ordered: Discount pricing, midterm elections, and structural tailwinds
Poor performance, modest flows, and depressed investor sentiment produce the perfect prescription for a positive Health Care sector surprise this year. And the sector is trading at a more than 20% discount relative to the broader stock market, producing a compelling valuation opportunity.
Volatility soars in midterm election years. The Health Care sector has outperformed the S&P 500 in 11 of the last 13 midterm election years by an annualized average of 8%. Coincidentally, 2018 and 2022, the only two calendar years Health Care bested the S&P 500 in the past decade were both midterm election years.17
Greater clarity on the Trump administration’s healthcare policy, deregulation, lower interest rates, and AI-led efficiency gains should benefit the sector’s outlook. Structural tailwinds from aging demographics and the continued determination to end terrible illnesses like cancer, dementia, and heart disease should also bolster Health Care’s prospects.
The cost of being early and why I’m repeating my Health Care call
One of the drawbacks of a value-based investment approach is that it can be early in identifying an opportunity. It requires discipline, patience, and conviction to stick with a struggling investment decision. Over the past decade, some of my surprise predictions didn’t play out in the calendar year I made them—but they did in the years that followed.
Being early is one thing; repeating a forecast two years in a row is another. I’ve done that only once in the past 10 years. After incorrectly predicting aerospace and defense stocks would outperform in 2021, I again predicted they would beat the market in 2022. I got it right the second time and aerospace and defense stocks have been on quite a run over the past few years.
Making that rare exception again, my third and final surprise is a repeat from last year: The Health Care sector will outperform the S&P 500 in 2026.
Agreement is expensive—lessons from a decade of market predictions
For the past decade, I’ve sought unloved assets with compelling valuations, with bad news already priced in and one-way investor sentiment. Using that simple framework, last year, I went two for three: correctly anticipating that the Fed would cut rates more than expected and that gold would breach $3,000. But I incorrectly forecast that Health Care would beat the S&P 500.
I’ve learned a lot from this decade-long experiment in forecasting. Around the time I began making my surprise predictions, I read Superforecasting: The Art and Science of Prediction by Philip Tetlock. Drawing on decades of research from the Good Judgment Project, Tetlock argues that successful forecasting has little to do with intelligence or privileged information. Rather, superforecasters share common attributes: humility, probabilistic reasoning, curiosity, and a willingness to update their views as new information emerges.
Superforecasters break complex questions into smaller components, avoid ideological rigidity, and treat beliefs as hypotheses to be tested—not positions to defend. Teams of superforecasters that encourage open debate and accountability consistently outperform lone experts.
Today, the intersection of prediction markets, commission free trading platforms, and increasingly sophisticated financial products has transformed how investors engage with markets. Whether your time horizon is measured in minutes or years, outcomes remain extraordinarily uncertain.
In a world where so much lies beyond investors’ control, the most reliable advantage is the one we can control: a consistent, disciplined, and repeatable investment process. That framework doesn’t eliminate surprises, but it improves the odds of navigating them successfully to reach your long-term financial goals.
The question isn’t whether markets will deliver surprises in 2026—they will. The more important question is whether your investment process is prepared for them.
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