With geopolitics still posing questions in the Middle East, oil prices still swinging up and down, and the artificial intelligence boom continuing to unfold at warp speed, there are two key domestic risks to watch for in the remainder of 2026: the midterms, set for November 3, and fears of an AI bubble bursting.
Midterms: Political Uncertainty and Economic Consequences
While separate risks in their own right, both risks have the potential to feed each other, increasing the likelihood of market volatility and driving sector rotation, as well as impacting monetary policy expectations heading into 2027. In general, midterm election years have always featured increased market volatility, lower-than-normal stock returns, and generally choppy performance.
As a quick refresher, the midterms will decide the outcome of races for the U.S. House of Representatives and 33 Senate seats (including special elections). As it stands today, Republicans will control the House (218-213) and Senate (53-45 with two independents aligned with Democrats) until January 2027. Historically speaking, midterm elections tend to result in the opposing party (Democrats in this case) gaining a majority. The reasons include fiscal and monetary policies becoming less certain, and greater unpredictability with spending, taxes, and economic activity.
As expected, markets hate uncertainty. The current outlook for the year is consistent with that seen in other midterm years — flat returns for the first few months, increasing volatility during the election season, and a high chance of sharp declines as the election season heats up.
Market Effects of Midterm Elections: Volatility and Sector Rotation
Based on data dating back more than 90 years, stocks tend to provide poor absolute returns, below the median, in midterm years compared to non-midterm years. On average, the S&P 500 provides sub-par gains in midterm years, especially during the first six months as stocks struggle to navigate policy uncertainty.
As measured by volatility (standard deviation of annualized returns), midterm years are characterized by significantly higher volatility than other years (nearly 16% versus about 13% in other years).
Another important consideration with the midterm elections is that affordability tends to be a major topic. Campaign proposals regarding housing affordability, cost-cutting measures related to healthcare, energy bills, and tax cuts could dominate the conversation. This means that the possibility exists for major changes to tax rates, deficits, deregulation, and new spending programs. Changes in the control of either chamber could impact policy direction in the U.S., which in turn will have implications for corporate profit margins and valuations.
In terms of specific sector impact, energy, defense, healthcare, and financials are all sensitive to midterms and may see substantial rotations depending on what party ends up controlling both or either chamber. Retirements and consumer discretionary stocks are likely to face headwinds due to increased volatility.
Even if voters go to the polls to make their choice, it does not necessarily mean that uncertainty will end immediately after. Until January of next year when a newly elected Congress takes office, the uncertainty is likely to continue. However, it is worth noting that post-midterm years tend to be very favorable for stocks — the S&P 500 has never posted a negative return in the first 12 months following a midterm election year going back to 1938 in many analyses.
AI Bubble: Overvaluation, Revenue Shortfall, and Correction Potential
As another risk factor to watch in the second half of 2026, the AI bubble remains a very real risk. It seems that the current capex boom among hyperscaler companies (Alphabet Inc, Amazon.com Inc., Meta Platforms Inc., and Microsoft Corp) and associated infrastructure spend on AI is likely to reach hundreds of billions of dollars just this year and is expected to climb closer to $3 trillion over the course of 2027-2028 combined. While Nvidia Corp and other tech giants drove the most recent equity market rally, valuation concerns keep rising as more money is spent building AI infrastructure while revenue is still in the low hundreds of billions in total for the top companies.
There are a number of reasons why this trend has the potential to become problematic:
The valuations of stocks exposed to AI and associated with technology (semiconductor manufacturing, software, etc.) have soared to new heights and resemble those characteristic of the late cycle and even dot com booms in some cases.
Earnings expectations for 2026 look far too aggressive, implying that any shortfalls in monetization (due to slower-than-expected enterprise adoption rates, longer-than-estimated return on investment, or more efficient competition) will drive down stock prices and result in substantial losses.
Several prominent surveys of market participants, such as from Bank of America or Deutsche Bank, indicate that a potential market rout among tech stocks and AI names tops the list of risk factors for 2026.
Given how much the market depends on megacap tech stocks at this stage, a bust in this segment is likely to hurt the overall S&P 500 index as well, and could have severe consequences on wealth effects and GDP growth. At the same time, the consensus is still that there is no popping on the horizon yet because the amount of infrastructure spend represents foundational investment and breakthroughs are likely to continue in AI in the coming years, including breakthroughs with agentic systems and productivity gains in specific industries.
Additional risks are compounded by the election outcome, as the new Congress can potentially increase regulation, enforce antitrust measures, and introduce data privacy laws that could reduce the profitability of these businesses. Conversely, policy continuity in Washington, as it is expected if Republicans retain control, may actually help maintain the current capex trend.
AI Bubble Watch and Interconnected Risks
As noted above, the risk of an AI bubble is likely to overlap with midterm risks because of the interdependence of different political and economic cycles, including the policy and monetary cycles in the U.S. and elsewhere. Given how large the investment is and how much attention has been paid to this particular topic recently, any developments related to AI will have to be watched closely as well. In addition, there are a number of additional risks that are relevant in this context:
Federal Reserve’s policy response to higher deficits and continued inflation.
Private sector credit exposure and risk of defaults among tech start-ups.
Energy price volatility amid fragile ceasefire in the region.
Geopolitical risks and the state of the world economy in general.
Historically speaking, stock markets usually managed to overcome midterm uncertainty successfully after the votes were counted, rewarding active investors and allowing them to take advantage of sector rotations.
AI-related investments are similar to the dotcom boom in some respects. Bubbles can form and persist for a while before they break, but the foundation behind the rise remains intact.
Investor Takeaways and Strategies
Given that both midterm risks and AI bubble risks pose legitimate threats to portfolio performance, careful risk management and disciplined approach become crucial. Some specific recommendations for the remainder of 2026 may include the following:
Diversify portfolios to mitigate volatility risk.
Choose high-quality businesses with solid finances, decent earnings, and reasonable valuations, including cyclicals and non-AI plays.
Use active approaches to benefit from sector rotations.
Consider using hedging techniques such as options and strategic allocations.
Look for attractive entry points on sharp price corrections.