Prediction: This Will Make or Break the S&P 500's Performance in 2026

Heading into 2026, it looks as though the S&P 500 (SNPINDEX: ^GSPC) will be coming off a third consecutive year of outperforming its long-run average of 10%. As of Monday's close, the index was up over 16% thus far in 2025, which is actually lower than the previous two years when it rose by more than 23%.

Investors have remained bullish on the stock market despite concerns of rising valuations and a potential bubble due to artificial intelligence (AI). Some, however, are worried that the market may be overdue for a steep correction, possibly even a crash given how expensive many stocks are.

I wouldn't be surprised to see another year of slowing returns for the market in 2026, but just how good or bad things will be will likely depend on one key decision.

A change in the Fed chairman could weigh on investor confidence

May 2026 is when the term of Fed Chairman Jerome Powell comes to an end. It's no secret that U.S. President Donald Trump hasn't been a fan of Powell's and has talked about firing him in the past. However, with the Fed being independent, there are questions about how plausible and legal a move like that would be. At the very least, it would be very controversial. In April, the markets and the U.S. dollar fell when President Trump was critical of Powell and called him a "major loser."

Trump has been critical of Powell for not lowering interest rates faster in order to help the economy. Powell, however, has made decisions based on data, with an aim of trying to control the rate of inflation. Under Powell, investors have trusted the process thus far, and the risk is that if there's a change in the Fed position to someone who may be more willing to cut interest rates for the sake of pleasing the president, that could negatively impact investor confidence.

Could a rush to cut rates trigger a bear market?

While May is when Powell's term ends, President Trump has said that he'll make a decision on the new Fed chairman early next year. In all likelihood, Powell isn't going to be staying on. Who his replacement is going to be and how much confidence investors and analysts have in that person's independence could ultimately dictate the path for the market in the months to follow.

The danger is that if someone is put in place as the new Fed for the sole purpose of cutting interest rates aggressively, investors may grow concerned about the fallout afterwards, as that may create greater uncertainty in the future, particularly with respect to inflation. If investors worry that inflation will be on the rise again, they could be tempted to pull their money out of the stock market in anticipation of another correction. Inflation was, after all, a significant contributing factor to the most recent bear market in 2022. The S&P 500 fell by more than 19% that year.

Investors should plan for adversity ahead

I do expect that there will be some pullback in the market next year, but whether it's just a modest increase or a significant correction will likely come down to who becomes the next Fed chairman. But with valuations high and tariffs still flowing through to consumer goods and impacting prices, there are multiple reasons for investors to consider diversifying and reducing some of their exposure to the market regardless of what ends up happening.

Now may be a good time to consider evaluating your portfolio to assess your risk and possibly move out of high-priced stocks and into diversified exchange-traded funds (ETFs) that can add some safety to your portfolio.

David Jagielski, CPA has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.