The S&P 500 has gained 12.3% this year. That’s with oil above $100 a barrel, consumer prices climbing 3.7% a year and a 10-year Treasury yielding 5.1%. Stocks are behaving as though none of that counts. So could inflation knock the index down 40%?

Can anyone call the market’s next move, whether that’s tomorrow, next week or a year from now?

Probably not. Still, some risks are too loud to tune out, and today’s are loud.

We count at least three that threaten the whole market. Each one fits in a single word.

Risk one: war

Actually, two wars, fought side by side. One is economic and uses tariffs. The Supreme Court threw out many of them, yet the steel tariffs are still in place, and so are the replacement tariffs. The other uses weapons. It’s being fought in Iran and throughout the Middle East, and this month Iran escalated its attacks near the Strait of Hormuz. Then there’s Russia-Ukraine, where, as Exxon’s chief executive Darren Woods put it in July, Ukraine has disabled about 1 million barrels a day of refining capacity in Russia.

Either kind discourages trade and breaks supply chains. The armed kind also shows up in oil. Crude averaged $60 a barrel in January, passed $90 on March 6 and is above $100 now. A year ago it was about $60. No blip, either: since March, oil hasn’t closed under $69. Across the board, energy costs 20% more than it did twelve months ago. And imports, whose prices held flat a year ago, now cost 8.1% more.

Risk two: immigration

Plenty of people back deporting immigrants, particularly those in the country illegally. But it’s a messy business. It likely pulls cheap labor out just as the economy is asking for more. In fairness, pay hasn’t felt the pinch so far: wages are up 3.0%, a slower pace than the 3.8% seen last year. Headcount tells a different story. According to the household survey, about 500,000 fewer people are working in America than a year ago, even though payrolls grew by about as many. When workers are scarce, it’s hard for an economy to produce more without charging more.

Risk three: taxes

Nobody objects to lower taxes. Keeping more of your paycheck is hard to argue with. The trouble is when it happens. Over the twelve months through September, Washington ran a deficit of about $2 trillion, compared with $1.8 trillion the year before. That’s extra cash landing in people’s pockets just as prices are high and workers are hard to find. So people do the natural thing and spend. Retail sales have grown 6.3% over the past year, following 3.7% growth in the prior one.

On its own, each of the three could be handled. The problem is that all three lean the same way.

Higher.

And then there’s AI

One more thing is feeding the fire, and hardly anyone files it under inflation.

It’s AI.

More than anything, AI is generating ideas, and a lot of those ideas involve spending. On power and energy. On data centers, equipment, silicon, batteries and building materials. And on energy again, because it bears saying twice: energy goes into everything.

The scale is startling. Amazon, Microsoft, Alphabet and Meta put $511 billion into capital projects over the twelve months ending June 30, against $291 billion in the prior twelve. That’s 77 cents out of each dollar of cash their operations generate. All that money buys real things, and it’s already lifting prices. Amazon says pricier memory chips pushed its 2026 spending plan from $200 billion to about $220 billion. In July, copper, the metal inside wiring and power lines, cost 39% more than a year before. Lumber was up 14%, electricity 4%.

The part most people miss

Every business everywhere wants to lead in AI. Shoes made better with AI. Better clothing. Better medical devices and healthcare, smarter materials. And they all want it right now. Why the rush? Because standing still means falling behind, and nobody can afford to ease off. Nike has to put money into AI faster and more wisely than Under Armour does, or it loses. Starbucks has to outpace Dunkin. You won’t find many CEOs or boards volunteering to spend less. In July, both Alphabet and Amazon lifted this year’s spending plans.

There’s an upside and a downside here. Upside: spending is booming. Downside: it may be booming too quickly. When demand this large chases goods this scarce, prices go up.

So much for AI’s effect on prices. Its effect on the market is where things start to crack. Computing keeps getting cheaper, and quickly. In May, Nvidia said that on its Blackwell Ultra systems the cost of a token, AI’s basic unit of output, had dropped 60% in six months. Lighter AI models already run on a laptop. The cloud giants are also relying less on Nvidia’s hardware. Microsoft plans to make its own Maia chip the main architecture it uses to run AI, Google has begun delivering its TPU systems into customers’ data centers, while Anthropic and OpenAI have both made multi-year commitments to Amazon’s Trainium.

Lower prices help the people using AI. Investors have to ask something else. If AI gets cheaper faster than people use more of it, all that spending will earn less than promised. The stocks priced on that promise are the hottest in the market. In fact, we think most paths to a big market drop come back to one question: who will keep paying for all this AI computing?

Add it all up and you get inflation

Take one number. Consumer prices in September were 3.7% higher than a year before. Twelve months earlier, the reading was 3.0%.

Take another. Gas is $4.33 a gallon, up from $3.06 a year ago.

Inflation has returned, and it pushes people around. It doesn’t listen to reason and it doesn’t scare easily. At least not quickly.

The Fed is already feeling it. Its rate began the year at 3.64% and sits at 3.88% now, which is a hike, not a cut. Bonds are feeling it too. On October 5, the yield on 10-year Treasurys reached 5.31%, its highest level in 24 years, and 30-year mortgages now cost 7.40%.

Stocks, on the other hand, seem untouched. The S&P 500 stands at 7,691, a gain of 12.3% this year.

That’s what concerns us.

Has it turned into runaway inflation? Not quite. Excluding food and energy, prices are climbing 2.6%, a slower pace than a year ago. For now, this is an energy shock with a spending boom layered on top.

Everything turns on that. Energy led in 1973. It led again in 2021-22. Each time, everything else followed.

The Fed’s options

The Fed knows the 2022 playbook: push rates up until spending slows. It has begun doing that already. Bond traders don’t think it’s finished. The 2-year Treasury yields 4.74%, comfortably above the Fed’s 3.88%, a gap that points to investors expecting further hikes.

That leads to the question that counts for your portfolio. When a 10-year Treasury pays 5.1%, guaranteed when held to maturity, how much should stocks have to pay you?

The S&P 500 is priced at about 25 times earnings, so its earnings come to about 4% of what you pay. That’s below the Treasury yield. In other words, you get paid less for carrying more risk.

Something has to give eventually. Earnings could jump. Bond yields could drop. Or stock prices could slide far enough for the numbers to add up again.

The highest flyers take the biggest hit. Buying a growth stock means betting on profits that are years away, and higher rates shrink what a dollar of 2030 profit is worth today. The more distant the profits, the harder the blow. It’s why the stocks with the brightest prospects dropped the most in 2022.

Sizing the worst case

The S&P 500 has a value of about $70.2 trillion, so a 40% drop would wipe out about $28 trillion. Too extreme? Declines that deep have happened three times since 1970. Below are the inflation sell-offs:

Market Crashes Compared shows how key stocks held up through each of these sell-offs.

Could it go deeper, to 50%? It wouldn’t take as much as you might expect. A drop of about a quarter in earnings, with investors paying 16 times earnings rather than about 25, would get there. History is even blunter. Since 1970, every one of the three declines of 45% or more needed only one of those two things to break badly. We lay out how to invest for both a crash and a rally.

Don’t count on the biggest names to be safe. Nvidia and Meta both dropped 62% between January 3 and October 12, 2022, while Microsoft, Alphabet and Amazon each gave up about a third. And today, the ten largest companies make up 40% of the index’s value.

A broad fall hits concentrated holdings hardest, as 2022 showed. See how to put a floor under a large position.

The odd thing about right now is that the damage is already happening. The index just can’t see it. Since oil went through $90 in March, tech stocks, as tracked by the XLK fund, have gained 36%. In that same period, Nike is off 33% and McDonald’s is off 25%. Inflation has already chosen its first victims, and we show which stocks it has hit, which are next and which are gaining.

What will Washington do?

With gas at $4.33 and voters paying attention, how does Washington respond? Does it change direction on tariffs, wars, taxes and deportations, or dig in? Some of that won’t come easily. The midterms fall on November 3.

We hope good sense wins out before inflation spreads. If it doesn’t, or if good sense shows up too late, the job falls to the Fed alone, and rates are its main tool.

The way out

There is good news. Inflation can be beaten, and once it is, markets bounce back fast. After the Fed crushed inflation, the 10-year Treasury yield dropped 4.2 points between October 1981 and October 1982, its largest twelve-month decline since at least 1960. Stocks soared too: the S&P 500 gained 58% in the year from August 1982 to August 1983.

The same thing played out not long ago. Inflation topped out near 9% in June 2022, and a year later it had eased to about 3%. Stocks followed. The S&P 500 climbed 24% in 2023, then 23% in 2024, then 16% in 2025.

Each time, the cost came first. In the early 1980s that meant a recession. In 2022 it meant the S&P 500 sliding 25%. The Fed may be facing that same trade again.

The number to watch

Keep an eye on one figure: prices excluding food and energy, currently 2.6%. If that rises above 3.5% while energy prices stay 20% higher, we’re back in the 2022 script, and the hardest hit would land on stocks whose prices lean furthest into the future. Mark the next Fed meeting and the next inflation report on your calendar.

Can You Protect Yourself From A 40% Fall?

You can’t stop the market from falling, but you can limit how much of a fall you take. A broad sell-off hits every portfolio, and it hits hardest where wealth is concentrated: in 2022, Nvidia and Meta each fell 62%, more than twice the S&P 500’s 25%. If a few big winners make up much of what you own, there are ways to put a floor under your losses, paid for by giving up some of the upside, and to spread the money out with less tax. Our partner advisory firm offers a free strategy review of how that would work for your holdings.

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