The Red River of the North starts at the confluence of the Bois de Sioux and Otter Tail rivers and forms most of the border between Minnesota and North Dakota. It then crosses into Manitoba and empties into Lake Winnipeg before its waters finally flow into the sea at Hudson Bay. Cities have grown up along its banks including Fargo, Grand Forks and Winnipeg and their residents are all too aware of one unfortunate feature of the river. Unlike most large U.S. rivers, it flows from south to north.
The Central Plains of the United States and Manitoba have long and cold winters and the further north you go, the colder it gets. This means that when spring finally arrives, the river thaws from the south and as the waters drip and trickle and stream and finally flow in torrents into the river, their passage is blocked by ice dams further north. Having nowhere to go, they spread out, inundating the populated areas and generally spreading misery. It is a chronic springtime problem – it’s easy for the water to flow into the river; it’s harder for it to leave.
The U.S. stock market has been a beneficiary of a similar phenomenon for many years, leading to performance that has exceeded any reasonable expectation of investors. There are structural forces, well beyond rising earnings and low interest rates, that have driven an increased demand for stocks. There are also significant forces holding money in the market and limiting the supply of publicly traded stocks. But what are these forces and what do they imply for investment strategy?
U.S. Equity Performance and the Fundamentals
In 1985, two economists, Rajnish Mehra and Edward Prescott published a much-quoted article entitled The Equity Premium: A Puzzle1. The puzzle was: why had stock returns outperformed the return on Treasury bills by so much more than a general equilibrium model would have predicted from 1889 to 1978? Before anyone rushes to download the paper, I should warn you that they didn’t solve the puzzle. They did, however, estimate the ex-post equity risk premium. Over this 90-year period, stocks provided an average annual total return that was 6.18% higher than on Treasury bills.
Remarkably, since then, this gap has only widened. Assuming no change in the S&P500 or Treasury yields between now and the end of this year, the S&P500 will have produced an annual average total return, between 1978 and 2025, of 12.4% - 8.3% better than three-month T-bills over the same period and a full 9.0% per year above CPI inflation.
Common sense, as well as commentary from economists, strategists and investors over much of this period, tells us that these stock market returns have been far better than was anticipated back in the late 1970s or 1980s. Moreover, although this period has generally seen lower inflation and rising profit margins, stock prices have outpaced improving fundamentals. One measure of this is the Shiller P/E ratio which was 9.3 times at the end of 1978 but is at roughly 40 times today2.
Forces Amplifying the Demand for Stocks – Inequality & 401Ks
So why have stocks done so well?
One key has been forces driving money into stocks and, in particular, rising inequality and structural changes in the U.S. retirement system.
As has often been noted, income inequality has increased greatly in recent years. Tax return data compiled by Emmanuel Saez3 show that, between 1946 and 1981, the top 10% of families received a fairly steady 32% of pre-tax income (excluding capital gains and government transfers). However, in the over four decades since then, the rich have prospered disproportionately and by 2022, the top 10% of families received over 52% of income.
This is significant for the stock market since, according to the Census Bureau’s consumer expenditure surveys, in 2023 the top 10% of households in terms of income saved 33% of their after-tax income while the bottom 90% saved just 2%. Of course much of this saving finds its way into the stock market so that rising inequality has also likely been feeding the stock market boom.
Changes in the retirement space have also been important.
Since the introduction of 401k plans in the late 1970s, defined contribution plans have grown much faster than defined benefit plans. According to the financial accounts of the United States, published by the Federal Reserve, in the first quarter of 1995, the total assets of defined benefit plans amounted to $1.176 trillion, roughly 34% higher than the $875 billion held by defined contribution plans. However, the advantages of defined contribution plans for employers has changed this landscape dramatically. By the second quarter of 2025, defined contribution plans held $9.853 trillion, more than three times as much as the $2.638 trillion in defined benefit plans.
One reason this is important for the stock market is the different behavior of institutional and individual investors. Corporate defined-benefit pension plans are far more disciplined in asset allocation than individual investors. In 1Q1995, defined benefit plans held 53% of their assets in equities and this had declined marginally to 50% by 2Q2025. In defined contribution plans, by contrast, we estimate that the equity allocation rose from 69% to 81% over the same period. All of this has pumped up demand for publicly-traded U.S. equities over recent decades.
Forces Dampening the Supply of Stocks – Unrealized Capital Gains, Private Equity and Buybacks
There are also forces reducing the supply of stock. One of the most important of these is capital gains.
Since 1979, the top federal tax rate paid on long-term capital gains has ranged between 15% and 29.2% and currently stands at 23.8% for high income households4. However, for investors, what matters is not so much the tax rate but taxes paid as a percent of proceeds. This has become a more important issue in recent years, precisely because the stock market has done so well.
To illustrate this point, consider an investor who buys a S&P500 index fund in a taxable account and sells it precisely 10 years later, paying the maximum rate on any capital gains. We estimate that, on average, since 1979, this would have implied a tax liability equal to 11.4% of the proceeds from the stock sale. However, if she had sold in January 2009, she would have actually realized a capital loss since the S&P500 was lower then than 10 years earlier. She could have used this loss to offset gains elsewhere or carried it forward for future tax mitigation. By sharp contrast, after the sparkling stock market gains of the past decade, if she sold today, she would owe roughly 16.6% in capital gains tax on the proceeds of the sale.
This is a significant issue for those considering selling out of the market. We estimate, based on the Federal Reserve’s survey of consumer finances, that the median age of U.S. equity owners, weighted by their average equity holdings, was 65.6 years in 2022. That is to say, half of U.S. household equity holdings were held by a household with a reference person aged over 65.6. Since much of this wealth is intended to be passed on to future generations and since most investors presumably understand the step up in basis at death, you have to be pretty sure about the need to reallocate assets before selling equities with substantial capital gains.
There is also the issue of the falling number of publicly-traded companies. Between 1997 and 2024, according to Bloomberg data as reported by Fortune5, the number of publicly-traded companies fell from 8,800 to 3,952. This is the result of a larger number of companies being acquired or taken private than going public through IPOs which, in turn, reflects the impact of tougher regulations on publicly-traded companies and the increasing availability of private capital allowing companies to avoid public listings.
Compounding this issue is the effect of growing stock buybacks. According to our colleagues in JPMorgan’s investment bank, U.S. buyback volumes through August were up 38% from a year earlier and could hit $1.5 trillion for 2025, continuing a long period of gradual increase. While this pace of buyback activity mathematically increases earnings per share, it also effectively reduces the available supply of U.S. equities on the market.
Investment Implications
Of course, there are, or should be limits to equity outperformance.
Strong earnings growth depends, to an extent, on strong nominal GDP growth. While both real GDP growth and inflation could rise in the first half of 2026, by the second half they should fade due to diminished fiscal stimulus, labor supply issues and less feed-through from tariffs. Low interest rates can boost P/E ratios. However, the Federal Reserve has indicated just one rate cut in 2026 while long-term interest rates are unlikely to fall in the absence of a recession – and, of course, a recession would be the last thing the stock market needs.
Longer-term there could also be some pushback on the forces that have driven equity outperformance. If political populism ever morphs into “tax the rich”, taxes on dividends and capital gains could rise, reducing expected long-term equity returns. Importantly, if a significant market correction does materialize, for whatever reason, unrealized capital gains will diminish and capital losses will accumulate, making it easier for investors to reallocate even within taxable accounts.
There will undoubtedly come a day when events precipitate a severe market correction or bear market. While we never know the timing of such a correction, we do know its location – it will very likely be centered in the areas of maximum hype and euphoria today. Many investors have portfolios that embed more risk and less balance than they intended and an important New Year’s resolution is to do something about this. This means rebalancing in a tax-smart way, using tax-alpha strategies, retirement accounts and annuities or just fresh cash to raise capital without paying Uncle Sam and directing that capital to bolster under-funded positions in non-mega-cap U.S. equities, international stocks and alternative investments.