Investors should not get too comfortable with the high double-digit equity market returns experienced in recent years, especially as the U.S. economy downshifts into 2026.
The S&P 500 has notched 20 all-time highs this year and the index’s forward price-to-earnings ratio is north of 22x. These facts, combined with the strength and speed of the post-“Liberation Day” recovery and the dominance of the “Magnificent 7” in equity market returns since 2022, have many investors worried that the U.S. equity market is in bubble territory.
It is possible to dismiss P/E valuation concerns – the composition of the equity market has shifted to become more tech-focused, which commands higher valuations as investors pay not for next-12-month earnings but for earnings over the next 5-10 years; and the interest rate environment is today easier than in most of the last five decades. It is similarly possible to dismiss concentration concerns – the emergence of AI is likely a secular theme; the “Magnificent 7” are mostly mature, multi-national companies with strong balance sheets and diversified revenue streams; and earnings growth is supportive of positive price performance.
However, another indicator is sounding a similar alarm, and it is harder to dismiss: the value of all U.S. corporate equity is currently equal to 363% of full-year nominal GDP through 2Q 2025. This is an all-time high, and substantially higher than the previous peak of 212% in 1Q 2000.
This ratio, similar to the “Buffett Indicator” – named for famed investor Warren Buffett and looking at the market capitalization of the Wilshire 5000 relative to U.S. GDP – changes depending on the growth of the U.S. equity market relative to the growth of the U.S. economy. In theory, overall corporate profits and GDP should grow at roughly the same level, with adjustments to margins equalizing across the market over time – for example, lower wages and input costs in one sector might be detrimental to margins in another. When equity prices get ahead of corporate profits – in the form of multiple expansion – the ratio of market capitalization to GDP increases and future return prospects diminish.
“Trees don’t grow to the sky”, and at some point this ratio must come back down to the earth. This does not mean that a correction is imminent. It does mean, however, that investors should not get too comfortable with the high double-digit equity market returns experienced in recent years, especially as the U.S. economy downshifts into 2026.
Thankfully, this challenge is not insurmountable, and there are plenty of ways for investors to rebalance and diversify. Within U.S. equities, even muted index-level returns may mask strong sector- or security-specific returns, underscoring the value of active management. Moreover, international stocks are in the best position for growth in the last two decades; and U.S. bonds offer an attractive combination of a strong coupon and the ability to “protect” through duration in the event that the economy tips into recession.