Data Update 2 for 2026: A Testing Year (2025) for US Equities
Climbing walls of worry!
It was a disquieting year , as political and economic news stories shook the foundations of the post-war economic order, built around global trade and the US dollar. In fact, if you had been read just the news all through the year, and were shielded from financial markets, and been asked what stocks did during the year, you would have guessed, based on the news, that they had a bad year. You would have been wrong, though, as equity markets proved resilient (yet again) and delivered another solid year of returns for investors. In this post, I will focus on US equities, starting with the indices, and then deconstructing the data to see the differences in the cross section. As has been my practice for the last few years, I will also use this post to update the equity risk premium for the S&P 500, my composite indicator for whether the market is richly priced or not, and estimate a value for the index, with a “reasonable” equity risk premium.
Back from the Brink: US Equities in 2025
At the start of 2025, the consensus view was that stocks were primed to do well, helped by what investors perceived would be a business-friendly administration and a Federal Reserve, ready to cut rates. In keeping with Robert Burn’s phrase that the best-laid plans of mice and men go awry, the year did not measure up to those expectations at least in terms of policy and rate changes, but stocks still managed to find a way through. Let’s start with a look at the S&P 500 and the NASDAQ, day-to-day through the year:
The first few weeks of 2025 saw of continuation of the momentum built up after the 2024 elections and stock prices continued upwards, but February and March saw a drawdown in stock prices as talk of tariffs and trade wars heated up before culminating in a dramatic sell off in early April, after liberation day, when breadth and magnitude of the tariffs blindsided markets. The sell off was brutal and short, and stocks hit their low point for the year on April 11, 2025. Over the next few months, stocks mounted a comeback, before leveling off at the end of September and coasting for the rest of the year. Early in the year, the S&P 500 held its value better than the NASDAQ, generating talk of a long-awaited tech sell off, but as stocks recovered in the subsequent months, the NASDAQ ended up moving ahead the S&P 500.
Across the entire year, the S&P 500 rose from 5881.6 to 6845.5, delivering price appreciation of 16.39% for the year. The dividends on the companies in the index for the year, based upon dividends in the first three quarters of 2025 and estimates for dividends in the last quarter amounted added a yield of 1.34%.
The S&P 500’s return in 2025 of 17.72% was a solid year, but to provide perspective on how it measures up to history, I looked at annual returns from US stocks from 1928 to 2025, and computed distributional statistics:
While 2025’s annual returns put it in the right in the middle of the distribution, close to the median and ranked 45th of the 98 years of US equity returns from 1928-2026, it represented a third consecutive year when the annual stock return exceeded the median returns, the longest streak since the mid 1990s; US equities between 2023 and 2025, a period where many market timers were suggesting not just caution but staying out the market, returned 85.32% to investors.
Deconstructing US Stock Price Performance
While stocks had a good year overall, the spoils were dividend unequally, as if often the case, across industries and sectors. To take a closer look at where the best and worst performance was in 2025, I started by looking at a breakdown by sector, where I computed the returns based on the change in aggregate market capitalization in 2025:
I have tracked the performance of each sector, by quarter, and across the year a measured the returns. The best performing sector in percentage returns was communication services (which includes Alphabet and Meta), up 30.63% for the year, followed by technology, which continued it sustained run of success by delivering 23.65% as an annual return; on a dollar value basis, it was not close with technology companies posting an increase of $4.17 trillion in market cap during the year. The worst performing sectors were consumer staples and real estate where the returns were about 2% for the year.
The problem with sector categorizations is the they are overly broad and include very diverse industry groupings, and to overcome that problem, I looked at returns by industry, with a breakdown into 95 industry groups. While you can find the full list at the end of this post, I ranked the industry returns in 2025, from best to worst, and extract the ten best and worst performing industry groups:
Download industry returns in 2025
The surge in gold and silver prices in 2025 carried precious metals companies to the top of the list, with a return of 169.2% for the year, and other energy and mining companies also made the best performer list, with a scattering of technology standouts. The worst performing businesses were primarily old economy, with chemicals, consumer product companies and food processing all struggling during the year.
One of the major changes that we have seen in cross sectional differences in the twenty first century has been the fading or even disappearance of two well documented phenomena from the twentieth century, the first being the small cap premium, where small market cap companies delivered much higher risk-adjusted returns that large market cap companies, and the value premium, where low price to book stocks beat high price to book stocks in the return game. I focused in how these categorizations behaved in 2025, and we did see small cap stocks and low price to book stocks return, at least in part, to favor:
If you are small cap or a value investor, though, I would not be celebrating the return on these premia, but I do think that we will start to see a return to balance, where the groupings will trade off winning in some years for losing in others.
As a final assessment, I did look at the seven stocks that have not only carried the market for the last few years, the Mag Seven, but have been the source of much hand wringing about how markets are becoming top-heavy and concentrated. I started by looking at the individual companies, and how they performed in 2025:
While the Mag Seven saw their collective market capitalization increase by 22.36%, Apple and Amazon lagged with single digit increases, and Nvidia (up 37.8%) and Alphabet (up 62.7%) for the year. Increasingly, the Mag Seven are diverging in their price paths, and that should be expected since they operate in very different businesses and have very different management running them. To examine how much the Mag Seven have carried the market, I tracked the market cap of the Mag Seven against the rest of US equity (close to 6000 companies) from 2014 through the four quarters of 2025.
The aggregate market cap of the Mag Seven has increased from 11% of the US equity market (composed of close to 6000 stocks) in 2014 to 30.89% of the market at the end of 2025, with the $3.9 billion in market cap added in 2025 accounting for 39.3% of the overall increase in market capitalization of all US equities during the year. While this Mag Seven party will undoubtedly end at some point, it did not happen in 2025.
US Equities: Too high, too low or just right?
This post, at least so far, has been a post mortem of the year that was, but investing is always about the future, and the question that we all face as investors, is where stocks will go this year. In my unscientific assessment of stock market opinion, from experts and market timers, there seems to a decided tilt towards bearishness at the start of 2026, for a variety of reasons. There are some who note that having had three good years in a run, stocks will take breather. Others point to history and note that stocks generally don’t do well in the second years of presidential terms. The most common metric that bearish investors point to, though, is the PE ratio for stocks at the start of 2026 is pushing towards historic highs, as can be seen in the graph below, where I look at three variants on the PE ratio - a trailing PE, where I divide the index by earnings in the most recent 12 months, a normalized PE, where I divide the index by the average earnings over the last ten years and a Shiller PE, where I average inflation-adjusted earnings over the last ten years:
Download historical PE ratios for US equities
Using every PE ratio measure, it is undeniable that the PE ratio for the S&P 500, at the start of 2026, is much higher than it has been at any extended period in history, perhaps with the exception with the late 1990s. While this may sound like a slam dunk argument for US stocks being over priced, it is worth remembering that this indicator would have suggested staying out of US equities for much of the last decade. The problem with the PE pricing metric is that it is noisy and an unreliable indicator, and before you use it to build a case that equity investors in the US have become irrational, you may want to consider reasons why US stocks have benefited able to fight the gravitational forces of mean reversion.
1. Robust Earnings Growth & Earnings Resilience: In this century, US stocks have increased more than four-fold, with the S&P 500 rising from 1320.28 at the end of 2000 to 6845.5 at the end of 2025, but it is also worth noting that US companies have also had a solid run in earnings, with earnings increasing about 356% during that same time period.
It is also notable that not only did earnings register strong growth over this period, there were only three years in this century when earnings declined - 2001 (dot com bust), 2009 (2008 crisis) and 2020 (Covid). US companies have become more resilient in terms of delivering earnings through recessions and other crises, pointing to perhaps less risk in equities. I will return in a later post to examine why that may be, with some of the answers rooted in changes in US equity market composition and some in management behavior.
2. Healthy cash returns: In conjunction with delivering earnings growth, US companies have also been returning large amounts of cash to their shareholders, albeit more in buybacks than in conventional dividends. In 2025, the companies in the S&P 500 alone returned more than a trillion dollars in cash flows in buybacks, and in the graph below, I look at how the augmented cash yield (composed of dividends and buybacks) has largely sustained the market:
While the dividend payout ratio, computed using only dividends, has been on a downward trend all through this century, adding buyback to dividends and computing a cash yield ratios yields values that are comparable to what dividend yields used to be, before the buyback era.
In sum, you can see why both bulls and bears retreat to their favored arguments, and there is no obvious tie breaker. The level of stock prices (PE ratios) should be a concern, but you cannot dismiss the benefits of growing and resilient earnings, and substantial cash return. To break the tie, in a very self serving away, I will revert to my favored metric for the US equity market, the implied equity risk premium, which in addition to looking at stock price levels, the growth in earnings and the cash return, also brings in the level of rates. The implied equity risk premium, as I compute it, is the based upon the index level and the expected cashflows (from dividends and buybacks, augmented by earnings growth), and very simply, is an internal rate of return for stocks. Netting out the riskfree rate yields an equity risk premium. The table below contains the computation of the implied ERP at the start of 2026:
Given the index level on January 1, 2026, of 6845.5, and the expected cash flows that I computed on that date (using the dividends and buybacks in the trailing 12 months as my starting point, and growing them at the same rate as earnings), I obtain an expected return on stocks of 8.41%. Subtracting out the US T. Bond rate (dollar riskfree rate) of 4.18% (3.95%) on that day yields an equity risk premium of 4.23% (4.46%) for the US. I want to emphasize again that this estimate is entirely a market-driven number and is model-agnostic.
If you are wondering how estimating this numbers lets you make a judgment on whether US stocks are over priced, all you need to reframe the equity risk premium by asking whether the current ERP is, in your view, too high, too low or just right.
If you believe that the market is pricing in too low an ERP, given the risks that are on the horizon, you are contending the stocks are over priced.
If your view is that the current ERP is too high, that is equivalent to arguing that stocks today are under priced.
If you are not a market timer, you are in effect arguing that the current ERP is, in fact, the right ERP for the market.
To illustrate this point, I have estimated the value of the index at equity risk premiums ranging from 2% to 6%:
With a 2% equity risk premium, you get an astounding value of 14834 for the S&P 500, which would make the index undervalued by 53%. At the other end of the spectrum, with a 6% equity risk premium, the index should trade at 4790, translating into an overvaluation of 43%. So, is the ERP of 4.23% (I will revert to this number, since my historical numbers did use the US treasury bond rate as the riskfree rate) at the start of 2026 a high, low or just-right number? Rather than make that judgment for you, I have computed the implied ERP for the S&P 500 going back to 1960:
Download historical implied ERP
There is something in this graph that almost every investor group can take comfort in, If you are market neutral, you will take comfort from the fact that the current ERP is almost exactly equal to the average for the 1960-2025 period. If you are bearish you will point to the fact that the ERP now is lower than it has been in the post-2008 period, backing up your case that an adjustment is overdue. I am leery of the bubble word, especially used in the context of this market, since unlike the end of 1999, when the ERP got as low as 2.05%, the current ERP is more in the middle of the historic range.
The Bottom Line
US equities had a good year in 2025, and there are signs of excess in at some parts of the market, especially related to AI. That said, the capacity of US companies to continue to deliver earnings and return cash flows even in the face of a tsunami of bad news continues to sustain the market. I am, at my core, a non market-timer, but I have held back on putting idle cash back into US equities in the last year, preferring to keep that cash in treasury bills. It is entirely possible that the market will continue to prove the naysayers wrong and post another strong year, but much as it may pain equity investors, the healthiest development for the market would be for it to deliver a return roughly equal to its expected return (8-9%) and clean up on pricing overreach along the way. For the bears, this may also be the year when the bad news stories of last year, including tariffs and political whiplash, will finally start to hit the bottom line, reducing aggregate earnings and cash flows, but waiting on the sidelines for this to happen has not been a good strategy for the last decade.
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Great read
Maybe a big ask but would you be keen on updating this wonderful paper from 2001 with the new 25 odd years?
https://pages.stern.nyu.edu/~adamodar/pdfiles/invfables/ch3new.pdf