• Investor emotion drives stock prices past intrinsic value
• Negative equity risk premiums signal low future returns
• Stretched markets require highly selective, alpha-focused strategies

Howard Marks of Oaktree Capital Management has long argued that markets are driven less by objective reality and more by the emotional pendulum of human psychology.

Over the course of the past ~30 years investing – I"ve also come to appreciate this.

Investor sentiment constantly swings between optimism and pessimism, greed and fear, pushing asset prices far above — or far below — their intrinsic value.

Momentum is a powerful force.

In periods of euphoria, investors become willing to pay increasingly higher multiples for the same stream of earnings, convinced that good times will persist indefinitely.

In periods of panic, that same market often sells quality businesses at deeply discounted prices, not because their long-term economics suddenly collapsed, but because fear overwhelms rationality.

The irony, as Marks often points out, is that investors feel safest when markets are most expensive, and most fearful when opportunities are greatest.

Buffett would tell us "be greedy when others a fearful; and be fearful when they are greedy"

Over time, these emotional cycles have become one of the defining forces behind market valuations.

Let me offer an example:

If the S&P 500 traded at the same multiple today as it did in March 2009, the index wouldn"t be sitting around 7,400. 

It would be around 3,000 (assuming EPS of $300 per share) – where the S&P 500 traded at a forward PE of around 10x. 

That was a time to be greedy…

Today the multiple is similar to what it was in 2007 – closer to 23x – a time to be fearful?

The "This Time Is Different" Argument

Whilst some of the gains today are the result of improved earnings, profitability and strong cash flows — we often underestimate the role of subjective investor optimism.

This diagram from Marks demonstrates the concept clearly: 

The various points show how investor sentiment oscillates above and below the (rising) mean.

For example, the long-term mean could be earnings growth (e.g, ~7-8% pa); or forward PE ratio (e.g., ~18x the past 10 years; or ~15.5x the past 100 years)

The irony of course is many investors:

• Add to stocks exposure when optimism is high; and
• Sell stocks when sentiment is deeply negative. 

This is the opposite of what successful investors do. 

What Do We Find Today?

Almost every major valuation measure —from price-to-cash-flow to price-to-book—it is sitting at an all-time high.

Even on a forward PE basis, we are 2.5 standard deviations above the mean.

For example:

• The median stock in the index is trading near an all-time high P/E of 19x.
• The overall index – skewed by a 37% weighting to just 7 stocks – sits ~23x P/E; and finally
• The equal-weighted index trades near ~17 P/E.

If you consider the US risk-free 10-year yield offers 4.60% (and likely headed higher given the weight of fiscal debts and deficits and sustained higher oil) — investors are paying a massive premium for equities.

Equity risk premium is an overlooked metric. It"s the amount you receive which is above that of the risk free rate (e.g. US 10-year treasury).

Today that is negative.

When the equity risk premium turns negative — investors are effectively being paid less to own a far riskier asset class.

Historically, these periods have often coincided with elevated optimism, stretched valuations, and weaker long-term forward returns for equities.

At roughly 23x forward earnings – the S&P 500 offers an earnings yield of around 4.3%, below the US 10-year Treasury yield above 4.5%.

In practical terms, investors are accepting greater volatility, drawdown risk, and uncertainty for a lower implied yield than they could earn lending to the US government.

While markets can remain expensive for extended periods, history suggests that buying equities when the equity risk premium is deeply compressed — or negative — has typically led to below-average returns over the following decade, largely because future gains become increasingly dependent on continued multiple expansion rather than underlying earnings growth alone.

For those interested – here is a great research paper by Aswath Damodaran on equity risk premium.

This article is also useful for context. Researcher Pim van Vliet states: 

• Historically, US equities have returned 10% annually, fueled by expanding valuation multiples, robust earnings, favorable demographics, and US market dominance.
• From 1926 to 2024, the ERP averaged 6.2%, peaking at 10.6% from 2015 to 2024.
• Yet, history reveals a pattern of mean reversion: strong decades often precede weaker ones.
• After high-return periods, the subsequent decade"s ERP typically underperforms the long-term average by ~1%, while weak decades lead to returns ~1% above average (Figure 1).

With that context – today"s setup does not auger well for the subsequent decades returns on the basis you are investing broadly.

This is a point made by van Vliet – who argues it signals a time to be very selective. He concludes:

• A declining ERP does not signal the end of investing; it demands a pivot to alpha-driven strategies.
• With US equity returns under pressure, systematic approaches like factor investing, defensive equities, and global diversification offer a path to resilient performance. In a zero-ERP world, alpha is not just a bonus; it"s the key to capital growth.
• As beta fades, alpha shines

Over the coming weeks and months I will talk more to achieving alpha… using real examples.

Profit Growth vs GDP

One of the most common arguments today is that the Magnificent 7 are distorting valuation metrics.

With the group accounting for ~37% of the S&P 500, the claim is that the remaining 493 companies are still reasonably priced.

But this argument overlooks a more fundamental reality: economic growth is finite.

Over long periods, corporate earnings growth has historically tracked GDP growth closely (as the chart below shows)

Businesses ultimately operate within the constraints of the broader economy.

While individual companies can outperform for a time (the argument made by van Vliet on why stock selection will be paramount) – aggregate corporate profits cannot indefinitely compound far faster than the economy that supports them.

Today we find corporate profits have expanded to record highs, while real GDP growth (i.e., when adjusted for inflation) continues to fluctuate around a modest 2–3% annually.

That disconnect matters.

When considering demographic headwinds, rising fiscal debt, structurally higher interest rates, and shifting immigration policies, investors need to ask whether the US economy can realistically sustain growth materially above its historical trend rate over the coming decade.

Because that is effectively what current valuations imply.

For example, the math around the Magnificent 7 creates a difficult contradiction.

Either the mega-cap technology companies continue growing at extraordinary rates indefinitely, or the remaining 493 companies must accelerate enough to offset any slowdown.

But if the broader economy itself remains constrained to low single-digit real growth, both outcomes become increasingly difficult to justify simultaneously.

Which is it?

What"s more – if the growth of the mega-caps eventually normalizes (e.g., AI commoditizes) — even if the other 493 improve — the index may still struggle given its strong concentration. 

The Buffett Indicator

Another way to frame this relationship between valuations and economic output is through the so-called Buffett Indicator: the ratio of total US stock market capitalization to GDP.

At one point, Warren Buffett described it as "probably the best single measure of where valuations stand at any given moment."

He has since softened that view, acknowledging that no single metric fully captures market conditions across different interest rate and economic environments.

Still, the underlying principle remains important:

Over the long run, markets cannot sustainably detach from the productive capacity of the real economy.

And that"s why the current asking multiple of 23x skews the risk/reward against the long-term investor. 

How Did We Get Here?

Slowly.

Secular bull markets are masters at normalizing the absurd.

From 2009 to 2026, the P/E of the S&P 500 expanded from ~10x to ~23x.

But it wasn"t a straight line…

However, what it does is condition investors to accept higher and higher multiples as the "new normal."

For example, if I was to say "wait for multiples to get back to say 16x forward" – you might say we will never get there. 

That"s a function of recency bias. It is hard to envisage. 

Remember – we were close to 16x April last year during the tariff tantrum (a good time to add exposure).

Now if you go back to 2012, corporate earnings were surging, banks were very well capitalized, and we had a massive runway for job growth.

Yet, the market traded at a rational ~12 multiple.

If you had suggested back then that the market deserved a "multiple of 23", you would have been laughed out of the room. 18x would have sounded absurd. 

This is the danger of letting the status quo dictate your strategy.

Yes, there are many in the mainstream who will argue that the late 1990s was proof that higher P/Es can coexist with higher rates, giving us plenty of room to run.

And you will hear near term calls for the S&P 500 to hit 8,000 or more this year or next. 

That should not be surprising.

But they conveniently forget that core PCE inflation averaged just 1.5% back then.

Here"s my take:

Hoping the market repeats a 3-standard-deviation event is not an investment thesis—it is gambling on a scenario that historically plays out only 0.3% of the time.

Predicting the Next 10 Years

One thing I can say about valuations is they are terrible timing tools for the next few quarters or even the next 12 months.

That"s something Buffett will readily admit.

On the other hand, they have historically been remarkably effective at predicting long-term returns over the following decade.

Buffett does not attempt to precisely time market tops. It"s a fool"s errand.

Instead, when valuations become detached from economic reality, he gradually shifts toward defence—even when markets continue climbing afterward.

• In the late 1960s, he wound down his partnership and held significant cash well before the brutal 1973–74 bear market.
• In the late 1990s, he avoided the speculative excess surrounding the dot-com bubble, enduring years of criticism before the eventual collapse validated his caution.

Look at a Barron"s headline from 1999: "What"s Wrong, Warren?" At the time, Berkshire"s stock had fallen 23%, while the Nasdaq was up 86%.

Today, Berkshire Hathaway sits on its largest aggregate cash (where cash can include short-term bills) position in history—around 35% of its portfolio.

During the late 1960s, the 1990s, and shortly before 2008, Buffett looked very "wrong" in the short term.

But over the long run, valuation discipline mattered far more than "one or two" years of momentum.

Rather than asking what it takes for this market to keep climbing, I will always ask what it takes for returns to go to zero?

If I want to lose half (or more) of my wealth over the next decade, what exactly should I do?

The answer requires a perfect storm of missteps:

• I would need to price assets for absolute perfection at 23x forward earnings
• Willingly accept a negative equity risk premium; and
• Blindly assume that historically anomalous multiples are simply the permanent new normal.

As the 10-year return chart showed earlier – historically tested models show an incredibly tight correlation between current valuations and forward 10-year returns.

Today, that model is forecasting a very low average annualized return for the next ten years.

Putting it All Together

Throughout time, it is vital to observe when a meaningful disconnect emerges between investor optimism and the underlying economic realities driving long-term returns.

Most of the time, valuations oscillate just either side of the mean.

But occasionally, excessive emotion pushes the limits further, and slowly but surely, the absurdity is normalized.

In a zero-equity risk premium world, doing well over the next decade demands caution when it comes to "blind" index investing.

It means killing the over-optimism and demanding a margin of safety—hunting for moated, non-cyclical assets where you can pay a rational multiple for real cash flow.

Regards,
Adrian Tout

If you were forwarded this email – you can subscribe here