Data Update 2 for 2026: A Test for US Equities

Key Concepts

• S&P 500 & NASDAQ: Major US stock market indices used for performance analysis.
• MAG 7: The seven largest US technology companies (Nvidia, Alphabet, Apple, Amazon, Microsoft, Meta, Tesla) significantly influencing market performance.
• Implied Equity Risk Premium: A metric calculating expected stock market returns based on current index levels, cash flows, earnings growth, and risk-free rates (T-bond yields).
• Small Cap Premium & Value Premium: Historical investment strategies based on the outperformance of small-cap and value stocks, respectively, which have shown diminished returns in recent decades.
• PE Ratio (Price-to-Earnings Ratio): A valuation metric comparing a company’s stock price to its earnings per share, used to assess whether a stock is over or undervalued.
• Cash Yield: The combined return from dividends and share buybacks.

US Equities in 2025: A Year in Review & Outlook for 2026

I. 2025: A Year of Contrasts

2025 was characterized by significant global economic and political upheaval, described as a period of “complete mayhem” akin to the opening scenes of a James Bond film. Despite a constant stream of negative news – including “Liberation Day” and massive tariffs impacting global trade – US equities delivered a solid return of 17.72% (including a 1.34% dividend yield). This contrasted sharply with expectations based solely on news headlines, which would have predicted a negative year for stocks.

II. Index Performance & Sector Analysis

• S&P 500: Rose from 5,881.66 to 6,845.5, representing a 16% increase. April 11th marked the year’s low point.
• NASDAQ: Initially underperformed the S&P 500, but rebounded to regain its leading position by September.
• Sector Performance:
  • Best Performing: Communication Services (+13.6%) – driven by the performance of two “Mag 7” stocks. Technology (+23.65%).
  • Worst Performing: Real Estate and Consumer Staples (around -2.2% to -2.5%).
• Total Value Added: US equities added $10.02 trillion in value, with tech companies contributing $4.2 trillion.

III. Industry Group Performance: Divergence in Returns

Analysis of 95 industry groups revealed significant disparities in performance:

• Best Performing: Precious Metals – benefiting from a surge in gold prices exceeding $4,000. Energy, including coal, also performed well.
• Worst Performing: Chemicals, Alcoholic Beverages, Household Products, and Food Processing. Some industries saw returns of 40-60%, while others lagged significantly.

IV. Reversal of Historical Trends: Small Cap & Value Premiums

Historically, small-cap stocks and value stocks (low price-to-book ratio) have outperformed large-cap and growth stocks, respectively. However, these “premiums” have been absent for decades. 2025 saw a partial reversal of this trend:

• Small Cap Outperformance: Small-cap stocks outperformed large-cap stocks for the first time in a long period.
• Value Stock Rebound: Low price-to-book stocks delivered 8.1% higher returns than high price-to-book stocks.
• Caveat: This is not necessarily indicative of a full return to historical norms, but rather a move towards a more balanced state.

V. The Dominance of the MAG 7

The “Mag 7” companies continued to exert a significant influence on the US equity market:

• Collective Return: The Mag 7 collectively rose 22.36%, adding $3.94 trillion in market capitalization.
• Individual Performance: Nvidia (+38%) and Alphabet (+63%) were the strongest performers, while Apple and Amazon saw more modest gains.
• Historical Trend: Since 2014, the Mag 7 have accounted for a growing proportion of the total US equity market capitalization, contributing 39% of the market’s increase in 2025 alone. They were responsible for 86% of the drop in US equities in the first quarter of 2025.

VI. Assessing Valuation: The PE Ratio & Beyond

Traditional valuation metrics, such as the Price-to-Earnings (PE) ratio, suggest that US equities are currently overvalued:

• PE Ratio Levels: Trailing, normalized, and Schiller PE ratios are all significantly higher than historical averages.
• Limitations of PE Ratio: The PE ratio has consistently signaled overvaluation for much of the past 15 years, despite continued market gains, indicating significant “noise” in the signal.

VII. The Implied Equity Risk Premium: A More Comprehensive Approach

To address the limitations of the PE ratio, the analysis introduces the “Implied Equity Risk Premium” (IERP):

• Calculation: The IERP is derived by discounting future cash flows (based on analyst earnings growth projections) back to the present value, using a risk-free rate (T-bond yield) and solving for the discount rate.
• Current IERP: The IERP at the start of 2026 is 4.23% - 4.46% (depending on adjustment for US credit rating downgrade).
• Interpretation: An IERP of 4.23% - 4.46% is roughly in line with historical averages, suggesting that stocks are fairly priced. However, a bearish perspective would argue that this premium is low compared to the crisis-driven environment of recent years.

VIII. Outlook for 2026 & Investment Strategy

Despite a strong 2025, concerns remain about the sustainability of US equity gains:

• Potential Risks: The impact of negative news events, potential earnings slowdown, and the possibility of a market correction.
• Investment Position: The speaker has increased their cash holdings and is cautiously exploring alternative investments like collectibles.
• Ideal Scenario: A more moderate market return (8-9%) would allow for consolidation and reduce excess.

Notable Quote:

“2025 was a year of stunning news…news that shook the foundations of an economic world order that has stood since the end of the Second World War.”

Conclusion:

2025 was a surprisingly strong year for US equities despite significant global challenges. While valuation metrics suggest potential overvaluation, the Implied Equity Risk Premium indicates that stocks are currently fairly priced. The dominance of the Mag 7 continues, and the reversal of historical trends in small-cap and value premiums warrants attention. The outlook for 2026 is uncertain, but a cautious approach and a focus on earnings growth and cash flow stability are recommended.