The S&P 500 has delivered a strong year-to-date return of around 16% and valuations remain high. Optimism around AI continues to dominate the narrative, while investors increasingly question the sustainability of the rally.
Does all this mean investors should stay away from the US equity market? This allocation question merits extensive comparisons across markets and scenario analysis. It helps to cover some core analytics to get started, however: what can we say about expected returns, and risk in the current environment? This approach suggests that the attractiveness of the US market depends on your investment horizon, though risks appear high across horizons.
Expected returns by horizon
When examining expected returns, we can encounter very different stories depending on the horizon we are looking at. The expected return over the next year for the S&P 500 is actually quite attractive relative to other equity markets. If we look at the 10-year expected return, on the other hand, the S&P sits much lower down in the table.
This pattern is actually perfectly possible with high valuation metrics we see for the US. Over the past few years, long-term equity premiums have been falling to near zero. Viewing prices as discounted cash flows into the future, the majority of total value comes from cash flow growth and discount rates over the longer term. This leaves room for short-term expected returns to remain relatively high.
It's also the case that both short-term and long-term expected returns have remained relatively flat this year. A common intuition amongst investors is that when prices go up, expected returns go down. The classic case of this applies to bond yields - a proxy for bond expected returns - that move inversely to bond prices.
Equities are slightly different, however. The 16% return must have come from one or a combination of improved growth outlook, lower rates, or lower risk premiums. Our models show that much of the gain reflects an improved growth outlook — the natural channel for optimism about AI and productivity – while rates and risk premiums have netted out. According to present value logic, better growth supports higher prices today without materially changing expected returns. This is exactly what we have seen since the start of the year.
Higher risks, and a 'hated' rally?
While we can explain in mechanical terms how higher shorter-term expected returns and valuations can co-exist, can we say anything on why this pattern occurs? The answer may lie in perceptions of risk.
Alongside the strong run-up in equity markets, we have seen investor caution also increase. The chart below shows the skewness of the distribution of returns on the S&P 500 over the next year, implied by option markets. A negative number means investors place a higher weight on negative return outcomes. This series is around the lowest it has been in the 20-year history for which we have estimates.
This means that worries about downside risk have been intensifying, and can potentially justify short-term expected returns holding up as investors want to be compensated through risk premiums. This seems like a manifestation of investors reluctantly participating in the market, pushing up prices while remaining wary, sometimes referred to as a 'hated' rally.
A big risk is that the market's growth optimism proves excessive – and any undershoot relative to this optimism can have bigger impacts on market returns than before. We can quantify this impact sensitivity through 'equity duration'. Our estimate of the duration of the S&P 500 is currently around 26 years, the highest level in over 20 years.
This implies that even small adjustments in long-term growth expectations can have large effects on prices. High duration means a high degree of sensitivity, and on this metric US equities carry more risk than at any point in the previous two decades. The long-term growth outlook in the US seems particularly uncertain at this point. There are significant technological and political changes that could push growth expectations in either direction.
What to do?
Rather than prescribing a specific positioning, it is useful to outline some guiding metrics and frameworks for investors to consider. A full assessment naturally involves comparing the expected returns and risks of the US equity market with those of other regions.
Scenario analysis can help clarify how key drivers — such as growth expectations, policy responses, and risk sentiment — might evolve under different conditions. For example, given what is currently priced into markets, how severe would the impact be if growth undershoots optimistic consensus? Conversely, how might valuations respond if policymakers provide support, or if policy remains neutral?
Ultimately, portfolio choices depend on each investor's individual objectives, constraints, and risk tolerance. Our aim is to equip investors with analytical tools that allow them to evaluate these trade-offs systematically and adapt their allocations accordingly.