A (0:04)

Hello and welcome to Notes in the Week Ahead, a JP Morgan Asset Management podcast that provides insights on the markets and the economy to help you stay informed in the week ahead. Hello, this is David Kelly. I'm Chief strategist here at JP Morgan Asset Management. Today's December 15, 2025 the Red river of the north starts at the confluence of the Bois de Sioux and Otter Tail rivers and forms most of the border between Minnesota and North Dakota. It then crosses into Manitoba and empties into Lake Winnipeg before its waters finally flow into the sea at Hudson Bay. Cities have grown up along its banks, including Fargo, Grand Forks in Winnipeg, and their residents are all too aware of one unfortunate feature of the river. Unlike most large US Rivers, it flows from south to north. The Central Plains of the United States and Manitoba have long and cold winters, and the further north you go, the colder it gets. This means that when spring finally arrives, the river thaws from the south, and as the waters drip and trickle and stream and finally flow in torrents into the river, their passage is blocked by ice dams further north. Having nowhere to go, they spread out, inundating the populated areas and generally spreading misery. It's a chronic springtime problem. It's easy for the water to flow into the river. It's harder for it to leave. The US Stock market has been a beneficiary of a similar phenomenon for many years, leading to performance that has exceeded any reasonable expectation of investors. There are structural forces well beyond rising earnings and low interest rates that have driven an increased demand for stocks. There are also significant forces holding money in the market and limiting the supply of publicly traded stocks. But what are these forces and what do they imply for investment strategy? In 1985, two economists, Rajneesh Mehra and Edward Prescott, published a much quoted article entitled the Equity Premium A Puzzle. The puzzle was why in stock returns as outperformed the return on treasury bills by so much more than a general equilibrium model would have predicted from 1889 to 1978. Before anyone rushes to download the paper, I should warn you they didn't solve the puzzle. They did, however, estimate the ex post equity risk Premium. Over this 90 year period, stocks provided an annual average return that was 6.18% higher than on treasury bills. Remarkably, since then, the gap between the returns on U.S. stocks and treasury bills has only widened. Assuming no change in the S&P 500 or treasury yields between now and the end of this year, The S&P 500 will have produced an annual average total return between 1978 and 2025 of 12.4%, 8.3 percentage points better than 3 month T bills of the same period, and a full 9.0 percentage points per year above CPI inflation. Common sense as well as commentary from economists, strategists and investors over much this period tells us that these stock market returns have been far better than was anticipated back in the late 1970s or 1980s. Moreover, although this period has generally seen lower inflation and rising profit margins, stock prices have outpaced improving fundamentals. One measure of this is the Shiller PE ratio, which was 9.3 times at the end of 1978 but is at roughly 40 times today. So why have stocks done so well? One key has been forces driving money into stocks and in particular rising inequality and structural changes in the US Retirement system. As has often been noted, income inequality has increased greatly in recent years. Tax return data compiled by Emanuel says show that between 1946 and 1981 the top 10% of families received a fairly steady 32% of pre tax income, excluding capital gains and government transfers. However, in the over four decades since then, the rich have prospered disproportionately and by 2022 the top 10% of families received over 52% of income. This is significant for the stock market since according to the Census Bureau's consumer expenditure surveys in 2023 the top 10% of households in terms of income saved 33% of their after tax income, while the bottom 90% saved just 2%. Of course, much of this saving finds its way into the stock market, so the rising inequality has also likely been defeating the stock market boom. Changes in the retirement space have also been important. Since the introduction of 401 plans in the late 1970s, defined contribution plans have grown much faster than defined benefit plans. According to the Financial Accounts of the United States published by the Federal reserve in the first quarter of 1995, the total assets of defined benefit plans amounted to $1.176 trillion, roughly 34% higher than the $875 billion held by defined contribution plans. However, the advantages of defined contribution plans for employers have dramatically changed its landscape. By the second quarter 2025 definition, defined contribution plans held $9.853 trillion, more than three times as much as the $2.638 trillion in defined benefit plans. One reason this is important for the stock market is the different behavior of institutional and individual investors. Corporate defined benefit pension plans are far more disciplined in asset allocation than are individual investors. In 1Q 1995, defined benefit plans held 53% of their assets in equities, and this has declined marginally to 50% by 2Q 2025 in defined contribution plans. By contrast, we estimate that the equity allocation rose from 69% to 81% over the same period. All of this has pumped up demand for publicly traded U.S. equities over recent decades. There are also forces reducing the supply of stock. One of the most important of these is capital gains. Since 1979, the top federal tax rate paid on long term capital gains has ranged between 15% and 29.2% and currently stands at 23.8% for high income households. However, for investors, what matters is not so much the tax rate, but taxes paid as a percent of proceeds. This has become a more important issue in recent years precisely because the stock market has done so well. To illustrate this point, consider an investor who buys an S&P 500 index fund in a taxable account and sells it precisely 10 years later, paying the maximum raise on any capital gains. We estimate that on average since 1979, this would have implied a tax liability equal to 11.4% of the proceeds from the stock sale. However, if she'd sold in January 2009, she would have actually realized a capital loss. Since The S&P 500 was lower then than 10 years earlier, she could have used this loss to offset gains elsewhere or carried it forward for future tax mitigation. By sharp contrast, after the sparkling stock market gains of the past decade in if she sold today, she would owe roughly 16.6% in capital gains tax on the proceeds of the sale. This is a significant consideration for those considering selling out of the market. We estimate based on the Federal Reserve Survey Consumer Finances, that the median age of US equity owners weighting by their average equity holdings was 65.6 years in 2022. That is to say, half of US household equity holdings were held by a household with a reference person aged over 66. Since much of this wealth is intended to be passed on to future generations, and since most investors presumably understand the step up and basis at death, you have to be pretty sure about the need to reallocate assets before selling equities with substantial capital gains, there's also the issue of a falling number of publicly traded corporations. Between 1997 and 2024, according to Bloomberg data, as reported by Fortune, the number of publicly traded companies fell from 8,800 to 3,952. This is the result of a larger number of companies being acquired and taken private than going public through IPOs which in turn reflects the impact of tougher regulations on publicly traded companies and the increasing availability of private capital, allowing companies to avoid public listings. Compounding this issue is the effect of growing stock buybacks. According to our colleagues in JP Morgan Investment Bank, US buyback volumes 2 August were up 38% from a year earlier and could hit $1.5 trillion to 2025, continuing a long period of substantial increase. While this pace of buyback activity mathematically increases earnings per share, it also effectively reduces the available supply of US equities on the market. Of course there are or should be limits to equity outperformance. Strong earnings growth depends to an extent on strong nominal GDP growth. While both real GDP growth and inflation could rise in the first half of 2026, by the second half they should fade due to diminished fiscal stimulus, labor supply issues and less feed through from tariffs. Low interest rates can boost PE ratios. However, the Federal Reserve has indicated just one rate cut in 2026. While long term interest rates are unlikely to fall in the absence of a recession, and of course a recession would be the last thing the stock market needs longer term, there could be some pushback on the forces that have driven equity outperformance. If political populism ever morphs into tax the rich, taxes on dividends and capital gains could rise, reducing expected long term equity returns. Importantly, if a significant market correction does materialize for whatever reason, unrealized capital gains will diminish and capital losses could accumulate, making it easier for investors to reallocate capital even within taxable accounts. There will undoubtedly come a day when events precipitate a severe market correction or bear market. While we never know the timing of such a correction, we do know its location. It will very likely be centered in the areas of maximum hype and euphoria. Today, many investors with portfolios embed more risk and less balance than they intended. An important New Year's resolution is to do something about this. This means rebalancing in a tax smart way using tax alpha strategies, retirement accounts and annuities or just fresh cash to raise capital without paying Uncle Sam and directing that capital to bolster underfund positions in non mega cap, US equities, international stocks and alternative investments. Well, that's it for this week. Please tune in again next week and if you have any questions in the meantime, please reach out to your J.P. morgan representative.