Over my four-decade career in professional investment practice, I’ve had the privilege of observing the evolution of the financial markets in the United States. From the highs to the lows, the journey has been filled with remarkable experiences. What stands out the most is the persistent decline in inflation and interest rates that has transformed the investment landscape. This change has not only spurred growth in the global economy but has also had significant social impacts, such as lifting more than a billion people out of extreme poverty, thanks to the mechanisms of capitalism.

One of the most striking outcomes of this trend has been the remarkable performance of the stock markets. In particular, the S&P 500 has experienced a dramatic rise, climbing a staggering 2,536% from 1981 to 2019. While corporate profits undeniably play a crucial role in driving stock prices, something else has been at play during this period: the systemic reduction in inflation and interest rates.

Profit Growth: A Driver, But Not the Only One

While it’s widely known that profit growth typically drives stock prices, it’s essential to ask: is it the only factor at play? A closer look at the S&P 500 from 1981 to 2019 reveals an interesting trend. During this period, the index’s earnings grew by 970%, yet the price of the S&P 500 skyrocketed by 2,536%. This suggests that other factors were influencing stock price growth.

One of the primary drivers during this time was the global decline in inflation and interest rates. Bond yields fell significantly, causing investors to shift their focus from bonds to stocks, which began to seem more attractive as the returns from fixed-income investments dwindled. From 1981 to 2019, the yield on the 10-year U.S. Treasury note dropped from 13.92% to just 2.14%. This massive decline in bond yields led to a shift in investor behavior, as lower yields on bonds made stocks more appealing.

Additionally, the price-to-earnings (P/E) ratios of stocks surged during this time, reflecting the impact of lower interest rates and inflation. From 1981 to 2019, the S&P 500’s P/E ratio increased from 8.0x earnings to 19.9x earnings. This shift indicates that investors were willing to pay more for earnings in an environment characterized by low inflation and interest rates. A historical look at bond yields versus P/E ratios underscores this relationship, showing how periods of declining rates lead to higher stock market valuations.

The Rising Tide of Declining Inflation and Interest Rates

In periods of declining interest rates and inflation, most companies benefit to some extent. The lower cost of capital allows businesses to expand profit margins, making it easier for them to thrive. This is akin to a rising tide lifting all boats—during times of falling inflation and interest rates, even companies with mediocre business plans tend to see improvements.

From 1981 to 2019, this phenomenon played out across the stock market. With the cost of capital continually shrinking, many companies enjoyed a favorable environment, contributing to overall market growth. This period saw index investing become increasingly popular, as passive strategies benefited from the general upward trend in stock prices.

However, this era of widespread market prosperity driven by declining inflation and interest rates may be coming to an end. The world is transitioning into a new economic environment, one where the forces of globalization that helped keep inflation and interest rates low for decades are slowing, if not reversing. The political and economic climate is shifting, with growing nationalistic tendencies replacing the global cooperation that characterized the past few decades. The rise of such sentiments, particularly in countries like China and the United States, signals the start of a new era in global trade and economic dynamics.

The “Market of Stocks” Concept

As we enter this new environment, the era of universal benefit from declining inflation and interest rates may be over. Inflation rates are likely to stabilize at higher levels than before, and the cost of capital is expected to rise as a result. This shift will likely create a widening gap between successful companies—those with strong profit growth and rising margins—and companies that struggle to keep up.

In this new reality, the broad performance of the stock market may no longer be as reliable. Rather than investing in the stock market as a whole, it may be more profitable to focus on individual stocks. As inflation and interest rates rise, the differences between the “winners” and “losers” will become more pronounced, and active management may offer an advantage in selecting those companies poised for success.

New Opportunities on the Horizon

As the investment environment changes, there will likely be new opportunities outside of U.S. large-cap stocks. Bonds, commodities, and real estate may all offer attractive returns, particularly as interest rates and inflation expectations adjust. For instance, the bond market, which has been historically influenced by inflation and interest rates, could see improved returns in the future, especially as real yields rise above inflation.

Though current bond yields still haven’t returned to long-term averages, the market’s shift from negative real yields to more favorable rates could make bonds an appealing investment option in the coming years. With inflation projected to hover around 3% to 4%, bonds offering yields above this range will likely become more attractive.

Looking Ahead

The world is transitioning into a new economic “passageway.” As we leave behind the era of consistently low inflation and interest rates, the fundamentals that drove capital into equity markets—particularly the systemic decline in inflation and interest rates—are changing. This shift will likely lead to more significant disparities in stock performance between winners and losers, with equity selection becoming more critical than ever.

Moreover, as the global economic landscape shifts, other asset classes may offer exciting opportunities. Bonds, commodities, and real estate are poised to become more appealing at the right time and price. Investors who adapt to these changing dynamics will find new ways to capitalize on emerging trends in the market.