Indrani De, CFA, PRM
Indhu Raghavan, CFA,
- The large US equity rallies in 2023 and 2024 have been driven mainly by valuation expansion, which accounted for almost three-fourths to more than half of total return in 2023 and 2024, respectively.
- In one sense that is a continuation of the structural trend since the height of the European debt crisis in 2010 after which US equities began to outpace global ex US markets and valuation expansion played a larger role in driving US equity returns than previously. During 2011-24, US equities returned 5x in cumulative total return while its global peers merely doubled.
- Annualized total return for the Russell 1000 index during 2011-24 was nearly double that during 2003-10, while earnings growth during 2011-24 was only marginally higher than the earlier period.
- Yet the 2023-24 US equity performance is different from cyclical trends, where historically post-recession (or recession fear years) the initial market rally has been driven by valuation expansion, to be quickly followed by earnings growth as the main driver. In contrast, in the recent 2023-24 rally, valuation expansion continued to be the main driver of equity returns.
- It suggests that US equity market fortunes may be more susceptible to changes in investor sentiment, particularly as it relates to the AI-fuelled tech rally, and that investors could potentially face greater equity market volatility going forward.
The US stock market recorded a second year of stellar double-digit growth in 2024. What can investors expect going forward?
A lot depends on the drivers of an equity rally, given that equity returns are driven by three main components – earnings growth, valuation changes and dividend yield. We analyze time series data of the valuation change, earnings growth and dividend yield components of US equity returns over the last 22 years. We look at how their relative contributions have evolved over time, and the pattern of these components at similar points in the economic cycle (e.g. years after recession, or recession fears on the back of monetary tightening.) This helps to think about the sustainability of these returns and the risk factors involved.
Exhibit 1 shows the annual total return for the US large-cap Russell 1000 index with a breakdown of contributions to that total return from price-to-earnings (PE) multiple expansion, earnings growth and dividend yield.
Methodology: We take the price index and IBES 12-month forward PE at any given point in time to calculate the implied earnings per share (EPS) for the index. We use the values from 31 December of each year for PE and EPS to then calculate each component’s growth rate from the year before. The dividend yield is calculated as the difference between index total return and price return for that year.
Exhibit 1: Russell 1000 total return decomposition, 12M, USD, Percent
Source: FTSE Russell and LSEG. Data as of 31 December 2024. Past performance is no guarantee of future results. Please see the end for important legal disclosures. Note: The total return for each year is indicated in the box. PE, EPS and DY show the valuation expansion, earnings growth and dividend yield components of total return, respectively.
The Russell 1000 index returned 26.5% and 24.5% in 2023 and 2024, respectively. Of the 26.5% total return in 2023, 19.4% pts (or nearly three-quarters) came from valuation expansion and 5.4% pts (or just one-fifth) from earnings growth. In 2024, 12.5% pts (or just over half of total return) came from valuation expansion and 10.5% pts (just over two-fifth) from earnings growth. The stock rally of the last two years also followed a massive pullback in equities in 2022 (-19.1% total return for Russell 1000), when the US Fed started aggressively tightening monetary conditions in response to spiralling inflation, sparking fears of a recession, and valuations contracted massively. In 2022, PE multiple contraction shaved off 24.5% pts from total return, while earnings growth of 4.0% and dividend yield of 1.4% softened the extent of the drawdown.
While the US avoided a recession during the subsequent two years after the monetary tightening that started in 2022, earnings growth was not the main driver of returns. How does this compare to history?
Is the current rally different from those in previous business cycles?
It is worth looking at two time periods when the US stock market recovered from sharp pullbacks—after the bursting of the Tech bubble during 2000-02[1] and the Global Financial Crisis during 2008-09.
During 2003-05, earnings growth contributed more to stock market returns than multiple expansion. In fact, multiples bounced in 2003 and then contracted subsequently in 2004 and 2005. In 2003, a total return of 29.9% was driven by 18.0% pts (or nearly two-thirds) of earnings growth, 9.8% pts of valuation expansion and 2.1% pts in dividend yield. In 2004 and 2005, earnings growth contributed 15.9% pts and 12.9% pts, respectively, to total return, which was about two-thirds and just over half of that return. At the same time, multiples contracted in 2004 and 2005.
We see a similar recovery during 2009-11 when multiples bounced back sharply in 2009, and earnings growth led stock market returns in the subsequent two years. In 2009, a total return of 28.4% was driven entirely by valuation expansion of 29.8% pts, while earnings contracted by 4.0% pts and dividend yield contributed 2.6% pts. In 2010 and 2011, earnings growth contributed 23.5% pts and 12.6% pts, respectively, to total return, which was about two-thirds and just under half of that return. Once again, multiples contracted during 2010-11.
The stock market recovery of 2023-24 seemed to follow a similar pattern initially—with a strong bounce back in multiples in 2023 and a more gradual recovery in earnings. Thereafter in 2024 things looked different this time. It is hard to miss that the level of earnings growth this time around is much lower and multiple expansion continued to contribute just over half of returns even in 2024.
These numbers may reflect both the narrowness of the US equity rally in the most recent period and the degree to which it was driven by sentiment. US returns have been dominated by the US Technology industry on the back of AI-fuelled optimism.
We do the same analysis for small caps to see if things look different for them relative to large caps. Looking at the small-cap space offers another perspective.
Exhibit 2 shows the annual total return for the Russell 2000 index with the breakdown of contributions from multiple expansion, earnings growth and dividend yield.
Exhibit 2: Russell 2000 total return decomposition, 12M, USD, Percent
Source: FTSE Russell and LSEG. Data as of 31 December 2024. Past performance is no guarantee of future results. Please see the end for important legal disclosures. Note: The total return for each year is indicated in the box. PE, EPS and DY show the valuation expansion, earnings growth and dividend yield components of total return, respectively.
The Russell 2000 small-cap index returned 16.9% and 11.5% over 2023 and 2024, respectively. This growth came primarily from multiple expansion of 19.7% pts and 8.2% pts, respectively, in 2023 and 2024, or over two-thirds of total return in both years. The contrast of this breakdown with the previous two time periods is starker. We see that during the 2003-05 recovery, it was earnings growth that dominated stock market returns in all the three years, and during 2009-11, earnings growth led the way in 2010 and 2011.The results for Russell 2000 are consistent with or even stronger than Russell 1000, i.e. market recoveries began with valuation expansion to be quickly followed by earnings growth as the main driver of returns, and the pattern of returns in 2023-24, of being led primarily by valuation expansion, is starkly different from past cycles.
US small caps are much more sensitive to domestic economic and monetary conditions than large caps. And small-cap earnings have recovered much less so than in the large-cap space and relative to history. It reinforces the idea that the stock market growth we have seen over the last two years in the US has been carried more by positive sentiment-led valuation expansion than a recovery in earnings compared to past cycles.
The expanding role of valuation expansion
In fact, if we look at the 14 years after the height of the European debt crisis in 2010, when US equity outperformance of global peers began in earnest,[2] we see that valuation expansion has played an increasing role in driving total returns in the US during 2011-24. The Russell 1000 index recorded a positive total return in 12 of those 14 years. Multiple expansion dominated returns in seven out of those 12 years, contributing between 50% and 90% of total return. By contrast, during 2003-10, when Russell 1000 had positive total returns in seven out of the eight years, only in one of those eight positive-return years was valuation expansion the primary driver for total returns.
Exhibit 3 shows the annualised total return for the Russell 1000 index during 2011-24 and 2003-10 and the contribution of each equity return component. We see that earnings growth contributed 7.9% pts and 7.5% pts to total return during 2011-24 and 2003-10, respectively. However, while multiples contracted during 2003-10 shaving off 2.3% pts from total return, multiple expansion contributed 3.8% pts (or nearly one-third) to total return during 2011-24. Simply put, annualized returns during 2011-24 were nearly double that during 2003-10, while earnings growth during 2011-24 was only marginally higher than the earlier period. Dividend yield, which tends to be more stable, was similar during both periods.
Exhibit 3: Annualized total return and contribution of valuation expansion, earnings growth and dividend yield, Percent
| Period | Ann. Total Return | PE | EPS | DY |
|---|---|---|---|---|
| 2011-24 | 13.6% | 3.8% | 7.9% | 2.0% |
| 2003-10 | 7.2% | -2.3% | 7.5% | 2.0% |
Source: FTSE Russell and LSEG. Data as of 31 December 2024. Past performance is no guarantee of future results. Note: The total return for each year is indicated in the box. PE, EPS and DY show the valuation expansion, earnings growth and dividend yield components of total return, respectively.
This shows that since 2010, valuation expansion has played a greater role in US equity performance than previously. In that context, the contribution of multiple expansion to total return over the last two years is not an anomaly. What is an anomaly is that compared to the recovery years post-recession in a business cycle, the market recovery over the last two years were different, where the rallies were still driven primarily by valuation expansion and not earnings growth. This anomaly could potentially point to correction risks in US equities.
Conclusion
The large US equity rallies in 2023 and 2024 have been driven mainly by valuation expansion. In one sense that is a continuation of the structural trend in recent history, post the European debt crisis, when valuation expansion has played a larger role in driving US equity returns than previously. Yet it is different from cyclical trends, where post-recession (or recession fear years) where the initial rally is driven by valuation expansion, but earnings growth picks up the baton very soon. In the market rally after the 2022 drawdown, valuation expansion has yet to turn the baton over to earnings growth as the main driver.
Given this predominance of multiple expansion as a driver of equity returns over the past two years, it suggests that US equity market fortunes may be more susceptible to changes in investor sentiment, particularly as it relates to the AI-fuelled tech rally. We saw an example of this in January 2025, when the release of the Chinese DeepSeek AI model, that was reportedly trained at a fraction of the cost of similar purpose US AI models, brought the tech rally to a halt. Tech stocks in the large-cap index returned zero in aggregate over January 2025. Technology was the worst performing equity industry (based on ICB industries) and US equities lagged developed market peers in Europe, the UK and Asia Pacific in January 2025. It also implies that investors could potentially face greater equity market volatility going forward.
1. We start our analysis in 2003 due to the availability of component data for index total return. The Russell 1000 index recorded negative total return in calendar years 2000 (-7.8%), 2001 (-12.4%) and 2002 (-21.7%), making 2003 the first calendar year of positive market returns after the bursting of the Tech Bubble.
2. As measured by the cumulative total returns of the FTSE USA index (507%) and the FTSE All-World ex USA index (95%) between end-2010 and end-2024.
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