It’s basketball playoff season. The San Antonio Spurs play the New York Knicks in the 2026 NBA Basketball Finals that start June 3rd. The Spurs team is looking to return to basketball's mountaintop for the sixth time, and the Knicks team is looking for its first championship in 53 years.
Basketball has a history of dynasties over time when teams have dominated for years:
· 1957-1969: Boston Celtics
· 1980-1991 Los Angeles Lakers
· 1991-1998 Chicago Bulls
· 1999-2014 Those same San Antonio Spurs in this year’s finals
· 2015-2022 Golden State Warriors
Like these basketball legends, the US stock market has been a stock market dynasty for the past 18 years, consistently outperforming most other stock markets around the world. Recently it has chalked up three double digit winning years in a row and is currently on track for a 4-peat in 2026 with another doble digit return.
The S&P 500 is up 11.2% through May 31, which annualizes to 29%. The US stock market is on trend to another winning big year. What will make it so? What could ruin this party? It all depends on where Price/Earnings ratios trend – up or down.
Momentum or Regression to the Mean?
Many currently believe that AI-fueled earnings growth will continue to deliver high returns in 2026. High earnings growth is certainly happening, and it is good for stock prices, but the critical factor is investor behavior as revealed in the stock market’s Price/Earnings ratio. Greed drives up P/Es while fear reduces them.
High earnings growth of 28% so far this year is fantastic and should have lowered P/E by increasing the “E”, but it did not. P/Es have increased to 41, the 2nd highest level ever.
High P/Es typically signal low subsequent returns because high P/Es typically decline from their frothy levels—they regress toward their historic mean of 15. The average historic price for a dollar of current earnings is $15, not $41. It could be that a dollar of earnings has become more valuable for some reason. Can you think of one?
High P/Es have historically preceded market declines as prices stabilize. In other words, it will require upward momentum in stock prices to sustain the current rally this year.
The following table brings the market’s puzzle pieces together. Earnings growth matters, but investor greed and fear matters even more, as reflected in P/E.
Which do you think will play out in the rest of 2026 – momentum or regression toward the mean? Investors are hedging their investments by moving outside US stocks and bonds into alternatives like commodities and gold.
Diversification is working this year
As shown in the following, diversification beyond US stocks has worked so far this year.
Even though this article is about the return on US stocks this year, investors can and should diversify their investments because doing so improves their reward per unit of risk. That’s what diversification does.
Conclusion
2026 is heading toward a 4-peat of double digit returns on US stocks, but it will require P/Es to remain high – investors need to remain optimistic. In the past when P/Es were high, investor fear kicked in and P/Es declined, causing stock market losses. Time will tell.
Regardless of your outlook for US stocks, diversification beyond US stocks is worth considering.
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