Date: January 13, 2026
With the S&P posting an 18%+ return in 2025 and bringing its total return since the end of 2022 to more than 85%, investors are increasingly asking “how long can the good times last?”. For now, the answer seems to be that as long as corporate earnings are increasing and inflation is mostly under control, the equity market can continue to move up the wall of worry. For some, the gigantic investments in artificial intelligence (AI) and the commensurate increase in market values of related stocks smell of a dot-com-like bubble that upon bursting will take its toll on all risk assets. While we don’t have a strong opinion on which of these views will prove correct in the months ahead, we do believe that 2026 may prove to be more of a continuation of the 2025 trends, albeit, with more muted equity returns.
The S&P 500 is currently trading around 24x earnings (at the high end of its historic range) and 2026 earnings growth estimates for the index are around 12%. For the index to generate a double-digit return, the market must retain its lofty valuation, and companies must deliver on projected earnings. As analysts develop earnings estimate for 2027, if the expected growth rate slips from 2026 levels, we believe the index is likely to face a valuation contraction, thus generating a lower return than projected earnings growth. We believe an equity return in the mid-single digits may end up a fair target.
On the fixed income side of the ledger, the Bloomberg US bond aggregate index generated an approximate 7% return in 2025, as the Federal Reserve’s Federal Funds Rate cuts allowed long term rates to decrease as well, with the US 10 Year note yield decreasing from around 4.7% to 4.15%, and leading to bond holdings’ total return to exceed current yields. At current levels, we believe US long term rates are likely to stay range-bound around 4.0% to 4.2% for the 10-year note. Most market participants seem to expect a pause in rate cuts by the Federal Reserve until a better read on labor trends and inflation breaks the stalemate one way or another.
As we look to manage portfolio duration, we view a 10-year bond yield near the higher end of the 4.0%-4.2% range as an opportunity to extend duration, whereas a yield near the bottom of the range would cause us to add shorter than 10 year maturities to our client portfolios.
With the upcoming replacement of the Chairman of the Federal Reserve in the Spring, the market projects roughly 50 bps of additional cuts for the year, after the now expected January pause in rate cutting. A steeper yield-curve to a great degree is a sign of a healthy economy, albeit with some concern about inflation still lingering. The known unknowns continue to be the impact of AI on labor trends (mostly negative), productivity (positive), and inflation (uncertain). Geopolitical risks abound which could create a flight to safety at any time (which would be a negative for risk assets, but positive for the US dollar).
A Deeper Look at Growth and Interest Rates
In establishing our yield bogey for managing duration, we have spent some time analyzing the relationship of the US 10-year bond yield to economic growth. While economic growth is often separated between inflation and “real” growth, long-term bond yields are affected by both portions of economic growth. Bond investors rightly wish to be compensated for the loss of their purchasing power over time (due to inflation) as well as the opportunity cost of foregoing capital appreciation due to economic growth. As can be seen in the attached chart, US nominal GDP growth (the sum of real GDP growth plus inflation) on a trailing 3 year average (in order to smooth out volatility) has tended to move in tandem with 10-year bond yields. Since 1949, the average nominal GDP growth has essentially equaled the average yield of the US 10-year bond over the same time frame (within 5 basis points).
Nonetheless, there are periods of significant divergence with up to 5 percentage points or more difference between the two, in either direction (both in times when nominal GDP is greater the bond yield as well as the bond yield being greater than nominal GDP) – see the blue bars on the chart.
Source: Federal Reserve Bank of St Louis, Forest Capital
Interestingly, in times of sustainable and increasing nominal GDP growth, an increase in the 10-year bond yield seem to “lag”. In these periods, roughly 1949-1958, 1961-1979, and 2012-current, the 10-year bond yield has averaged 140 bps lower than nominal GDP growth. In time of contracting nominal GDP growth (1980-2009) the picture is a bit more muted, but nonetheless, the bond yield has generally lagged the GDP growth contraction. In other words, in rising nominal GDP environments the 10-year bond yield seems to stay below nominal GDP growth, whereas in decreasing GDP environments, the 10-year yield seems to stay above GDP growth. This possibly confirms the old Wall Street adage that “bonds are from Missouri, the Show Me State”: in periods of increasing GDP, bond yields are slow to react upwards, and in periods of contracting GDP growth, bond yields are slow to react downward.
Were these correlations to continue, it would be helpful to know, or have an idea, whether we are in a period of increasing GDP growth or contracting GDP growth. The following two charts separately show nominal GDP growth and the US 10-year bond yield plotted against their respective 20-year moving average and bands representing one positive/negative standard deviation from the mean.
These charts seem to show that, on a 20-year smoothed out basis, nominal GPD has turned upward, and the 10-year yield may be at the precipice of following suit. In addition, current levels for nominal GDP and the 10-year bond yield are at or close to one standard deviation above their respective moving average. Furthermore, in periods of increasing nominal GDP growth (the periods we noted above), GDP growth and the 10-year bond yield tend to stay at or above one standard deviation from their respective moving averages. If nominal GDP growth continues to increase, the yield of the 10-year bond indicated by its current upper one standard deviation band may prove to be the low point of the next long-term cycle. That level is currently 4.1%. Our goal of adding portfolio duration at a US 10-year yield at or near 4.2%, and shortening duration at a yield of 4.0% has been set based on this analysis. Since estimates for growth (real and inflation) are constantly changing we will continue to monitor this relationship between growth and rates, and make adjustments to our targets as needed.
Please feel free to reach out to us with any questions or comments.
Dimitri Triantafyllides, CFA
Chief Investment Officer/Portfolio Manager
dtriantafyllides@forestcapital.net
Wilhelm Karlsson
Graduate Intern