Contrary to popular belief, earnings growth has a very low correlation with decadal stock returns. The primary driver is the change in the valuation multiple (e.g., P/E ratio expansion or contraction). The correlation between 10-year real returns and 10-year valuation changes is a staggering 0.9, while it is tiny for earnings growth.

Historically, US earnings outgrew the world by 1%. Post-GFC, this widened to 3%. Investors have extrapolated this recent, higher rate as the new normal, pushing the US CAPE ratio to nearly double that of non-US markets. This represents a historically extreme valuation based on a potentially temporary growth advantage.

A powerful market signal is the "quad count," or the forecasted sequence of economic regimes. A progression from Quad 4 (recession fears) to Quad 3 and then to Quads 2 and 1 creates a powerful contrarian setup. This allows investors to buy assets like small caps when recession probabilities are priced at their highest.

The S&P 600 small-cap index has massively outperformed the more popular Russell 2000. The key difference is the S&P 600's requirement for profitability, which screens out speculative, pre-revenue "junk" companies that drag down the Russell 2000's returns, especially during speculative bubbles.

Current market multiples appear rich compared to history, but this view may be shortsighted. The long-term earnings potential unleashed by AI, combined with a higher-quality market composition, could make today's valuations seem artificially high ahead of a major earnings inflection.

With the Federal Reserve signaling a market backstop, capital is flowing from concentrated large-cap tech winners into more cyclical, under-loved small-cap stocks (IWM). This support de-risks 'Main Street' sectors and signals a potential broadening of the market rally.

The current market is not a simple large-cap story. Since 2015, the S&P 100 has massively outperformed the S&P 500. Within that, the Magnificent 7 have doubled the performance of the other 93 stocks, indicating extreme market concentration rather than a broad-based rally in large companies.

Anchoring valuation on a company's typical price-to-sales ratio helps identify buying opportunities when margins are temporarily depressed. This avoids the pitfalls of methods like the Magic Formula, which can mistakenly favor companies at their cyclical earnings peaks, leading to underperformance.

Despite record market highs, the S&P 500's underlying earnings per share (EPS) have not yet recovered to their peak from early 2022. This "narrative violation" points to a hidden earnings recession for large-cap stocks, a fact that has been masked by market enthusiasm and multiple expansion.