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.

The S&P 500's historical earnings growth is ~6.7%. The ~9% growth of the last decade was an exception, driven by the unprecedented hyper-growth of a few mega-cap tech firms. As the law of large numbers catches up to these giants, investors should anticipate future index returns to revert to historical, lower norms.

A key tension in modern investing is that the best businesses often appear perpetually expensive (e.g., 30x+ P/E). However, their ability to continue delivering double-digit returns challenges the core value investing principle of buying at a low multiple, demonstrating the immense power of long-term quality and compounding.

The old PE model is obsolete in software. With high revenue multiples (7-8x) and low leverage (30% debt), firms must genuinely grow the business to generate returns. About two-thirds of value now comes from selling a larger, more profitable company (terminal value), not from stripping cash flow.

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.

Today's high S&P 500 valuation isn't a bubble. The market's composition has shifted from cyclical sectors (where high margins compress multiples) to mature tech (where high margins expand them). This structural change supports today's higher price-to-sales ratios, making the market fairly valued.

Shelby Davis's core strategy involved buying stocks where earnings would increase and, in parallel, the market would re-rate the stock with a higher P/E multiple. This dual effect created exponential returns far beyond what earnings growth alone could provide, turning a good investment into a multi-bagger.

Investment gains often come from "multiple expansion," where the market's perception of a business improves, causing it to trade at a higher valuation. This sentiment shift is frequently more impactful than pure earnings growth, and underestimating it is a primary reason for selling winning stocks too early.

In 2025, US stocks underperformed global peers despite superior earnings growth. Non-US markets saw significant price increases on flat or negative earnings, a divergence that Goldman Sachs Wealth Management believes is unsustainable, reinforcing their long-term US overweight thesis based on earnings fundamentals.