Overview:

• Rising inequality and steady retirement contributions push huge amounts of money into equities every year. 

• The shift from pensions to 401(k)s has increased stock exposure. Individual investors usually hold more equities and rebalance less often, which steadily raises demand.

• With fewer companies going public, rising private ownership, and record stock buybacks, the supply of public shares is shrinking. 

For years, the US stock market has delivered returns that seem wildly disconnected from the pace of economic growth. Wages rise slowly, GDP expands modestly, yet stock indices continue to scale new highs. This gap between Wall Street and the real economy isn’t an accident. It’s the result of powerful structural forces that have steadily pushed more money into equities while quietly shrinking the supply of available stocks.

A useful way to understand this imbalance is to imagine a river that flows easily in one direction but struggles to drain in the other. Money has been pouring into the stock market for decades, but multiple barriers make it difficult for capital to flow  back out.

Stock Returns vs. Economic Reality

Historically, stocks have always outperformed safe assets like Treasury bills, but the scale of that outperformance has become extraordinary. Economists first highlighted this mystery in the 1980s, calling it the ‘equity premium puzzle.’ At the time, stocks already looked unusually generous compared to government bonds.

Since then, the gap has grown even wider. From the late 1970s to today, US equities have delivered double-digit annual returns, far exceeding inflation, bond yields, and even what long-term earnings growth alone could justify. Valuations tell the same story. Measures like the Shiller P/E ratio, once in single digits, now sit near historic extremes, signaling that prices have risen much faster than corporate fundamentals. So what’s fueling this sustained surge?

Rising Inequality Is Fueling Stock Demand

One major driver is income inequality. Over the past four decades, a growing share of national income has flowed to the wealthiest households. This matters because high-income families save far more than everyone else, and much of that savings ends up in the stock market.

While lower- and middle-income households typically save very little, top earners often invest a significant portion of their income. As wealth has concentrated at the top, so has investment power. The result is a persistent, structural bid for equities that doesn’t depend on short-term economic conditions.

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Retirement Systems Quietly Push Money Into Stocks

Another powerful force is the transformation of the US retirement system. Decades ago, pensions were dominated by defined-benefit plans, where professional managers carefully balanced assets. Today, defined-contribution plans like 401(k)s dominate, and individual investors tend to favor stocks.

Over time, these retirement accounts have grown enormously, with equity allocations steadily increasing. Unlike pension funds that rebalance conservatively, individual savers often remain heavily invested in stocks, even during market volatility. Every paycheck contribution adds to demand, reinforcing long-term upward pressure on stock prices.

Why Stocks Don’t Easily Flow Back Out

While demand for stocks has surged, supply has quietly tightened. One reason is capital gains taxes. After years of strong market performance, many investors sit on large unrealized gains. Selling stocks triggers a sizable tax bill, discouraging reallocation. For older investors who now hold a significant share of total equity wealth, this effect is even stronger, especially given the incentive to pass assets on with a stepped-up tax basis.

The number of publicly traded companies has decreased significantly over time. Many businesses prefer to remain private or be bought rather than go public. There are fewer IPOs, meaning fewer new stocks are being introduced to the market.

The number of stocks available to investors is shrinking amid a massive surge in share buybacks. Companies are buying back their stock with cash at record rates, and as a result, they have less stock available to the investor and more ‘mechanical’ earnings per share (EPS).

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What This Means for Investors

There are limits to this stock vs economy dynamic, and stock prices cannot continue to outpace economic growth indefinitely. Economic growth is slowing; moreover, interest rates remain high, and fiscal stimulus is being reduced. Thus, you can expect that, over time, these factors will create pressure on stock valuations.

The government may impose higher taxes on wealth and capital gains, which will also create a drag on long-term returns for stocks. Typically, when a correction occurs, it will be in the areas of concentration and extreme optimism. I believe that many investors are taking on more risk than they realise.

The message is not to get out of stocks but rather to rebalance. A more resilient portfolio would have a broader equity allocation, international asset exposure, alternative assets, and tax-efficient vehicles. While there are powerful forces behind stock prices, it is important to keep in mind that cycles still exist. It’s always essential to be prepared for the reversal of the market when it eventually occurs.

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FAQs

1. Why are stocks rising faster than the economy?

Stocks benefit from long-term money flows that don’t depend on short-term growth. Retirement savings, wealthy investors, and corporate buybacks keep demand strong even when wages and GDP grow slowly.

2. Does income inequality really affect the stock market?

Yes. Wealthier households save much more money and invest heavily in stocks. As income concentrates at the top, more capital flows into markets, increasing demand regardless of broader economic conditions.

3. How do 401(k) plans push stocks higher?

401(k) plans regularly receive contributions from millions of workers. Most of that money goes into stock funds and stays invested for decades, creating steady and reliable demand for equities.

4. Why don’t investors sell stocks more often?

Large capital gains taxes discourage selling. Many investors prefer to hold assets long term, especially older investors who plan to pass wealth on and benefit from tax advantages later.

5. Can this stock outperformance last forever?

No. Markets can outpace the economy for long periods, but not indefinitely. Slower growth, higher taxes, or market corrections can reduce returns. Balance and diversification still matter.