Can anything stop the stock market? The U.S. economy recently weathered the worst pandemic in 100 years, the worst inflation in 40 years, and the highest interest rates in 20 years. Yet from 2019 through 2024, the S&P 500 grew by an average of nearly 20 percent a year, about double its historical average rate. Despite President Donald Trump’s erratic economic policies, which include the highest tariffs since the 19th century, the market is already up by about 8 percent in 2025.
As the stock market soars ever higher, the theories of why it rises have suffered the opposite fate. One by one, every favored explanation of what could be going on has been undermined by world events. The uncomfortable fact about the historic stock-market run is that no one really knows why it’s happening—or what could bring it to an end.
According to textbook economics, the stock market’s value reflects what are known as “fundamentals.” An individual company’s current stock price is derived from that firm’s future-earnings potential, and is thus rooted in hard indicators such as profits and market share. The value of the market as a whole, in turn, tends to rise and fall with the state of the broader economy. According to the fundamentals theory, the market can experience the occasional speculative bubble, but reality will bite soon enough. Investors will inevitably realize that their stocks are overvalued and respond by selling them, lowering prices back to a level that tracks more closely with the value justified by their fundamentals—hence the term market correction.
The fundamentals story held up well until the 2008 financial crisis. Within six months of the U.S. banking system’s collapse, the market fell by 46 percent. In response, the Federal Reserve cut interest rates to almost zero and pushed money back into the economy by purchasing trillions of dollars in securities from financial institutions.
The Fed’s goal was to get the economy going again quickly. This didn’t happen. For most of the 2010s, corporate earnings were modest, GDP and productivity growth were low, and the labor market remained weaker than it had been before the crisis. In other words, the fundamentals were not great. Yet the stock market soared. From 2010 to 2019, it tripled in value.
This gave rise to what became known as the “liquidity” theory of the market. In this telling, the force driving the ups and downs of markets was the Federal Reserve. As long as the central bank was willing to keep flooding the financial system with cash, that money would eventually find its way into the stock market, causing valuations to rise regardless of what was happening in the real economy.
The apotheosis of the liquidity theory came in early 2020: The stock market crashed when the coronavirus pandemic hit, and the Fed once again responded by turning on the money taps. By mid-summer, unemployment was still above 10 percent, but the stock market had already rebounded past its pre-pandemic peak.
But the liquidity theory’s run was short-lived. In 2022, as inflation replaced unemployment as the economy’s biggest problem, the central bank reversed course, quickly raising interest rates and selling its securities. As the liquidity theory would predict, the stock market took a nosedive, falling by close to 20 percent. Then something strange happened. The Fed continued to raise interest rates over the course of 2023, to their highest levels in two decades, and kept them there in 2024. It also drained about $2 trillion of liquidity from the financial system. Yet the market took off once again. The S&P 500 rose by nearly 25 percent in both 2023 and 2024, making it the market’s best two-year run of the 21st century. “Between 2008 and 2022, the view on Wall Street was we were experiencing a liquidity-driven market,” Mohamed El-Erian, an economist and the former CEO of the asset-management firm PIMCO, told me. “That wasn’t at all the case in ’23 and ’24.”
The stock market’s performance in those years was unusual for another reason. More than half of the S&P 500’s total growth in 2023 and 2024 was driven by the so-called Magnificent Seven companies: Apple, Amazon, Alphabet, Meta, Microsoft, Tesla, and Nvidia. During those two years alone, Tesla’s value rose by 286 percent, Meta’s by 355 percent, and Nvidia’s by 861 percent. The biggest firms have always been responsible for a disproportionate share of the market’s growth, but never had the gains been so acutely concentrated. The phenomenon couldn’t be explained solely by superior business performance; the Magnificent Seven’s stock prices had begun to exceed earnings by record amounts, implying that their valuations had more to do with expectations about future growth.
This gave rise to a new theory: The stock market was being supercharged by the coming AI revolution—or, at least, by belief in it. The Magnificent Seven’s extreme surge began in early 2023, shortly after the release of ChatGPT, which kicked off a wave of interest and investment in the AI sector. The seven companies seem especially well positioned to prosper from the emerging technology, either because they provide crucial inputs to the development of AI models (Nvidia), are investing heavily in building their own models (Meta, Microsoft, Alphabet), or stand to benefit significantly from automation (Amazon, Tesla, Apple).
To some experts, the situation has all the markings of a speculative bubble. In a recent blog post, Torsten Sløk, the chief economist at the asset-management firm Apollo, pointed out that the top 10 companies in the S&P 500 today are more overvalued—meaning their stock prices exceed their earnings by larger factors—than the top 10 companies at the height of the 1990s dot-com bubble were.
Take Nvidia, the chipmaker that recently became the first company in history to hit a $4 trillion valuation. Historically, the average price-to-earnings ratio for a company in the U.S. market has been about 18 to 1, which means that to buy a share of stock, investors are willing to pay $18 for every $1 of the company’s yearly earnings. Nvidia’s current price-to-earnings ratio is 57 to 1.
AI boosters argue that these valuations are justified by the technology’s transformative potential; skeptics respond that the technology is far from being adopted at scale and, even if it eventually is, that there’s no guarantee that these seven specific companies will be the ones to rake in the profits. “We’ve seen this story play out before,” Jim Bianco, an investment analyst, told me, pointing to the dot-com crash of the early 2000s. “Just because there’s a truly revolutionary technology doesn’t mean stocks are correctly pricing in that reality.”
If the current market froth is indeed an AI bubble, then a day must come when the bubble bursts. For a moment, that day appeared to have arrived on April 2, when Trump announced his “Liberation Day” tariffs. Over the next week, the stock market fell by 12 percent, and the Magnificent Seven took even steeper hits.
But then, on April 9, Trump backed down from his most extreme tariff proposals and, a few weeks after that, de-escalated what seemed like an imminent trade war with China. The market swiftly recovered and launched into a bonanza even wilder than those of the previous two years. The S&P 500 has risen nearly 30 percent since its post–Liberation Day low, setting all-time records, and the Magnificent Seven have come roaring back. This gave rise to the concept of the “TACO trade,” as in “Trump always chickens out.” The idea is that Trump hates falling stock prices and will back off from any proposal that puts the market in jeopardy. So rather than sell their stocks every time the president threatens to impose crippling trade restrictions, investors should continue to pour money into the market, confident that the proposals Trump ultimately leaves in place won’t do much damage.
The flaw in the TACO theory is that Trump hasn’t completely chickened out. Tariffs are the highest they’ve been in more than a century, and the president is announcing new ones all the time. Still, the market appears largely unfazed. When Trump announced “trade deals” with the European Union and Japan that set the tariff on most goods arriving from those places at 15 percent, the stock market actually rose. Even last week, when the president announced a sweeping new set of global tariffs—an announcement immediately followed by a brutal jobs report suggesting that tariffs were weakening the economy—the market suffered only a blip. As of this writing, it is higher than it was before the announcement.
This leaves a final theory, one that has nothing to do with Trump, AI, or the Federal Reserve.
Thirty years ago, almost all of the money in the U.S. mutual-fund market was actively managed. Retirees or pension funds handed over their savings to brokers who invested that money in specific stocks, trying to beat the market on behalf of their clients. But thanks to a series of regulatory changes in the late 2000s and early 2010s, about half of fund assets are now held in “passive funds.” Most retirees hand their savings over to companies such as Vanguard and Fidelity, which automatically invest the money in a predetermined bundle of stocks for much lower fees than active managers would charge. The most common type of passive fund purchases a tiny share of every single stock in an index, such as the S&P 500, proportional to its size.
Some experts believe that this shift is the best explanation for the otherwise inexplicably resilient performance of the stock market. “The move to passive funds is a radical shift in the structure of financial markets,” Mike Green, the chief strategist at Simplify Asset Management, told me. “To think that wouldn’t dramatically impact how those markets behave is just silly.”
Active investors are highly sensitive to company fundamentals and broader economic conditions. They pore over earnings reports, scrutinize company finances, and analyze market trends, and will often sell at the first sign of an economic downturn or poor company performance, which causes markets to “correct.” Passive investors, on the other hand, typically just pick a fund or two when they set up their retirement accounts and then forget about them, meaning they are automatically buying stocks (and rarely selling), no matter what. In June 2020, for example, Vanguard released a statement bragging that fewer than 1 percent of its 401(k) clients had tried to sell any of their equities from January to the end of April, even as the economy was melting down.
Thus, whereas a market dominated by active investors tends to be characterized by “mean reversion”—in which high valuations are followed by a correction—a market dominated by passive investors is instead characterized by “mean expansion,” in which high valuations are followed by even higher valuations. “When there’s a constant flow of passive money coming in, betting against the market is like standing in front of a steamroller,” Green said. “You’d be crazy to do it.”
A market dominated by passive investors also naturally becomes more concentrated. Active investors tend to avoid larger stocks that they believe might be overvalued, but the opposite is true for passive investors. Because they allocate funds based on the existing size of companies, they end up buying a disproportionate share of the biggest stocks, causing the value of those stocks to rise even more, and so on.
The explosion of passive funds over the past 15 years could explain why the market has become less sensitive to real-world downturns, more likely to keep going up no matter what, and dominated by a handful of giant companies. Or that theory could end up being disproved by unforeseen events. It wouldn’t be the first.
Support for this project was provided by the William and Flora Hewlett Foundation.
