Today’s post is a break from my regularly-scheduled e-commerce programming to discuss something much more riveting: academic financial analysis.

There’s a puzzle in today’s markets. Even with interest rates up, valuations haven’t returned to historical norms. The S&P 500 trades at a forward P/E of 21. The Shiller CAPE ratio has averaged over 30 since 2010, far above its 20th-century average of 16.8.

Many people argue this is a bubble. But is it? What if higher valuations reflect a structural shift in how investors participate in the market?

40 years ago, almost every dollar in the stock market was actively managed. Investors either picked stocks themselves or paid someone to do it. That meant high fees, concentrated portfolios, and frequent taxable trades.

But since then, passive investing has exploded. Index funds and ETFs now account for over 50% of US equity fund assets, and more than 60% of daily trading volume. Most retirement accounts default workers into passive target-date funds. The average investor used to own 10–20 stocks. Now they own thousands. Diversification has gone from a luxury to a default. While market (beta) risk remains, that means lower idiosyncratic risk (the risk of a few stocks tanking your portfolio).

Fees: Active fund fees used to be 1–2% per year. Index fund fees are now as low as 0.03%. That’s a full 1–2% boost to net return.

Taxes: Active funds frequently realize gains. Passive ETFs defer them. Most investors now use retirement accounts or ETFs with low turnover. Tax drag has fallen dramatically.

Each of these reduces the effective return investors need. That means they should be willing to pay more, all else equal, for the same expected future earnings.

Here’s the math using the Gordon Growth Model: if you expect 4% earnings growth, and you demand a 10% return, you’ll pay:

1 / (0.10 - 0.04) = 16.7 × earnings

But if you only need 7%–because your portfolio is diversified, low-fee, and tax-efficient–you’ll pay:

1 / (0.07 - 0.04) = 33.3 × earnings

The shift in required returns due to lower risk directly changes expected multiples.

Markets used to be priced by people who paid 2% fees to pick 20 stocks and got taxed every time a manager blinked. Now they’re priced by people who own 4,000 companies in a 401(k) for 0.03% a year.

In that world, it makes sense that investors demand lower expected returns; they’re taking less risk of missing their investment goals. Therefore, it’s not a bubble–lower required return is reflected in higher multiples.