It’s been a while since we’ve had Mr. Arithmetic here, but with Donald Trump coming back to the White House, we may need him around. The immediate reason for consulting his expertise is the projections for big stock market gains in 2025.

It seems the median forecast is for the S&P 500 to rise by roughly 10 percent over the course of 2025 from its year-end 2024 level. Many are forecasting considerably larger gains. Basically, the story is that all the good news for corporate profits in recent years will continue and the stock market will keep going higher at close to the pace it has been rising.

There is a problem in this story that seems to be getting little attention. The price-to-earnings (PE) ratio for the S&P 500 is already near the peaks that it hit in the 1990s bubble. Robert Shiller’s cyclically adjusted level stands at more than 38 to 1. (The cyclical adjustment compares current prices to inflation-adjusted profits over the last decade.) This is more than twice the long-period average and only slightly below the peaks hit in the late 1990s bubble.

The question I asked Mr. Arithmetic is whether we can expect to see 10 percent returns in 2025, like the median analyst projected. He immediately suggested that we have to look to profit growth. While no one knows exactly how much profits will grow in 2025, we can look for forecasts.

A good starting place here is the Congressional Budget Office (CBO). Its most recent projections showed corporate profits growing 3.5 percent in 2025. This means that if we’re starting from a PE ratio of 38 to 1, with a 10 percent stock rise and 3.5 percent profit growth, we will have a PE ratio of over 40 at the end of 2025, even closer to the peak of the nineties bubble.

The picture doesn’t look any better going further out. The CBO projections show average profit growth over the next decade of just 2.7 percent annually, only slightly higher than the 2.3 percent average projected inflation rate, using the Consumer Price Index.

This means that, assuming the projections are right, if the PE ratio were to just remain at its near record high, and not reach new records, the average real increase in stock prices would be just 0.4 percent annually. Even adding in 2.5 percent for dividends and share buybacks, this would still give a real return of around 3.0 percent, less than a percentage point above the 2.2 percent return investors would get on an inflation-indexed government bond.

It’s possible that investors would be willing to hold stocks for returns that are only slightly higher than an entirely risk-free asset, but historically that has not been the case. The returns from stock have averaged more than 4.0 percentage points higher than the returns on government bonds.

It may also be the case that we will see the PE ratios rise to new records and just keep rising. Anything is possible, but that scenario also does not seem likely.

What If the Projections are Wrong?

CBO projections deserve to be taken seriously, but they are not written in stone. CBO has been wrong in the past and they will surely be wrong in the future. It is worth noting that CBO is rarely an outlier. While their projections are model driven, they try to produce numbers that put them near the middle of professional forecasts. The point is to produce numbers that can........

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