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 reasonably be taken as a basis for policy. CBO is not trying to stake out an outlier position. With this in mind, it is still possible that profits will grow considerably more rapidly than CBO has projected, but that means the consensus in the profession is likely off the mark, not just CBO. There are two ways that profits can grow more rapidly than CBO projected. The first is if there is a redistribution from wages to profits. (There can also be a redistribution from the government sector to higher after-tax profits, as a result of lower corporate tax rates. I’ll come back to this.) There already has been a redistribution from wages to profits of more than 4.0 percentage points since the turn of the century. Roughly half of this has been since the pandemic. The CBO projections show some shift back to wages, with the profit share of national income being 1.2 percentage points lower in 2034 than it was 2024. Perhaps this reversal won’t take place and the profit share stays roughly at the current level. In that case, profits will rise at an average nominal rate of 3.0 percent over the next decade. That would make the real return from holding stock, assuming a constant PE ratio, of 3.2 percent, roughly a percentage point above the rate on inflation-indexed government bonds. That still doesn’t sound very attractive.It is possible that we will see a further shift from wages to profits, but this seems unlikely barring major changes (i.e. much higher unemployment) in the shape of the labor market. It seems the possibilities for much more rapid profit growth due to a redistribution from wages are limited.The other way that profits can grow more rapidly is if the economy grows considerably more rapidly than CBO projects. CBO currently is projecting an average annual growth rate of 1.8 percent over the next decade. This is lower than the historical rate because CBO projects very slow labor force growth due to the retirement of the baby boom cohorts. With immigration likely to be restricted for the foreseeable future, any substantial increase in GDP growth above CBO’s current projections would almost certainly have to come from faster than expected productivity growth. This is not impossible given the impact of AI and other recent innovations. Also, we have been seeing faster than projected productivity growth in recent quarters, although these data are highly erratic so that may not tell us much about the future. Suppose that productivity growth averaged 1.0 percentage points higher than CBO now projects and that translates into 1.0 percentage point more rapid annual GDP and profit growth. That would translate into 3.7 percent annual profit growth or 1.4 percent real growth. Assuming the PE ratio stays constant at its near-record high, this would mean real returns from holding stock of roughly 3.9 percent annually, 1.7 percentage points above the return on inflation-indexed government bonds. That still is well below the historic gap, but we’re getting closer.However, it is also worth noting that if we sustain this more rapid pace of productivity growth for a decade, the economy would look very different in 2034 than is currently projected. Most immediately, wages would be considerably higher in 2034 than is now projected. Instead of real wage growth of 1.2 percent annually, assuming income shares are constant, real wages would grow at a rate of 2.2 percent a year. In 2034 the average worker in 2034 would have a real wage more than 26 percent higher than the average worker does today. This would amount to the most rapid sustained real wage gains since the Golden Age from 1947 to 1973. That would be a pretty positive story. It would also mean that, barring major changes in policy, the debt-to-GDP ratio and the interest burden of the debt would not be rising. If this more rapid rate of real wage growth was sustained, it would eliminate most of the projected long-term (75-year) shortfall in the Social Security trust fund. This also would show clearly that funding Social Security is a political problem, not an economic problem. Suppose real wages are 26 percent higher than in 2034 than they are today. Would anyone really say that workers in 2034 would have much grounds for complaint if the Social Security tax was 1.0 percentage point higher than it is now, leaving their after-tax real wage 25.0 percent higher in 2034, rather than 26.0 percent higher? Politicians may not want to ever talk about taxes (we did raise the tax repeatedly from the founding of the program until 1990), but it is hard for serious people to see grounds for complaint. It would also be a small matter in terms of living standards to divert a portion of these gains from faster growth towards accelerating the transition to a green economy. If we diverted one percentage point more of GDP in 2034 towards reducing greenhouse gas emissions, we would still have 9.0 percent more in that year than CBO current now projects to spend on other things.  Anyhow, if we really want to say that we think profits will grow far more rapidly than CBO is now projecting, it would be worth filling out this picture. Either we will see a substantial further redistribution from wages to profits or we can anticipate that we will be far richer in the future than we currently expect, and many of the issues that seem like major problems today will seem trivial.

Reducing Corporate Income Taxes
What shareholders ultimately care about is after-tax profits, not profits. After-tax profits can rise more than profits if we reduce the effective tax rate on corporate income. There is some room for this. According to CBO’s data, corporate income tax payments increased from 10.2 percent of profits in 2019 to 15.3 percent in 2023. Some of this rise is likely random timing factors, however some of it likely stems from increased enforcement. The Biden administration made it clear that it expected the I.R.S. to enforce the tax law on wealthy individuals and large corporations and even secured additional funding for this effort. By contrast, Trump and Republicans have called these enforcement efforts “harassment” and seem fine with a situation where the wealthy and large corporations don’t have to pay their taxes if they choose not to.It seems likely that corporate income tax payments will fall as a share of profits under the Trump administration. This is partly due to an occasionally stated desire by Trump to lower the corporate income tax rate further (he reduced it from 35 percent to 21 percent in his first administration) and also the result of lax enforcement.For purposes of these calculations, we can assume that the effective tax rate falls back to the 2019 level of slightly over 10.0 percent. This would mean that after-tax profits would grow by roughly 6.0 percentage points more than the amount projected by CBO. This would allow for an annual real return that is 0.6 percentage points higher than would be implied by the profit growth projection from CBO, or 3.6 percent annually. That is still well short of the 6.2 percent annual return that would be needed to maintain a 4.0 percentage point gap between returns from equities and returns on government bonds. 

Stock Returns and Profit Growth: Summing Up
The table below shows the stock returns that would be consistent with the various scenarios discussed above and both a stable PE ratio and the 2034 PE ratio in markets if the returns on stock matched their historic premium of 4.0 percentage points over the return on government bonds.
In the base case, as noted the real return consistent with a stable PE ratio would be 3.0 percent, just 0.8 percentage points above the return on inflation-indexed government bonds. If we assume that stocks pay their historic 4.0 percentage point premium, the PE ratio will rise to 54 by 2024. If we assume that the profit share remains stable, rather than income shifting back somewhat to wages, as projected by CBO, then the return consistent with a stable PE is 3.2 percent. Alternatively, if we assume that stocks pay their historic 4.0 percentage point premium, the PE will rise to 53 by 2024. The faster growth scenario discussed above would allow a 4.0 real return on stocks in the constant PE scenario. If stocks delivered their historic premium, then the PE ratio will rise to 49 by 2034.In the lower taxes scenario, the real return consistent with a stable PE ratio would be 3.5 percent. For stocks to deliver their historic premium the PE ratio would have to rise to 51 by 2034.This analysis implies that in all these scenarios either investors will have to accept a much lower equity premium than they have received historically, or that PE ratios will rise far above previous records. While there is no limit in principle to how high the PE ratio can go, a higher PE means that returns going forward will be even lower. If PE ratios near or above 50 are not impossible, they do at least seem implausible.There is also the possibility that we will see even more extreme scenarios than outlined above. Perhaps growth will be even more rapid than the 1.0 percentage point boost shown here, or maybe corporate taxes will be eliminated altogether. These scenarios, while possibly far-fetched, are not impossible. For those who want to ascribe to such scenarios, it would be useful if they would at least be explicit in their assumptions so that the implications can be drawn out for the economy. For example, if stock projections are based on the assumption that growth will be 2.0 percentage points above the numbers projected by CBO, then the implication is that we will be almost unimaginably wealthy in the not very distant future. In that world concerns about deficits and Social Security solvency would be incredibly silly. And we certainly should have no fear spending considerably more money to avert global warming.   If people expect to be taken seriously in their projections for stock gains, they should at least be able to etch out the economic scenario that would go along with it. The reporters who write down stock projections should keep this in mind.  More By This Author:Best Bet For 2025: Stronger Trade Ties Between Europe And China
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