S&P 500: Are return expectations for 2025 too high?

In a , I discussed Wall Street’s 2025 return estimates for . To know:

“We have some early indications of Wall Street measures of the S&P 500 index, and as always, they are bullish on the year ahead. The median estimate is that the market will rise to 6600 next year, which would be a disappointing Returning at just 8.2% after two years with 20% plus gains, however, the high estimate from Wells Fargo suggests a return of 14%, with the low estimate from UBS at just a return of 5%. In particular, there is no estimate available for a negative return.”

However, it’s not just Wall Street analysts who are optimistic about 2025 returns. Retail investors are the most optimistic about higher stock prices in 2025 of the most recorded.

Not surprisingly, this sentiment resulted in the psychological rush to overpay for assets, pushing 1-year valuations sharply higher.

Note that I stated that optimism about returns in 2025 is primarily a function of psychology. Over the past 15 years, stock market returns have been well above the long-term average of around 8%. Over the long term, which is the last 125 years, stocks have returned around 6% from capital appreciation and 4% from dividends on a nominal basis. But since inflation has averaged approx. 2.5% in the same period, the real return is approx. 7.5% annually.

The diagram below shows average annual inflation-adjusted total return (including dividends) since 1948. I used total return data from Aswath Damodaran, NYU Stern School of Business. The chart shows that from 1948 to 2024 the market returned 9.26% after inflation. After the financial crisis in 2008, however, inflation-adjusted total returns increased by almost three percentage points for the last three observation periods.

Here’s the problem. Total real (inflation-adjusted) stock market returns are easy to calculate. They are a function of economic growth (GDP) plus dividends minus inflation. It was like that from 1948 to 2000. But since 2008, growth has averaged around 5% with a yield of 2%, yet returns have far exceeded what the economy can generate in earnings.

These consistently higher returns over the past 15 years have trained investors to expect elevated portfolio returns from the financial markets.

But is it realistic?

A decade and a half of great returns

As we move into 2025, we need to review what drove these large returns over the past 15 years and review what conditions exist today to support elevated returns in the future.

As mentioned, in the long term there is an obvious connection between the stock market and the economy. This is because economic activity creates companies’ income and earnings. As such, stocks cannot infinitely grow faster than the economy over long periods of time. When stocks diverge from the underlying economy, the ultimate solution is lower stock prices.

For example, the chart below compares the three from 1947 through 2024. The increase in earnings in 2021 was due to the reopening of the closed economy in 2020, but it reversed in 2022 and returned to normal growth rates in 2023-2024 along with economic growth. However, as shown above, asset price returns are well above normal despite slower earnings and declining economic growth rates.

Since 1947, the earnings per share has grown by 7.72%, while the economy has grown by 6.4% annually. The close relationship in growth rates is logical given the significant role that consumer spending plays in the GDP equation.

As we saw in 2021, the difference between earnings and GDP growth is due to periods when earnings can grow faster than the economy. This is the case when the economy is coming out of a recession. But while nominal share prices have averaged 9.36%, there are gradual returns to underlying economic growth. This is because corporate earnings are a function of consumption expenditure, corporate investment, imports and exports.

So if the economic and earnings relationship is true, what explains the market disconnect from underlying economic activity over the past 15 years? In other words, what drives portfolio returns, all else being equal? Two differences in the previous 15 years did not exist until 2008.

The first is share buybacks by companies. While corporate buybacks are not new, the rampant use of buybacks to increase earnings per share accelerated. share after 2008. :

“In a previous study by the Wall Street Journal, 93% of respondents point to “share price influence” and “external pressure” as reasons for manipulating earnings numbers. This is why share buybacks have continued to rise in recent years. After the “pandemic shutdown” they skyrocketed.

The second is monetary and fiscal intervention, which is unprecedented since the financial crisis.

As “the psychological change is a function of more than a decade of fiscal and monetary interventions that have disconnected financial markets from economic fundamentals. Since 2007, the government and the government have continuously injected about $40 trillion in liquidity into the financial system and economy to support growth.

This support fed into the financial system, lifting asset prices and boosting consumer confidence to support economic growth.

Over the past two years, however, as the Federal Reserve reduced its balance sheet and raised interest rates, stocks soared higher on expectations that the Fed would eventually reverse course.

At the same time, federal spending has continued to swell, offsetting the reduction in the Fed’s balance sheet and higher borrowing costs.

The high correlation between these interventions and the financial markets is evident. The only outlier was during the financial crisis, when the Fed launched the first round of quantitative easing (QE). What followed were more public bailouts, support for the housing and financial markets, zero interest rates and finally direct checks to households in 2020.

Given the repeated history of financial interventions over the past 15 years, it is not surprising that investors now expect elevated portfolio returns in the future.

However, there are headwinds to these assumptions as we enter 2025.

Headwinds in 2025

Since the election, optimism has increased that the Trump administration will enact policies that will increase economic activity, reduce regulations and reduce tax rates.

This increase in optimism was evident in the latest survey by the National Federation of Independent Business ().

However, there are risks associated with these more optimistic assumptions about strong economic growth and continued strong portfolio returns. As mentioned, we must assume several factors for the market to deliver an above-average return.

• Economic growth remains more robust than the average 20-year growth rate.
• Wage and labor growth must reverse (weaken) to maintain historically elevated profit margins.
• Both interest rates and inflation must fall to support consumer spending.
• Trump’s planned tariffs will increase costs on some products and may not be fully offset by replacement and substitution.
• The planned reductions in public spending, debt issuance and deficits does not occur supports the company’s profitability ().
• Slower economic growth in China, Europe and Japan must reverse to support demand for US exports.
• The Federal Reserve continues to lower interest rates and slows or stops the reduction of its balance sheet to support market liquidity.

However, current data trends do not support these assumptions. This is especially true when current valuations deviate from the long-term exponential growth trend. Earnings must grow rapidly to justify the overvaluations. However, if these earnings fall short of lofty expectations, the eventual reversal of market prices to align valuations with earnings realities could be somewhat brutal.

As Jeremy Grantham noted:

“All 2-sigma equity bubbles in developed countries have broken back into the trend. But before they did, a handful went on to become superbubbles of 3-sigma or larger: in the United States in 1929 and 2000, and in Japan in 1989. There were also residential superbubbles in the United States in 2006 and Japan in 1989. All five of these superbubbles corrected right back into the trend with much greater and longer than average pain.

Today, in the United States, we are in the fourth superbubble in the last hundred years.”

Whether you agree or not that we are developing another market bubble is a choice. However, the deviation from long-term growth trends is unsustainable. Repeated financial interventions by the Federal Reserve and the government have caused the current deviation to be far beyond anything seen in previous history.

Therefore, a return to their long-term funds seems inevitable unless the Federal Reserve is committed to an endless program of zero interest rates and quantitative easing.

Given current market dynamics, it’s hard to see how future returns won’t be disappointing compared to the last decade. However, the excess returns investors have grown accustomed to were the result of a monetary illusion. The consequence of removing this illusion will be a challenge for investors.

Will this mean that investors will NOT make money in 2025 or later? No. It just means that returns are likely to be significantly lower than investors have witnessed recently. But again, it may be to get an average return in 2025 “feel” very disappointing for many.