The Math Behind Earnings Growth Supporting High Stock Prices

“It takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!" Lewis Carroll’s Alice Through the Looking Glass

Pundits are justifying currently high stock prices by pointing to high expectations for strong earnings growth in the future. They imply that investors will continue to pay high prices for those earnings. The underlying math is unlikely to hold up.

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In its January 3, 2025 article entitled Stock Market and Budget Projections: Do the Numbers Add Up?, ?the Center for Economic and Policy Research reports that the Shiller Price/Earnings (P/E) ratio of the US stock market is near its record high at 38, and that expected earnings growth of 10% in 2025 might sustain this expensive market.? The article then goes on to evaluate this forecast under various scenarios, most of which don’t support status quo P/Es.

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As a supplement to the above article, I offer the following table that reports 2025 returns based on various combinations of earning growth and ending P/E. The table is not an opinion – it’s math. You can choose your own forecasts of P/E and earnings growth ?to see the return on the market in 2025. It’s a do-it-yourself forecast table.

?Here are a few highlights from the table:

·?????? IF earnings grow at 10% in 2025 and P/Es at the end of 2025 remain near the historical high of 35, the stock market will return 12% in 2025, as shown in green highlight. This is above the historical average return of 10%

·?????? BUT if P/Es retreat to their long-term average of 15,? stocks will lose more than 50% regardless of earning growth, as shown in red highlight.

·?????? Any meaningful decrease in P/E leads to a stock market loss. The bigger the decline, the bigger the loss. No level of earnings growth changes that.

Conclusion

P/Es could increase beyond the currently high levels. Stocks could become even more expensive, but as shown in the following graph from My Money Blog, the greater the P/E the lower the subsequent return, and the more confidence in posting a lower return.

Focusing on the red circle in the exhibit, when P/Es have reached 35 in the past, stock markets have returned near zero in the subsequent decade. And when P/Es have been above 35, stock markets have suffered losses in the subsequent decade.

So, increasing stock prices decrease subsequent returns. To state this in an obvious way, overpaying for something reduces your subsequent profit. In this case, a multiple above 35 has always preceded investment losses, so rising prices portend future losses.?

Prices can continue to rise, until they don’t.

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