The Single-Best Predictor Of Stock Market Returns Is Urgently Trying To Tell You Something

The Single-Best Predictor Of Stock Market Returns Is Urgently Trying To Tell You Something
Stéphane Renevier, CFA

over 2 years ago4 mins

  • When investors allocate too much to stocks, stocks subsequently go down. When they allocate too little, stocks subsequently go up.

  • And right now, investors are holding an extreme amount of stocks, suggesting that future returns will be very poor – and even negative.

  • To protect yourself, you could underweight stocks until investors’ average allocation to stocks drops below 40%.

When investors allocate too much to stocks, stocks subsequently go down. When they allocate too little, stocks subsequently go up.

And right now, investors are holding an extreme amount of stocks, suggesting that future returns will be very poor – and even negative.

To protect yourself, you could underweight stocks until investors’ average allocation to stocks drops below 40%.

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When it comes to forecasting stock returns, there are more than a dozen models competing for the title of “world’s greatest predictor”. But one obscure choice is head and shoulders above the rest – and it’s flashing a serious warning sign.

What’s this indicator?

The idea – conceived by the anonymous author of this 2013 blog post – is simple: when investors on aggregate allocate too much of their capital to stocks, stocks subsequently underperform. The reverse is true too: when investors shun stocks for other investments, stocks subsequently outperform.

In fact, simply looking at investors’ average stock allocation would’ve historically helped us predict – incredibly accurately – whether subsequent 10-year returns would be high or low. Every time investors have allocated more than 40% to stocks, they’d have experienced losses over the following decade. The higher the allocation, the lower the subsequent returns.

Chart of annualized S&P 500 returns including dividends versus investors' stock market allocations
Annualized S&P 500 returns including dividends versus investors' stock market allocations (Source: Philosophical Economics blog, Fred data, Finimize)

How can you tell how much investors are allocating to stocks?

Investors’ average allocation to stocks is simply the market value of all stocks over the total value of all financial assets (which includes stocks, cash, and all types of bonds). It’s not actually as easy to work out as it seems, but fortunately you don’t need to: the creator of this indicator kindly does it for you here.

What you do need to know is how to calculate the numerator of that equation: the market value of all stocks is the total number of shares multiplied by the price of those shares. Put simply, it’s the total market capitalization of every stock in the world. Meanwhile, the denominator - the total value of all financial assets – doesn’t just include the market value of stocks, but also the total amount of liabilities of all borrowers (i.e. cash and bonds).

How does this indicator predict stock market returns?

To make sense of that, we need to look at the calculation above more closely:

Investors’ average allocation to stocks = market value of stocks / (market value of stocks + total value of liabilities of all borrowers)

If the total liabilities of all borrowers grows with the economy – a realistic assumption given that businesses finance a big part of their expansion through loans or bonds – then the market value of stocks must also grow. Investors, after all, want to keep their allocation to stocks steady. And if the denominator increases, the numerator needs to as well in order for the ratio to remain constant.

So if the target stock allocation is constant, the market value of stocks has to increase. And there are two ways that can happen: either companies issue new shares, or the price of all stocks – i.e. the stock market – goes up.

And that’s where it gets interesting: the corporate sector realistically can’t issue enough shares each year to keep up with the increasing supply of cash and bonds, so stock prices have to rise over the long term if investors want to keep the same allocation to stocks.

That’s what’s genius about this framework: it not only explains why stocks go up over the long term, it also links portfolio allocation decisions to stock market performance. In other words, if investors have temporarily overallocated to stocks and need to adjust lower, stock prices will go down.

In fact, this indicator can explain things other valuation models can’t – like, say, the bull market of the 1980s. What happened back then was puzzling: prices skyrocketed in a period when interest rates were high and earnings contracted. Traditional models justified the rally by pointing to investors’ “irrational exuberance”, but the real reasons lay elsewhere.

First, prices had to rise to match the significant increase in the total value of liabilities during that period. Second, investors were massively underweight stocks at the time: numbers show their average stock allocation was only 20%. So when investors rebalanced their equity allocation to a more acceptable level, prices had to rise. And they did.

What does the current forecast look like?

Investors' average stock allocation is currently close to 50% – the second-highest reading in history. So unless investors permanently hold a higher allocation of stocks (which I think is unlikely), stock prices will decrease over the coming decade – by around 4% per annum over the next decade, according to this indicator.

Source: Philosophical Economics blog, Fred data, Finimize
Source: Philosophical Economics blog, Fred data, Finimize

As for whether that should worry you… well, yep: this indicator does indeed look like the best predictor of future stock returns. In fact, it historically predicted the S&P 500’s future 10-year returns better than any other, much more common valuation metrics – think price-to-earnings ratio (P/E ratio), CAPE ratio, market cap to GDP, or the Fed model, to name a few. In other words, make sure you add this “average stock allocation” number to your watchlist…

What’s the opportunity here?

You could use this as a contrarian timing indicator. If the average stock allocation is below 40%, you can breathe easy: it’s not too extreme and you’re better off buying and holding stocks. But if it’s above 40% – and remember, it’s at 50% right now – you could reduce your stock allocation by that same amount, and keep it there until investors’ stock allocation falls back below the 40% mark.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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