This Indicator Is Pointing To A Lost Decade For US Stocks

This Indicator Is Pointing To A Lost Decade For US Stocks
Stéphane Renevier, CFA

about 2 months ago2 mins

A lot of things can influence short-term stock returns: interest rates, economic data, geopolitical stuff, investor sentiment – even weather. But for long-term returns, one factor rules them all: the proportion of assets that investors are parking in stocks.

This ratio has proven to be the most reliable predictor of stock returns over a ten-year horizon, outshining even heavyweight factors like valuations. It says that when investors go big on stocks, their long-term returns tend to be below average. That’s because investors typically aim for a steady mix of stocks versus other assets, historically between 30% and 40% (blue line). When they over-allocate, three things can bring the proportion back down: liabilities grow, more shares are issued, or prices fall. (I explain more about this important process here). Usually, the adjustment happens via falling share prices.

There are three important takeaways from this. First, stocks don’t perpetually climb: they can have “lost decades” – times when stocks fluctuate but ultimately don’t deliver positive returns. This has happened even to the best-performing assets: US stocks (as you can see from this chart’s shaded rectangles). Second, investor over-allocation to stocks has been the most precise warning signal of those lost decades. A spike in allocations to stocks (blue line, red shaded circles) preceded both the lost decade of the 1970s and the early 2000s. This may give you a pretty good idea when the odds aren’t in your favor. Third, with the average allocation dangerously high right now, US stocks could face another lost decade.

If you expect investor allocations to stocks to return to their longer-term average, there are two things you could do to prepare for it. First, consider rebalancing your asset mix: less stocks, more bonds, commodities, and other assets. Second, check out stock markets that have less extreme positioning – for example, in Europe, the UK, Japan, and emerging markets. It might not pay off immediately (certainly not in just one year), but in the long run, the odds look pretty promising.



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