Valuations Are Fine, But This Secret Indicator Works A Lot Better

Valuations Are Fine, But This Secret Indicator Works A Lot Better
Stéphane Renevier, CFA

about 1 year ago6 mins

  • Two factors drive long-term stock returns. The first explains why stocks go up over time: as the total supply of debt and cash grows with the economy, stock prices must commensurately increase to keep investors’ average allocation to stocks constant.

  • The second factor – changes in the aggregate allocation to stocks – explains why stocks will deliver above- or below-average returns over a ten-year period. That’s because when investors want to hold more stocks, demand increases, and their price increases.

  • Right now, they’re both indicating low future returns for stocks for the next year.

Two factors drive long-term stock returns. The first explains why stocks go up over time: as the total supply of debt and cash grows with the economy, stock prices must commensurately increase to keep investors’ average allocation to stocks constant.

The second factor – changes in the aggregate allocation to stocks – explains why stocks will deliver above- or below-average returns over a ten-year period. That’s because when investors want to hold more stocks, demand increases, and their price increases.

Right now, they’re both indicating low future returns for stocks for the next year.

Mentioned in story

Forget everything you know about the long-term drivers of stock prices. Sure, earnings growth and valuations matter. But according to some pretty neat (and anonymous) research, the key to forecasting future returns lies elsewhere – and it’s the amount that investors allocate to stocks that deserves all your attention.

Why does that matter?

Traditionally, earnings growth and changes in multiples are perceived to drive long-term capital gains. If you can take a decent stab at those, and add the dividend yield, you get a pretty good estimate of the long-term returns you can expect. This is the methodology I’ve used to estimate the long-term returns of the S&P 500. But according to this research, capital gains are driven by two completely different factors: changes in investors’ exposure to stocks, and changes in the supply of cash and bonds. Add them together, and add the dividend yield, and you’ve got your estimate of future returns (I wrote a deeper dive on the method, here).

It makes sense. See, investors always have the choice between holding stocks, bonds, and cash. While we don’t know what each individual investor holds, we can calculate the mix of stocks, bonds, and cash that investors hold on aggregate. For instance, we can tell how much investors are allocating to stocks by dividing the market value of all stocks by the total value of all financial assets (which includes stocks, cash, and all types of bonds). Calculating it isn’t as straightforward as it may appear, but thankfully, the author shared the live series here.

Investors’ average stock allocation = market value of all stocks / market value of all financial assets. Sources: Philosophical Economics, Federal Reserve Economic Data.
Investors’ average stock allocation = market value of all stocks / market value of all financial assets. Sources: Philosophical Economics, Federal Reserve Economic Data.

With that background in mind, let’s look at the two drivers of stock prices.

Driver 1: Growth in the total supply of cash and bonds

When the economy grows, companies, households, and governments generally use debt to finance their expansion. As they do so, the total supply of cash and debt – i.e. the total quantity multiplied by its prices – increases.

Here’s where it gets interesting: if investors want to hold the same allocation to stocks, the total supply of stocks must increase commensurately. Otherwise, stocks would become a smaller and smaller percentage of the aggregate investor portfolio and deviate from its target. The required increase in the supply of stocks can happen in two ways: either companies have to issue new shares, or share prices have to rise. Since companies simply can’t (and often don’t want to) issue enough shares to match the increase in cash and debt, the adjustment usually happens through rising stock prices.

This is a pretty tidy way of explaining why stock prices tend to go up over the long term: as the total supply of debt and cash grows with the economy, stock prices must commensurately increase to keep investors’ average allocation to stocks constant. This is the equivalent of “earnings growth” in the traditional model.

Driver 2: Changes in aggregated investors’ allocation to stocks

Factors like demographics, culture, and sentiment influence the proportion of stocks that investors want to own relative to other assets. On average, investors have historically held about 35% of their assets in stocks – never more than 55% and never less than 20% (as you can see from the previous chart).

But, let’s say investors are currently invested 20% in stocks and want to raise their allocation to 30%. It could be because bonds are looking less attractive, or demographics are booming. If, on aggregate, investors want to increase their allocation to stocks, the demand for them will increase their price until the total supply of stocks reaches the target level in relation to other assets. The opposite happens if investors want to reduce their allocation to stocks: demand falls, and prices go lower, meaning forward returns are lower.

Now, while changes in the total supply of cash and bonds explain why stocks go up over the long term, changes in investors’ aggregate allocation to stocks explain why stocks will deliver above- or below-average returns over the medium-term (say, a ten-year horizon). This is the equivalent of the impact from “valuations” in the traditional model, but it’s better in terms of predictive power.

So, what can you take from this?

The best time to invest is when there’s room for the economy to grow and take on more debt, and when investors are holding a much lower-than-normal allocation to stocks. That way, you’ll not only benefit from the rise in price required to keep the portfolio allocation constant, but also from the additional return from stronger demand.

In fact, the investors’ average allocation to stocks has an exceptional track record (much better than any other valuation indicator, but that’s an insight for another day) at predicting future price returns (which – FYI – include the return from the first driver too).

When investors have a high allocation to stocks, subsequent returns disappoint. Source: Finimize.
When investors have a high allocation to stocks, subsequent returns disappoint. Source: Finimize.

As you can see from the chart, the higher the allocation, the lower the future returns. When investors on aggregate allocated more than 40% to stocks at the beginning of the period, future returns were often negative. So, to achieve the highest returns, you’d have wanted to jump in when investors were shunning stocks, and holding less than 30% in them. Impressively, the average allocation here explains almost 80% of the variability of returns that follow (geeks like me would point out that’s what the R-squared number in the equation tells you). Put simply, it means it’s really important in driving long-term returns.

So, how’s the future looking?

Unfortunately, neither of stocks’ big drivers is looking very supportive today. The economy isn’t just slowing; it’s also maxed out on debt, meaning there’s less room for additional growth. Even worse: investors have allocated a near-record 44% to stocks (light blue line, inverted scale), even after the recent selloff. Based on the historical relationship, that suggests low capital gains of less than 2% per year for the next ten years (red line). If you add a dividend yield of about 2%, you can expect total returns of about 4% per year for the next decade.

Investors’ high current allocation to stocks (44%) implies yearly capital gains of only 2% over the next decade. Source: Finimize.
Investors’ high current allocation to stocks (44%) implies yearly capital gains of only 2% over the next decade. Source: Finimize.

For returns to be higher than that, you’d need to see investors’ allocation to stocks expand even further, and breach new records. Since bonds are becoming increasingly attractive at higher rates and the macroeconomic backdrop has darkened, I’d say that’s pretty unlikely. What’s more likely is that the growth of debt and cash will slow, and investors will reduce their allocation to stocks. Both point to lower returns going forward. While we looked at long-term stock returns using a completely new methodology, the results are the same: over the next ten years, US stocks are unlikely to give you the high returns you’ve been accustomed to.

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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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