The Single Greatest Predictor of Future Stock Market Returns | PHILOSOPHICAL ECONOMICS

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The Single Greatest Predictor of Future Stock Market Returns

Posted on December 20, 2013 by philosophicalecon@gmail.com

Consider the following chart, which shows the average investor portfolio allocation to equities from January 1952 to December 2013:

The metric in this chart takes no input from any variables traditionally associated with valuation: earnings, book values, profit margins, discount rates, etc.  It consists only of a simple ratio between two numbers that can easily be calculated in FRED.  Yet, as a predictor of future stock market returns, it dramatically outperforms all other stock market valuation metrics commonly cited.

In this piece, I’m going to do five things.  First, I’m going to explain, in very simple terms, the accounting principles behind the metric.  The explanation will include instructions (with ready-made links) for how to graph the metric in FRED.  Second, I’m going to discuss the dynamics of asset supply, with a special focus on equities.  Third, I’m going to challenge the conventional framework for understanding the relationship between valuation and stock market returns.  Fourth, I’m going to introduce a new framework, one that relates stock market returns to equity asset supply.  Fifth, I’m going to present a scatterplot of the predictive performance of the metric alongside other metrics, and discuss what the metric is currently forecasting for U.S. equity returns.  I’m going to conclude by briefly touching on the question of whether or not the current U.S. stock market is "overvalued."

Accounting Principles: Cash, Bonds, Stocks

To begin, let’s arbitrarily divide the universe of financial assets into three categories: (1) cash, (2) bonds, and (3) stocks.  By "cash", I mean bank deposits and circulating currency.  By "bonds", I mean any certificate of obligation to repay borrowed cash–commercial paper, bills, notes, bonds, etc.  By "stocks" (or "equity"), I mean shares of ownership in a corporation (public or private).  Note that these definitions are intentional simplifications.

Financial markets function on the following principle.  For every unit of every financial asset in existence, some investor somewhere must willingly hold that unit in a portfolio at all times.  By "investor", I mean whoever owns wealth.  There are intermediaries–hedge funds, mutual funds, pension funds, financial advisors, etc.–that help investors allocate wealth.  But these entities are not the actual investors–their clients are.

The financial market is the place where investors decide–via trades–who will hold what units of what assets.  Note that cash, as an asset, is special in that respect.  It is the medium through which trades occur.  Investors can only switch from one stock or bond to another stock or bond by going through cash.  The going rate of exchange (bid or offered) between a unit of an asset and cash is the market price of the asset.

At the margin, if no investor can be found that wants to hold a given unit of a given asset at the prevailing market price, then the market price will fall until a willing holder is found.  With respect to shares of a stock or bond, the application is straightforward.  If no one wants to hold a given share at $100, then we try $95.  Still no takers?  Then we try $90, then $85, then $80, and so on.  We continue until some investor emerges that finds the share sufficiently attractive to hold at the offered price.  The concept applies analogously to cash–if no investor wants to hold cash, then the price that is bid on everything else will rise until everything else becomes so expensive and unattractive that some investor somewhere capitulates and agrees to hold cash instead.  Measured in terms of other assets, the price of cash falls.

The "supply" of an asset is the total market value of it in existence–the total number of outstanding units times the market price of each unit.  Put differently, supply is the amount of the asset available to be held in investor portfolios–the amount available for investors to allocate their wealth into.  In aggregate, investors have to want to hold the total supply of each asset in existence in their portfolios.  If there is too much supply of a given asset relative to the amount that investors want to hold in their portfolios, then the the market price of the asset will fall, and therefore the supply will fall.  If there is too little supply of a given asset relative to the amount that investors want to hold in their portfolios, then the market price will rise, and therefore the supply will rise.  Obviously, since the market price of cash is always unity, $1 for $1, its supply can only change in relative terms,...