CHAPEL HILL, N.C. – A good chunk of the bull market’s excesses have been worked off, according to the “Single Greatest Predictor of Future Stock Market Returns.” And that’s good news.
I’m referring to the indicator, first proposed by the Philosophical Economics blog in 2013, that is based on the average household’s portfolio allocation to equities. It is a contrarian indicator, with higher equity allocations associated with lower subsequent market returns, and vice versa. According to econometric tests to which I’ve subjected it and other well-known valuation indicators, it does indeed have one of the best—if not the best—track record predicting the S&P 500’s
subsequent 10-year total real return.
According to just-released Federal Reserve data, this indicator over the last calendar quarter experienced one of its biggest (and therefore bullish) drops since the early 1950s, which is how far back data extend. But for the quarter encompassing the waterfall decline in March 2020 that accompanied the initial lockdowns of the COVID-19 pandemic, you have to go all the back to the final quarter of 1987—which included the worst crash in stock market history—to find a quarter in which this indicator fell as much as it did in this year’s June quarter.
As of midyear, this indicator stood at 44.8%, down from 51.7% at the end of last year. At the lows of the seven bear markets of the last 25 years in the calendar maintained by Ned Davis Research, the indicator averaged 37.1%. So of the 14.6 percentage point spread above this average that existed at the end-of-2021 value, 6.9 percentage points have now been worked off—or nearly half.
And the indicator almost certainly is lower today than at midyear. We don’t know because the data on which the indicator is based are updated only quarterly, and even then with a couple-month time lag. The most recent update, reflecting the end of the second quarter, came out on Sept. 9. The next update, which will reflect end-of-September data, won’t be released until December.
You might object to the positive spin I’m putting on the indicator’s drop by arguing that it was caused by nothing more than the decline in the value of households’ equity holdings. But that can’t be more than a small part of the explanation, since bonds have been in a bear market of their own; the year-to-date decline in long-term Treasurys
for example, is actually greater than the stock market’s
The drop in the indicator instead means that the average household has significantly cut back its commitment to equities.
All this means that the bear market is doing its job. The absolutely essential role that bear markets play in the market cycle is bringing the market back down whenever it gets too far ahead of itself. And that definitely was the case with this indicator at the bull market’s highs at the end of last year, when it was tied for being the highest on record (tied with the top of the Internet bubble, as you can see from the accompanying chart).
To appreciate the work that this bear market has already achieved, consider a simple econometric model I constructed that bases its predictions on the historical correlation between the indicator and the stock market. This model is now projecting that the S&P 500’s total return will closely match inflation over the next decade. This is in contrast to a projection of minus 4.6% annualized at the beginning of the year and minus 3.3% annualized as the end of the first quarter.
Keeping up with inflation may not excite you, but it’s a lot better than losing 4.6% a year for 10 years. And keeping up with inflation is most likely better than what long-term bonds will do over the next decade.
Valuation indicators don’t yet support a new bull market
Separately, the table below shows how each of my eight valuation indicators stacks up against its historical range. As you can see from the column comparing current valuations to those prevailing at the end of last year, today’s market valuations are significantly more attractive than in January.
|Latest||Month ago||Beginning of year||Percentile since 2000 (100 most bearish)||Percentile since 1970 (100 most bearish)||Percentile since 1950 (100 most bearish)|
|Buffett ratio (Market cap/GDP )||1.54||1.62||2.03||88%||95%||95%|
|Average household equity allocation||44.8%||49.7%||51.7%||85%||88%||91%|
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at firstname.lastname@example.org.