Yet there is another indicator without nearly as high of a profile that has outperformed the aforementioned indicators significantly when it comes to both forecasting and tactical asset allocation. That indicator, known as the Aggregate (or Average) Investor Allocation to Equities (AIAE), was developed by the pseudonymous financial pundit, Jesse Livermore, and published on his blog in 2013. (View Highlight)
Accordingly, the AIAE is computed by taking the total market value of equities and dividing by the sum of a) the total market value of equities, b) the total market value of bonds, and c) the total amount of cash available to investors (i.e., that in circulation plus bank deposits): (View Highlight)
This ratio gives the market-wide allocation to equities (or, equivalently, the average investor allocation to equities weighted by portfolio size). (Note that every share of stock, every bond, and every unit of cash in existence must be held in some portfolio somewhere at all times.) (View Highlight)
The supply of equities can increase either by new equity issuance or by price increases. Historically, net new equity issuance has been negligible (with issuances being offset by buybacks and acquisitions). Thus, in order for equities not to become an ever-smaller portion of the average investor’s portfolio, the price of stocks must rise over the long-term. (View Highlight)
While we often hear that stock prices follow earnings, in the 1980s earnings fell slightly from the beginning of the decade to the end of the decade, yet stocks rose at an annualized rate of 17% during that time. How could this be? (View Highlight)
Well, at the beginning of the decade the average investor’s portfolio had a 25% allocation to equities. During the decade, the supply of bonds and cash rose strongly. (View Highlight)
One notable characteristic of the AIAE is that its computation involves only market-based, i.e., endogenous, quantities—the market value of equities, the market value of bonds, and the supply of cash. In contrast, the other indicators involve exogenous quantities—earnings, book value, GDP, GVA, etc. (View Highlight)
As a result, the AIAE appears able to provide insight on equity market dynamics that the other indicators cannot. (View Highlight)
As of April 26, 2021, the AIAE is forecasting 1.05% annualized over the next 10 years for U.S. equities. The 10-year yield is at 1.57%. Thus, the expected equity risk premium is -52 basis points. (Note that the expected equity risk premium was negative for over 4 years(!) during the run-up to the dotcom market top and for two months prior to the 2007 market top.) (View Highlight)