The Single Greatest Predictor of Future Stock Market Returns
The Single Greatest Predictor of Future Stock Market Returns

The Single Greatest Predictor of Future Stock Market Returns

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. (View Highlight)

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. (View Highlight)

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. (View Highlight)

For every unit of every financial asset in existence, some investor somewhere must willingly hold that unit in a portfolio at all times. (View Highlight)

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. (View Highlight)

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. (View Highlight)

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. (View Highlight)

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. (View Highlight)

The question we want to answer is this: what would the average of all of these investors’ portfolio allocations look like, weighted by size? More specifically, what would the average investor allocation to stocks be? And how would that average compare to the averages of the past? (View Highlight)

It turns out that this question predicts the market’s future long-term returns better than any other classic valuation metrics to date developed–price to earnings (P/E), price to book (P/B), price to sales (P/S), CAPE, q-ratio, Market Cap to GDP, Fed Model, etc (View Highlight)

To answer the question, we need to know two things: (1) the total amount of stocks that investors in aggregate are holding, and (2) the total amount of cash and bonds that investors in aggregate are holding. (View Highlight)

Now, to calculate the total quantity of cash and bonds in investor portfolios, we might think that we can just sum the total quantity of cash and bonds in existence outright–the total amount floating around the economy. After all, these securities have to be held by investors. But this approach won’t work. The reason is that a large portion of the bonds in existence are actually held by banks, not by investors. This fact extends to the central bank (the Federal Reserve), which presently owns an unusually large quantity of bonds. (View Highlight)

The entities that create net new financial assets (that investors can hold) are not banks, which are just intermediaries, but rather real economic borrowers. The universe of real economic borrowers consists of five categories: Households, Non-Financial Corporations, State and Local Governments, the Federal Government, and the Rest of the World. (View Highlight)

It follows, then, that if we want to get an estimate of the total amount of bonds and cash that investors are holding at any given time, all we have to do is sum the total outstanding liabilities of each of the five categories of real economic borrowers. Those liabilities either translate into cash that an investor somewhere is holding (if the entity took a loan from a bank, which expands the money supply), or they translate into a bond that an investor somewhere is holding (if the entity borrowed directly from the investor). (View Highlight)

Investor Allocation to Stocks (Average) = Market Value of All Stocks / (Market Value of All Stocks + Total Liabilities of All Real Economic Borrowers) (View Highlight)

Now, the Rest of the World creates an interesting complication. Parts of our portfolios are composed of stocks, bonds and cash denominated in foreign currencies (which do not show up in these series and are not being counted, though they should be). But in the same way, some parts of the portfolios of individuals in other countries are composed of stocks, bonds and cash denominated in our currency (which do show up in these series–and are being wrongly counted, given that our goal is to know our own allocations as domestic investors). (View Highlight)

The supply of cash and bonds that investors in an economy must hold perpetually increases with the economy’s growth. The cash and bonds in investor portfolios are literally “made from” the liabilities that real economic borrowers take on to fund investment–the fuel of growth. (View Highlight)

The supply of equities can increase in one of two ways: through the issuance of new shares, or through price increases, i.e., increases in the level of the stock market. The chart below shows the corporate sector’s net issuance of new equity, as a percentage of total market value, back to 1950. (View Highlight)

As we see in the chart, the corporate sector is inherently averse to the issuance of new equity. Each year, it adds very little additional supply, on net. In various periods since the early 1980s, it’s actually been a net destroyer of equity supply–taking supply off the market through acquisitions and buybacks. (View Highlight)

The total return of an equity security depends on two factors: (1) the change in price from purchase to sale, and (2) the dividends paid in the interim. Dividends matter, but price is king. It drives total return. (View Highlight)

nvestors don’t want their returns to be subject to the arbitrary “vote” of other people, and so they pretend that as stock market speculators they are actually genuine businessmen who “buy” and “own” companies to hold forever. They tell themselves that their returns will somehow emerge directly from the cash flows of the underlying businesses, regardless of what the market decides to do with price. (View Highlight)

This point of view ignores the fact that it takes decades to recoup an equity investment via dividends, the only cash flows that are ever are actually paid out to buy-and-hold investors. (View Highlight)

Once we agree that price is king, the next question is: how is price determined in a market? Value mavens tend to think that price is determined through the “rational” application of normative valuation principles, such as “The stock market’s P/E ratio should be 15, plus or minus a few points. If interest rates are low, add a few points. (View Highlight)

There’s certainly some truth to this view, but it doesn’t give the whole story. Ultimately, the price of equity is determined in the same way that the price of everything is determined–via the forces of supply and demand. (View Highlight)

Now, there’s absolutely nothing that says that this process has to equilibriate at any specific valuation. History confirms that it can equilibriate at a wide range of different valuations. For perspective, the average value of the P/E ratio for the U.S. stock market going back to 1871 is 15.50. But the standard deviation of that average is a whopping 8.4, more than 50% of the mean (View Highlight)

Again, it’s all up to the allocators–they decide how much of their wealth they are going to allocate into stocks, how much exposure they are going to take on. Their preferences–or rather, their efforts to put those preferences in place, by buying and selling–set the price. (View Highlight)

Now, in the real world, valuation concerns can and do push back on the equity allocation process. But, outside of extremes, they don’t tend to push back with very much force, at least not on their own. Let me now explain some of the reasons why. (View Highlight)

We can divide asset allocators into two types: mechanical allocators, and active allocators. Mechanical allocators are individuals that adhere to a strict allocation formula, regardless of circumstance. Two examples would be buy-and-hold investors that are always 100% invested (or always 60/40 invested, periodically rebalancing, etc.), and 401K/retirement investors that invest automatically in accordance with a pre-defined program. These asset allocators follow their processes come rain or shine, therefore they cannot be relied upon to push back against valuation excesses. Though they are not the majority of the market, they are a significant part of it–their presence makes a difference. (View Highlight)

Active allocators, in contrast, dynamically alter their allocations so as to maximize their returns. How do they try to maximize their returns? By allocating their wealth into the assets whose returns they consider to be the most attractive, adjusted for risk. It’s a competitive process–they choose among their options, based on their assessments of what those options are likely to produce. (View Highlight)

To estimate forward earnings for stocks, we have to answer difficult questions about the future: What will the trajectory of nominal growth be? How will profit margins evolve? Who can answer these questions with a significant degree of empirical confidence, enough to be a contrarian that consistently fights the market’s trends? Very few people, and therefore the answers to the questions end up reducing to biased reflections of prevailing mood, extrapolations of recent experience. (View Highlight)

It turns out that even if fundamental questions about the future yields of cash, bonds, and equities were resolved, asset allocation still would not be as simple as choosing the security that offers the highest yield (risk-adjusted). The goal, again, is to maximize return. Return is not the same thing as yield. (View Highlight)

The only way that you can know what the future valuation of stocks will be–so as to estimate future returns–is to apply some conception of what’s fair, appropriate, reasonable, normal. But the range of what can be rationalized as fair, appropriate, reasonable, normal is extremely wide, too wide to be useful, and far too wide to provide reliable pushback against a supply-driven market advance. Any number that is chosen will likely be nothing more than a reflection of the prevailing allocation preference–the prevailing appetite to be in or out of the asset class, based on primordial “hunches” for where things are headed, themselves just manifestations of recency bias. Once again, the market will not get the valuation pushback that it needs. (View Highlight)

Because valuation is a learned perception, driven by anchoring and by social and environmental feedback, it tends to follow the market. As valuations rise in a bull market, prior anchors wear off, and people get accustomed to higher valuations–over time, the valuations stop feeling “high”–making room for them to go even higher. Their perceived appropriateness gets reinforced–socially, in the market discussion, and environmentally, through the incredibly powerful feedback of actually making money. In a long, slogging bear market, the opposite occurs. Everything gets driven downwards. (View Highlight)

However, it’s hard for valuation to pick up steam in this way, because unlike other themes that might move markets, it has no objective basis–it’s a personal opinion, easy to dismiss. (View Highlight)

Value mavens will tell you that the market’s P/E ratio (either simple trailing twelve months, or Shiller CAPE) is inversely correlated with future returns over the long-term. A high P/E ratio implies low future returns, a low P/E ratio implies high future returns. (View Highlight)

We can aribtrarily separate price return into the part that comes from Earnings Growth, and the part that comes from the change in the P/E multiple. Leaving the math intentionally imprecise, we end up with the following equations: (View Highlight)

The problem with this construction, of course, is that it doesn’t model the real reasons that stock prices, in aggregate, change. Stock prices don’t change because market participants choose to assign stocks different P/E multiples. Rather, they change because the eagerness of the aggregate investment community to allocate wealth into stocks rises or falls. (View Highlight)

As equity investors, we talk a lot about asset allocation. It’s essentially the most important aspect of portfolio management–how we’re allocated within the space of individual stocks and bonds, and across the space of assets in general. I’m 85% equity, 15% cash/bonds. You’re 50% equity, 50% cash/bonds. Joe over there is 100% equity, 0% cash/bonds, etc. (View Highlight)

Take the previous equation, and substitute “Aggregate Investor Allocation to Stocks” and “Increase in Supply of Cash and Bonds” for “P/E Multiple Change” and “EPS Growth.” We then have, (View Highlight)

Total Return = Price Return from Change in Aggregate Investor Allocation to Stocks + Price Return from Increase in Cash-Bond Supply (Realized if Aggregate Investor Allocation to Stocks Were to Stay Constant) + Dividend Return (View Highlight)

If you buy in periods where the investor allocation to equities is low, you will get the dividend return plus the price return necessary to keep the portfolio equity allocation constant in the presence of a rising supply of cash and bonds, plus the price return that will occur when equity allocation preferences return to more normal levels. (View Highlight)

If you buy in periods where the investor allocation to equities is high, you will get the dividend return plus the price return necessary to keep the portfolio equity allocation constant in the presence of a rising supply of cash and bonds, but then you will have to subtract the negative price return that will occur when equity allocation preferences fall back to more normal levels. This is what happened to investors in the 2001-2003 bear market. (View Highlight)

Right now, at its current value, the metric suggests a future 10 year nominal total return for equities of around 6%. Historically, whenever the market was at the current level, the low end of the return was a tad less than 5%, and the high end was around 9%. (View Highlight)

How would that even be sustainable? If equities were offering an 8% to 10% return, we would all choose to allocate the bulk of our portfolios into them, rather than languish in the ZIRPY nothingness of bonds and cash. (View Highlight)

But timing the market doesn’t mean boycotting it until it hands you, on a silver platter, the high returns that you’re demanding. After all, there’s an excellent chance that it won’t hand them to you–there’s no reason it has to. General societal progress–particularly in the area of economic policymaking–reduce the odds that it will. Rather, timing the market means monitoring for the types of processes that tend to cause markets to sell off–capturing equity returns except when there are signs of those processes emerging. (View Highlight)