The Single Greatest Predictor of Future Stock Market Returns by Philosophical Economics (some excerpts)

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

Future Stock Market Returns

Future Stock Market Returns

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.”

Future Stock Market Returns

Future Stock Market Returns

Future Stock Market Returns

Future Stock Market Returns

Future Stock Market Returns

 

Future Stock Market Returns

A Note on “Overvaluation”

There’s a raging debate right now between bulls and bears over whether the U.S. stock market is presently overvalued.  The debate rages on because the term is poorly defined.  What, precisely, does it mean to say that something is “overvalued”?

When we say that the stock market is “overvalued”, we might mean that it’s currently valued more expensively than it typically has been in the past.  Over its history, the U.S. stock market has offered, on average, some expected total return–say 8% to 10%.  But now it’s priced for 5% or 6% (using our metric).  So it’s “overvalued.”

Fair enough, bulls shouldn’t disagree.  There are tons of reasons why the present stock market is unlikely to produce the 8% to 10% returns that it has produced, on average, throughout history.  On almost every relevant measure, it’s starting out from a higher-than-average level.

The more important question, however, is this: why should the stock market offer investors the average historical return right now?  If, over the next 10 years, bonds are offering investors 2.8%, and cash is offering them less than 1%, why should stocks be priced to offer them 8% to 10%?

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.  There obviously isn’t enough equity supply for all of us to allocate in that way, and so the price would get pushed up, and the expected return pulled down–very quickly.

Now, it’s a mistake, obviously, to make an assessment of valuation based strictly on a comparison between the yields of stocks and bonds, as the Fed Model suggests we do.  The yield of an equity security, again, is not the same as its return.  You can buy the market at 33 times earnings–a 3% earnings yield–but your return over the next 10 years isn’t going to be 3%.  It will probably be 0% (or less), as the market contracts from the obscene valuation at which you bought it.  If you were to try to justify the stock market’s price by comparing its 3% yield to the 10 year bond yield at 1%, touting the healthy risk premium (2%–greater than the historical average), you would obviously be making a huge mistake.  The real risk premium on your stock investment would be negative–you would end up with a loss.

But if you properly estimate long-term equity returns using other methods–for example, the method I’ve proposed, which puts the future return for the stock market at 5% to 6%–then it makes perfect sense to assess the “appropriateness” of the current valuation through a process of comparison with the investment alternatives.  In the current case, the alternatives of cash and bonds are offering much less than 5% to 6%–so there’s a decent risk premium in place for equities.  The market is not “overvalued”–it doesn’t “belong” at a lower valuation.  To the contrary, it’s priced where it should be, given the alternatives. Investors have done their jobs properly, leaving no easy arbitrages to exploit.

Now, if bears want to argue that it’s unwise to lock in 5% to 6% equity returns right now (or even 3% or 4%), because the market cycle will eventually produce selloffs in which greater returns are made available, my response would be: who said anything about locking anything in?  Let’s time the market–as bears seem to want to do.  I’m all for that approach.

Full article here