Here are some highlights and key takeaways from “The Single Greatest Predictor of future stock market returns”.
- Stock prices have to rise over the long-term
- Total portfolio return is a function of the shifting sentiment, preferences and expectations of other people
- Valuation is a learned perception, and (PE ratio, Shiller CAPE) a byproduct of supply and demand
- Equity allocation preference is mean reverting
Average Investor Equity Allocation is the single best predictor of 10 year SPX total return.
Accounting Principles: Cash, Bonds, Stocks
The universe of financial assets can be categorized into three categories:
- Cash — bank deposits and circulating currency.
- Bonds — any certificate of obligation to repay borrowed cash–commercial paper, bills, notes, bonds, etc.
- Stocks — shares of ownership in a corporation (public or private)
New financial assets can be only created by the real economic borrowers. The universe of real economic borrowers consists of: 1. Households 2. Non-Financial Corporations 3. State and Local Governments 4. The Federal Government 5. Rest of the world
When these entities borrow directly from investors, the investors get new bonds to hold. When the entities borrow from banks, the investors get new cash to hold. That’s because when a bank makes a loan, the money supply expands. The loan creates a new deposit that didn’t previously exist–some investor must now hold that deposit in his portfolio of assets.
Estimating total outstanding liabilities
The sum of the total outstanding liabilities of each of the five categories of real economic borrowers gives an estimate of the total amount of bonds and cash that investors are holding at any given time. This holds because 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).
Note that the average bond trades close to par (with some above, and some below), so, in aggregate, the value of the liabilities approximates the total market value of the bonds.
Estimating total amount of stocks
The total amount of stocks in investor portfolios is thet total market value of all stocks in existence.
Investor Allocation to Stocks (Average) = Market Value of All Stocks / (Market Value of All Stocks + Total Liabilities of All Real Economic Borrowers)
Total equity and total liabilities outstanding can be separately downloaded from this FRED data:
Accounting for Rest of the World:
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. As an estimation, it works to assume that the two cancel each other out.
Supply of Financial Instruments:
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.
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.
Why stock prices rise over the long term?
The corporate sector does not issue sufficient amounts of new equity each year to keep up with the continually increasing supply of cash and bonds, stock prices have to rise over the long-term.
If they don’t, stocks will become a smaller and smaller percentage of the aggregate investor portfolio. Unless investors, on average, want stocks to be a smaller component of their portfolios–because, for example, they increasingly prefer to hold other assets–this outcome will not be allowed. Stock prices will get pushed up on the growing relative scarcity until the aggregate equity allocation preference is satisfied.
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.
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. For any given stock (or for the space of stocks in aggregate), price is always and everywhere produced by the coming together of those that don’t own the stock and want to allocate their wealth into it, and those that do own the stock and want to allocate their wealth out of it. If there is a different supply sought by the first group than offered by the second, the price will shift until the imbalance equalizes.
History confirms that it can equilibrate 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. One standard deviation in each direction is worth 243% in total return, or 13% per year over 10 years.
The same is true of the popular Shiller CAPE. Its long-term average is 15.30–but with a standard deviation of 6.5, again almost 50% of the mean. Over the last 100 years, its value has stretched from as low as 5, to as high as 40–a difference of 700% in total return. Note that the periods in which it took on depressed values were hardly brief. It spent the entire decade of the 1940s at bargain basement levels, frequently falling into single digits–this in an environment where interest rates were pinned at zero.
Valuation is a byproduct of supply and demand
Valuation is a byproduct of this process, not a rule that it has to follow. In the 1940s, investors decided, for whatever reason–memories of the Depression, a World War that the country might have lost, price controls, high inflation–that they didn’t want large stock market exposure. The fact that bond yields were meager did little to alter this preference. And so valuations stayed extremely depressed. When a vibrant, prosperous peacetime economy emerged in the 1950s, this preference obviously changed, and the biggest bull market in history ensued.
Buy-and-hold is painted as the informed, responsible, pro-American thing to do with a portfolio. But, in terms of financial stability, it can actually be a very destructive behavior. Consider the classic buy-and-hold allocation recommendation: 60% to stocks, 40% to bonds (or cash). If everyone were to jump on the buy-and-hold bandwagon, and decide to allocate 60/40, but equities were not already 60% of total financial assets, then they would necessarily become 60% of total financial assets. The excess bidding would not stop until they reached that level. It doesn’t matter that the associated price increase would cause the P/E ratio to rise to an obscenely high value. The supply-demand dynamic would force it to go there.
Valuation as a learned perception
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.
Ironically, it is anchoring, not “valuation discipline”, that keeps the market from doing crazy, bubbly things. People don’t like to pay higher prices tomorrow than they could have paid today, or sell for lower prices today than they could have sold for yesterday.
Admittedly, when enough people grab onto and act on concepts, arguments, data points, etc., they can become powerful forces that drive market outcomes, especially when they have a basis in reality that gives them credibility and forces people to believe them. The reflexivity of price confirmation increases their allure and persuasiveness, which causes more people to latch onto them, which fuels further price changes, therefore more price confirmation, and so on in a feedback loop that continues until reality pushes back.
Asset Supply: A New Framework for Thinking About Equity Returns
Equity total return is a function of price return and dividend return. The price return comes from Earnings Growth and change in P/E multiple.
Total Return = Price Return + Dividend Return
Total Return = Price Return from P/E Multiple Change + Price Return from Earnings Growth (Realized if P/E Multiple Were to Stay Constant) + Dividend Return
Now, suppose that the market has a P/E ratio of 100. Why does it have to produce a low or negative return? If corporate earnings are growing at the rate of nGDP, say 6%, and the P/E ratio stays at 100, then the return will be 6%–a perfectly healthy number.
Value mavens will respond that the P/E ratio cannot stay at 100. It mean-reverts over the long-term. Its mean-reversion is the basis for its inverse correlation with long-term future returns. If you buy at a price below the normal P/E range, you will get the dividend return, plus the return from earnings growth, plus the boost from multiple expansion. Thus your return will be higher than normal. Conversely, if you buy above the normal range, you will get the dividend return, plus the return from earnings growth–but those two gains will then be offset by losses from multiple contraction. Thus your total return will be lower than normal.
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. More investors try to “put money to work” than try to “take money off the table”, and vice-versa. In the presence of the imbalance, the price has no choice but to change.
A new way of framing equity total returns
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.”
Total Return = Price Return + Dividend Return 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
In this new way of thinking, the supply of cash and bonds grows normally as the economy grows. If the preferred allocation to stocks stays the same, the price has to rise (that is the only way for the supply of stocks to keep up with the rising supply of cash and bonds–recall that the corporate sector is not issuing sufficient new shares of equity to help out). That price rise produces a return. When the preferred allocation to equities increases alongside this process, it boosts the return (price has to rise to keep the supply equal to the rising portfolio demand). When the preferred allocation to equities falls, it subtracts from the return (price has to fall to keep the supply equal to the falling portfolio demand).
Equity allocation preference is mean reverting
Instead of saying that the P/E multiple is mean-reverting, we say that, for a given set of environmental contingencies– e.g., history, culture, demographics, etc.–the equity allocation preference is mean reverting. It rises in expansionary parts of the cycle, as people become more optimistic about the future and more eager to maximize what they see as attractive returns.
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.
This way of thinking about stock market returns accounts for relevant supply-demand dynamics that pure valuation models leave out. That may be one of the reasons why it better correlates with actual historical outcomes than pure valuation models.
Comparing difference metrics on Performance
Equities returns to Average Investor Equity Allocation
Equities returns to Market value of non-financials to GDP
Equities returns to GAAP Shiller CAPE
Equities returns to Trailing PE (GAAP)
A Note on “Overvaluation”
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.”
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%?