What This Unknown Predictor Says About An Overvalued Market

Investors always look for the next crystal ball or market prophet. Despite the oft-repeated wisdom that we should invest for the long term in quality companies, rather than try to time the markets, we humans are a bit addicted to the pursuit of instant riches, and we keep looking for anything to give us an edge.

Enter another purported predictor of market returns. Except this one predicts future returns better than any other, and it doesn't fall into either the bear or bull camp -- instead, it gives a level-headed look at the market.

It's the average investor equity allocation, and here's what it says about your future returns.

The simple explanation
In a simplified world, investors can keep their money in a few different places: stocks, bonds, or cash. The percent allocated to asset changes over time, depending on what the investor believes to be the most advantageous to either returns or their current needs. If you need liquidity for a major purchase, like a house, you'll have a bit more allocated to cash. And if you believe stocks might outperform bonds, you'll have a bit more allocated toward stocks.

If a majority of investors favor stocks at a certain time, that demand will increase prices for equities. And, on the other hand, if a majority of investors have a smaller-than-average allocation to stocks, the prices for equities will fall.

Taking aggregate data from the Federal Reserve, we can find the average allocation to equities, which, when mapped with market returns for the next 10 years, is a fairly accurate take on what returns will be for the future. In fact, when comparing it to other traditional valuation metrics, it dominates in terms of correlation. (For those without a background in statistics, R-squared is a measure of predictive power, and the closer to one, the more exact its prediction should be.):

Valuation Metric R-Squared
Average investor equity allocation 0.913
Market cap to GDP 0.761
Shiller P/E 0.664
Trailing P/E 0.5

Too see a much more detailed explanation and where this idea originated, visit the Philosophical Economics blog.

What it says about the future
Given its accuracy, what does this indicator say for the current level of the S&P 500 (SNPINDEX: ^GSPC  ) ? Right now, we can expect annual returns for the next 10 years to be around 6% based on average investor equity allocation. This is a bit lower than the standard average of 8% to 10%, so those who say the market is overvalued have an argument. But even though the market may be priced higher than is typical, the opportunity cost of not capturing that return and waiting for a correction could outweigh whatever gains you would see from waiting to put your money in.

The blog's author argues that valuation itself is not a reason for a lower-priced market in the future:

Big sell-offs usually occur in association with recessions. That's where market timers make their money -- by anticipating turns in the business cycle. A hint to bears: if you're calling for a recession right now, in this monetary environment, you're doing it wrong.

What it means for you
This should be just another tool to help you make decisions, as even the best predictor is not always correct. And if you're into investing in single companies, such a broad metric obviously won't help. But what this can do for you is set expectations and help plan your future finances. For example, if you're attempting to calculate for retirement or a large purchase, the indication that the market may only return 6% instead of the historic 9% can guide you to adjust your actions today so that you can still achieve your goals.

So the average investor equity allocation should simply be another tool for investors to help plan their long-term investments.

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