Markets: News  

By Mark Hulbert

My monthly review of stock market valuation indicators

According to an indicator known as the "Single Greatest Predictor of Future Stock Market Returns," equities over the next decade will merely keep pace with inflation.

This indicator is based on the average investor allocation to equities. It was introduced in 2013, and given this auspicious name, by the anonymous author of the Philosophical Economics blog. The indicator's creator reported that it had a better track record predicting the stock market's 10-year return than any of the other valuation indicators of which he/she was aware. I also have failed to find an indicator with a better record.

There are two reasons to write about this indicator now. The first is that it is updated only quarterly based on data in the "Financial Accounts of the United States" report from the Federal Reserve, and earlier this month the latest such report was published by the Fed. The second is that we're approaching the 10-year anniversary of the Philosophical Economics' introduction of the indicator, so we now have the first real-time test of its prediction.

According to the just-released Fed data, the average investor allocation to equities currently is 44.9%. Since the indicator is interpreted in a contrarian fashion, it's good news that this latest ready is significantly below the 51.7% that prevailed at the end of 2021. The bad news is that the current reading is still well above the seven-decade average of 35.7%. In fact, the indicator's current level stands at the 92 percentile of its historical distribution. Its improvement over the last year therefore only partially works off the market's extreme overvaluation at the top of the bull market at the end of 2021.

According to a simple econometric model based on the historical correlation of the indicator and the S&P 500's subsequent 10-year real total return, the current average investor allocation translates to a predicted return between now and 2033 of 0.2 percentage points below inflation. In other words, stocks will more or less simply hold their own against inflation.

The first real-time test

What about the last 10 years, the first real-time test of the indicator's track record? It did creditably. The average investor equity allocation stood at 35.4% a decade ago, which--via my simple econometric model--translated to a subsequent 10-year total real return of 5.9% annualized. The upper end of the 95% confidence interval for that projection was 9.9% annualized.

As fate would have it, the stock market's real total return over the last decade has been 9.9% annualized, right at the upper edge of the 95% confidence interval. Not bad. The accompanying chart plots the entire history of the indicator's correlation with the stock market since 1951, which is when data first became available.

Notice from the chart that the stock market's projected 10-year return has been steadily falling since 2013, and stands now at minus 0.2% annualized over the next decade. The 95% confidence interval around this projection is from a low of minus 4.8% annualized to a high of plus 4.3% annualized.

How other valuation models stack up currently

Adding credence to this sobering projection is that other valuation indicators with excellent long-term records are telling a similar story. The indicators that, according to my research, have the best records predicting the stock market's 10-year total real return are listed in the table below, along with where each stands relative to its historical distributions.

                                     Latest  Month ago  Beginning of year  Percentile since 2000 (100% most bearish)  Percentile since 1970 (100% most bearish)  Percentile since 1950 (100% most bearish) 
P/E ratio                            23.08   22.98      22.23              60%                                        74%                                        81% 
CAPE ratio                           28.86   28.86      28.46              73%                                        81%                                        86% 
P/Dividend ratio                     1.74%   1.71%      1.74%              72%                                        81%                                        86% 
P/Sales ratio                        2.32    2.32       2.24               91%                                        96%                                        97% 
P/Book ratio                         3.99    3.98       3.85               93%                                        92%                                        94% 
Q ratio                              1.63    1.63       1.58               88%                                        94%                                        93% 
Buffett ratio (Market cap/GDP)       1.53    1.55       1.49               90%                                        96%                                        96% 
Average household equity allocation  44.9%   44.9%      44.9%              88%                                        89%                                        92% 

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com.

-Mark Hulbert

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March 27, 2023 12:28 ET (16:28 GMT)

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