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This ‘single greatest predictor of future stock-market returns’ has fallen sharply — and that’s a bullish sign

CHAPEL HILL, NC – According to the “Single Greatest Predictor of Future Stock Market Returns,” much of the bull market’s excesses have been wiped out. And that’s good news.

I’m referring to the indicator, first suggested by the Philosophical Economics blog in 2013, which is based on an average household’s portfolio allocation to equities. It is a contrarian indicator, where higher stock allocations are associated with lower subsequent market returns, and vice versa. Indeed, according to econometric tests I’ve subjected it to and other well-known valuation indicators, it has one of the best – if not the best – track record predicting the S&P 500’s SPX,
-1.43%
subsequent 10 years of total real return.

According to the data just released from the Federal Reserve, this indicator experienced one of its biggest (and therefore bullish) declines since the early 1950s in the last calendar quarter, and that’s how far back the data goes. But for the quarter that included the March 2020 waterfall drop that accompanied the initial lockdowns from the COVID-19 pandemic, you have to go all the way back to the last quarter of 1987 — including the worst crash in stock market history — to get a quarter in which this indicator fell as much as in the June quarter of this year.

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At the middle of the year, this indicator stood at 44.8%, compared to 51.7% at the end of last year. At the lows of the seven bear markets over the past 25 years in the calendar tracked by Ned Davis Research, the indicator averaged 37.1%. So of the spread of 14.6 percentage points above this average that existed at the end of 2021, 6.9 percentage points has now been eliminated – or almost half.

And the indicator is almost certainly lower today than it was mid-year. We don’t know because the data on which the indicator is based is only updated quarterly, and even then with a delay of a few months. The most recent update, reflecting the end of the second quarter, came out on September 9. The next update, which will show the data from the end of September, will not be released until December.

You can object to the positive spin I am putting on the indicator’s decline by arguing that it was caused by nothing more than the decline in the value of household stocks. But that can’t be more than a small part of the explanation, as bonds have gone through a bear market of their own; the year-to-date decline in long-term Treasurys TMUBMUSD10Y,
3.712%,
is actually bigger than the stock market’s DJIA, for example,
-1.17%

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COMP,
+1.31%.
The decline in the indicator, on the other hand, means that the average household has significantly scaled back its commitment to equities.

More: US equities suffer largest weekly outflow in 11 weeks

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All this means that the bear market is doing its job. The absolutely essential role bear markets play in the market cycle is to bring the market back down when it gets too far ahead of things. And that was certainly the case with this indicator at the peak of the bull market late last year, when it leveled as it was the all-time high (equivalent to the top of the internet bubble, as you can see in the attached chart).

To appreciate the work this bear market has already accomplished, consider a simple econometric model I constructed that bases its predictions on the historical correlation between the indicator and the stock market. This model now predicts that the total return of the S&P 500 will be closely aligned with inflation over the next decade. This contrasts with a projection of minus 4.6% yoy at the beginning of the year and minus 3.3% yoy at the end of the first quarter.

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Keeping up with inflation may not excite you, but it’s a lot better than losing 4.6% per year for 10 years. And keeping up with inflation is probably better than what long-term bonds will do over the next decade.

Valuation Indicators Not Supporting New Bull Market Yet

Separately, the table below shows how each of my eight valuation indicators compares to its historical range. As you can see in the column comparing current valuations to late last year, current market valuations are significantly more attractive than in January.

Last

A month ago

beginning of the year

Percentile since 2000 (100 most bearish)

Percentile since 1970 (100 most bearish)

Percentile since 1950 (100 most bearish)

P/E ratio

19.68

20.57

24.23

36%

59%

69%

CAPE ratio

28.35

29.83

38.66

70%

80%

85%

P/dividend ratio

1.75%

1.59%

1.30%

70%

80%

86%

P/Sales ratio

2.32

2.45

3.15

89%

89%

89%

P/Book ratio

3.74

3.93

4.85

90%

86%

86%

Q ratio

1.59

1.67

2.10

73%

86%

90%

Buffett ratio (market cap/GDP)

1.54

1.62

2.03

88%

95%

95%

Average household wealth allocation

44.8%

49.7%

51.7%

85%

88%

91%

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings keeps investment newsletters that pay a fixed fee to be audited. He can be reached at [email protected].

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