A stock market gauge with one of the best track records is cheering investors

It’s bullish for the stock market that the average household’s equity allocation has declined as much as it has.

I’m referring to an indicator that its creator, the anonymous author of the Philosophical Economics blog, dubbed “The Single Greatest Predictor of Future Stock Market Returns.”

The average household’s portfolio allocation to equities is a contrarian indicator, with higher allocations correlated with lower stock-market returns and vice versa.

According to econometric tests to which I subjected this and other valuation indicators, it has one of the very best, if not the best, track records when forecasting the stock market’s real total return over the subsequent decade.

There are other contrarian signs with the same upshot. Institutional investors over the past 12 months have poured significantly more money into U.S. equity funds than retail investors have taken out. And it’s rare that the stock market falls for two years in a row, suggesting 2023 could be a pivotal year for the S&P 500 Index
SPX,
+0.59%
after this year’s bear market.

This average household equity allocation hit its all-time high, and therefore its most bearish posture, at 51.73% in March 2000, the month of the top of the internet bubble. We all remember what happened next.

That indicator was almost as high one year ago, in December 2021, at 51.66%. Since the date of that reading, the Vanguard Total Stock Market ETF
VTI,
+0.55%
— whose 4,026 stocks represent the U.S. market as a whole — has lost 19.9% of its value.

The indicator is updated every quarter, and even then with a several-week lag. Two weeks ago the Federal Reserve released the third-quarter data that are the inputs to the indicator, and its latest value is 43.62%. While this most recent reading is still above the historical average, it no longer implies a negative real total return for the S&P 500 over the next decade. It instead projects that the stock market will beat inflation by an average of 0.6% a year.

Beating inflation by less than a percentage point may not strike you as anything to write home about. But this is first time since the beginning of the pandemic that the indicator is projecting a positive return.

Furthermore, I wouldn’t be surprised if the stock market over the next decade beats this projected return. That’s because of the particular circumstances that caused the indicator to drop so much over the past year. During a typical bear market, the average household’s portfolio allocation to stocks will decline more or less automatically as equities lose ground and bonds rise in value. When that happens, investors don’t need to actually sell any of their stocks for this average allocation to drop.

In the current bear market, in contrast, bonds have performed just as poorly as stocks, if not worse. As a result, the decline in the average household’s equity allocation this past year has been caused in large part by actual sales of equities. From a contrarian point of view, those sales have much more bullish significance than the decline in equity allocations that result when stocks fall and bonds rise.

How eight valuation models are stacking up

The table, below, lists the eight valuation indicators I highlight in this space every month. I am not aware of any others that have superior historical track records. As is the case with the average household’s equity allocation, many of the other indicators in the table have also pulled back from overvaluation extremes at the end of 2021.

 

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

20.43

21.81

24.23

40%

62%

71%

CAPE ratio

27.97

29.86

38.66

69%

79%

85%

P/dividend ratio

1.74%

1.68%

1.30%

73%

82%

87%

P/sales ratio

2.30

2.45

3.15

89%

89%

89%

P/book ratio

3.82

4.07

4.85

90%

86%

86%

Q ratio

1.63

1.73

2.10

80%

89%

92%

Buffett ratio (Market cap/GDP )

1.51

1.61

2.03

88%

95%

95%

Average household equity allocation

43.6%

43.6%

51.7%

75%

84%

88%

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.

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