The Best Stock Market Indicator?

Investors search for the ideal indicator or signal that tells them when to change their investment portfolios. Here’s the latest candidate, from the blog Philosophical Economics. It’s not a traditional market indicator at all and doesn’t even use any of the traditional stock market metrics. The indicator is the ratio of the total amount of stocks people hold to the total amount of everything else (stocks, bonds, and cash). According to the data in the post, the indicator is a better predictor of future returns (over 10 years) than any of the other indicators discussed in the financial world.

The indicator is very rational and worth following. But it’s not the perfect timing indicator that so many people want. It estimates returns over 10 years. You still could lose money in the short term even when the indicator says you should buy more stocks. Also, it’s tough to look at the graph and come up with rules for specific points at which you should increase and decrease your equity allocations and by how much. There’s a lot more work to do than simply calculating the number. I’ve always recommended that you not try to find one piece of data or indicator. Instead, look at a range of data that have been reasonably reliable over time and always maintain some level of diversification. It is rare when an investor should be 100% in or out of stocks.

The question we want to answer is this: what would the average of all of these investors’ portfolio allocations look like, weighted by size?  More specifically, what would the average investor allocation to stocks be?  And how would that average compare to the averages of the past? It turns out that this question predicts the market’s future long-term returns better than any other classic valuation metrics to date developed–price to earnings (P/E), price to book (P/B), price to sales (P/S), CAPE, q-ratio, Market Cap to GDP, Fed Model, etc.

To answer the question, we need to know two things: (1) the total amount of stocks that investors in aggregate are holding, and (2) the total amount of cash and bonds that investors in aggregate are holding.  Mathematically, the total amount of stocks that investors are holding divided by the total amount of everything (stocks plus bonds and cash) that they are holding just is the average investor allocation to stocks.

Consider this opening paragraph from a subsequent post on the blog:

My prior piece on asset supply has received significant interest, and so I feel an obligation to clarify.  The title, “The Single Greatest Predictor of Future Stock Market Returns”, was something of an intentional exaggeration, chosen not only to draw attention to an out-of-the-box (and, in my opinion, useful) way of thinking about equity returns, but also to take a subtle jab at commonly-cited valuation metrics.  The title was not meant to be taken literally.