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Investors Should Catch This ‘Secret Indicator’ Before It Rattles Markets

Last Updated January 7, 2024 1:12 PM
Giuseppe Ciccomascolo
Last Updated January 7, 2024 1:12 PM
Key Takeaways
  • There is a secret indicator that can help predict the future of the stock market.
  • This indicator is based on the idea that investors tend to over allocate to stocks when they are confident about the future.
  • It has been quite accurate in predicting stock market crashes in the past.

In the realm of predicting long-term stock returns, numerous models vie for the title of the “world’s greatest predictor.” However, one unconventional option stands out prominently – and at present, its outlook is far from optimistic.

What’s the name of this indicator? How does it work? Who created it? But, most importantly, why don’t all of investors care about it?

What’s This Mysterious Indicator?

The concept, born from an anonymous 2013 blog post , is straightforward: when investors collectively allocate an excessive portion of their capital to stocks, subsequent stock performance tends to lag. Conversely, when investors divert from stocks to other investments, stocks tend to outperform.

Remarkably, examining  the average stock allocation of investors has been a highly accurate predictor of future 10-year returns. Historically, whenever investors allocated more than 40% to stocks, they encountered losses over the following decade. The correlation is clear: the higher the allocation, the lower the subsequent returns.

Indicator chart
The indicator suggests that stocks’ returns aren’t likely to be positive over the next decade. Source: Philosophical Economics blog, FRED data, Finimize.

This inverse relationship between allocation and returns, often observed in overallocated portfolios, stems from several interconnected factors. Now, it’s time to analyze it.

How Can I Gauge Investors’ Stock Allocations?

The average allocation of investors to stocks is derived from the market value of all stocks over the total value of all financial assets, encompassing stocks, cash, and various bonds. Though calculating this may seem intricate, the creator of this indicator provides the necessary figures.

To grasp the prediction mechanism behind stock market returns, a closer examination of the calculation is warranted:

Investors’ average allocation to stocks = market value of stocks / (market value of stocks + total value of liabilities of all borrowers)

Assuming that the total liabilities of all borrowers grow with the economy, a reasonable assumption given businesses’ reliance on loans or bonds for expansion, the market value of stocks must also grow to maintain a steady allocation. As the denominator increases, reflecting the growing liabilities, the numerator must rise to keep the ratio constant.

In essence, if the target stock allocation remains constant, the market value of stocks has to increase. This can occur through either the issuance of new shares by companies or an overall increase in stock prices. Given the practical constraints on companies issuing enough shares annually to match the expanding cash and bonds supply, stock prices must rise over the long term for investors to maintain a consistent allocation to stocks.

Connecting Allocation And Market Performance

The brilliance of this framework lies in its ability to not only elucidate why stocks generally rise over time but also to connect portfolio allocation decisions with stock market performance. Consequently, if investors temporarily over-allocate to stocks and need to readjust lower, stock prices will decline.

Average investor stock allocation
This chart shows the average investor stock allocation (horizontal axis) and the total returns for that investment over the following ten years (vertical axis). Sources: Philosophical Economics blog, Federal Reserve Economic Data (FRED), Finimize.

Moreover, this indicator can explain phenomena that other valuation models struggle with, such as the bull market of the 1980s. Contrary to traditional models attributing the rally to “irrational exuberance,” this framework highlights that prices needed to rise to match the substantial increase in the total value of liabilities during that period. Additionally, investors were significantly underweight in stocks at that time, with an average stock allocation of only 20%. When investors rebalanced their equity allocation to a more reasonable level, prices had to rise, which they did.

How Does The Current Forecast Appear?

Investors currently allocate an average of 46% to stocks. While this is an improvement from a year and a half ago (when it reached 50%, the second-highest in history), it still surpasses the critical 40% threshold.

Unless investors plan to permanently maintain a higher stock allocation (which is conceivable but improbable), this indicator suggests a slight decrease in stock prices over the next decade.

Should this concern you? Absolutely. This indicator has proven to be a superior predictor of future stock returns compared to more common metrics like the price-to-earnings (P/E) ratio, CAPE ratio, market cap to economic growth, or the Fed model.

While circumstances may differ this time (thanks to AI), it’s prudent to take its warning seriously. At the very least, consider adding this “average stock allocation” figure to your watchlist.

How Can I Benefit From It?

Consider utilizing this as a contrarian timing indicator. When the average stock allocation dips below 40%, you can feel assured – it’s not excessively extreme, and a strategy of buying and holding stocks seems prudent.

However, if it exceeds 40% (currently at 46%), consider reducing your stock allocation. Maintain this adjustment until the average stock allocation drops below the 40% threshold again.

Keep in mind that these indicators function like a slow cooker, offering insights into long-term trends. So, persist and avoid hastily uncovering the pot; they won’t predict short-term events in 2024 or 2025.

Also, remember that indicators are not infallible. Make sure you do your own research and never invest more money than you can afford to lose.

Disclaimer

Please note that the contents of this article are not financial or investing advice. The information provided in this article is the author’s opinion only and should not be considered as offering trading or investing recommendations. We do not make any warranties about the completeness, reliability, and accuracy of this information. The cryptocurrency market suffers from high volatility and occasional arbitrary movements. Any investor, trader, or regular crypto user should research multiple viewpoints and be familiar with all local regulations before committing to an investment.

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