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

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?

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.

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

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.

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?

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