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Philosophical Economics
The Single Greatest Predictor of Future Stock Market Returns
Posted on December 20, 2013
Consider the following chart, which shows the average investor portfolio allocation to equities
from January 1952 to December 21!"
#he metric in this chart ta$es no input from any variables traditionally associated with
valuation" earnings, boo$ values, profit margins, discount rates, etc% &t consists only of a simpleratio between two numbers that can easily be calculated in '()D% *et, as a predictor of future
stoc$ mar$et returns, it dramatically outperforms all other stoc$ mar$et valuation metrics
commonly cited%
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&n this piece, &+m going to do five things% 'irst, &+m going to eplain, in very simple terms, the
accounting principles behind the metric% #he eplanation will include instructions -with ready.
made lin$s/ for how to graph the metric in '()D% 0econd, &+m going to discuss the dynamics
of asset supply, with a special focus on equities% #hird, &+m going to challenge the conventional
framewor$ for understanding the relationship between valuation and stoc$ mar$et
returns% 'ourth, &+m going to introduce a new framewor$, one that relates stoc$ mar$et returnsto equity asset supply% 'ifth, &+m going to present a scatterplot of the predictive performance
of the metric alongside other metrics, and discuss what the metric is currently forecasting for
%0% equity returns% &+m going to conclude by briefly touching on the question of whether or
not the current %0% stoc$ mar$et is overvalued%3
Accounting Principles: Cash, Bonds, Stocks
#o begin, let+s arbitrarily divide the universe of financial assets into three categories" -1/ cash,
-2/ bonds, and -!/ stoc$s% 4y cash3, & mean ban$ deposits and circulating currency% 4y
bonds3, & mean any certificate of obligation to repay borrowed cashcommercial paper, bills,
notes, bonds, etc% 4y stoc$s3 -or equity3/, & mean shares of ownership in a corporation -public
or private/% 6ote that these definitions are intentional simplifications%
'inancial mar$ets function on the following principle% 'or every unit of every financial asset
in eistence, some investor somewhere must willingly hold that unit in a portfolio at all
times% 4y investor3, & mean whoever owns wealth% #here are intermediarieshedge funds,
mutual funds, pension funds, financial advisors, etc%that help investors allocate wealth% 4ut
these entities are not the actual investorstheir clients are%
#he financial mar$et is the place where investors decidevia tradeswho will hold what units
of what assets% 6ote that cash, as an asset, is special in that respect% &t is the medium through
which trades occur% &nvestors can only switch from one stoc$ or bond to another stoc$ or bond
by going through cash% #he going rate of echange -bid or offered/ between a unit of an asset
and cash is the mar$et price of the asset%
7t the margin, if no investor can be found that wants to hold a given unit of a given asset at the
prevailing mar$et price, then the mar$et price will fall until a willing holder is found% 8ith
respect to shares of a stoc$ or bond, the application is straightforward% &f no one wants to hold
a given share at 1, then we try 95% 0till no ta$ers: #hen we try 9, then ;5, then ;,
and so on% 8e continue until some investor emerges that finds the share sufficiently attractive
to hold at the offered price% #he concept applies analogously to cashif no investor wants to
hold cash, then the price that is bid on everything else will rise until everything else becomes
so epensive and unattractive that some investor somewhere capitulates and agrees to holdcash instead% <easured in terms of other assets, the price of cash falls%
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#he supply3 of an asset is the total mar$et value of it in eistencethe total number of
outstanding units times the mar$et price of each unit% =ut differently, supply is the amount of
the asset available to be held in investor portfoliosthe amount available for investors to
allocate their wealth into% &n aggregate, investors have to want to hold the total supply of each
asset in eistence in their portfolios% &f there is too much supply of a given asset relative to the
amount that investors want to hold in their portfolios, then the the mar$et price of the asset will fall, and therefore the supply will fall% &f there is too little supply of a given asset relative to
the amount that investors want to hold in their portfolios, then the mar$et price will rise, and
therefore the supply will rise% >bviously, since the mar$et price of cash is always unity, 1 for
1, its supply can only change in relative terms, relative to the supply of other assets%
The Aggregate Investor Allocation to Equities
6ow, suppose that we open up every investor+s portfolio and calculate, for each investor, his
percent allocation to stoc$s, bonds, and cash% <y portfolio might be allocated ;5? to stoc$s,
15? to bonds, ? to cash% *ours might be allocated 5? to stoc$s, 2? to bonds, !? to
cash% 7nd so on%
#he question we want to answer is this" what would the average of all of these investors+
portfolio allocations loo$ li$e, weighted by si@e: <ore specifically, what would the average
investor allocation to stoc$s be: 7nd how would that average compare to the averages of the
past: &t turns out that this question predicts the mar$et+s future long.term returns better than
any other classic valuation metrics to date developedprice to earnings -=A)/, price to boo$
-=A4/, price to sales -=A0/, C7=), q.ratio, <ar$et Cap to BD=, 'ed <odel, etc%
#o answer the question, we need to $now two things" -1/ the total amount of stoc$s that
investors in aggregate are holding, and -2/ the total amount of cash and bonds that investors
in aggregate are holding% <athematically, the total amount of stoc$s that investors are holding
divided by the total amount of everything -stoc$s plus bonds and cash/ that they are holding
ust is the average investor allocation to stoc$s%
6ow, to calculate the total quantity of cash and bonds in investor portfolios, we might thin$
that we can ust sum the total quantity of cash and bonds in eistence outrightthe total
amount floating around the economy% 7fter all, these securities have to be held by
investors% 4ut this approach won+t wor$% #he reason is that a large portion of the bonds in
eistence are actually held by ban$s, not by investors% #his fact etends to the central ban$ -the
'ederal (eserve/, which presently owns an unusually large quantity of bonds%
'ortunately, there+s a convenient way to get around the problem% (ecall that when the 'ederal(eserve buys bonds -treasury, <40, etc%/, it doesn+t add any net financial assets to investor
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portfolios% (ather, it ta$es bonds out of investor portfolios, and puts newly created cash into
investor portfolios% &t changes the cash.bond mix of the assets that investors holdbut not the
total amount%
&t turns out that private ban$s do essentially the same thing when they buy assets% #hey ta$e
the assets out of the hands of investors, and put their own liabilitiesin the form of their own bonds or deposits -cash/into investor hands% -#hey can also fund purchases with equity sales,
but the equity component of a ban$s balance sheet is small enough to ignore%/
#he entities that create net new financial assets -that investors can hold/ are not ban$s, which
are ust intermediaries, but rather real economic borrowers% #he universe of real economic
borrowers consists of five categories" ouseholds, 6on.'inancial Corporations, 0tate and
Eocal Bovernments, the 'ederal Bovernment, and the (est of the 8orld% 8hen these entities
borrow directly from investors, the investors get new bonds to hold% 8hen the entities borrow
from ban$s, the investors get new cash to hold% #hat+s because when a ban$ ma$es a loan, the
money supply epands% #he loan creates a new deposit that didn+t previously eistsome
investor must now hold that deposit in his portfolio of assets%
&t follows, then, that if we want to get an estimate of the total amount of bonds and cash that
investors are holding at any given time, all we have to do is sum the total outstanding liabilities
of each of the five categories of real economic borrowers% #hose liabilities either translate into
cash that an investor somewhere is holding -if the entity too$ a loan from a ban$, which
epands the money supply/, or they translate into a bond that an investor somewhere is holding
-if the entity borrowed directly from the investor/% 6ote that the average bond trades close to
par -with some above, and some below/, so, in aggregate, the value of the liabilities
approimates the total mar$et value of the bonds%
4an$s don+t generally hold stoc$s% 0o to estimate the total amount of stoc$s in investor
portfolios, what we need to $now is the total mar$et value of all stoc$s in eistence% 8e end up
with the following equation"
&nvestor 7llocation to 0toc$s -7verage/ F <ar$et Galue of 7ll 0toc$s A -<ar$et Galue of 7ll
0toc$s H #otal Eiabilities of 7ll (eal )conomic 4orrowers/
8e can get all of the information in this equation from the 'low of 'unds report% #he
information is also conveniently available in '()D Braph% 7 lin$ to the calculated metric is
provided1 , and to a separately downloadable version of each series2%
1 http://research.stlouisfed.org/fred2/graph/?g=qis
2 http://research.stlouisfed.org/fred2/graph/?g=qab
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6ow, the (est of the 8orld creates an interesting complication% =arts of our portfolios are
composed of stoc$s, bonds and cash denominated in foreign currencies -which do not show up
in these series and are not being counted, though they should be/% 4ut in the same way, some
parts of the portfolios of individuals in other countries are composed of stoc$s, bonds and cash
denominated in our currency -which do show up in these seriesand are being wrongly
counted, given that our goal is to $now our own allocations as domestic investors/% 7s anestimation, it wor$s to assume that the two cancel each other out%
The Unique Dna!ics o" Equit Asset Suppl
#he supply of cash and bonds that investors in an economy must hold perpetually increases
with the economy+s growth% #he cash and bonds in investor portfolios are literally made from3
the liabilities that real economic borrowers ta$e on to fund investmentthe fuel of growth%
#he following chart shows the annual growth of the total liabilities of all real economic
borrowerswhich, again, is the total supply of cash and bonds in investor portfoliosfrom 1952
to present% #he growth rate has ranged anywhere from around 5? per year to around 15? per
year% (ight now, it+s at the low end of the spectrum%
#rivially, if the aggregate investor is going to maintain a constant portfolio allocation to
equities, the supply of equities must grow commensurately with the supply of cash and
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bonds% (ecall that investors, in aggregate, have to hold all of these assets at all times% &t follows
mathematically that the ratios of the total supplies outstanding must equal the ratios inside the
average3 investor+s portfolio%
#he supply of equities can increase in one of two ways" through the issuance of new shares, or
through price increases, i%e%, increases in the level of the stoc$ mar$et% #he chart below showsthe corporate sector+s net issuance of new equity, as a percentage of total mar$et value, bac$ to
195%
7s we see in the chart, the corporate sector is inherently averse to the issuance of new
equity% )ach year, it adds very little additional supply, on net% &n various periods since the
early 19;s, it+s actually been a net destroyer of equity supplyta$ing supply off the mar$et
through acquisitions and buybac$s%
7s we eplained in our earlier piece on earningless bull mar$ets!, because the corporate sector
does not issue sufficient amounts of new equity each year to $eep up with the continually
increasing supply of cash and bonds, stoc$ prices have to rise over the long.term% &f they don+t,
stoc$s will become a smaller and smaller percentage of the aggregate investor portfolio% nless
investors, on average, want stoc$s to be a smaller component of their portfoliosbecause, for
eample, they increasingly prefer to hold other assetsthis outcome will not be allowed% 0toc$
3 http://philosophicaleconomics.ordpress.com/2!13/!"/2!/earningless#bull#mar$ets#h%#do#the%#happen/
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prices will get pushed up on the growing relative scarcity until the aggregate equity allocation
preference is satisfied%
#aluation: Challenging the Conventional Understanding
#he total return of an equity security depends on two factors" -1/ the change in price frompurchase to sale, and -2/ the dividends paid in the interim% Dividends matter, but price is
$ing% &t drives total return%
<any investors don+t li$e the fact that price drives total return% &f price drives total return, it
follows that total return is a function of the shifting sentiment, preferences and epectations of
other peoplethose who ma$e up the mar$et and vote3 on what the price will be% &nvestors
don+t want their returns to be subect to the arbitrary vote3 of other people, and so they pretend
that as stoc$ mar$et speculators they are actually genuine businessmen who buy3 and own3
companies to hold forever% #hey tell themselves that their returns will somehow emerge
directly from the cash flows of the underlying businesses, regardless of what the mar$et decides
to do with price%
#his point of view ignores the fact that it ta$es decades to recoup an equity investment via
dividends, the only cash flows that are ever are actually paid out to buy.and.hold investors% #o
claim a return on a stoc$ in any other contet, an investor needs someone to sell it to% #he price
that other people are wiling to pay is therefore importantsupremely important% (ather than
resist this fact puristically, our responsibility as investors is to accept it and wor$ within it, by
understanding the behavioral propensities of our fellow mar$et participants, and getting in
front of emerging trends in how they choose to allocate their wealth%
>nce we agree that price is $ing, the net question is" how is price determined in a
mar$et: Galue mavens tend to thin$ that price is determined through the rational3 application
of normative valuation principles, such as #he stoc$ mar$et+s =A) ratio should be 15, plus or
minus a few points% &f interest rates are low, add a few points% &f they are high, ta$e a few points
off%3 >n this view, when the actual =A) ratio is above the appropriate value, disciplinedinvestors sell% 8hen it+s below that value, they buy% #hrough their buying and selling, the price
moves to where it should3 be, to fair value3, given the earnings% )very so often, emotions
disrupt the process, but as with everything, they eventually pass, and the process ta$es hold
again% Galue mavens loo$ for these disruptions as an opportunity to capture ecess return%
#here+s certainly some truth to this view, but it doesn+t give the whole story% ltimately, the
price of equity is determined in the same way that the price of everything is determinedvia
the forces of supply and demand% 'or any given stoc$ -or for the space of stoc$s in aggregate/,price is always and everywhere produced by the coming together of those that don+t own the
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stoc$ and want to allocate their wealth into it, and those that do own the stoc$ and want to
allocate their wealth out of it% &f there is a different supply sought by the first group than offered
by the second, the price will shift until the imbalance equali@es%
6ow, there+s absolutely nothing that says that this process has to equilibriate at any specific
valuation% istory confirms that it can equilibriate at a wide range of different valuations% 'orperspective, the average value of the =A) ratio for the %0% stoc$ mar$et going bac$ to 1;I1 is
$%&%'% 4ut the standard deviation of that average is a whopping (&), more than 5? of the
mean% >ne standard deviation in each direction is worth *)+ in total return, or $+ per year
over 1 years%
#he same is true of the popular 0hiller C7=)% &ts long.term average is $%&+'but with a
standard deviation of -&%, again almost 5? of the mean% >ver the last 1 years, its value has
stretched from as low as %, to as high as )'a difference of .'' in total return% 6ote that
the periods in which it too$ on depressed values were hardly brief% &t spent the entire decade
of the 19s at bargain basement levels, frequently falling into single digitsthis in an
environment where interest rates were pinned at @ero%
7gain, it+s all up to the allocatorsthey decide how much of their wealth they are going to
allocate into stoc$s, how much eposure they are going to ta$e on% #heir preferencesor rather,
their efforts to put those preferences in place, by buying and sellingset the price% Galuation is
a byproduct of this process, not a rule that it has to follow% &n the 19s, investors decided, for
whatever reasonmemories of the Depression, a 8orld 8ar that the country might have lost,
price controls, high inflationthat they didn+t want large stoc$ mar$et eposure% #he fact that
bond yields were meager did little to alter this preference% 7nd so valuations stayed etremely
depressed% 8hen a vibrant, prosperous peacetime economy emerged in the 195s, this
preference obviously changed, and the biggest bull mar$et in history ensued%
4uy.and.hold is painted as the informed, responsible, pro.7merican thing to do with a
portfolio% 4ut, in terms of financial stability, it can actually be a very destructive
behavior% Consider the classic buy.and.hold allocation recommendation" -' to stoc$s, )' to bonds -or cash/% 8hat rule says that there has to be a sufficient supply of equity, at a fair3
or reasonable3 valuation, for everyone to be able to allocate their portfolios in this
ratio: #here is no rule%
&f everyone were to ump on the buy.and.hold bandwagon, and decide to allocate KA, but
equities were not already K? of total financial assets, then they would necessarily become
K? of total financial assets% #he ecess bidding would not stop until they reached that level% &t
doesn+t matter that the associated price increase would cause the =A) ratio to rise to anobscenely high value% #he supply.demand dynamic would force it to go there%
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6ow, in the real world, valuation concerns can and do push bac$ on the equity allocation
process% 4ut, outside of etremes, they don+t tend to push bac$ with very much force, at least
not on their own% Eet me now eplain some of the reasons why%
8e can divide asset allocators into two types" mechanical allocators, and active
allocators% <echanical allocators are individuals that adhere to a strict allocation formula,regardless of circumstance% #wo eamples would be buy.and.hold investors that are always
1? invested -or always KA invested, periodically rebalancing, etc%/, and 1LAretirement
investors that invest automatically in accordance with a pre.defined program% #hese asset
allocators follow their processes come rain or shine, therefore they cannot be relied upon to
push bac$ against valuation ecesses% #hough they are not the maority of the mar$et, they are
a significant part of ittheir presence ma$es a difference%
7ctive allocators, in contrast, dynamically alter their allocations so as to maimi@e their
returns% ow do they try to maimi@e their returns: 4y allocating their wealth into the assets
whose returns they consider to be the most attractive, adusted for ris$% &t+s a competitive
processthey choose among their options, based on their assessments of what those options
are li$ely to produce%
0ome might interpret this to mean that they loo$ at the earnings yields on stoc$s, the yields to
maturity on bonds, and the yield on cash, and then choose% Eet+s suppose that asset allocation
were this easyust find the asset class with the highest yield, ris$.adusted, and allocate into
it% 8e would still have to answer the question" what is the future yield -at the current price/ of
each asset class, adusted for ris$: #o answer this question with respect to cash is hardwe
have to estimate future short.term interest rates% 8ith respect to bonds, even harderwe have
to estimate credit ris$% 8ith respect to stoc$s, the hardest of allwe have to estimate forward
earnings%
#o estimate forward earnings for stoc$s, we have to answer difficult questions about the future"
8hat will the traectory of nominal growth be: ow will profit margins evolve: 8ho can
answer these questions with a significant degree of empirical confidence, enough to be acontrarian that consistently fights the mar$et+s trends: Gery few people, and therefore the
answers to the questions end up reducing to biased reflections of prevailing mood,
etrapolations of recent eperience% 8hen the mood is high, and when recent eperience has
been positive, investors embrace optimistic assessments of what the future holdstherefore,
equities loo$ cheap, attractive% #he mar$et gets the opposite of the valuation pushbac$ that it
needs% 8hen the mood is low, and when recent eperience has been negative, investors
embrace more pessimistic assessments of what the future holdstherefore, equities loo$
epensive, unattractive% 7gain, the mar$et gets the opposite of the valuation pushbac$ that itneeds%
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&t turns out that even if fundamental questions about the future yields of cash, bonds, and
equities were resolved, asset allocation still would not be as simple as choosing the security that
offers the highest yield -ris$.adusted/% #he goal, again, is to maimi@e return% (eturn is not
the same thing as yield%
Branted, if a security is held to maturity, or, in the case of equities, for an infinite period oftime, the return will mathematically converge on the yield -provided, in the case of equities,
that all earnings are eventually distributed as dividends/% 4ut who among us buys bonds to
hold to maturity, or stoc$s to hold forever: <ost investor time hori@ons are not on the order
of decades, centuries or infinity, but on the order of days, months and yearsa few days -the
time hori@on of a swing trader/, a few months -the epiration date on a portfolio manager+s
grace period with clients, at which point they will start leaving if things aren+t wor$ing/, or a
few years -long.term value investors playing with their own money/%
#o $now the return of a security on a daily, monthly, or yearly time hori@on, it+s not enough to
$now what the yields are% *ou need to $now how the price is going to change% Biven future
cash flows -which we+ll assume you+ve accurately estimated/, this requires $nowing what the
future valuation will be%
#o illustrate, suppose that the =A) multiple on stoc$s is 2, the 1 year bond yield is 2?, and
the rate on cash is ?% 0uppose further that the earnings of each of these securities are going
to remain constant% Can you say which security will offer the highest return over the net few
years: *ou might say stoc$sthe earnings yield is 5?, a healthy !? more than bonds% #he
premium3 between the two is meaningfully higher than the historical average% 4ut that doesn+t
tell you what the return of stoc$s will be% &f the investment mood sours ever so slightly over the
net few years, and the mar$et concludes that a =A) of 1I is more appropriate3 than a =A) of
2, the return will be negativema$ing stoc$s significantly less attractive than the other
available assets, despite the higher earnings yield%
#he only way that you can $now what the future valuation of stoc$s will beso as to estimate
future returnsis to apply some conception of what+s fair, appropriate, reasonable, normal% 4utthe range of what can be rationali@ed as fair, appropriate, reasonable, normal is etremely wide,
too wide to be useful, and far too wide to provide reliable pushbac$ against a supply.driven
mar$et advance% 7ny number that is chosen will li$ely be nothing more than a reflection of the
prevailing allocation preferencethe prevailing appetite to be in or out of the asset class, based
on primordial hunches3 for where things are headed, themselves ust manifestations of
recency bias% >nce again, the mar$et will not get the valuation pushbac$ that it needs%
ltimately, valuation is a learned perception, learned through a process of social andenvironmental reinforcement% #he part of it that is not learned is ust a crude manifestation of
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the behavioral bias of anchoringudging the attractiveness of a price -or a ratio/ by comparing
it to the price -or ratio/ that one is accustomed3 to seeing% &ronically, it is anchoring, not
valuation discipline3, that $eeps the mar$et from doing cra@y, bubbly things% =eople don+t li$e
to pay higher prices tomorrow than they could have paid today, or sell for lower prices today
than they could have sold for yesterday% #hat+s true regardless of what any valuation metric
says%
#o illustrate, suppose that you spend a significant amount of time in an environment where the
average valuation is 25 times -or more/% *ou acclimati@e to that valuation, it becomes your
anchor, what you are used to seeing% 7ll of the pundits3 that you watch on #G tell you that it+s
normal% 7ll of your friends, your fellow investors, say that it+s normal% <ost importantly,
whenever you+ve bought at or below that valuation, it+s worked the mar$et has rewarded you
with a positive outcome% 7nd so you+re comfortable buying at that valuation%
>bviously, in such an environment, you will come to perceive 25 times earnings as a perfectly
appropriate3 price for the mar$eta fair3 multiple% &f given an opportunity to buy the mar$et
at a lower pricefor eample, 2 timesyour reward circuitry will fire off, creating an appetite
to loc$ in the bargain3, ump on the big gains3 that it is offering%
4ut now switch the =A) in the eample from 25 to 15% 0uddenly, the same =A) of 2 will ma$e
you feel li$e you+re overreaching, eposing yourself to danger, buying too high% Bee, what if
the =A) falls bac$ to 15, where it usually is, what &+m used to seeing&+ll lose 25? in one moveM &
can+t afford that%3
4ecause valuation is a learned perception, driven by anchoring and by social and
environmental feedbac$, it tends to follow the mar$et% 7s valuations rise in a bull mar$et, prior
anchors wear off, and people get accustomed to higher valuationsover time, the valuations
stop feeling high3ma$ing room for them to go even higher% #heir perceived appropriateness
gets reinforcedsocially, in the mar$et discussion, and environmentally, through the incredibly
powerful feedbac$ of actually making money% &n a long, slogging bear mar$et, the opposite
occurs% )verything gets driven downwards%
#o illustrate, consider the eample of the most recent cycle% #here was a time, before the crisis,
when we tal$ed about trailing =A)s of 1; or 19 times earnings as reasonablemaybe even a
bargain, relative to the bubble that we had previously come out of% &f we thought the trailing
=A) was too high in the summer of 2I, we were told to ignore itbecause the mar$et was still
very cheap on forward estimates -themselves ust a reflection of the optimism/%
#hen, we had the Breat (ecession, a massive, negatively.reinforcing series of economic eventscompletely unrelated to stoc$ mar$et valuation, mind youthat shattered everyone+s equity
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world view% 8e suddenly found ourselves seriously debating whether 1 times trailing
recessionary earnings was appropriate% 8e were supposedly in a new normal3, which, we
feared, implied structurally lower valuations%
#he crisis eventually abated, and the economy entered a recovery% 4ut people still had to wor$
off their fear conditioning and their anchoring% 7s the mar$et rose, the discussion shifted to whether 12 times was appropriate% #hen, 1 times% 6ow, 1I times% #he anchor, the goalpost,
has continued to move with the mar$et% =retty soon, the discussion will come full circle again,
and we will be as$ing ourselves whether 1; or 19 times is appropriate% 7nd, if the cycle isn+t
cut short by eternalities, as it was the last time, we may one day find ourselves discussing the
appropriateness of 25 timeswhich has been debated before in mar$et history -a few years
before the mar$et proceeded to go to /%
#he drivers of this recurring pattern are obvious" not some innate sense3 of fair value3, but
anchoring and the social.environmental reinforcement of the mar$et cycle itself% #he
perception of valuation is not capable of creating persistent, reliable resistance to the mar$et
cycle because it is an evolving function of the mar$et cycle% 7t etremes, it can push bac$but
it can+t push bac$ when it falls within the very wide range of what can be rationali@ed, which is
where it usually falls, and where it is now%
ltimately, we should be s$eptical of claims that investors are innately hardwired to act in a
certain way in response to any specific concept, argument, or data pointwhether it be
valuation3, or anything else% &nvestors elicit behavioral responses to these types of
informational inputs, but the responses are not innate% #hey are learned from the environment
through a process of conditioning and reinforcement%
&nvestors attend to concepts, arguments, and data points, etc% as a means to an endthe end of
predicting what the return will be, which, in practice, means predicting where the price is
headed% &f investors already have a hunch for where the price is headedwhich they often do
they will choose to embrace whatever concepts, arguments, data points, etc% fit that hunchor
they+ll ust ignore the mumbo umbo3 altogether, and go with their feel%3 0imilarly, if they are ust using the constructs to save face in social debateto avoid having to admit to themselves
and to others that they are wrongthey will ump on whatever concepts, arguments, data
points, etc% show that they are right -and ignore everything else/%
8hen investors don’t have a hunch for where prices are headed, and are genuinely trying to
use concepts, arguments, data points, etc% to assess what to do, the ensuing assessment ends
up being something inherently insecure, subect to constant feedbac$ and molding from the
mar$etresponsive to the result , and ditched when no longer wor$ing%
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*ou might confidently thin$, for eample, that good obs number3 means the recovery is
pic$ing up steam3, and that you should increase your equity ris$but if the mar$et starts
consistently telling you that this is wrong, by its actual result , you will be affected by the
feedbac$% *ou may eventually find yourself pulled to function in accordance with the opposite
rule, that good is bad%3 3<aybe & shouldn+t rush to increase my eposure here% <aybe these
good obs numbers will lead the 'ed to tightenmaybe that+s why the mar$et is sellingoff% >ops%3
7dmittedly, when enough people grab onto and act on concepts, arguments, data points, etc%,
they can become powerful forces that drive mar$et outcomes, especially when they have a basis
in reality that gives them credibility and forces people to believe them% #he refleivity of price
confirmation increases their allure and persuasiveness, which causes more people to latch onto
them, which fuels further price changes, therefore more price confirmation, and so on in a
feedbac$ loop that continues until reality pushes bac$%
owever, it+s hard for valuation to pic$ up steam in this way, because unli$e other themes that
might move mar$ets, it has no obective basisit+s a personal opinion, easy to dismiss% &t
represents a resistance to what the mar$et itself is doingand is therefore already on the road
to being disconfirmed simply by the fact that it is being raised% &f valuations are too high, then
why are we where we at them: 8hy aren+t we falling: 7bsent some $ind of confirmation or
feedbac$, the theme can+t go anywhere%
>utside of cyclical downturns in which profits themselves plunge, valuation never enters the
discussion as a surprise, an insult3, but rather is only introduced gently, gradually, as the
mar$et advancesusually by those who are not part of the advance% <ar$et participants
therefore have time to acclimati@e to it as a theme% &t can+t produce the $ind of shoc$ and
surprise that would catch people offsides and provo$e mounting, refleively self.fulfilling
reactions% #hat+s why it usually ta$es a recessionor some $ind of noious catalystto unwind
a valuation ecess% #he ecess alone can+t correct itself%
&n the tech bull mar$et, the overvaluation theme had a hard time pushing bac$ even when inde=A)s were in the !s and s% =eople tal$ed about overvaluation, they worried about it% 4ut
then they $ept watching the price go upso what do you do: *ou don+t tell the mar$et that it+s
wrong, you trust your environment, you go with the flow% &n the end, it too$ a tight 'ed, a
recession with falling earnings, a slew of corporate ban$ruptcies and scandals, unfamiliar
accounting changes that led to further earnings plunges, a terrorist attac$, a war in the <iddle
)ast, and so on, to finally get the mar$et moving reliably in the downward direction, so that the
valuation ecess could be corrected%
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7s equity investors, we tal$ a lot about asset allocation% &t+s essentially the most important
aspect of portfolio managementhow we+re allocated within the space of individual stoc$s and
bonds, and across the space of assets in general% &+m ;5? equity, 15? cashAbonds% *ou+re 5?
equity, 5? cashAbonds% Joe over there is 1? equity, ? cashAbonds, etc%
8hat+s funny is that we never thin$ to as$" how is it possible for all of us to get to within areasonable range of these preferred allocations at the same time: 7fter all, we+re trading a
limited supply of things amongst each other% #he answer, of course, is that the supply, properly
understood, automatically shifts to meet our allocation preferences via the changes in price
that we cause when we try to put those preferences in placethat is, when we buy and sell at
the margin% &n bull mar$ets, we frequently find ourselves searching for opportunities to put
our allocation preferences in placeour equity eposures are rarely as high as we would li$e
them to be%
& therefore propose a new way of framing equity total returns% #a$e the previous equation, and
substitute 7ggregate &nvestor 7llocation to 0toc$s3 and &ncrease in 0upply of Cash and
4onds3 for 3=A) <ultiple Change3 and )=0 Browth%3 8e then have,
-1/ #otal (eturn F =rice (eturn H Dividend (eturn
-2/ =rice (eturn F =rice (eturn from Change in 7ggregate &nvestor 7llocation to 0toc$s H =rice
(eturn from &ncrease in Cash.4ond 0upply -(eali@ed if 7ggregate &nvestor 7llocation to 0toc$s
8ere to 0tay Constant/ H Dividend (eturns
Combining -1/ and -2/,
-!/ =rice (eturn F =rice (eturn from Change in 7ggregate &nvestor 7llocation to 0toc$s H =rice
(eturn from &ncrease in Cash.4ond 0upply -(eali@ed if 7ggregate &nvestor 7llocation to 0toc$s
8ere to 0tay Constant/ H Dividend (eturn
&n the previous way of thin$ing, the earnings grow normally as the economy grows% &f themultiple stays the same, the price has to risethis price rise produces a return% 8hen the
multiple increases alongside the process, the return is boosted% 8hen it decreases, the return
is attenuated% #he multiple is said to be mean.reverting, and therefore when you buy at a low
multiple, you tend to get higher returns -because of the boost of subsequent multiple
epansion/, and when you buy at a high multiple, you tend to get lower returns -because of the
drag of subsequent multiple contraction/%
&n this new way of thin$ing, the supply of cash and bonds grows normally as the economygrows% &f the preferred allocation to stoc$s stays the same, the price has to rise -that is the only
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way for the supply of stoc$s to $eep up with the rising supply of cash and bondsrecall that the
corporate sector is not issuing sufficient new shares of equity to help out/% #hat price rise
produces a return% 8hen the preferred allocation to equities increases alongside this process,
it boosts the return -price has to rise to $eep the supply equal to the rising portfolio
demand/% 8hen the preferred allocation to equities falls, it subtracts from the return -price
has to fall to $eep the supply equal to the falling portfolio demand/%
6ow, instead of saying that the =A) multiple is mean.reverting, we say that, for a given set of
environmental contingenciese%g%, history, culture, demographics, etc%the equity allocation
preference is mean reverting% &t rises in epansionary parts of the cycle, as people become more
optimistic about the future and more eager to maimi@e what they see as attractive returns
-Lelly, we believe in this bull mar$et, we+re fully invested, our clients are fully invested%3
something you hear frequently on C64C these days/, and it falls in contractionary parts of the
cycle, as people become less optimistic about the future and more concerned about protecting
themselves from losses -<aria, we+re cautious here, we+ve raised cash, we want to see signs of
stabili@ation before we deploy it%3something that you heard frequently on C64C in +; and
early +9/%
&f you buy in periods where the investor allocation to equities is low, you will get the dividend
return plus the price return necessary to $eep the portfolio equity allocation constant in the
presence of a rising supply of cash and bonds, plus the price return that will occur when equity
allocation preferences return to more normal levels% *ou will get in front of the equity supply
squee@e of the net bull mar$et, when ris$ appetite and the associated desire to be invested in
equities recovers% #hus your return will be higher than normal% #his is what happened to
investors in the 19;s%
&f you buy in periods where the investor allocation to equities is high, you will get the dividend
return plus the price return necessary to $eep the portfolio equity allocation constant in the
presence of a rising supply of cash and bonds, but then you will have to subtract the negative
price return that will occur when equity allocation preferences fall bac$ to more normal
levels% #his is what happened to investors in the 21.2! bear mar$et%
#his way of thin$ing about stoc$ mar$et returns accounts for relevant supply.demand
dynamics that pure valuation models leave out% #hat may be one of the reasons why it better
correlates with actual historical outcomes than pure valuation models%
&t can eplain, for eample, the earningless bull mar$et of the 19;s% nbe$nownst to many,
earnings were not rising in the 19;s bull mar$et% #hey actually fell slightly over the period
4 http://philosophicaleconomics.ordpress.com/2!13/!"/2!/earningless#bull#mar$ets#h%#do#the%#happen/
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which is unusual% 4ut prices didn+t carethey s$yroc$eted% #he =A) ratio ended up rising well
above 2, despite interest rates near 1?a valuation disparity never before seen in
history% Galuation purists can+t eplain this movethey have to postulate that the common
sense3 rules of valuation were temporarily suspended in favor of investor cra@iness%
4ut if we loo$ at what investor allocations were bac$ then, we will see that investors werealready dramatically underinvested in equities% &f prices hadn+t risen, if investors had instead
respected the rules of valuation3 and refrained from ac$ing up the =A) multiple, the etreme
underallocation to equities would have had to have grown even more etreme% &t would have
had to have fallen from a record low of *% to an absurd $+ -see blue line in the chart below,
which shows how the allocation would have evolved if the =A) multiple had not
risen/% >bviously, investors were not about to cut their equity allocations in half in the middle
of a healthy, vibrant, inflation.free economic epansiona period when things were clearly on
the up% 7nd so the multiple eploded%
6ow, recogni@e that this framewor$ leaves plenty of room to ac$nowledge the relevance of
classical valuation considerations% Disparities in valuationbetween equities and their own
history -the valuation levels investors are anchored to, accustomed to seeing, that they considerto be normal3/ and between equities and other asset classes -bonds and cash/can certainly
cause investors to want to change their allocations and eposures, especially when the
disparities are significant and can+t be dismissed or rationali@ed away% &f such a change unfolds,
prices will rise or fall accordingly% 4ut if such a change doesn+t unfold, then prices are not going
to respond% 6or should3 they%
&n a way, the metric already offers a rough estimation of classical valuation% &f the average
investor allocation to equities is abnormally low, then prices are probably abnormally lowthe
mar$et+s probably cheap% Ei$ewise, if the average investor allocation to equities is abnormally
high, then prices are probably abnormally highthe mar$et+s probably epensive% 7nd so an
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investor that is value.sensitive can still use the metric as a way of assessing the mar$et
opportunity%
Co!paring the 4etrics on Per"or!ance
#he following chart is a scatterplot of the new metric% #he y.ais is 1 year 0=O total return,
the .ais is the average investor equity allocation% #he solid red line is the current value of the
metric% 6ote the ecellent fit%
(ight now, at its current value, the metric suggests a future 1 year nominal total return for
equities of around -% istorically, whenever the mar$et was at the current level, the low end
of the return was a tad less than %, and the high end was around 5%
#he following charts show scatterplots of the other metrics% &t+s not even worth speculating on
what returns they are suggesting right now, because the fits are atrocious, especially in the
current valuation range% #he )quity P.ratio, for eample, puts the mar$et+s current future 1
year returns anywhere from as low as * to as high as 5% #he 0hiller C7=) puts the returns
anywhere from as low as ' to as high as $'with an ironic bias to the upside% <ar$et Cap
to BD= puts returns anywhere from 6+ to * -which is why it has become fashionable among
bears/%
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&n our earlier piece5
, we pointed out that the classic 0hiller C7=) wrongly labeled the <arch2! mar$et as significantly overvalued, and the <arch 29 mar$et as barely below fair value
-an epic, inecusable blunder/% 8e pointed out that one advantage of the pro.forma C7=),
which tried to eliminate accounting inconsistencies, was that it correctly identified the mar$et+s
attractive valuation in these periods% &t called <arch 2! a decent value, and <arch 29 a
screaming buy%
&t turns out that li$e the pro.forma C7=), this metric also called 2! and 29 correctly% &t
signaled the <arch 2! mar$et as a reasonable buy, and the <arch 29 mar$et as a
screaming buy, on par with levels seen at the secular low of the last bear mar$et, 19;2%
5 http://philosophicaleconomics.ordpress.com/2!13/12/13/shiller/
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A /ote on 78vervaluation9
#here+s a raging debate right now between bulls and bears over whether the %0% stoc$ mar$et
is presently overvalued% #he debate rages on because the term is poorly defined% 8hat,
precisely, does it mean to say that something is overvalued3:
8hen we say that the stoc$ mar$et is overvalued3, we might mean that it+s currently valued
more epensively than it typically has been in the past% >ver its history, the %0% stoc$ mar$et
has offered, on average, some epected total returnsay ( to $'% 4ut now it+s priced for
% or - -using our metric/% 0o it+s overvalued%3
'air enough, bulls shouldn+t disagree% #here are tons of reasons why the present stoc$ mar$et
is unli$ely to produce the ( to $' returns that it has produced, on average, throughout
history% >n almost every relevant measure, it+s starting out from a higher.than.average level%
#he more important question, however, is this" why should the stoc$ mar$et offer investors
the average historical return right now: &f, over the net 1 years, bonds are offering
investors *&(, and cash is offering them less than $, why should stoc$s be priced to offer
them ( to $':
ow would that even be sustainable: &f equities were offering an ;? to 1? return, we would
all choose to allocate the bul$ of our portfolios into them, rather than languish in the Q&(=*
nothingness of bonds and cash% #here obviously isn+t enough equity supply for all of us to
allocate in that way, and so the price would get pushed up, and the epected return pulled
downvery quic$ly%
6ow, it+s a mista$e, obviously, to ma$e an assessment of valuation based strictly on a
comparison between the yields of stoc$s and bonds, as the 'ed <odel suggests we do% #he yield
of an equity security, again, is not the same as its return% *ou can buy the mar$et at !! times
earningsa !? earnings yieldbut your return over the net 1 years isn+t going to be !?% &t
will probably be ? -or less/, as the mar$et contracts from the obscene valuation at which you bought it% &f you were to try to ustify the stoc$ mar$et+s price by comparing its !? yield to the
1 year bond yield at 1?, touting the healthy ris$ premium -2?greater than the historical
average/, you would obviously be ma$ing a huge mista$e% #he real ris$ premium on your stoc$
investment would be negativeyou would end up with a loss%
4ut if you properly estimate long.term equity returns using other methodsfor eample, the
method &+ve proposed, which puts the future return for the stoc$ mar$et at 5? to K?then it
ma$es perfect sense to assess the appropriateness3 of the current valuation through a processof comparison with the investment alternatives% &n the current case, the alternatives of cash
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and bonds are offering much less than 5? to K?so there+s a decent ris$ premium in place for
equities% #he mar$et is not overvalued3it doesn+t belong3 at a lower valuation% #o the
contrary, it+s priced where it should be, given the alternatives% &nvestors have done their obs
properly, leaving no easy arbitrages to eploit%
6ow, if bears want to argue that it+s unwise to loc$ in 5? to K? equity returns right now -oreven !? or ?/, because the mar$et cycle will eventually produce selloffs in which greater
returns are made available, my response would be" who said anything about loc$ing anything
in: Eet+s time the mar$etas bears seem to want to do% &+m all for that approach%
4ut timing the mar$et doesn+t mean boycotting it until it hands you, on a silver platter, the
high returns that you+re demanding% 7fter all, there+s an ecellent chance that it won+t hand
them to youthere+s no reason it has to% Beneral societal progressparticularly in the area of
economic policyma$ingreduce the odds that it will% (ather, timing the mar$et means
monitoring for the types of processes that tend to cause mar$ets to sell offcapturing equity
returns except when there are signs of those processes emerging% Galuation3at least in the
range that we+re currently atis not one of the processes that cause mar$ets to sell off -or, for
that matter, that stop mar$ets from selling off/% 0o stop worrying about it%
4ig selloffs usually occur in association with recessions% #hat+s where mar$et timers ma$e their
moneyby anticipating turns in the business cycle% 7 hint to bears" if you+re calling for a
recession right now, in this monetary environment, you+re doing it wrong%
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