This ‘greatest predictor of future stock-market returns’ has fallen sharply—and that’s a bullish sign.

Chapel Hill, NC – According to “Single Greatest Predictor of Future Stock Market Return,” a good portion of bull market excesses have been worked out. And this is good news.

I am referring to the indicator, first proposed in 2013 by the Philosophical Economics blog, which is based on the average household portfolio allocation in equities. This is a contrarian indicator, with higher equity allocations being associated with lower after-market returns, and vice versa. According to econometric tests to which I’ve subjected this and other well-known valuation indicators, it is actually one of the best – if not the best – predictors of the S&P 500’s SPX -1.54% over the subsequent 10-year period. total actual return.

In the last calendar quarter, the indicator experienced its biggest (and therefore sharpest) decline since the early 1950s, according to recently released Federal Reserve data, an extension of previous data. But for the quarter involving the fall in the waterfall in March 2020, which coincided with the initial lockdown of the COVID-19 pandemic, you have to go back to the last quarter of 1987 – which included the worst crash in stock market history – to find one. The quarter in which this indicator fell as much as it had fallen in the June quarter this year.

By mid-year, this indicator stood at 44.8%, down from 51.7% at the end of the previous year. The indicator averaged 37.1%, at the low of seven bear markets of the past 25 years in the calendar created by Ned Davis Research. So the 14.6 percentage points spread above this average that existed at the end of 2021, 6.9 percentage points is now worked out or almost half.

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And the indicator is almost certainly lower today than it was mid-year. We do not know because the data on which the indicator is based is only updated quarterly, and even then with a lag of a few months. The most recent update, which marks the end of the second quarter, surfaced on September 9. The next update, which will feature data from the end of September, won’t be released until December.

You can object to the positive spin I am making on the indicator’s decline by arguing that it was nothing but a fall in the value of the equity holdings of the homes. But this may be no more than a small part of the explanation, as bonds have been in a bear market of their own; For example, the long-term Treasury TMUBMUSD10Y’s year-over-year decline, 3.714%, is actually higher than the stock market’s DJIA, -1.25% comp, +0.44%. Instead, a fall in the indicator means that the average household has significantly reduced its commitment to equity.

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All this means that the bear market is doing its job. The role a bear market plays in a market cycle is bringing the market back down whenever it gets too far ahead of itself. And that was certainly the case with this indicator at the bull market highs at the end of last year, when it tied for the highest on record (as you can see from the accompanying chart, from the top of the Internet bubble). Bound up) .

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To appreciate the work that this bear market has already achieved, consider a simple econometric model I built that bases its predictions on the historical correlation between the indicator and the stock market. This model is now predicting that the total return of the S&P 500 will closely match inflation over the next decade. This is in contrast to estimates of minus 4.6% annualized at the beginning of the year and minus 3.3% annually at the end of the first quarter.

Keeping up with inflation may not excite you, but it is much better than losing 4.6% a year for 10 years. And keeping up with inflation is most likely what long-term bonds will do over the next decade.

Valuation indicators don’t support a new bull run yet

Separately, the table below shows how each of my eight valuation indicators stacks up against its historical range. As you can see from the column that the current valuation is compared to the valuation prevailing at the end of last year, today’s market valuation is much more attractive than January.

Latest Month First Year Beginning of 2000 (100 Slowest) Percentage Since 1970 (100 Slowest) Percentage Since 1950 (100 Slowest) P/E Ratio 19.68 20.57 24.23 36% 59% 69% CAPE Ratio 28.35 29.83 38.66 70% 80% 85% P/Dividend Ratio 1.75% 1.59% 1.30% 70% 80% 86% P/Sales Ratio 2.32 2.45 3.15 89% 89% 89% P/Book Ratio 3.74 3.93 4.85 90% 86% 86% Q Ratio 1.59 1.67 2.10 73% 86% 90% Buffett Ratio (Market Cap/GDP) 1.54 1.62 2.03 88% 95% 95% Average Household Equity Allocation 44.8% 49.7% 51.7% 85% 88% 91%

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Mark Hulbert is a regular contributor to MarketWatch. Their Hulbert Ratings track investment newsletters that pay a flat fee to be audited. He can be contacted at [email protected]

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