Investor Portfolio Allocation to Equities
Ever since reading about it here at the always insightful Philosophical Economics blog, I have been fascinated by the notion of Investor Portfolio Allocation to Equities, a statistic tracked by the U.S. Federal Reserve here. The metric provides a good picture of the relative appetite/demand for equities and is thus an interesting predictor of future returns. If you view financial markets as complex systems that experience infrequent, but very impactful sudden events and transitions, understanding underlying shifts in investor behavior are quite relevant.
The Federal Reserve calculates this metric as:
The argument can be explained as follows:
- Total Liabilities in the denominator is defined as cash and debt held by real economic borrowers, literally the liabilities that are created as the economy grows.
- Total Liabilities always increase, as the economy grows in some form or another and money is “created”.
- Given that, to maintain an average allocation of stocks, the numerator must rise as well which is why, over the long run, the value of stocks in aggregate goes up.
- The value of stocks can change in two ways in this framework:
- Prices can rise, while the average/preferred allocation of stocks to total stocks+cash+bonds stays the same.
- Prices of stocks rise, but the average/preferred allocation of stocks to total stocks+cash+bonds goes up or down. When it goes up, returns are boosted beyond norms and when it goes down, returns are depressed or go negative.
The following scenarios can play out. In periods of below average Investor Portfolio Allocation to Stocks, if you are a buyer of stocks, you get 3 return drivers:
Dividend Return +
Price Return Needed to Keep the Metric Ratio Constant +
Price Return to Mean-Revert Upward to Average Equity Allocation Preferences
In periods of above average Investor Portfolio Allocation to Stocks, if you are a buyer of stocks, you get the first two 2 return drivers, but can experience negative returns due to the 3rd.
Dividend Return +
Price Return Needed to Keep the Ratio Constant –
Price Return to Mean-Revert Downward to Average Equity Allocation Preferences
Where Are We Now?
Since the publication of the data, there have been 5 occasions where the Investor Allocation ratio has hovered at/above 40 for at least 12 quarters. For purposes of the article, I am calling this the Red Zone. There is no reason that these levels or timeframes need to maintain relevancy in the future. However, in the past, they have been areas from which demand for equities has mean reverted downward. Looking at 1-, 2-, 3-, 5-, and 10-year returns subsequent to these 12 quarter periods, the probability of future negative returns goes up.
1-, 2-, 3-, 5-, 10-Year Annualized Returns on S&P 500 After Entering 12-Quarter Red Zone
To date, the current 5th period has bucked the trend. The metric has been in the Red Zone since July of 2016, yet 1-, 2- and so far 3-year returns have been stellar.
Current Red Zone Period Returns
|Date||1 Year||2 Year||3 Year||5 Year||10 Year|
Of note, the metric has now been in the Red Zone for a record 22 quarters, eclipsing by 1 quarter, the previous record of 21 quarters from 1997-2002.
It’s possible that investor demand/appetite for equities has reset to a higher average level. As I’ve discussed before, we are in an era tilted toward private sector confidence, which may be one explanation for this upward reset. This was conventional wisdom during the dot-com era when most everyone thoughts stocks only went up. While the tech sector is on a tear, this era is certainly lacking the misplaced euphoria of the dot-com bubble. Perhaps, more robust and liquid private markets (with companies staying private longer) have absorbed some of the euphoria that would otherwise present itself more widely in public markets.
If this time isn’t different, then the appetite for equities will mean revert and 5- and 10-year returns may be depressed.
Any opinions or forecasts contained herein reflect the personal and subjective judgments and assumptions of the author only. There can be no assurance that developments will transpire as forecasted and actual results will be different. The accuracy of data is not guaranteed but represents the author’s best judgment and can be derived from a variety of sources. The information is subject to change at any time without notice.