The “greatest single predictor of future stock market returns” has a message for us from 2030

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The 10-year return potential of the stock market is better now than it was at the end of 2019, for reasons unrelated to the shape of the economic recovery or the speed at which a vaccine COVID-19 is developed.
This is surprising because some market averages – like the Nasdaq Composite
COMP,
+ 0.98%

  • have climbed considerably higher this year.

This improvement can be explained by a reduction in the share of financial assets of households invested in equities. The distribution of household stocks is a contrary indicator, inversely correlated with the performance of the stock market over the following 10 years. The credit for inventing this indicator goes to the anonymous author of the blog Philosophical Economics, who a few years ago called him “the single biggest predictor of future stock market returns.”
Note that the distribution of household equity is the flip side of household money – sometimes referred to as secondary cash. Higher cash levels are therefore bullish and, of course, household cash allocations have increased markedly, as equity allocations have declined. But backtests have shown that the distribution of household equity is the best predictor. In fact, according to Ned Davis Research, he is able to account for 77% of the variation in stock market performance over all 10-year periods since 1951. I do not know of any other indicator that does that too. At the end of last year, the distribution of household stocks stood at 56.3%, near the peak established at the top of the markets in 2000 and 2007, as you can see in the attached graph. This is why, at the start of this year, even before the coronavirus appeared, the 10-year outlook for the stock market was bleak.

How dark? Let’s take a simple econometric model that I built from quarterly data on the distribution of household stocks since 1951 and total return adjusted for stock market inflation at each stage of the process. Based on the 2019 year-end allocation level, this model predicted an adjusted 10-year inflation return of 1.3% annualized.
Note that household equity allocation is not a short-term market synchronization tool. That’s just as good, as the data is only updated quarterly by the Federal Reserve, and with a significant lag. Data for the first quarter of 2020, for example, was released recently. But they show that the allocation stood at 49.0% at the end of March, down 7.3 percentage points from three months earlier. This is the largest quarterly decline since the start of data collection in 1951.
According to my econometric model, this reduced allocation resulted in a real projected return over 2.3 years of 2.3% annualized compared to the level on March 31.
Admittedly, the stock market has recovered strongly since then, further reducing the 10-year yield projection. However, the model still predicts a total inflation-adjusted return for the S&P 500
SPX,
+ 1.13%

by 0.5% by the end of the first quarter of 2030. This is much better than the actual annualized return of minus 1.3% expected at the end of last year.

Stocks look better than Treasurys – but that doesn’t mean much

To predict nominal stock market performance rather than inflation-adjusted, we need to predict how much inflation will be. According to a model constructed by the Cleveland Federal Reserve, expected inflation over the next decade is 1.2% annualized. Add the projected real return of 0.5% annualized from the household equity model and you get an estimate of total inventory return of 1.7% annualized over the next decade.
Since this projection is close to the current stock market dividend yield, it implies that most of the total stock market return over the next decade will come from dividends. In other words, on a price basis only, the S&P 500 and the Dow Jones Industrial Average
DJIA,
+ 1.22%

will likely trade at more or less current levels in March 2030. So watch out for dividends. They are more important than ever.
I recognize that you may not find these expected returns very exciting. But they are much better than for American Treasurys. 10-year TIPS is currently trading at minus 0.5%, which means that if you buy and hold for 10 years, you are guaranteed to lose as much compared to inflation.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert assessment follows investment slips that pay fixed costs to be audited. We can reach him at [email protected]
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