This “one big predictor of future stock market returns” has fallen sharply — and that’s a bullish sign.

CHAPEL HILL, NC – Much of the bull market excesses have been eliminated, according to the “Single Greatest Predictor of Future Stock Market Returns”. And this is good news.

I am referring to the indicator, first proposed by the Philosophical Economics blog in 2013, which is based on the portfolio allocation of an average family to stocks. It is a contrarian indicator, with higher equity allocations associated with lower successive market returns and vice versa. According to the econometric tests I have subjected it to and other well-known rating indicators, it actually has one of the best, if not the best, track record in predicting the SPX of the S&P 500,
-1.40%
subsequent 10-year total real return.

According to the Federal Reserve data just released, this indicator in the last calendar quarter has experienced one of its largest (and therefore bullish) drops since the early 1950s, which is how far the data extends back. But for the quarter that includes the cascading decline in March 2020 that accompanied the initial freezes 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 a quarter in which this indicator fell as much as it did in the June quarter of this year.

At mid-year, this indicator stood at 44.8%, down from 51.7% at the end of last year. At the lows of seven bear markets over the past 25 years in Ned Davis Research’s calendar, the indicator averaged 37.1%. Thus, of the 14.6 percentage points of spread above this average that existed at the end of 2021, 6.9 percentage points have been eliminated, or nearly half.

And the indicator is almost certainly lower today than in the middle of the year. We do not know because the data on which the indicator is based are updated only quarterly, and also in this case with a time lag of a couple of months. The most recent update, which reflects the end of the second quarter, was released on September 2nd. 9. The next update, which will reflect late September data, will not be released before December.

You might object to the positive twist I am giving to the decline in the indicator by arguing that it was caused by nothing more than the decline in the value of household equity holdings. But that can’t be more than a small part of the explanation, since bonds have been in a bear market of their own; the year-to-date decline in long-term Treasuries TMUBMUSD10Y,
3.705%,
for example, it is actually greater than the stock market’s DJIA,
-1.16%

COMP,
+ 1.09%.
On the other hand, the decline in the indicator means that the average household has significantly reduced its commitment to shares.

Moreover: US equities suffer the largest weekly outflows in 11 weeks

More: Investors poured $ 83.4 billion into these 10 bond funds last year. But here’s what happened

All of which means that the bear market is doing its job. The absolutely essential role that bear markets play in the market cycle is to bring the market back down whenever it gets too far ahead of itself. And this was certainly the case with this indicator at the highs of the bull market at the end of last year, when it was tied to be the highest on record (tied to the top of the internet bubble, as you can see from the accompanying chart).

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

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

Valuation indicators do not yet support a new bull market

Separately, the table below shows how each of my eight valuation indicators rank relative to its historical range. As you can see from the column comparing current valuations to those prevailing at the end of last year, today’s market valuations are significantly more attractive than in January.

Last

one month ago

Beginning of the year

Percentile since 2000 (100 plus bearish)

Percentile since 1970 (100 plus bearish)

Percentile since 1950 (100 plus bearish)

P / E ratio

19.68

20.57

24.23

36%

59%

69%

CHAPTER report

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 Capital / GDP)

1.54

1.62

2.03

88%

95%

95%

Average allocation of household equity

44.8%

49.7%

51.7%

85%

88%

91%

Mark Hulbert is a regular MarketWatch contributor. His Hulbert Ratings tracks investment newsletters that pay a flat rate to be audited. He can be contacted at mark@hubertratings.com.

Now read: Powell took sides, but what’s worse for you: inflation or recession?

More: If you sell stocks because the Fed is raising interest rates, you may be suffering from an “inflation illusion”

AND: Americans feel poorer for good reason: household wealth has been destroyed by inflation and rising interest rates

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