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The Financial Time’s Unhedged blog recently noted that “for the highest quintile of observations for stock allocation, the average annualised return of the S&P 500 over the subsequent 10 years is 5%; for the lowest quintile, 16%. This inverse relationship has been very consistent over time.”

Equity exposure as a percentage of the market portfolio is a leading indicator of out- and underperformance for the asset class: the pinnacle comes before a market fall and the nadir before a rebound.

This chimes with popular investment “just so” stories: from Joseph Kennedy dumping his stocks after he got a hot tip from a shoeshine boy in 1929, to the adage that a bear market ends when the last bull throws in their hand.

I looked at whether this held for European fund investors, using Lipper data for all European-domiciled mutual funds and ETFs for the century so far, looking at the relationship of both total net assets and funds flows relative to the performance of the FTSE All World TR EUR index and Lipper’s Equity Global fund classification (see chart).

Rolling five-year returns, FTSE All World TR EUR index and Lipper Equity Global, 1999-2024 (%)

(Click on image to enlarge)

Source: LSEG Lipper

Some things do tally. For example, the last TNA peak as a percentage of all fund assets, with a subsequent five-year return history, was in 2006-7 (41.44%). And we all know what happened then.

The average rolling five-year return between 2000 and 2020 was 47.99% for the FTSE All World TR EUR and 30.06% for the Lipper’s Equity Global index. For 2006-11, the five-year return for the FTSE All World TR EUR was -4.65%, and for Equity Global, -12.69%.

Equity exposure has been more than 40% since 2020, and in 2024 was 44.92%. Should we worry? Clearly, if you had taken the previous pre-GFC peak as a sell signal, you’d have missed a lot of growth since 2020. But 2024’s figure is a lot higher: does that scream “sell”?

Before I try to answer this, let’s look at the obverse: the relationship between the nadir of equity exposure and market rebounds.

The highest five-year returns are for 2008-2013 (FTSE All World: 108.3%; Lipper Equity Global: 86.25%). In 2008, equity exposure was 29.39%—the lowest figure for the period. But this relationship doesn’t hold consistently. The second lowest percentage of equity assets was 2000, as markets teetered into the dotcom bust. Overall, the correlation between equity exposure and the following year’s returns is slightly negative, but statistically insignificant. So, while it might be legitimate to argue that the peaks and troughs indicate turning points in rolling five-year returns, that these are turning points can only be determined after the fact.

Last year’s equity exposure is certainly high by historic standards, but that doesn’t mean it can’t go higher.

These turning points are an effect of revaluation rather than any kind of useful indicator: as equity markets recover, values increase and the weight of equities within the market portfolio will therefore increase. More investors get on board, as bears morph into bulls, amplifying the effect. On the other hand, as equity valuations crash, their weight within the market portfolio will decrease, encouraging more investors to jettison equities.

These effects feed off each other. Flows can drive performance, especially in short-term or momentum-driven markets; and performance can drive flows, as investors chase returns or flee losses.

There is no magic number at top or bottom, indicating buy or sell. Circa 41% was peak equity exposure before the global financial crisis but has been higher in recent years. There seems no intrinsic floor or ceiling. The only clear view is in the rear view mirror.

Are flows an indicator?

One influential research paper by Xavier Gabaix and Ralph Koijen found that the “aggregate stock market is surprisingly price-inelastic, so that flows in and out of the market have a significant impact on prices and risk premia.” Flows have much more of an impact on performance than is generally acknowledged in market analysis focused on fundamentals, argued the authors.

It’s a thorough and impressive piece of work. But European fund flows over the century don’t seem to provide clear, usable signals. The relationship of flows to subsequent five-year returns in percentage terms is problematic, as equity flows can be either positive or negative, in combination with aggregate flows that can also be positive or negative in either the same or the opposite direction as equity flows.

Average annual equity flows between 2000 and 2024 were €35.49bn. The largest annual equity inflows were in 2003 (€120.86bn), 2020 (€172.54bn), 2021 (€303.49bn), and 2024 (€142.4bn). The five years from 2003 saw negative returns capturing 2008’s GFC market falls (FTSE All World: -5.53%; Lipper Equity Global: -14.06%).

Short of resorting to tea leaves, it is not possible to determine the subsequent five-year returns of the latter three periods. However, apart from the period beginning 2017 (where returns are broadly in line with the average over the century), every five-year period since 2008 has exceeded the average for the FTSE All World index over the century. Above-average inflows may therefore be driving returns in the way the Gabaix and Koijen paper argues, but they don’t give any indication of when this might reverse.

The largest annual equity outflows were in 2001 (-€119.92bn) and 2008 (-€145.14bn). Five-year rolling returns from 2008 to 2013 were the largest of the sample period (108.3% and 86.25%, respectively). Returns from 2001 were positive if muted.

The correlation between annual equity flows and returns for the following year is statistically insignificant. That said, 25 years is a limited sample: while I’ve not exactly tortured the data, I’m definitely not on its Christmas card list, so any conclusions are provisional. However:

1. A peak or trough in equity exposure is only evident after the fact.
2. That equity exposure peaks before market falls or troughs before market rises is inherently tautological, as the subsequent interlinked revaluations and investor behaviour are the causes of these turning points.

I can’t comment on the usefulness of shoeshine boys as contraindicators, as they’re pretty thin on the ground these days.

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