Market Timing Using Aggregate Equity Allocation Signals

When it comes to predicting long-term equity returns, several well-known indicators come to mind—for example, the CAPE ratio, Tobin’s Q, and Market Cap to GDP, to name a few.

Yet there is another indicator without nearly as high of a profile that has outperformed the aforementioned indicators significantly when it comes to both forecasting and tactical asset allocation.

That indicator, known as the Aggregate (or Average) Investor Allocation to Equities (AIAE), was developed by the pseudonymous financial pundit, Jesse Livermore, and published on his blog in 2013.

In an essay titled, “The Single Greatest Predictor of Future Stock Market Returns,” Livermore makes the case that the primary driver of long-term equity returns is not valuation, but rather the supply of equities relative to the combined supply of bonds and cash.

Accordingly, the AIAE is computed by taking the total market value of equities and dividing by the sum of a) the total market value of equities, b) the total market value of bonds, and c) the total amount of cash available to investors (i.e., that in circulation plus bank deposits):

This ratio gives the market-wide allocation to equities (or, equivalently, the average investor allocation to equities weighted by portfolio size). (Note that every share of stock, every bond, and every unit of cash in existence must be held in some portfolio somewhere at all times.)

Livermore explains that, in practice, the total market value of bonds plus cash can be estimated by the total liabilities held by the five classes of economic borrowers: Households, Non-Financial Corporations, State and Local Governments, the Federal Government, and the Rest of the World.

This follows from the fact that if these entities borrow directly from investors, new bonds are created. Whereas, if they borrow directly from banks, new bank deposits (cash) are created.  

As the economy grows, the supply of bonds and cash steadily increases. Historically, the rate of increase of the supply of bonds and cash has been about 7.5% per annum. Consequently, if the market portfolio is to maintain the same allocation to equities, the supply of equities must increase at the exact same rate.

The supply of equities can increase either by new equity issuance or by price increases. Historically, net new equity issuance has been negligible (with issuances being offset by buybacks and acquisitions). Thus, in order for equities not to become an ever-smaller portion of the average investor’s portfolio, the price of stocks must rise over the long-term.

While we often hear that stock prices follow earnings, in the 1980s earnings fell slightly from the beginning of the decade to the end of the decade, yet stocks rose at an annualized rate of 17% during that time. How could this be?

Well, at the beginning of the decade the average investor’s portfolio had a 25% allocation to equities. During the decade, the supply of bonds and cash rose strongly. If the price of equities had not risen, the average investor’s allocation to equities would have fallen to a mere 13% (as the supply of cash and bonds grew). Thus, equities had no choice but to rise despite the fall in earnings.

Livermore proposes a new framework for how we view the components of the equity market’s total return. Instead of viewing the total return in a classic way, namely:

he suggests we should instead view the components as:

As Livermore states:

“This way of thinking about stock market returns accounts for relevant supply-demand dynamics that pure valuation models leave out.  That may be one of the reasons why it better correlates with actual historical outcomes than pure valuation models.”

In a subsequent essay titled “Valuation and Stock Market Returns: Adventures in Curve Fitting,” 1 Livermore throws a bit of cold water on all indicators (including the AIAE) used to “forecast” future stock returns. He notes:

“[L]ooking backwards and fitting valuation metrics to precise returns so as to come up with a precise estimate is not a productive exercise.  Unless the ensuing “value v. return” charts are rigorously and extensively tested out of sample (without the chart-maker already knowing the answer, and being able to spend time “tweaking” out a visually-pleasing hindsight fit that takes advantage of happenstance coincidences in market history), their predictions should be ignored, or at least taken very lightly, as an extremely general comment about the future.”

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Disclaimer: Performance figures contained herein are hypothetical, unaudited and prepared by Alpha Architect, LLC; hypothetical results are intended for illustrative purposes only. Past ...

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