Stock allocations are historically high

Good morning. Yesterday, US second-quarter GDP was revised higher, while jobless claims fell notably from the prior week. The macroeconomy remains solid in aggregate, even while parts of it — housing and job growth, for example — are in rough shape. And speaking of rough: Unhedged is losing a great colleague today; see below. Send congratulations to Aiden, and condolences to the rest of the Financial Times’ New York newsroom: [email protected].

Investor allocations vs valuations

A few days ago we wrote about allocations to cash and cash-like assets in investor portfolios. The topic is interesting because of the intuition that if individual and institutional portfolios have larger cash buffers, markets ought to be more stable. If investors have a cash buffer in place, and therefore a less extreme allocation to risk assets, it makes sense that they would be less likely to sell at the first sign of trouble, amplifying the sell-off. Whether this intuition is reliably correct, I’m not sure. Worse, I was unable to find much hard data on cash allocations, and had to resort to surveys. 

As it turns out, however, Ned Davis Research tracks household cash allocations, based on data from the Federal Reserve’s Flow of Funds report and mutual fund data from the Investment Company Institute. It includes direct household ownership and indirect ownership through mutual and pension funds. Here is NDR’s chart, going back 75 years:

Cash, at about 20 per cent, is the lowest it has been in the postwar era, barring a brief period during the dotcom bubble. This is a little scary, but notice that cash allocation has been quite low since 2018 or so, and the market has held together.

Allocation to stocks might be a better indicator, though. Here’s the chart from NDR showing stock allocations at an all-time high as of the end of June; they are very likely higher now:

London Stockton of NDR pointed out to me 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 per cent; for the lowest quintile, 16 per cent. This inverse relationship has been very consistent over time.

Many readers will notice these are the sorts of claims that are often made for valuation ratios such as the cyclically adjusted price/earnings ratio (Cape): high valuations and high stock allocations alike predict poor long-term returns. This stands to reason: when prices run up quickly, portfolio allocations automatically rise, and so do valuations. And indeed if you plot the Cape the same way as NDR has plotted stock allocations, the similarities jump out at you, even if they are not perfect. My (crude) chart:

The logic of valuations as predictors of long-term returns is that equity investors are paying for a stream of cash flows, and what they are willing to pay for a given amount of cash is mean-reverting over the long run. The logic of portfolio allocations as predictors of future returns would be that investor risk appetites, as expressed in portfolio allocations, also vary around some fundamental, normal level. The two seem like different ways of looking at the same thing. But there is something alluringly simple about the lens of allocations: the basic market variable is as simple as the balance of risky versus safe assets people want to own. If that is mean reverting, investors can, to a limited extent, see into the future.

(Armstrong)

Au Revoir from Aiden

Loyal Unhedged readers and occasional Unhedged skimmers: I am sad to say today is my last day on the newsletter and at the Financial Times. I am heading to another outlet to do straight beat reporting on US economic policy and its reverberations on Wall Street and Main Street. It was a tough decision; my time on Unhedged and at the FT has been truly wonderful. But it feels like the right time to stretch my wings.

I just celebrated Rosh Hashanah, the Jewish New Year, a time to look back on the year past and what one is grateful for, and to look ahead to new possibilities. As I sat in synagogue, I reflected on how lucky I have been to work on Unhedged — to have the guidance and mentorship of the illustrious Rob Armstrong, to have the resources and backing of a world-class newspaper, and, miraculously, to get paid to think and write every day. Most of all, I am grateful to you, readers. Thank you for engaging in our reporting and opinions, for writing back to us, and for supporting independent journalism.

I won’t be far — reach out any time.

(Reiter)

One good read

The costs of anti-ageing.

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