Over the past few years, there has been a fairly persistent narrative throughout a number of widely-publicized investor newsletters, blogs, conference discussions, and in our own meetings with investors and market professionals. It has typically sounded something like this:
“The U.S. stock market will likely continue to rise because investors still hold large amounts of investable cash in their portfolios.”
“There is still a large population of underinvested individuals, and as these people continue to move money into the market, it should propel stock prices higher.”
Although this narrative actually rings true for many individual investors and advisers with whom we’ve met, we decided to further investigate these claims to see if they were in fact representative of the market at large. What we found is that this common narrative is not only inaccurate, but it is actually the opposite of what the data shows!
According to data provided by the U.S. Federal Reserve and displayed in Figure 1, the average investor’s portfolio allocation to equities is now around 43%. And though this figure likely doesn’t sound extreme to most, it is actually near record highs. In fact, there’s only been one other time since 1951 in which today’s average equity allocation was surpassed - at the top of the dot-com bubble in 1999-2000, when it reached an average of ~49%.
So what does this mean for U.S. stocks and expected returns going forward? Well, in the short-term, it doesn’t mean much, as this data holds little value as a short-term market-timing tool. For example, the average investor equity exposure has been above the pre-financial crisis peak of 40% since 2013, and as we all know, U.S. equity markets have continued their upward march ever since, despite these elevated levels. That being said, the true value of this indicator lies in its long-term return forecasting abilities for the U.S. stock markets. More specifically, the correlation between this measure and future 10-year returns from stocks is negative 0.90, indicating a significant inverse relationship. In other words, when investor equity exposure rises, the returns from stocks over the next 10 years have declined nearly in lock-step. Figure 2 presents this relationship visually by showing the average investor equity exposure (green line/left axis) and the subsequent 10-year return of U.S. stocks (blue line/right axis).
Another way of looking at this is the scatter plot depiction in Figure 3. The key takeaway from this chart is that whenever average investor equity allocations have risen to today’s levels (43% or higher), returns for U.S. stocks over the following 10-year period have been well below average or negative.
The bottom line from our perspective is that the narrative of “U.S. investors remain underinvested in stocks” or “there’s ample cash still on the sidelines” is likely just narrative and not based on the data. Moreover, the current data made available by our friends at the Fed paints a very different picture of the average investor’s equity exposure today. As such, we feel investors should use this data set along with other evidence-based tools to gauge equity risk going forward instead of the latest market narrative.
Disclaimer: These materials have been prepared solely for informational purposes and do not constitute a recommendation to make or dispose of any investment or engage in any particular investment strategy. These materials include general information and have not been tailored for any specific recipient or recipients. Information or data shown or used in these materials were obtained from sources believed to be reliable, but accuracy is not guaranteed.