Top In Already? Record Retail Allocations, Bullish Exuberance Could Suggest So
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Household equity allocations are again sharply rising, as the or fuels a near panic mentality to chase markets higher. As Michael Hartnett from Bank of America recently noted:
S&P 500 Price 20-Week Change
As discussed in the recent we can only identify bubbles in hindsight. Such is the problem with trying to a market top, as they can last much longer than logic would predict. George Soros explained this well in his theory of reflexivity.
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In simplistic terms, Soros says that once the bubble inflates, it will remain inflated until some unexpected, exogenous event causes a reversal in the underlying psychology. That reversal then reverses psychology from to
What will cause that reversion in psychology? No one knows.
However, the important lesson is that market tops and bubbles are a function of The manifestation of that manifests itself in asset prices and valuations that exceed economic growth rates.
Once again, investors are piling into equities and
An Economic Underpinning
To understand the problem, we must first realize from which capital gains are derived.
Capital gains from markets are primarily a function of market capitalization, nominal economic growth, plus dividend yield. Using formula, we can mathematically calculate returns over the next 10-year period as follows:
Therefore, IF we assume that GDP could maintain 2% annualized growth in the future, with no recessions ever, AND IF current market cap/GDP stays flat at 2.0, AND IF the dividend yield remains at roughly 2%, we get forward returns of:
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But there are a in that assumption. Most importantly, we must also assume the Fed can get inflation to its 2% target, reduce current interest rates, and, as stated, avoid a recession over the next decade.
Yet, despite these essential fundamental factors, retail investors again throw caution to the wind. As shown, the current levels of household equity ownership have reverted to near-record levels. Historically, such exuberance has been the mark of more important market cycle peaks.
Household Equity Ownership vs S&P 500
If economic growth is reversed, the valuation reduction will be quite detrimental. Again, such has been the case at previous peaks where expectations exceed economic realities.
Household Equity Ownership vs S&P 500 Valuations
Bob Farrell once quipped investors tend to buy the most at the top and the least at the bottom. Such is simply the embodiment of investor behavior over time. Our colleague, Jim Colquitt, previously made an important observation.
The 10-year forward returns are inverted on the right scale. This suggests that future returns will revert toward zero over the next decade from current levels of household equity allocations by investors.
Average Investor Allocation to Equities vs 10-Yr Forward Returns
The reason is that when investor sentiment is extremely bullish or bearish, such is the point where reversals have occurred. As Sam Stovall, the investment strategist for Standard & Poor’s, once stated:
Everyone is very optimistic about the market. Bank of America, one of the world’s largest asset custodians, monitors risk positioning across equities. Currently, is in the 83rd percentile and at levels that have generally preceded short-term corrective actions.
Global Equity Risk-Love
The only question is what eventually reverses that psychology.
A Disappointment Of Hopes
In January 2022, Jeremy Grantham made headlines with his market outlook titled The crux of the article is summed up in the following paragraph.
While the market corrected in 2022, the reversion needed to reverse the excess deviation from the long-term growth trends was not achieved. Therefore, unless the Federal Reverse is committed to a never-ending program of zero interest rates and quantitative easing, the eventual reversion of returns to their long-term means remains inevitable.
Such will result in profit margins and earnings returning to levels that align with actual economic activity. As Jeremy Grantham once noted:
Historically, real profits have always eventually reverted to underlying economic realities.
Cumulative Change In Price vs Profits to GDP Ratio
Many things can go wrong in the months and quarters ahead. Such is particularly the case at a time when deficit spending is running amok, and economic growth is slowing.
While investors cling to the that the Fed has everything under control, there is a reasonable chance they don’t.
The reality is that the next decade could be a disappointment to overly optimistic expectations.
