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Using Fred

A determinedly anonymous blogger at philosophicaleconomics.wordpress.com/201.../ has documented a very tight correlation between the percentage of equities in the average portfolio and stock market returns over the next decade. He adduces a lot of interesting evidence with a high degree of statistical sophistication.

From a contrarian perspective, his finding makes perfect sense. When stocks are popular, investors bid up their prices, reducing the potential for future gains, and vice versa. What's surprising is how well-correlated portfolio composition is with future returns (R² = 0.91), better than for most popular indicators.

You might wonder how you can possibly figure out the percentage of equities in the average portfolio. Surprisingly, the St Louis Fed publishes this data on a quarterly basis: research.stlouisfed.org/fred2/graph/?g=qis#. The most recent (2014-01-01) level is 40%.

A graphical display at the head of the article allows one to translate this number into a high probability prediction of an average 5% annual return for US equities over the next decade. Here's the relevant table:

% Stocks % Return
50% -2.0%
45% 2.0%
40% 5.0%
35% 9.5%
30% 13.0%
25% 17.0%

One can say that we should expect above-average returns when the portfolio equity percentage is below 35% and below average returns when it's above 35%. It's certainly reasonable to suggest that PEP above 40% would be a flashing red light while levels below 30% would be steady green. But note that returns can be depressed or elevated for decades, that the data is available only months after the fact, that a lot of volatility can happen over ten years, and that below-average returns may still be better than the next best alternative. Today, for example, a 5% return looks a lot better than a ten-year Treasury return of 2.6%.

There's still no magic stock market predictor. The correlation described here can add some confidence to a prediction for relatively weak stock market returns over the next decade, which is a reasonable time frame for most investors. One would certainly be more alert to the potential for market selloffs at this level than if the portfolio equity percentage were down around 30%.