Interesting equity return "predictor" - Household Equity Percentage

[JohnDoe123]

We all heard about the CAPE, but here's another interesting equity return predictor: Household Equity Percentage (HEP):

The Single Greatest Stock Market Predictor Is... What? | via FinanciaLibre.com

The value of equities as a % of the household has a 0.91 time-series correlation with 10-year forward nominal S&P500 returns, 0.74 correlation with real returns (since the 1950s!). That's better than the CAPE on a stand-alone basis. The author claims (quite correctly, I find) that the HEP and CAPE (in conjunction) are a nice way to gauge future returns. Right now both CAPE and HEP point to quite disappointing equity returns going forward. Of course, considering still substantial error bounds...

Working in finance myself I have seen my fair share of nonsensical indicators, but from a purely economic and fundamental perspective there should be some merit:

• Mean reversion: If stocks overreact in price without pulling the rest of economy (and hence net worth) with them, then they should pull back again.

• Smart Money vs. Dumb Money: When the bulk of households jumps on the bandwagon it's usually too late. Or vice versa, when households all hate stocks it's usually a good time to buy. Fear vs. greed cycles that overreact and mean-revert again.

So, I'm just putting this out for discussion. I hope people enjoy FinanciaLibre's analysis. He has a good sense of humor, too!

 

[brett]

Not sure about CAPE or HEP but I am a big believer in buying when every one else is selling and selling when everyone is buying. Did something similar with several career moves.

I apply this to equities, household purchases,etc. and we are currently practicing it by renting in the down real estate market where we live with an eye to snagging the right buy opportunity if it presents itself. We do the same with travel opportunities. Just part of our personalities I guess.

 

[kgtest]

Not sure about CAPE or HEP but I am a big believer in buying when every one else is selling and selling when everyone is buying. Did something similar with several career moves.

I apply this to equities, household purchases,etc. and we are currently practicing it by renting in the down real estate market where we live with an eye to snagging the right buy opportunity if it presents itself. We do the same with travel opportunities. Just part of our personalities I guess.

So in terms of index funds, should we be selling, or buying?

 

[JohnDoe123]

So in terms of index funds, should we be selling, or buying?

Well, unfortunately, the HEP and CAPE valuation signals both look pessimistic. But: I ain't selling! I am buying less. That's because, where else do we want to invest? Bonds, when rates are going up? I shift new money mostly into real estate (through Private Equity funds) and cross my fingers and hope for the best in the equity market.

 

[haha]

So, I'm just putting this out for discussion. I hope people enjoy FinanciaLibre's analysis. He has a good sense of humor, too!

No comment on his "humor", but I must have missed the data source. Where does one get the data to follow this?

Ha

 

[GrayHare]

Interesting indicator. If stock prices are high, and we know bond prices are very high, that leaves real estate and gold as undervalued, and both of them have their own issues. So where are we supposed to invest all this QE money?

 

[Options]

Careful: correlation does not at all necessarily mean causation.

I don't read anything with the word "prediction", "predictor", "forecast", etc. in it. Click bait. Financial porn. Noise. Remember, Fidelity did a recent study in the last couple of years and found it's most successful clients were either dead or had forgotten they had accounts with Fidelity.

Read this book and you'll never think of "expert" (or other) predictions and forecasts the same way again:

Superforecasting: The Art and Science of Prediction by Philip E. Tetlock — Reviews, Discussion, Bookclubs, Lists

As Wharton professor Philip Tetlock showed in a landmark 2005 study, even experts’ predictions are only slightly better than chance.

 

[big-papa]

We all heard about the CAPE, but here's another interesting equity return predictor: Household Equity Percentage (HEP):

The Single Greatest Stock Market Predictor Is... What? | via FinanciaLibre.com

The value of equities as a % of the household has a 0.91 time-series correlation with 10-year forward nominal S&P500 returns, 0.74 correlation with real returns (since the 1950s!). That's better than the CAPE on a stand-alone basis. The author claims (quite correctly, I find) that the HEP and CAPE (in conjunction) are a nice way to gauge future returns. Right now both CAPE and HEP point to quite disappointing equity returns going forward. Of course, considering still substantial error bounds...

Working in finance myself I have seen my fair share of nonsensical indicators, but from a purely economic and fundamental perspective there should be some merit:

• Mean reversion: If stocks overreact in price without pulling the rest of economy (and hence net worth) with them, then they should pull back again.

• Smart Money vs. Dumb Money: When the bulk of households jumps on the bandwagon it's usually too late. Or vice versa, when households all hate stocks it's usually a good time to buy. Fear vs. greed cycles that overreact and mean-revert again.

So, I'm just putting this out for discussion. I hope people enjoy FinanciaLibre's analysis. He has a good sense of humor, too!

First time I saw this idea was from a site called philosophicaleconomics.com in December 2013. There was a lot of discussion about it on this over at bogleheads.

Here's the link:
The Single Greatest Predictor of Future Stock Market Returns | PHILOSOPHICAL ECONOMICS

And here's a link to the author's follow up.
Valuation and Stock Market Returns: Adventures in Curve Fitting | PHILOSOPHICAL ECONOMICS