Once again we find ourselves in a bizarre market environment with a lot of noise and very few signals. I feel like this is going to be the case for the foreseeable future. These types of environments are dangerous as many narratives surface that appeal to our innate desire to want to be able to explain things. Furthermore, it’s awfully easy to get whipsawed around by selling at close to maximum fear and buying at close to maximum greed. Note: We advise against this type of activity.
So as we contemplate where we are right now here are a few thoughts.
What we know
- Both bonds and stocks are rising, apparently reflecting a difference of opinion among stock and bond investors.
- The ongoing trade war between the U.S. and China may or may not come to an end soon. It appears many in the markets are pricing in an end to the war. Both sides want and need to find a resolution.
- No further rate increases, at least in 2019, are currently expected.
- Cyclical stocks have been outperforming defensive stocks by a healthy margin YTD.
- Small caps have recently begun to outperform large caps.
- High yield bonds are healthily outperforming Treasuries YTD.
What we don’t know
- Who’s right? Stock traders? Bond Traders? Both?
- Will a resolution to the U.S./China trade war the market can get behind actually occur?
- Will a resolution to the trade war solve China’s perceived problems?
- Will the Fed’s next move be a rate cut or a rate increase?
- Will the Fed stop letting assets roll off its balance sheet?
- Is slowing growth in the U.S. and abroad going to present a problem for investment markets in 2019?
I was recently reminded of a blog post I read several years ago that introduced an alternative way of looking at the stock market utilizing principles of supply and demand while critiquing traditional valuation metrics. You can find the post here.
At a high level, the author suggests monitoring investors’ average allocation to equity is a better predictor of future market returns than traditional valuation metrics.
Here is a chart from the post. Please note the data is only updated through 2013 when the post was published.
Source: Philosophical Economics
Here is the average investor equity allocation updated for the most recent data (3Q18).
Source: FRED, Philosophical Economics
Interestingly, at the end of 3Q18, the average investor equity allocation was at its second highest level ever for this data set. We all know what proceeded to happen in 4Q18 with market returns. The Flow of Funds report for 4Q18 is due to be released in March, which will provide an update for this metric. While there’s no silver bullet for predicting future market returns, this metric at least warrants close monitoring.