Popularity of stocks today means poor returns tomorrow

Stocks are good investments if they go up. A bull market attracts new investors to the market, and their purchase pressure pushes stock prices up. A virtuous cycle is created. Investors want to increase their equity weighting since stocks are performing well. As stocks are performing well, there is a desire to maintain, or even increase, their high weighting relative to other assets.

A rise in stock prices that exceeds earnings growth will eventually lead to a situation where the expected future return on stocks is poor. The process is reversed. The equity weighting is reduced, either through selling or through price declines, until the equity weighting in an asset class that has become unpopular is sufficiently low.

Equities are currently at record levels of popularity in the US. After a 20-year hiatus following the tech-bubble, the percentage of households owning shares has risen from 50% to nearly 60%.

The share of equities in financial assets (including stocks and fixed income investments but excluding real estate) has risen to a record high of about 35%. Comparing the equity weighting and the subsequent 10-year equity returns, history suggests that, at least in the past, a high equity weighting has been a harbinger of poor returns over the next 10 years. For example, the high equity weighting of the tech-bubble in 2000 was followed by negative total returns on stocks over the next ten years. On the other hand, the record-low equity weighting of the 1970s was followed by an unprecedented two-decade stock rally. The US bull market after the financial crisis was also led by a low equity weighting.

The current equity weighting begs the question: how much better can it get? Although stocks seem like an excellent investment today, there have been times in the past when they were not considered smart investments.

The equity weighting can be reduced in several ways. Other financial assets, in practice debt (one person's debt is another's financial assets), can grow faster than the stock market. The US federal debt undeniably "generates" huge amounts of investment assets. However, previous periods of high equity weighting have thawed with stock market crashes.

This is not a very precise indicator. The equity weighting of US households appears to be trending up. But that was also the case before the terrible stagflation of the 1970s. Still, it is a cautionary tale for investors who are now buying American stocks by the truckload. There are almost certainly darker times ahead if we look at the return potential years from now.