Notes on Philosophical Economics: Predicting equity returns from supply/demand not valuation


If there is too much supply of a given asset relative to the amount that investors want to hold in their portfolios, then the market price of the asset will fall, and therefore the supply will fall. If there is too little supply of a given asset relative to the amount that investors want to hold in their portfolios, then the market price will rise, and therefore the supply will rise. Obviously, since the market price of cash is always unity, $1 for $1, its supply can only change in relative terms, relative to the supply of other assets.

Aggregate investor allocation to equities is the best predictor of future returns. This equals:

Market Value of All Stocks / (Market Value of All Stocks + Total Liabilities of All Real Economic Borrowers)

A description of various economic data used to calculate the total liabilities

His constructed chart


  • The rest of the world holdings of domestic assets cancels out US investors holdings of foreign assets.
  • The supply of cash and bonds that investors in an economy must hold perpetually increases with the economy’s growth. The cash and bonds in investor portfolios are literally “made from” the liabilities that real economic borrowers take on to fund investment–the fuel of growth. Chart shows how this grows at 5-15% per year.
  • For investors’ allocation to equities as a proportion of total assets, equity prices must rise commensurately or new share issuance must fill the gap. Equity issuance has actually been declining since the 1980s. Thus stock prices must levitate if the investor preference for equity is unchanged while the economy grows (which can only happen via cash and debt growth)

Price is a supremely important determinant of return!

Price balances supply/demand of allocators and “there’s absolutely nothing that says that this process has to equilibrate at any specific valuation. History confirms that it can equilibrate at a wide range of different valuations. For perspective, the average value of the P/E ratio for the U.S. stock market going back to 1871 is 15.50. But the standard deviation of that average is a whopping 8.4, more than 50% of the mean. One standard deviation in each direction is worth 243% in total return, or 13% per year over 10 years.”

There is no explicit link which mandates price and value must be sensibly related which highlights the risk of owning equities.

“Consider the classic buy-and-hold allocation recommendation: 60% to stocks, 40% to bonds (or cash). What rule says that there has to be a sufficient supply of equity, at a “fair” or “reasonable” valuation, for everyone to be able to allocate their portfolios in this ratio? There is no rule.”

Markets contain both ‘mechanical’ and ‘active allocators’ with active allocators varying allocations based on perceived risk and expected returns whereas ‘mechanical’ allocators are systematic investors who simply allocate on a pre-defined or regular basis typically without regard to price. They are a minority but significant part of the market.

Decomposing drivers of return:

Mostly price change, not dividends. The price change is a function of multiple changes and earnings changes.

Return = Change in price + dividend return

…but decomposing the price return:

Change in price = Price Return from Change in Aggregate Investor Allocation to Stocks + Price Return from Increase in Cash-Bond Supply (Realized if Aggregate Investor Allocation to Stocks Were to Stay Constant)

So the mechanism of return conceptually is reframed:

“In the previous way of thinking, the earnings grow normally as the economy grows. If the multiple stays the same, the price has to rise–this price rise produces a return. When the multiple increases alongside the process, the return is boosted. When it decreases, the return is attenuated. The multiple is said to be mean-reverting, and therefore when you buy at a low multiple, you tend to get higher returns (because of the boost of subsequent multiple expansion), and when you buy at a high multiple, you tend to get lower returns (because of the drag of subsequent multiple contractions).

In this new way of thinking, the supply of cash and bonds grows normally as the economy grows. If the preferred allocation to stocks stays the same, the price has to rise (that is the only way for the supply of stocks to keep up with the rising supply of cash and bonds–recall that the corporate sector is not issuing sufficient new shares of equity to help out). That price rise produces a return. When the preferred allocation to equities increases alongside this process, it boosts the return (price has to rise to keep the supply equal to the rising portfolio demand). When the preferred allocation to equities falls, it subtracts from the return (price has to fall to keep the supply equal to the falling portfolio demand)”

“If you buy in periods where the investor allocation to equities is high, you will get the dividend return plus the price return necessary to keep the portfolio equity allocation constant in the presence of a rising supply of cash and bonds, but then you will have to subtract the negative price return that will occur when equity allocation preferences fall back to more normal levels. This is what happened to investors in the 2001-2003 bear market. This way of thinking about stock market returns accounts for relevant supply-demand dynamics that pure valuation models leave out. That may be one of the reasons why it better correlates with actual historical outcomes than pure valuation models. ”

How can this explain the earningless bull market of the 1980s

It can explain, for example, the earningless bull market of the 1980s. Unbeknownst to many, earnings were not rising in the 1980s bull market. They actually fell slightly over the period–which is unusual. But prices didn’t care–they skyrocketed. The P/E ratio ended up rising well above 20, despite interest rates near 10%–a then unprecedented valuation disparity. Valuation purists can’t explain this move–they have to postulate that the “common sense” rules of valuation were temporarily suspended in favor of investor craziness.

But if we look at what investor allocations were back then, we will see that investors were already dramatically underinvested in equities. If prices hadn’t risen, if investors had instead respected the rules of “valuation” and refrained from jacking up the P/E multiple, the extreme underallocation to equities would have had to have grown even more extreme. It would have had to have fallen from a record low of 25% to an absurd 13% (see blue line in the chart below, which shows how the allocation would have evolved if the P/E multiple had not risen). Obviously, investors were not about to cut their equity allocations in half in the middle of a healthy, vibrant, inflation-free economic expansion–a period when things were clearly on the up. And so the multiple exploded.

This framework has a much higher correlation with future returns than any of the popular valuation based models

This table shows the R-squared stats for different methods

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