Mark Hulbert: Why your neighbor’s stock buying should worry you

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U.S. households’ equity exposure — perhaps the broadest-based sentiment measure available — has risen to near-record levels.

That’s not a good contrarian sign, of course, but that hasn’t stopped the bulls from trying to put lipstick on this pig. They insist that investors still hold lots of cash that is available to propel the stock market higher.

Just last week, for example, a widely-shared article in the blogosphere blared: “An investing legend who has nailed the market at every turn just got even more bullish on stocks.” His reasoning? “Ample cash remains on the sidelines.” A number of the investment newsletters have been trumpeting the same theme; the editor of one recently wrote to clients: “There is still a huge population of underinvested individuals.”

I’m not buying this argument, and you shouldn’t either. Whenever household equity exposure levels have risen to levels as high as they are now, the stock market’s subsequent 10-year return has been well-below average.

Currently, according to Ned Davis Research, stocks represent 40% of total household financial assets, much higher than the 28.2% average allocation since 1951. There’s been only one other occasion since 1951 in which stock allocation was higher than it is today — at the top of the late 1990s internet bubble, when it rose to 47.5%.

Every other major stock market top of the last seven decades, in contrast, occurred when households’ equity allocation was lower than today’s level. At the 2007 stock market top, for example, the allocation peaked at 37.1%.

Skeptics will point out that, earlier this year when the first quarter data became available, I advanced a similar argument: I reported that household equity allocation stood at a dangerously high 39.2%. And, yet, far from stopping the bull market, it has continued to power higher. So why worry that this allocation is at even loftier levels today, at 40%?

It’s important to remember that households’ equity allocation is not being proposed as a short-term market timing indicator. On the contrary, its true value is as a long-term forecaster, since it has an unparalleled correlation with the stock market’s subsequent 10-year return. Philosophical Economics, the investment blog to which Ned Davis credits with discovering this correlation, referred to household equity allocation as the “Single Greatest Predictor of Future Stock Market Returns.”

So you shouldn’t dismiss the high household-equity allocation just because the stock market has been so strong over the past six months. Assuming the future is like the past, the market’s returns between now and 2027 are likely to be mediocre at best — regardless of the direction stocks head in the next several months.

See: Welcome to the second biggest bull market since World War II

Also: ‘Nonexistent’ stock-market euphoria means start of long decline unlikely: Goldman

The bottom line? Hayes Martin is president of Market Extremes, an investment consulting firm that focuses on major market turning points. In an interview, he referred to the near-record levels of household equity allocation as creating the preconditions for an eventual bear market. “We’re in the late innings of the ballgame,” he said. “Perhaps the 7th or 8th inning.”

Furthermore, lofty household equity allocation levels tell us that the bear market, when it eventually comes, could be particularly severe. “When we do top out, we could have a very big drop,” Hayes said.

What is ‘sideline cash,’ anyway?

Another reason to question the bulls’ argument about sideline cash is that it’s not clear what it really refers to. For pointing this out, I am indebted to Cliff Asness of AQR Capital Management.

Several years ago in the Financial Analysts Journal, Asness wrote: “There are no sidelines. Those saying this seem to envision a seller of stocks moving her money to cash and awaiting a chance to return. But they always ignore that this seller sold to somebody, who presumably moved a precisely equal amount of cash off the sidelines.”

Asness implores us to view the markets as an equilibrium. While “there can be a sideline for any subset of investors, … someone else has to be doing the opposite. Add us all up and there are no sidelines.”

For more information, including descriptions of the Hulbert Sentiment Indices, go to The Hulbert Financial Digest or email mark@hulbertratings.com.