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Time for Fear or Greed?


Only a week ago did I come across an intriguing article written by a former economic advisor and VP of the Federal Reserve Bank of St. Louis. Dr. Daniel Thornton’s article discussed the relationship between: 1) household net worth (“HNW”), and 2) disposable personal income (“DPI”). Studying the relationship between HNW and DPI made sense to me. Though HNW is not entirely driven by DPI, it seems to me that that DPI is a major factor in determining HNW.

INet-Worth-DPI_2016-05f you click on the first graph, then you will see the relationship between HNW-to-DPI (blue line) in the past 70 years. In the first 50 years, HNW-to-DPI was in a fairly tight range of ~450% to ~550%. It also averaged ~500% (green line), meaning HNW was normally about 5-times DPI.

That all changed in the past twenty years as HNW-to-DPI has experienced large swings and ranged wildly. It has also averaged much higher at 565% (red line). Thornton attributes the volatility and surge in HNW-to-DPI to asset bubbles.


Tech Stock and Real Estate Bubbles

Thornton convincingly showed that the Tech and Subprime Bubbles were attributed to stratospheric rise in NASDAQ-listed stock and housing prices, respectively. That was certainly no surprise given the names of these two bubbles. What I found particularly interesting about Thornton’s article was it persuasively showed that the recent surge in HNW-to-DPI to as high as 653% in 2015 was driven by both stock and real estate prices. In other words, we may be witnessing two asset bubbles right now. Not surprisingly, “[Thornton] predicts that the current level of household net worth is not sustainable.”


Stock Market Bubbles

Staying consistent with Thornton’s analysis of HNW being a function of DPI but given my personal interest on common stock-based wealth, I decided to modify Thornton’s analysis to study: 1) households’ investments in corporate equities (“HCE”), and 2) DPI.

Equities-DPI_2016-05If you click on the second graph, then you will see that HCE-to-DPI (blue line) has normally ranged between ~50% to ~90%. It has also averaged ~70%, meaning household stock portfolios were typically 70% of DPI. There have been times it has temporarily gone outside that range leading to either incredible long-term stock market gains or losses. Given that observation, I decided to plot HCE-to-DPI against subsequent long-term stock market returns.

The data is quite compelling. The correlation between HCE-to-DPI vs. 12-year subsequent S&P 500 (orange line) returns is very, very high at -89%. This means HCE-to-DPI has moved in virtual inverse lockstep with subsequent 12-year returns.

Starting with the good news, if you had invested in the S&P 500 index anytime in the 1980s when households appeared to have been extremely bearish (given HCE-to-DPI was often less than 40% during that decade), then you would have done very well making average returns of more than +10% annually over the next 12 years. You would have done even better if you had invested soon after Black Monday, which was when the S&P 500 crashed by more than 20% on just one single day: Monday, October 19, 1987. Annual returns astonishingly averaged more than +15% for the subsequent 12 years after Black Monday. In other words, investing when investors are extremely bearish is a very opportunistic.

The bad news though occurred during the Nifty Fifty and Tech Bubbles. In both instances, when investors were extremely bullish (given HCE-to-DPI exceeded 90%), subsequent 12-year average, annual returns were less than zero.  Hence, investing when investors are extremely bullish is very regrettable.

Since the Subprime Bubble peaked less than 12 years ago, we are yet to know what subsequent 12-year returns will be. We do know though that households were very bullish given their stock portfolios were worth 98% of their DPI back in 2007. A regression analysis of: 1) subsequent 12-year returns, against 2) HCE-to-DPI, shows a very high coefficient of determination (a.k.a. R-squared) of 79%. This indicates HCE-to-DPI explains 79% of the variability of subsequent 12-year returns. T

The regression also estimates 12-year subsequent returns (red line) beginning in 2007 should average only +3% annually. In 2014 and 2015, HCE-to-DPI surged pass 100%, suggesting the stock market is currently in another bubble. The regression analysis further estimates 12-year subsequent returns beginning in 2015 should average roughly +2% per year. This really isn’t surprising given where valuations stand.


Time to Be Fearful or Greedy?

HCE-to-DPI looks to be a measure of bearishness and bullishness. When households are investing a low (or high) proportion of their DPI into corporate equities, then it is a sign of bearishness (or bullishness). HCE-to-DPI appears to be a reliable gauge of fear and greed. This may be important given the Warren Buffett quote: “. . . be fearful when others are greedy and greedy when others are fearful.” Now that HCE-to-DPI is currently at more than 100% indicating households are extremely bullish or greedy, then it would seem now is an appropriate time to be fearful.

Whether or not you believe HCE-to-DPI is a reliable measure of fear and greed or in Warren Buffett’s adage of fear and greed, please consult an investment fiduciary before making any investment decisions.


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