Now, suppose that we open up every investor’s portfolio and calculate, for each investor, his percent allocation to stocks, bonds, and cash. My portfolio might be allocated 85% to stocks, 15% to bonds, 0% to cash. Yours might be allocated 50% to stocks, 20% to bonds, 30% to cash. And so on.
The question we want to answer is this: what would the average of all of these investors’ portfolio allocations look like, weighted by size? More specifically, what would the average investor allocation to stocks be? And how would that average compare to the averages of the past? It turns out that this question predicts the market’s future long-term returns better than any other classic valuation metrics to date developed–price to earnings (P/E), price to book (P/B), price to sales (P/S), CAPE, q-ratio, Market Cap to GDP, Fed Model, etc.
To answer the question, we need to know two things: (1) the total amount of stocks that investors in aggregate are holding, and (2) the total amount of cash and bonds that investors in aggregate are holding. Mathematically, the total amount of stocks that investors are holding divided by the total amount of everything (stocks plus bonds and cash) that they are holding just is the average investor allocation to stocks.
Now, to calculate the total quantity of cash and bonds in investor portfolios, we might think that we can just sum the total quantity of cash and bonds in existence outright–the total amount floating around the economy. After all, these securities have to be held by investors. But this approach won’t work. The reason is that a large portion of the bonds in existence are actually held by banks, not by investors. This fact extends to the central bank (the Federal Reserve), which presently owns an unusually large quantity of bonds.
Fortunately, there’s a convenient way to get around the problem. Recall that when the Federal Reserve buys bonds (treasury, MBS, etc.), it doesn’t add any net financial assets to investor portfolios. Rather, it takes bonds out of investor portfolios, and puts newly created cash into investor portfolios. It changes the cash-bond mix of the assets that investors hold–but not the total amount.
It turns out that private banks do essentially the same thing when they buy assets. They take the assets out of the hands of investors, and put their own liabilities–in the form of their own bonds or deposits (cash)–into investor hands. (They can also fund purchases with equity sales, but the equity component of a banks balance sheet is small enough to ignore.)
The entities that create net new financial assets (that investors can hold) are not banks, which are just intermediaries, but rather real economic borrowers. The universe of real economic borrowers consists of five categories: Households, Non-Financial Corporations, State and Local Governments, the Federal Government, and the Rest of the World. When these entities borrow directly from investors, the investors get new bonds to hold. When the entities borrow from banks, the investors get new cash to hold. That’s because when a bank makes a loan, the money supply expands. The loan creates a new deposit that didn’t previously exist–some investor must now hold that deposit in his portfolio of assets.
It follows, then, that if we want to get an estimate of the total amount of bonds and cash that investors are holding at any given time, all we have to do is sum the total outstanding liabilities of each of the five categories of real economic borrowers. Those liabilities either translate into cash that an investor somewhere is holding (if the entity took a loan from a bank, which expands the money supply), or they translate into a bond that an investor somewhere is holding (if the entity borrowed directly from the investor). Note that the average bond trades close to par (with some above, and some below), so, in aggregate, the value of the liabilities approximates the total market value of the bonds.
Banks don’t generally hold stocks. So to estimate the total amount of stocks in investor portfolios, what we need to know is the total market value of all stocks in existence. We end up with the following equation:
Investor Allocation to Stocks (Average) = Market Value of All Stocks / (Market Value of All Stocks + Total Liabilities of All Real Economic Borrowers)
We can get all of the information in this equation from the Flow of Funds report. The information is also conveniently available in FRED Graph. A link to the calculated metric is provided here, and to a separately downloadable version of each series, here.
Now, the Rest of the World creates an interesting complication. Parts of our portfolios are composed of stocks, bonds and cash denominated in foreign currencies (which do not show up in these series and are not being counted, though they should be). But in the same way, some parts of the portfolios of individuals in other countries are composed of stocks, bonds and cash denominated in our currency (which do show up in these series–and are being wrongly counted, given that our goal is to know our own allocations as domestic investors). As an estimation, it works to assume that the two cancel each other out.
