The Equity Share Cycle

Abstract

Standard financial portfolio theory recommends increasing the equity share of the portfolio as the equity premium rises. On the other hand, purely mechanically high stock prices imply low expected returns. Motivated by these opposite predictions I use data from 16 developed economies between 1873 to 2015 to study the composition of aggregate household wealth portfolio and document that in most countries the equity share has moved in very low-frequency cycles, which take decades to mean revert. I document a negative relationship between equity share and subsequent stock market returns with equity share having significant predictive power over future returns while outperforming the historical mean and traditional predictors in- and out-of-sample. I derive two new decompositions based on present value identities that help to understand these results in a framework of multiple assets classes. Furthermore, a high level of equity share is associated with a higher probability of a financial crisis. Standard asset pricing models have difficulty explaining the presented facts but a behavioral model where households have extrapolative expectations driven by unobserved market sentiment can offer a solution.