The theory here is simple. High prices relative to the money stock indicates a high demand for equities and high appetite for risk. That makes shares vulnerable to a fall, because they are in effect over-owned. Low prices relative to money, however, indicate that demand for risk is low and demand for safe assets is high, implying that shares are cheap.
Sadly, however, there's a complication here. The price-money ratio has trended downwards over time. Demand for money has grown faster than demand for equities, which might be a symptom of secular stagnation.
However, if we correct for this trend, the price-money ratio has two immense virtues.
One is that its measure of equities' over or undervaluation is commonsensical. It tells us that shares were overpriced in 1987, 2000, 2007 and in 2015, but under-priced in the early 1980s, mid-1990s, 2003-04 and in 2009.
Secondly, this indicator works as a predictor of returns. I'm thinking here of the three-yearly change in the All-Share index. It makes sense to judge valuation measures by this metric because in the short run overvalued markets can become even more overvalued, and 'cheap' ones can become even cheaper. Valuations predict returns only over longer horizons.
Since 1980 our detrended price-money ratio has on its own predicted almost two-fifths of the variation in subsequent three-year returns. This relationship has been stable; the same is true if we consider only post-1996 data.
What's more, the ratio has worked especially well when you'd expect it to have done so - when share price moves have been due to past misvaluations rather than to exogenous shocks. The ratio predicted returns beautifully around the time of the tech bubble and burst. But it failed to fully foresee the scale of the 2008-09 crash because that was due more to the exogenous shock of the banking crisis than to shares being over-priced - though they were slightly expensive in 2007.
So, what's this ratio telling us now? At the end of June (the latest period for which we have monetary data) shares were slightly over-priced: given their rally since then they have probably become more so. If the post-1980 relationship continues to hold, this points to the All-Share index rising by less than 5 per cent over the next three years, with a roughly 40 per cent chance of it being lower in mid-2019 than it is now.
This implies that shares will probably outperform cash - once one takes account of the dividend yield - but not by a great amount.
If this seems like a lacklustre prediction, it should. In a moderately well-functioning market, shares should only rarely be significantly mispriced.
