I found this post from the ‘Philosophical Economics’ blog to be very thoughtful. It offers some interesting ways of thinking about equity price levels, and what drives them. The author makes a convincing argument that despite the fact that many believe price changes are largely a function of valuation multiples (e.g., P/E ratios), they are actually caused by relative changes in the aggregate investor allocation to equities.
Essentially, the post makes the case that aggregate demand for equities as a proportion of all financial securities — or average asset allocation to equity across all investor portfolios — does a much better job of explaining subsequent returns than traditional mean-reversion metrics. When demand for equities in aggregate increases (decreases), expected future returns decrease (increase). This is because equity allocations cannot fall below zero or rise above 100%, and in practice they generally fall between 25-50%.
For example, if the current equity allocation level is high, this implies that there’s much more room for the level to decrease rather than rise over a medium term time horizon. When it does decrease, the excess supply will drive down prices and thus returns. This chart shows the strength of the relationship:
The post is long, but the arguments are carefully constructed and compelling.