Blame the homeowners for high stock valuations

The Federal Reserve often refers to the ‘wealth effect’ of its interest rate decisions. The idea is that if the Fed cuts interest rates, asset prices go up (in particular house prices) and that makes people feel richer. While there is plenty of evidence to support that in the US, the evidence outside the US is mixed, so don’t try to extrapolate today’s insights to countries other than the US. You have been warned.

If house prices rise, many Americans feel richer, and that may change their behaviour. Because they feel like they have more money, they may start to invest more in stocks and other financial assets. Indeed, Americans may not only feel richer, but actually become richer if they sell their houses and cash in some of their gains before buying a new home.

But retail investors famously invest differently than institutional investors, so you might see a different investment pattern depending on the past increase in house prices. And indeed, Brent Ambrose and his collaborators found an interesting link between house price increases in the US and stock market returns.

They realised that one can measure the investment behaviour of retail investors in different parts of the US by looking at the share prices of companies with headquarters in this region. We know that retail investors invest more heavily in companies that are headquartered near the home of the investor, the so-called ‘local bias’ in stock markets.

So, what happens if house prices rise? How do valuations of stocks in the region change, and what does that mean for future expected returns?

The chart below shows how higher house price returns influence the future expected return for stocks by valuation. Growth stocks (i.e. stocks with the highest valuations) show a marked decline in future abnormal returns. This is just a roundabout way of saying that homeowners who experience an increase in the value of their house tend to buy more stocks. And when they buy stocks, they tend to predominantly buy growth stocks with high valuations, which pushes their valuations even higher and reduces their future returns. Note also that they tend to purchase deep value stocks, but to a lesser extent than growth stocks.

Impact of house price increases on future stock market returns

Source: Ambrose et al. (2025)

The chart above points to an intriguing possibility. Because retail investors predominantly buy growth stocks rather than value stocks, one would expect that the valuation premium of growth stocks vs. value stocks rises if house prices rise. And the faster house prices increase in a region, the more this valuation premium increases. As a result, when house price increases stop, growth stocks in areas with large house price increases in the past will underperform value stocks in that region more than in regions where house price increases have been more modest.

And that is precisely what one can observe in the US. The chart below shows the change in future excess returns of value stocks vs. growth stocks for all households and whether house price increases have been low, medium, or high (the left three columns in the chart). The faster house prices have increased, the more value stocks outperform in the future.

If you go to the middle section of the chart, you see that this effect is far more pronounced with stocks that have low institutional ownership. It completely disappears for stocks with high institutional ownership on the right-hand side of the chart.

Value vs. growth outperformance depending on ownership and house price return

Source: Ambrose et al. (2025)

What these charts tell us is that the outperformance of value stocks vs. growth stocks is, to a large part, driven by retail investors, not institutional investors. And it tells us that as long as asset valuations are supported by monetary policy (e.g. quantitative easing or rate cuts), growth stocks will continue to outperform value stocks.

Only when the monetary policy support disappears can valuations correct, which partly explains the long-term outperformance of growth stocks in the US over the last 15 years. Since the Fed has never really normalised interest rates until 2022, the rug under expensive valuations of growth stocks in the US has never been pulled. Until 2022, of course, when value started to outperform growth in the US for a year or two until interest rates peaked.

But it also tells us something else about stock markets. The bigger the trading volume of retail investors relative to institutional investors becomes in stock markets, the more likely it is that stock market bubbles develop and expensive stocks become even more costly. In other words, the rise of low-cost retail investing and the ‘democratisation’ of investments may have contributed to permanent mispricing in stock markets and the persistently expensive valuations of US stocks.