by Brian Pretti CFA, Contrary Investor. December 11, 2009
A while back on our subscriber site, we penned a discussion trying to put the whole “mountain of money” thesis into perspective. The bottom line is that there is less than meets the eye, especially as that applies to households and corporations. Simply put, the private sector does not appear to have meaningful cash resources when the data is looked at relative to both current asset values (of equities) and relative to historical behavior of households and corporations to be a hugely powerful force in terms of moving financial asset prices. Yes, this is the same US private sector now engaged in deleveraging of a magnitude whereby the year over year change in private sector credit balances has entered negative territory - a first in the sixty years of available data! Of course we all know that at the moment, the mountain of money that is influencing markets and the economy is coming from none other than the Fed/Treasury/Administration. And quite the mountain it is.
Only one little problem though. Once you’ve “taught” investors you’ll provide the money, and keep on providing it in spades at even the first sign of trouble, how do you stop doing that at ever increasing rates without risking market values themselves in big way? Start to take away the money candy and the terrorist banks (commercial and investment) will tell the Fed the world is about to come to an end. They’ll pull the pin on themselves and supposedly take everyone else with them unless the Fed comes across. It will be fascinating to watch the Fed ultimately be forced to stop the free money game. But that’s a story for “tomorrow”. Unfortunately, at least as per the current numbers, there will be no mountain of money at the household or corporate level to pick up the slack when that day arrives.
Anyway, given the pretty darn tumultuous events of the last few years in financial markets, it seems high time for a quick check in on financial asset allocation on the part of a number of meaningful investment constituencies - households, corporations (pension funds) and what’s happening in the foreign community. As a percentage of financial assets, where do these folks stand in terms of equity and bond exposure relative to historical trends and levels? Is there room for these folks to increase allocation to equities with what little cash resources they do have? This is not going to change financial market outcomes tomorrow. But by watching the longer-term trends and rhythm in this data, a number of important messages arise. At worst, it helps identify and put into perspective important questions that deserve monitoring ahead. Let’s get right to it.
As of the end of the second quarter of this year, total household allocation to equities as a percentage of total financial assets stood at 23.6%, just a hair above the near 65 year average of 22.3%. Reversion to the mean in action? You better believe it. Unfortunately most of this change in allocation came the hard way - declines in equity values.
You can see the long-term ebb and flow of cycle allocation over time. The quintessentially classic cycle of fear and greed playing out in rhythmic fashion, very much akin to truly long term equity value fluctuations between mid-single digit multiples and high teens to high twenties multiples within the context of secular equity bull and bear cycles. THE big question looking ahead is whether the currently rising equity market will entice household investors to “jump back in” to equities and raise their allocations. So far in the current year as characterized by equity fund inflows, that’s not happening at all. In fact quite the opposite. What we do not know at the moment is whether reversion "to and through" the mean is a possibility. It's very infrequent in really any cycle that reversion stops at the mean itself and reverses. It seems it would take meaningful equity market weakness from here to prompt households to further reduce equity allocations. We'll just have to see what happens. But what households have been doing lately as opposed to potentially upping equity exposure is to pile into bond funds and bond oriented ETFs in literally record numbers.
The chart below looks at household bond allocation over time. The irony, of course, is that in the early 1980’s when bond yields hit generational highs, household bond investors were nowhere to be found. Why? Simple, they were acting in a manner consistent with what had already happened, not what was about to happen. And now that interest rates broadly have hit generational lows, the public is piling in dramatic antithesis of their behavior almost precisely three decades back. They can’t buy them fast enough, at least for now.
Is Bernanke watching this? By making money funds and safe government securities completely unpalatable to the public, and especially those living on interest income, via microscopic nominal yields on short paper, he has in essence forced investors into riskier assets to find any type of yield. But the path household investors have chosen this year is bonds, not stocks. Just how do you think this will end for these investors jumping into bond funds with yields currently at generational lows? You already know the answer, just not the timing. On a YTD basis through 2Q, household ownership of “credit market instruments” (translation? bonds) is up 13.4% on an annualized basis. And that was BEFORE the record bond fund inflows of the summer to the present. Believe it or not this growth in household ownership of bonds is virtually entirely accounted for by increased household ownership of Treasuries through the 2Q data!!! Sorry to sound so pessimistic, but longer term this is an accident waiting to happen. Since Treasuries have shown us negative performance through 2Q, this increased allocation to bonds by households is accounted for by increased nominal dollar buying, not price gains. God almighty, the public piling into bond funds at current nominal yield levels. Thanks, Ben. To save your buddies on Wall Street and at the banks you've sparked a public panic into the last major asset bubble in the financial markets of magnitude - US Treasuries. And all just to eek out a few more basis points of yield in what is a macro income challenged environment. It’s a shame the Fed Flow of Funds data for 3Q is not yet available at this writing (it will be soon). Because through 3Q corporate bond funds have also been a highlight of public’s hunt for yield. It’s not just Treasuries.
Through 2Q, household equity exposure had increased by 13.2%, but you know that’s mostly price appreciation, substantiated by the fact that equity fund flows are running negative YTD (and continue to through the present in late November). As a very quick tangential aside, recent research from some of the highest bonus paying investment banks on the Street suggesting that before this cyclical bull has run its course, the public will essentially have no choice but to up equity allocations meaningfully. To be honest, this will be one of the most interesting watch points as we move forward. Has the public been burned one too many times? Or are animal spirits alive and well on Main Street as well as Wall Street. So far this year, again as characterized by equity fund outflows, Main Street seems deserted. Bottom line? It appears households have become very risk averse in their investment allocations for the current year. I’ve never seen an equity market up as much as we have experienced since the March lows of this year without the public beating down the doors to get into equity funds...until now. They're still beating down the doors, but this time to get out.
A final little two second peek at one perspective of household financial circumstances from the 2Q period – household cash relative to liabilities. You already know household cash less liabilities has never been a negative number until this decade. Have we begun the journey back toward positive territory? If so, just what does that mean for consumption, let alone households sitting on a theoretical “mountain of money”? Again, in relative terms of larger household balance sheet (liability) circumstances, what mountain?
Again, in a recent subscriber site piece we took a look at corporations and the fact that so far YTD, they have been issuing not only new debt, but new equity as well. And the numbers excluded the “capital challenged” financial sector. This is a first (new debt AND equity issuance concurrently) in many, many years. Corporations are husbanding their cash. Internal funds generation less capital expenditures is off the charts to the upside. It says these folks are not in the spending mood, whether for financial assets or business related spending. And that’s probably a good thing from a longer term standpoint in that many of these companies, especially the old line blue chip behemoths, are right on the cusp of facing what will be increased boomer related pension payouts. Same goes for the public pension fund crowd. So while corporate revenues and ultimately earnings are under pressure, this new “cost” will become a rising Phoenix directly ahead. For the public funds, it’s a massive issue as concurrently they face income, retail sales and property tax revenues that are dropping like rocks. Quite the bind for State and local municipalities. You may have seen the chief actuary for CALPERS (California State Public Employees Retirement System) publicly announce about a few months back that CALPERS needs to consider renegotiating benefits for covered employees. A shot across the proverbial bow? Sure sounds that way.
The following two charts update private and public pension fund allocations to equities and fixed income as a percentage of total financial asset holdings. Relative to their public fund counterparts, private pension funds have been “lighter” on equity allocations, per se, for many years now. But we need to remember that these sophisticated folks were early adopters of hedge fund and private equity exposure (which are also financial assets), so in the much broader definition of equities, real exposure is well beyond what you see below. As stated, private pension exposure to equities as of the end of 2Q rested at a level not seen in over forty years. And as we look back since year-end 2007 to the present, the drop from 45% to just under 35% in allocation has been price driven. It’s the loss in equity values that has changed this allocation, not pension funds actively reallocating away from equities.
Is there room here for private pension funds to up their allocation to equities ahead? From the perspective of longer-term cycle experience, there is room and plenty of it. The question becomes one of capacity and funding source. In a world where corporations are straining to maintain bottom line earnings per share integrity at virtually all costs (or more precisely cost cutting), additional expenses (of which pension contributions is one) need to be prioritized. Additional pension contributions to fund an increased equity allocation at present? Probably not a big priority right here and right now fro the corporate crowd, do you think?
In terms of the change in fixed income institutional private pension allocation in the chart above, the decline in equity values is the primary driver of the increase in bonds as a percentage of total financial assets. But incredibly enough, YTD private pension fund allocation to Treasuries through 2Q is up close to 6%. Allocation to corporate bonds increased 3% and agency exposure has been flat. We know corporate bonds have rallied this year, but Treasuries have not. So it seems the increase in Treasury exposure was an active (fear based?) decision. No matter what, does it really make sense to up allocations to Treasuries at these nominal levels? IF this is representative of behavior at the private fund level, it seems one big leap of faith that these folks would heavily allocate back to equities so soon after turning up the heat on the Treasury allocation, but we do know performance pressures at the pension fund level are every bit as acute as we see at the mutual fund level. You never know. The continued equity rally could “force” some private funds back to equities as the never ending short term performance derby can and does influence decision making for better or for worse.
On the public pension fund side of the equation it’s a bit of a different story. The public funds have been slower adopters of allocations to financial exposure alternatives such as hedge and private equity exposure. Hence, straightforward stock and bond exposure dominates the allocation to financial assets as is clear in the combo chart below. As of the end of 2Q, which is a good bit stale at this point, public fund exposure to equities stood at a level that was also seen close to a decade and one half ago. The decline in allocation between year end 2007 and present is clearly a reflection of price as opposed to an active asset allocation decision.
And the same goes for bonds. The increase in fixed income allocation in 2008 and this year is simply the mirror image of the decline in equities. Nominal dollar public pension fund holdings of “credit market instruments” is actually below 2007 year end levels as of 2Q 2009. It would seem there is not a very big chance of public funds significantly increasing cash funding that would lead to a meaningful upward allocation to equities any time in the near future. As we all know, State and local municipalities are under severe fiscal pressure at the moment, and this is not about to change any time soon.
Back in April I penned a discussion entitled, Pension Tension. In it I touched on the current and projected under funded status of private and public plans. I continue to believe this will be a meaningful issue ahead. Below is a very quick update on where values of where nominal dollar public and private pension fund financial assets stand as of 2Q period end. Point to point we are looking at no growth at all over the last decade. In other words, this experience mirrors that of the S&P on a price only basis. Of course over this same period you can be assured that “projected benefit obligations” of these plans kept barreling right ahead year after year. And now so many of these funds face meaningful declines in values of their commercial real estate holdings that will only serve to widen the actuarial under funded status of many of these plans.
I know this sounds melodramatic, but I have the very strong feeling that at some point ahead, public pension funds are going to need bailouts themselves to make good on the forward obligations they have promised their constituencies. Either that, or benefits promised will have to be renegotiated, as per the message of the CALPERS official. We’re not there quite yet as the boomers are just rolling into their retirement collection years, but the obligations versus available funding problem will grow ever more obvious. This will be a big issue in the next decade. On so many fronts there are simply a lot of constituencies that have a vested interest in higher equity prices. No wonder the Fed seems relatively unconcerned about the liquidity they have injected into the system that appears morbid (unable to get into the real economy) for now. Morbid except for certain firms' record “trading profits”, that is.
A while back I touched on foreign buying of US assets that has really been in net aggregate decline for over a good year now. Important why? It’s the sign of less foreign capital flowing into the US that has been a key source of support for US financial markets and the real economy as a whole for decades now. Near term, this decline in foreign flows has had very little impact on price of US financial assets as the deterioration in foreign flows to the US markets has been masked by the unprecedented monetary largesse of the Fed.
So the charts that lie below are a bit of a spin on the ball in that we are looking at foreign holdings of US Treasuries, agencies, corporate bonds and equities as a percentage of these outstanding asset classes in their totality. Important why? Because they are showing us the foreign community is actively “reallocating” away from these asset classes. What you see below has very little to do with price declines. In fact little to nothing. All else being equal, in an asset class price decline analysis, foreign community percentage holdings of these asset classes would have remained academically stable…if they had not been selling. I’ll move through this with just about zero commentary.
2009 is the first time since 1999 that we have seen foreign holdings of Treasuries fall as a percent of total Treasuries outstanding. So just who have been the buyers if not the foreign community? The banks, households in a very minor way (as we described), private pension funds (a rounding error in terms of buying, but positive nonetheless), and of course the good old Fed - all of which are unsustainable longer term.
Point blank, the foreign community have been active sellers of US government agency bonds. This has been going on for two years now and continues through to the present. The selling is clearly reflected in the chart below. And this is happening despite agency bonds effectively having become US Treasuries (clearly additive to total US government debt outstanding).
It’s no wonder why it is becoming common knowledge that the US government has now become THE key support underneath US mortgage markets over the past year+. At current nominal yield levels there is very little incentive for the foreign community to come back to US agency paper. And that suggests the government will become ever more meaningful in supporting mortgage markets ahead.
Somewhat surprisingly, the foreign community has become a net seller of US corporate paper over the last few years. In a bit of irony, the foreign community has not been a big seller of US equities, but the selling in corporate bonds has been heavy and consistent until literally the last three months or so in off and on fashion. As you can see, there has not been a down year in this ratio since the early 1990’s until just the last few years.
Finally equities. This is the one asset class that has held firm in terms of foreign community commitment to the asset class.
There you have it. Short and sweet, although I’m not so sure about the sweet part. For now, we simply need to realize that a key buyer of US financial assets over the last few decades is “reallocating” their precious investment capital to other “opportunities”. Again, the Fed liquidity extravaganza of the last year plus has masked a potential price impact here, but that masking will not continue indefinitely. This is key change at the margin.
Okay, in hopefully very quick and basic summation, we are watching reversion to the mean in asset allocation to equities at the household and pension fund levels. Although I wish I had the answers to my own questions, looking ahead we need to monitor for potential declines to and through long term mean asset allocation levels. And despite the allocation reversion we have seen so far largely driven by price declines, we need to ask ourselves where the funding would come for these financial market “constituencies” to increase their allocations (especially) to equities now that these allocations rest at levels quite low relative to historical experience? For now, I’m having a tough time seeing how pension outfits or households would have the discretionary financial wherewithal to increase funding. Simultaneously, in all asset classes with the exception of equities, on a net basis the foreign community has been liquidating or simply marking time for a few years now. This simply highlights just how meaningful Fed/Treasury/Administration liquidity has become as a support mechanism to the financial markets at present (which deserves intent monitoring and anticipation of change itself). And as we know has been coming for some time now the perceptually strong 3Q GDP number was also primarily attributable to that same Fed/Treasury/Administration triumvirate. Neither good nor bad, but simply reflective of a private sector not yet ready to stand on its own two feet without assistance.
© 2009 Brian Pretti