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December 2009
On Allocation
On
Allocation…A
while back in 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 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 numbers we see, 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, we thought it 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?
We promise this is not going to change financial market
outcomes tomorrow. But
by watching the longer term trends and rhythm in this data, we
believe a number of important messages arise.
At worst, we believe it helps identify and put into
perspective important questions that deserve monitoring ahead.
Let’s get right to it. HOUSEHOLDS
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 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 (we can’t believe it personally to be honest), 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, we’ve seen 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, we believe 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 A
final little two second peek at one perspective of household
financial circumstances from the 2Q period we had not updated for
you as of yet – 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?
CORPORATIONS
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 we showed you excluded the “capital
challenged” financial sector.
This is a first (new debt AND equity issuance concurrently)
in many, many years. As
we suggested, 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 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 we see 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. As
you know from our coverage in the past, 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. Although we
clearly do not get to make asset allocation decisions for public
funds, 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 we penned a discussion entitled, Pension Tension.
In it we touched on the current and projected under funded
status of private and public plans.
We 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 we can assure you 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 (as we have discussed a number of
times recently showing you the NCREIF data) that will only serve
to widen the actuarial under funded status of many of these plans.
We
know this sounds melodramatic, but we 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.
FOREIGN
SECTOR A
while back we 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 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.
We’ll move through this with just about zero commentary. 2009
is the first time since 2009 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
It’s
no wonder why it is becoming common knowledge that the Somewhat
surprisingly, the foreign community has become a net seller of
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 we’re 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. We
suggest 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 we wish we had the answers to our 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, we’re 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.
As we see life, 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 is 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.
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Copyright ContraryInvestor.com © 2009