Equities Are Dead - Long Live Equities

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Includes: DIA, SPY
by: Oscar Sahlberg

I normally do not venture in to the macro world in these pages and tend to use the space to explore quirky stocks. However, one issue that’s been bouncing around, which piqued my interest has been the household asset allocation question. The bears point out that the portfolio allocation of the US households is biased towards equities and cite that the treasuries held by households (which is around 480bn out of their total financial assets of around $39trn) is a minuscule portion of household financial assets. Disgusted with two equity bubbles and with the beginning of the baby boomer generation retirement, they argue, the populace will now flock to the security of fixed income.

I take couple issues with this approach. First is that we should look at the total asset allocation question: so we cannot just assume that it is the treasuries that satisfy the fixed income appetite of the investors. An aggregation of the household balance sheet shows that FI allocation stands at a paltry level. But similarly, equity allocation is at historic lows. What is most prevalent is that households have been outsourcing financial risk management (not a surprise given the rise of the insurance and mutual fund industries).

(Note: Annual data except for the last two datapoints which shows Q1 & Q2 of 2009) (Source: Federal Reserve)

So a fairer analysis will be based on looking through the assets of what the other managed funds actually hold, to give a “fully consolidated.” Here is the picture when I break down the other managed by their asset allocations:

(The remaining other managed are government insurance and pension reserves and “miscellaneous.”)

Based on this, we’re currently standing at a historical low in terms households’ allocation into equities. Now who is to say that we cannot hover around this level? But a larger move away from equity allocation may be a little too aggressive.

But can we really confidently make these comparisons given changing underlying demographics? After all, people’s risk aversion as they go through life. Although people tend to be more risk seeking in their early years they usually have a small amount of financial assets, while those in their retirement have a large amount of financial assets but want to place them into less risky assets. So the demographic sweetspot tends to lie in-between the 30+s up to retirement age who not only accumulate financial assets but also allocate to equities and other risk assets to capture the long-term risk premium. Looking at this ratio of young-to-mature workers adjusted by those in their retirement we see a similar pattern to risk asset allocation.

(Data from census.gov and federal reserve)

According to this, as of 2Q 2009, there is an overshoot away from equity allocation. However, the directional response to the allocation is not clear… Will we flatline and converge to the long-term trend by staying at this level or will there be a jump back to around 35% level (which would imply a 5% more allocation on the $39trn financial assets that is equivalent to $2trn – though this does not have to be pure money flow or pure rise in prices and will more likely to be both if it happens)? Another big question mark is that will these demographic assumptions hold true? As life expectancy increases, and as more people are start to retire later, allocation to risky assets could persist longer (effectively shifting the right tail of the blue line).

The main conclusion from all this is that calling the end of equities will likely to prove too premature.

Disclosure: None