Just Where Is The Equity In All Of This?
Dent In The Story?...Recently
demographer Harry Dent and Dave Rosenberg have been discussing the
fact that as we look ahead over the next 12 years or so, the 45-55
year old population segment in the US is set to decline.
It's the population wave coming after the boomers and before the
gen-xer's. Of course, and as the graph below so eloquently
displays, following the boomers in terms of a population bubble is
one hard act as you can see what the boomers did to the 45-55 year
old population segment in terms of growth from the early 1980's
until literally now.
For anyone who has been a
demographics devotee, this should not be new news at all. As
you know, Dent has made a very nice living as demographer and
financial market commentator, basing his ongoing economic and
financial market outlook on forward demographics. To be
honest, there is a lot of validity in his approach and we suggest
his comments be included as one tool in the greater toolbox of
longer term decision making. As both Dent and Rosenberg have
recently pointed out, and as the graph above unmistakably
presents, the last time we saw a decline in the 45-55 year old US
population segment was from the mid-1970's to the early 1980's.
Specifically, this population group peaked in March of 1973 and
then troughed in July of 1983 before literally exploding higher
until just recently when we have again seen yet another peak for
now. Dent expects a steady 45-55 year old population segment
decline into the 2021-22 period. Both Dent and Rosenberg
suggest investors focus in on this fact intently as it's the 45-55
year old age bracket that is the largest consumer segment, the
largest investor segment, etc. If indeed nominal body count
decline lies ahead, then just what does that say for the
economy and financial asset prices that theoretically are a
reflection of the real economy?
In the following table, we
basically singled out the period described above of covering the
peak and trough of this population segment in the 70's and 80's.
And what we are looking at is the increase in real US GDP over the
3/74 to 7/83 period. For a bit of compare and contrast, we
took equivalent roughly nine year periods both before and after
this population slowdown to see what real GDP growth looked like
when the 45-55 year old crowd was a growing population segment.
Do you think Dent and
have a point germane to investment decision making? Of
course they do.
To Point Growth In Real GDP
No wonder Dent is so uber
bearish, right? To make matters a bit more somber, you may
remember back to our "You Dream Of Columbus" discussion
in September. One of the key themes we were trying to get
across in that commentary was that as long as the US Government is
levering up, there will be a downward bias to US GDP growth,
exactly as we have seen in
for a few decades now. So, it appears we have demographics
and financial gravity telling us to expect economic volatility and
fragility looking out over the next decade.
Although we believe the Dent
and Rosenberg driven analysis above is very much to be taken into
decision making consideration ahead (and we will), we are not
bringing this up to regurgitate what both of these analysts have
already said regarding the projected character of the domestic
economy ahead. In fact, you don't want to know what Dent is
saying, to be honest. He sounds a lot like Bob Prechter in
terms of forward equity index targets. Just remember that
when Dent was bullish decades ago also due to demographics, he put
huge targets on the equity indices that were never reached.
Not even close. In fact, we never even made it half way to
his targets for equity indices. So for now we take the
downside nominal price targets with a grain of salt. For
now. And in no way do those prior equity market targets that
never came to be negate the fundamental message of how
demographics can shape both domestic economic and financial market
Before really getting to the
heart of this discussion, one last data point concerning the 45-54
population. The chart below is a quick peek at current
unemployment circumstances for this group. We're looking at
the number of folks in this age demographic that have been
unemployed now for half a year to a year. At least over the
history of the numbers, we've never seen anything like this in any
prior cycle. Also, a bit of the reconciliation you see
lately is more a result of folks falling off of unemployment
benefit rolls as opposed to finding jobs. Just another log
on the fire of demographic consideration? You bet.
The point of this discussion is
to veer off into a bit of a different compare and contrast
exercise relating directly to US equities. At the very
worst, we hope we are asking the right questions. Point
blank, what does history have to say about how equities may react
when the 45-55 year old population goes into decline over the next
decade plus? If indeed real GDP growth slows meaningfully as
has been the case so far into the current recovery cycle, perhaps
compounded by the fact that Government leveraging by necessity
will only put more downward pressure on economic growth, what
influence will that have on equity valuations, etc.? And
lastly, are there any important differences between the period of
the mid-1970's through early 1980's relative to our present cycle
circumstances, and if so how will these differences potentially
impact US financial markets ahead?
Let's start with a quick look
back at the S&P during the period where we last saw the 45-55
population go into multi-year decline. It's exactly what you
see below and we have marked the points of 45-55 year old
population peak and trough experience on the S&P chart itself.
Very quickly, did the equity
market discount the temporary lull in population growth for this
very economically important demographic segment? You better
believe it did. As is clear, equities peaked in late 1972, a
year before the 44-55 population segment peaked in what had been
continuous growth up to that point. In like manner, the
S&P bottomed for the final time in mid-1982 just prior to
blasting off into one of the greatest
equity bull markets of all time. This was exactly one year
before the 45-55 year old population segment bottomed. Like
equities, growth in the 45-55 segment then blasted off into the
greatest growth in the 45-55 year old age bracket in the history
. The boomer bulge bracket is all too familiar a story and
central to Dent's prognostications. So, the wonderful
efficient equity market that discounted this demographic shift a
year in advance of both the peak and trough showed us equity
prices that went absolutely nowhere for a decade (late 1972
through mid-1983) as this demographic segment lull in growth
occurred. No wonder Dent is so somber about the next decade,
right? Yep, this is pretty much the Dent story. So
what can we expect ahead? Yet another range bound equity
market that has really already been the case over the last 12
years? Another lost decade so we can join the
economic and financial market fan club?
Just Where Is The Equity In
All Of This?...In
contemplating just how forward demographics will potentially
influence equity markets ahead, just one more quick qualitative
look back. Remember, in the early 1970's, the baby boom
generation was just warming up in terms of how they would
profoundly influence both the real economy and financial markets.
With the enactment of ERISA in 1974, corporations and government
entities were now being mandated to provide retirement benefits
for this explosive demographic group that was to blossom over the
years ahead, along with pension contributions. So in 1974,
we were then staring at the next three and one half decades of
corporations, and ultimately individuals, acting to fund
retirement pools of assets in a one way street characterization of
cash flows. You know the story, this was a generational
headwind demand for broad based equity "consumption"
(purchasing) unrivaled in
history. With ERISA also came the introduction of the IRA
vehicle that was yet another non-pension related source of equity
demand, all of this coming together in simultaneous fashion.
And as the baby boomers matured and their wages accelerated,
equities became close to a national pastime over the next quarter
century. That one time demographic and legislated driven
demand for retirement asset purchases rode the path of the ever
aging boomer that at this point is not so much any longer
interested in accumulation, but rather how this thirty five years
of asset accumulation will be spent down in retirement years.
Exactly the same can be said for pension plans, especially defined
benefit plans. After all, corporations have zero interest in
over funding defined benefit plans as from an actuarial basis they
would love the last nickel in plan assets to be paid out five
seconds before the last boomer breathes their last.
In addition to demographically
driven demand for equities vis-à-vis the largely ERISA driven
retirement mandate, the boomers also helped herald in the greatest
credit cycle expansion the
has ever experienced. We've covered this so many times, you
know exactly how this very positively influenced economic outcomes
over the 1980-2000 period. This was the landscape that lay
before us in the early 1970's during the first 45-55 year old
population downturn. Fast forward to today and this virtuous
set of circumstances for both the economy and financial asset
demand has just about been completely turned on its proverbial
head. The generational credit cycle has peaked.
Probably the last thing the 45-55 year old population needs to do
today is to take on more debt. In case you have not been
with us over the last few years, credit cycle dynamics are now an
economic boat anchor around the neck of the economy, with the
focal point being US households. Secondly, with the downturn
in household net worth and the generational collapse in interest
rates, those boomers who hoped to retire on their savings and earn
perhaps a safe 5% rate of return are now wondering just how they
could have been so wrong. Terrified, they are faced with the
reality of spending both earnings and principal in their
retirement years. We believe it is very fair to say so many
folks simply never saved enough and came to count on equity and
residential real estate price appreciation until the hereafter.
As the boomers age, they will now draw down defined benefit plan
assets, IRA's, 401(k)'s, etc. The one way street of
contributions will reverse to become steady distributions in the
decades ahead. As mentioned, 180 degrees from the
circumstances faced in 1973. Is this about to have a
dramatic impact on financial assets tomorrow? Hardly.
This is big macro and will play out over decades. But it
tells us that the buy and hold macro of baby boomer and pension
plan accumulation years is well behind us. A different era
macro simply calls for a different investment decision making game
plan. It's not the end of the world by a long shot.
Okay, here come the charts.
Hope you are ready. We'll make this quick. We want to
review the current composition and character of the component
owners of US equities as of 1Q 2010 numbers. Where are the
liquidation risks ahead given the clear need of the boomers to
monetize these assets in the decades ahead? As of right now,
ownership of US equities can be characterized by the chart below.
As seen, households and mutual funds are the two largest equity
owners. Remember, households include the Warren Buffet's
(although his equity has theoretically been gifted), Larry
Ellison's, etc. of the world. Is there a lopsided skew here?
You bet there is. But between households and equity mutual
funds, you are looking at over 55% of total publicly traded
equity ownership. And it's households that represent the
bulk of mutual fund ownership. Will at least some of this be
liquidated in the years ahead to fund living needs?
Absolutely. Although we'll come back to this in a minute, we
really want to focus in on the institutional owners of US
equities. As we see it, these will be the most at risk
sellers of US equities in the decades that lie in front of us.
Collectively, private and public pension funds as well as
insurance companies (think annuities) own 25% of the current
equity market. Will they in 10 or 20 years? Doubtful.
And perhaps more importantly, to whom will they sell?
It's not just
the question of potential liquidation that looms a bit large right
now. Also very important to the discussion is the question
of whether this collective group of significant equity buyers of
the last three plus decades will be important buyers ahead?
As we see it, a few will not. The chart below look sat
current equity ownership of US households. We're looking at
their asset allocation here, if you will, as we measure US
equities as a percentage of total household assets. For now,
US households are very near their long term average exposure.
But the important question ahead is will they again ramp up equity
buying relative to alternative financial assets, especially since
the folks with most of the money (boomers) are entering retirement
years where they cannot afford to lose anymore than has already
been the case over the last decade plus? You can see the
character of the generational cycles of household equity ownership
over time. It would be our bet that returning to prior asset
allocation peaks is out of the question any time soon. You
already know we've seen consistent equity mutual fund sales over
what is close to the last 30 weeks, rallies or no rallies.
Have households simply had it with the volatility? Sure
could be. Thank you SEC and Administration for turning a
clearly determined blind eye to how electronic trading has
recharacterized short term equity market outcomes.
ownership of US equities as a percentage of total financial assets
has been very steady between 15-20% really over the last close to
the last four decades. Although this may sound wild, if we
had to pick a constituency that just might end up being an
important buyer of US equities ahead, this would be it. Why?
Because we expect many emerging nations to ultimately travel down
the path of social benefit creation the
has walked over the last three to four decades. And if so,
they may indeed be interested in large blue chip
equities that are essentially in many cases global mutual funds in
and of themselves. After all, so many global blue chips have
global name recognition. Plus, we certainly expect household
disposable income to rise meaningfully in the emerging nations in
the decades ahead. We'll just have to see what happens
ahead, but this may be a bright spot.
next five charts are really the focal point for this discussion.
Below we are looking at the "institutional" holders of
US equities. We're talking insurance companies and private
and public pension funds. They have ridden the boomer wave
of asset accumulation and will necessarily be buffeted by forward
retirement living expense payouts and distributions in the decades
ahead. If there is to be a sourced headwind for US equities
ahead, these folks would be ground zero. After an almost
uninterrupted three to four decades of accumulation of financial
assets, we're about to move right into distribution mode.
The top clip of the chart below covers insurance companies in
aggregate (life and PC), but by far the largest exposure here is
life companies. Just think variable annuities. As the
boomers ramped up retirement savings into the equity bull market,
insurance company exposure to equities close to doubled in the
prior fifteen years relative to the five prior decades. As
annuities are drawn upon in the years ahead, just where do you
think this ratio will go? As the boomers age, we'd
personally expect a return at least to the longer term average.
And that assumes equities do not experience serious price trouble
along the way. Distributions and payouts alone could drive
the ratio back to the longer term average. These folks are
certainly a source of equity liquidation ahead.
major issue for the pension industry as a whole in the
is under funding of plan assets. For the private sector
under funding will be reconciled out of corporate earnings over
time. You can see in the bottom clip above the history of
total nominal dollar private sector pension assets. As of
now, we're just not that far away from where we stood in 1999.
Ten years and not a lot of growth means very large under funding
potential. Important why? Because if equity prices do
not "behave" ahead, private pension sponsors may be
quick to pull the plug on volatile equities. Why risk a
deeper under funding hole at the expense of sacred reported
earnings? You know these folks used to be considered longer
term investors. With the baby boomers aging by the day that
is definitively no longer the case. Private
pension fund equity exposure seen below in the top clip is just a
touch misleading. Although the ratio appears pretty darn
steady over the last four decades with a recent drop off more than
apparent, underneath change has surely been afoot.
Alternative asset exposure in the relatively progressively
thinking private pension world has grown markedly. Is
private equity also equity? Sure it is, but you won't see it
below. How about hedge exposure? You bet. You
get the picture. The true reality of equity exposure here is
higher than you see. If there is to be a very meaningful
seller ahead, this would be our pick. Why? Most
private sector pension plans are defined benefit. As
mentioned, by academic definition these should be self liquidating
as the boomers ultimately age and leave us. As wild as this
may sound, private sector pension plans may be a distant memory in
thirty or forty years. So what will happen to these assets?
Are you kidding? They will be sold. As of the second
quarter of this year, private pension funds were holding $1.67
trillion of US equities. That's about 9% of the total
It has been
estimated that pension under funding at the State and Local muni
level is near $3 trillion as we speak. We fully expect a
government bail out at some point. But given that level of
current under funding risk, just look at how exposed these folks
are to equities as seen in the bottom clip of the chart above!
They are the last folks that can tolerate a severe and prolonged
downturn from here. Let's just hope a lot of these folks do
not take Harry Dent's newsletter. If they do, they have not
been sleeping for quite some time. These assets are clearly
at risk of liquidation due to payout and distributions over time.
Exposure at the end of 2Q 2010? $1.45 trillion. Public
and private pension funds are sitting on $3.1 trillion of equities
as of mid-year. These are the very folks who will be
liquidating to pay out benefits in the next few decades.
Moreover, looking ahead at actual payouts and realizing a glaring
under funding exists in public pension plans, the State and muni
entities have a number of choices. Put up the cash to fully
fund the plans - not feasible. Use existing pension assets
and muni general fund assets to make payments ahead - not likely
as per the general funds kicking in so early in the pension payout
game. Fund payouts solely out of plan assets, risking deeper
under funding ahead - bingo, near term choice of fiscal
expediency. You get the picture.
States and municipalities will liquidate plan assets prior to
digging into general fund assets. To
the point, public pension funds have much greater under funding
problems than is the case with the private sector at the moment.
And the public sector is also under the most fiscal pressure as we
speak. Does having such a high allocation to equities only
heighten State and municipal solvency issues? Without
it's the institutional holders of equities that we need to monitor
ahead. These are the folks who will be liquidating assets to
make promised and requested payouts/distributions to the boomer
crowd. As mentioned, collectively these folks own 25% of
equities outstanding. Below is the collective
"institutional" allocation to equities of these three.
We're above longer term averages by about 10% at present.
And it gets much tougher as we
move ahead. With current bond yields at generational lows,
just where are institutional holders of US equities to find simple
nominal rate of return? Equities seem the logical choice
over bonds. But for institutions who are nothing short of
certainly faced with promised distributions in the years and
decades ahead, just how much investment risk can be tolerated and
for how long?
The world is not about to come
to an end, but demographics and the character of institutional
holders of US equities will be a mandatory analytical focal point
as we move forward. Have we hit or are very near to hitting
something along the lines of an institutional tipping point in
terms of the supply/demand balance for equities? This set of
circumstances helps argue for a range bound market, volatility as
a key construct, and the need for active asset allocation ahead.
As a very quick anecdote, right now the pension system in
has begun liquidating JGB's (Japanese Government Bonds) to meet
pension obligations. This is a first and certainly a trend
that will continue. Watching Japanese experience will be
important as their baby boom contingent is about a decade ahead of
. What were once demographic tailwinds for US equities are
set to become headwinds. Again, this is not end of the world
stuff here. As in sailing, tailwinds turning to headwinds
just requires a change in navigational technique inconsistent with
the prior approach. Range bound, volatility and active asset
allocation will hopefully get us safely to shore as the winds of
change gather force with demographics. Can we avoid landfall
on the equity index targets suggested by Mr. Dent? We
believe they are extreme, but he has the direction of the trade
December 1, 2010
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