From the Contrary Investor
Just Where Is The Equity In All Of This?
Little 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 US 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 Rosenberg have a point germane to investment decision making? Of course they do.
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 Japan 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 outcomes.
Before really getting to the heart of this discussion, one last data point concerning the 45-54 year old US 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 year old US 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 US 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 of the US . 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 Japan 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 US 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 US 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 US 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 US 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.
Foreign 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 US has walked over the last three to four decades. And if so, they may indeed be interested in large blue chip US 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.
The 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.
An absolutely major issue for the pension industry as a whole in the US 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 US equity market.
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 question.
As mentioned, 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 total US 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 Japan 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 the US . 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 winds correct.