9/21

IS EVERYONE IN YET?

Is Everyone In Yet?...Maybe at this point in the market cycle it's a redundant question.  It would simplistically appear to us that most everyone who has wanted a "piece of the action" in the US equity market has had ample opportunity to partake at anytime over the last few years.  It's hard for us to believe that there are a whole new flock of potential buyers just waiting to strike.  Maybe this is why the market indices have not provided their typical flare gun investment performance returns this year.  Luckily the Fed does give us a little insight into the activities of some of these buyers in the Flow of Funds report we began dissecting on Tuesday.  Sit back, have a look at some charts and tables, and you be the judge.

Private Pension Funds

Here we are largely looking at the pension fund asset allocation of corporate America.  They seem pretty full, don't you agree?  As you know, private sector pension funds largely come in two flavors - defined benefit plans and defined contribution plans.  In one, corporations promise to provide a certain benefit at retirement to their employees and are essentially on the hook for funding this promise.  In defined contribution plans, corporations or employers only promise a certain contribution to the fund, not an ultimate dollar benefit.  In the evolution of pension plan existence, defined benefit plans are becoming relics.  After all, can you blame corporate plan sponsors?  Why promise a stated dollar benefit when funding that benefit can potentially become a noticeable liability on your balance sheet and possibly ding the old bottom line from time to time.  Hence the incredible popularity of 401(k) and defined contribution plans.

As with all plan sponsors, corporate pension committees are fiduciaries and are subject to the dictates of the Prudent Person Act.  Would a prudent person up the asset allocation to equities above 65% of total assets in one of the most highly valued stock markets in US history?  (Before you answer, pretend you are on a witness stand.)  This very fact may argue that private pension plan asset allocation may be nearing top end in terms of equity exposure.

Another lesser know, but incredibly telling, set of facts is what private pension plan sponsors are actually doing in defined benefit and defined contribution plans.  The following table details net private defined benefit and defined contribution plan purchases of equities and equity mutual funds over the last twelve years:  

As would seem rational and fiduciary-like, defined benefit plan sponsors have been net sellers of equities as the market has risen and their allocation to equities has risen over time.  Rational not only as prudent person devotees, but also rational in terms of the corporate bottom line.  With many defined benefit plans "underfunded" in the late 1980's, the 1990's bull market has simply been a godsend.  Essentially these plan sponsors are acting to lock in funding gains that will allow them to skip contributions to the fund (from what would otherwise be corporate profits).

Amazingly enough, where there is not the corporate bottom line riding on investment gains, plan sponsors and employees continue to feed equity asset allocation in defined contribution plans.  We hope for those dependent on eventual defined contribution payoffs, that the stock market continues to be obliging.  For the corporations subject to ultimately making defined benefit payments, it appears that they are taking care of their bottom line liabilities just fine.

The bottom line is that for all pension funds, there has to be some type of upper limit to equity allocation.  The chances of private pension fund equity allocations going to 100% is basically zero.  Are we pushing the upper boundaries as we speak?  Netting out the sum of defined benefit and defined contribution purchases of equities over the last few years appears to say as much.

Public Pension Funds

As you can see, the public funds have been a bit more daring.  There are some real heavyweights in this category such as a Calpers, State of Wisconsin, etc.  Current asset allocation to equities exceeds that of their private pension fund brethren.  Well, just what do you expect when these public boards are wined and dined by some of the finest salesmen on the Street?  Salesmen whose annual salaries are usually 10x or greater than their public board member "clients".

In 1980, public pension funds had less than 30% of their total assets in equities.  In 1988 in was less than 40%.  Clearly the public funds have currently arrived.  At this point there appears to be a real leveling off in equity exposure over the last few years.  Are we looking at the fiduciary "fright zone"?  Let's put it this way, there is no way they are going to double their allocation to equities over the next ten years as they have done in the past ten.

Life Insurance Companies

Clearly this has been a dramatic little shift over the last six-plus years.  To be fair, very few insurance companies are loading up on equities for their own accounts.  What we believe you are looking at is the wonderful product known as variable annuities.  Translation: invested in whole or in part in stocks.  As you know, in these insurance contracts, it is really the buyer who is taking the risk in the equity market, not the company (or more clearly, not the company's profits).  How much higher this allocation goes is completely up to mom and pop America.  Who knows.  Americans have abandoned personal savings, believing the stock market will do it for them.  Maybe they will abandon the need for life insurance as surely the stock market would compensate.  We better watch it.  We just may die laughing (and wouldn't you know it, without a variable life policy to our name).  Crazily enough, life funds in equities in 1988 was less than 10%.  As with most assets, the public had to make sure values were really going up before they jumped in with both feet in the last 3-4 years.

Foreigners

As is often typical, foreigners have come a bit late to the US equity party.  Maybe they were just waiting for the trade deficit wampum before ponying up.  Foreign exposure to US equities is as high as it has been in almost two decades.  Can it go higher?  Sure.  If we keep exporting dollars like banshees, it may be a given.  Unfortunately, foreigners have to keep their eye on two spinning balls in holding US equities - domestic US equity market health and cross border currency movements.  

What all of this data suggests to us is that a number of major players in the US equity market may be getting pretty full right about now from an asset allocation standpoint.  Surely the rate of change of the rate of change in their appetite for equity exposure is and has been diminishing greatly over the recent past.  If the stock market continues higher, these entities would become natural sellers if they chose to maintain a constant equity exposure from here on out.  For the pension fund crowd, this seems a real and present possibility.  At worst, they are no longer buyers.  To us, this data suggests that a good amount of folks are already in.

Who's Next?... Wouldn't you know it, the one group we have not addressed yet is Main Street America.  The public has had a voracious appetite for financial assets over the past six plus years.  Up until 2000, everything has worked out just dandy.  This year is a bit different.  Have a look at the following table:

Equity Inflows through July 2000 and 2000 index performance through August.

So far in 2000, Americans have put more quarters in the equity pinball machine than any year on record (albeit the bulk of it in 1Q) and they have only ended up tilting the game.  Is the machine broken?  Where's the replay button?  Since the little softening in equity indices during 2Q of this year, flows have slowed down considerably relative to the 1Q average monthly experience.  By historical standards, Americans today have a significant amount of their financial and total wealth tied up in equities.  With correspondingly high debt and low personal savings, the question of where the next round of big public inflows is going to come from at least has to be asked.