Imagine the stock market as a national park with just three kinds of animals: bulls, bears, and pigs. The saying “bulls make money, bears make money, pigs get slaughtered” conveys the idea that one can be bullish or bearish and be successful depending on the market environment, whereas greedy pigs are almost always set up for catastrophe.
Over the course of secular market cycles, the number of “animals in the park” varies greatly. Near secular market peaks such as those found in the U.S. in 1929, 1965, and 2000– there tends to not only be a lot of animals in the park, but they tend to mostly be bulls, with a healthy pig population, most of whom have falsely conceived of themselves as bulls. The bears are in the park; after all, most of them are converted bulls who have come to believe the ride is over, but they are simply on the sidelines, or in hibernation, waiting patiently for better opportunities. Conversely, near secular market bottoms, such as 1920, 1942, and 1982, not only are there not very many bulls, and practically no pigs, there just aren’t many animals left in the park period. During true secular stock market bottoms, there just aren’t many interested parties around any more. It is not fear or greed which dominates, but total indifference. I guess that’s why nobody hears the bell go off.
Howard Marks off the mark?
I believe Howard Marks is one of the most successful investors around today and I always appreciate his clear-sighted and clearly written memos. I’m sure he would agree however, that his views are not infallible and I believe now is one of those times where he is missing the mark. In a March 13, 2013 memo titled The Outlook for Equities, Mr. Marks revisits his “three stages of bull and bear markets” to assess where the U.S. stock market stands in the behavioral continuum from bull to bear market. This type of analysis is essential as accurately assessing sentiment gives one insight into the relative eagerness of buyers and sellers– and which camp is likely to have a more dominant influence on prices going forward:
“the study of market history only makes us better investors if it teaches us how to assess conditions as they are, rather than in retrospect. (…) a year ago, it was my feeling that equities were in the first stage of a bull market. Experience had been so bad for so long– and the level of dinsinterest was so high– that only a few investors thought equities could ever catch on again. No one should say the likelihood of improvement is entirely unrecognized today, as would have to be the case for this to still be stage one. I think the existence of improvement is generally accepted, but that acceptance is neither extremely widespread nor terribly overdone. Thus I’d say we’re somewhere in the first half of stage two. (…) when attitudes are moderate and allocations are low, like I feel is currently the case with equities, there’s little likelihood of investing being a big mistake.”
Howard Marks is hardly the only one suggesting that skepticism is high, Barry Ritholz discusses in Exuberance? Euphoria? Hardly . . . the idea that “since 2009, this continues to the most hated rally in market history. Until that changes, I suspect it has farther to run.”
The fact is that apart from some data on pension fund allocations, which I’ll discuss below, anecdotes that skepticism is high, expectations and participation are low, cash remains on the sidelines and the like, are only anecdotes. Not only are they anecdotes that market bulls like to share with one another (don’t worry, us bears have our own anecdotes that help get us fired up too) but they can be uniformly refuted with quantifiable evidence about actual positioning of traders and money managers as well as sentiment surveys.
What Howard Marks, Barry Ritholz, and other very smart, experienced, and observant investors are missing is a structural or secular shift in what bull and bear market attitudes look like. When there is not only a cyclical continuum between fear and greed, but a secular continuum between indifference and prevalence, one must look at past long-term cycles both domestically and in foreign countries, to help truly “assess conditions as they are.”
Different, but similar
Of course, the bulls are right that sentiment today is not the same as it was at other market tops over the last 13 years. Day trading is no longer a national past-time, cocktail party conversations rarely center around hot stocks, and there are not many 27 year old sub-prime mortgage traders driving Lamborghinis. However, that is no argument that we’ll ever get to that kind of sentiment before stocks top out again. In fact, if we continue on down the line of this long-term bear market, the one thing we can expect is each successive peak coming with less exuberance than the prior one, until there is very little exuberance or interest at all, even when the market does rise. With that said, the currently quantifiable sentiment measures are certainly lop-sided enough to produce a major top concurrent with what John Hussman calls “over-bullish” conditions.
Mutual fund cash as a % of assets is near the all time low of 3.5% and at similar levels as 2007, 2000, and 1972 which saw subsequent declines of 46%, 43%, and 56%. Conversely, major market lows of 1974, 1982, and 1990 all saw mutual fund cash levels over 10%. The Wall Street Journal reported that number of bond funds which own stocks has climbed to 352 up 25% in the last year and the highest number in 18 years.
The net commercial hedger position in all stock index futures combined (inversely plotted) is now at a record dollar value of $55 billion net short. This means that speculators hold a record net long position valued at $55 billion, about the level of late 2006/2007.
The total amount of margin debt at NYSE member firms is back to near-record levels, reaching or exceeding peaks last seen in 2000 and 2007.
The correlation of long-short equity “hedge” funds monthly performance has risen to 0.9, meaning they are mostly betting on a market advance.
Additionally, various surveys of manager and advisor positions are showing elevated levels of bullishness. The National Association of Active Investment Managers sentiment survey, which asks investment managers whether they are long or short, hit a levered long position of 104% for the first time ever earlier this year and is just off that mark now.
A similar message is conveyed by the Hulbert Newsletter Writers Stock Sentiment survey
and the and Consensus Inc. % Bulls survey
Last, but not least, is the Barron’s Big Money survey, the cover of which featured a Bull on a pogo stick
Even so, the managers aren’t just bullish on U.S. stocks, but on equities generally. Some call it the TINA trade, for “there is no alternative” to stocks in a slow-growth, ultra-low interest rate world. Eighty-six percent of poll respondents are bullish on stocks for the next 12 months, and a whopping 94% like what they see for the next five years. Real estate has similar approval ratings.
As a reminder of what sort of indicator the cover of Barron’s featuring a bull might be, a picture courtesy of John Hussman is worth a thousand words.
In Barry Ritholz’s May 8th piece, Exuberance? Euphoria? Hardly . . . he writes
While I keep hearing some people claim there is an excess of giddiness, please excuse me for failing to see it. My frame of reference is the 1999-2000 top, and I certainly do not see anything remotely resembling that sort of sentiment…Remember the Dow 10,000 hats on CNBC? The insane expense accounts, lavish spending? The forecasts of Dow 36,000?
We’ll have to forgive Barry for missing the March 7, 2013 op-ed in Bloomberg, Market Record Shows How to Get to Dow 36,000 where the author of the now infamous 1999 book “Dow 36,000″ reminds us
From its low of 6,547 on March 9, 2009, the Dow has risen 117 percent. Another 117 percent in four years would put it at 31,022, just 16 percentage points shy of the magic number.
You can judge the author’s logic and credentials for yourself, but I can’t resist to mention that he is the Executive Director of the George W. Bush Institute, the standards for analytic rigor being what they are.
Yet despite all this quantifiable evidence that sentiment is well entrenched on the bullish end of the spectrum, something is clearly different. Individuals, the so called “mom and pop” investors just don’t seem to be participating, the “wealth effect” of rising asset prices does not seem to be driving economic growth, and overall interest in the finance market “game” just isn’t there. This is what Howard Marks, Barry Ritholz and others are seeing and if they are waiting for a return to the same prevalence of bullish sentiment, they will be waiting for a very long time.
Secular markets: from prevalence to indifference
Secular market cycles are driven by many things including demographics and generational attitudes towards risk and investing. Stock market valuations, and thus stock market returns, are driven by the propensity to own equities. The propensity to own stocks is driven by a large share of folks in their peak earnings and savings years AND a favorable view of those folks towards the benefit of owning stocks. In other words, if a large share of the population has sufficient savings to invest and have mainly only experienced bull markets with above average returns, they will continue to invest incremental savings into stocks. Conversely, if a larger share is retiring and spending down their investment assets and/or are no longer enamored with the returns they have been receiving, they will continue to sell their stocks and move out of the market.
This is why there is a well documented relationship between market valuations (P/E ratio), and the ratio of 40 year old (savers and stock buyers) to 60 year olds (spenders and stock sellers), called the M/O ratio.
It is instructive to look at how households and pension funds (in which households hold a significant portion of investment assets) allocate among stocks, bonds, and cash and how that allocation changes over time. I think most would agree that a very high allocation to stocks is a negative indicator of future returns as there are fewer incremental dollars to be allocated toward stocks and that low allocation to stocks represents an opportunity for future investment and returns.
Many investors and commentators point to the decline in stock allocations among US. pensions and households over the last 13 years as evidence that there remains a high degree of skepticism and money on the sidelines that will find its way into the market. One such chart, courtesy of Barry Ritholz, shows the asset allocation survey results from the American Association of Individual Investors which asks what percentage investors are allocating to stocks.
This chart shows the relative weighting to equities from the “historical average”– 1987 to date of 60%. What the chart does not show is that the “average” is always changing and in the case of the last 13 years, it is declining, just as it was rising during the 1990′s. Thus, today’s roughly 63% allocation for these folks may actually represent an overweight to a new future average which could be quite lower. How much lower? Let’s look at some data from the OECD on household assets and pension fund allocations.
Direct ownership of U.S. equities represents approximately 32% of household assets. When we add mutual and pension funds (likely a blend of stocks and bonds around 50%), we get a total right around 50% of financial assets allocated to equities in one form or another. Compare this to 2000, when, according to the OECD, direct ownership of stocks alone accounted for 50.1% and the net allocation to equities was closer to 65%.
Contrast these levels of stock ownership with a country like Japan where total equity allocations are below 10%. Japan is real-time evidence of the power of a secular indifference to equities that spans a generation with a low propensity to own stocks. This is what a secular low for sentiment looks like.
Note the wide variation of asset allocation inside of pension funds around the globe. For example, according to the OECD, from 2001 to 2011, pension fund allocations to stocks fell in the U.S. from 54.6% to 48.1%, which may be a sign of the first leg of a secular bear market, whereas allocations in Japanese pension funds fell from over 27% to approximately 9%, surely the sign of a more advanced secular bear market driven by demographics and a two decade long response to a credit bubble .
An excellent report from the McKinsey Global Institute “The Emerging Equity Gap” highlights how asset allocation has trended over time in various countries. For example, at previous generational lows and subsequent secular bull markets in the U.S., allocations to stocks stood between 25% and 35%, a full 1/2 to 2/3 lower than the previous bull market peak. Similarly, Japanese household equity allocations have dropped over 2/3 from the peak in 1988, from 31% to under 10% today. So if history is any guide, we can expect a further move away from equities in the U.S., much greater than what we have seen so far.
Data from the Investment Company Institute (ICI) and others supports the view that what we are seeing is not simply a cyclically diminished appetite for equities, but a secular or structural one which will only be healed with passage of time and a restoration of value in the markets, as opposed to a continued rise which is what market bulls seem to be looking for. Ordinarily, and particularly during secular bull markets, there is a positive correlation between market returns and fund flows. That is why Howard Marks, among others, observes “a move upward can be powered by a switch from the fear of losing money to the fear of missing opportunity.” However, since 2009 in a rally that has produced triple digit returns, we have seen a net cumulative outflow from equity funds.
The idea is supported by attitudes and actions of investors across generations as reported in a variety of recent articles:
- among 401(k) participants in their fifties in 2001, 46% had more than 80 percent of their 401(k) accounts invested in equities As of 2011, only 25% of 401(k) participants in their fifties had more than 80 percent of their accounts invested in equities. (ICI)
- in a survey of nearly 1,000 Gen Y investors with more than $100,000 worth of investible assets, 52% of the respondents agreed with the statement: “I will never feel comfortable investing in the stock market” vs 23% for all age groups, and collectively held a 33% allocation to cash, more than any other age group. (MFS Investment Management)
- in a survey of approximately 600 higher education employees across Generation Y (ages 21-32), Generation X (ages 33-46) and Baby Boomers (ages 47-65), younger employees were found to be using the same asset allocation strategies as their older counterparts, with Gen Y using a similar asset mix (50% stock, 35% bond/annuity and 15% cash) as Gen X and Baby Boomers. (Fidelity)
Finally, in a study titled “Depression Babies: Do Marcroeconomic Experiences Affect Risk Taking,” Ulrike Malmendier and Stefan Nagel found that people who have experienced low stock-market returns throughout their lives are more pessimistic about future returns and subsequently less likely to invest in stocks. Given a shorter frame of reference to draw on, young people are especially prone to making decisions based on recent events. While the memory of past events fade over time and are replaced by new experiences, the researchers use periods lasting 20-50 years to find a correlation between past return experiences, future expectations, and stock market participation.
Stop and imagine for a minute what it is like to be a 35 year old saver. You became of aware of the market just as it was peaking (you may have even bought JDSU for $330/share from your dorm room in 2000 as I did) and have seen the ugly side of two bubbles, but fortunately have had very little savings to put into the markets. You have watched the value of your parents retirement portfolio stagnate and their U.S. stocks lose real purchasing power over the last 13 years as they push off the prospect of retirement. You have seen evidence of significant fraud and malfeasance as well as general greediness and ineptitude that accompanies every period of market excess. Add to that general mistrust, a lack of confidence in Wall Street bankers and those in Washington charged with overseeing them, a debt and deficit profile that reduces the prospect of receiving material support from social security, coupled with rapidly expanding income inequality benefiting the top 1%. Now that you’ve finally paid off that college debt, bought your first house, and have an expanding pool of savings, what are you going to do with it? Day trade the market and compete with high frequency traders? Hand it off to a financial services industry, that has hardly been the beacon of fiduciary duty, to compete for meager or non-existent returns after fees and taxes?
In summary, what we are seeing today is a “lower high” in the downward trending interest in stock market investing. Interest and sentiment likely peaked with bubble in 2000 and has experienced several cyclical lows and peaks over the last 13 years and will continue to make lower lows and lower highs until the secular bottom is finally in.
Bringing it all home: what a true market bottom looks like
At Sitka Pacific Capital Management we are often asked why we do not think the March 2009 low will prove to be the beginning of a new secular bull market in stocks lasting a decade or more. While the low around 666 on the S&P 500 could very well mark the nominal low in prices, we believe the stock market valuations will continue to decline as the challenges presented by demographics, deficit spending, and debt lead to higher inflation and much lower participation in the markets. Lower valuations, measured in a variety of ways, have accompanied every secular stock market bottom that we have studied both in the U.S. and abroad over the last 200 years and we expect this time to be no different.
A few signposts of a durable secular market bottom include generational disdain for stocks among tomorrow’s savers with a corresponding low allocation, a total lack of interest in the market, and valuations that reflect little hope for future value creation. These valuations have historically been below 10x normalized or cyclically adjusted P/Es, whether reported inflation and interest rates are high (as in early 1980s) or low (as in early 1940s) with stocks trading around book value, and cheap relative to real assets like gold and commodities. Some stock markets, like that of Japan, are much closer to this point, while others, like the U.S. are very far off indeed.