Of Mountains And Molehills
Of Mountains And Molehills...As we move into the new year and 2010 forecast after forecast hits the Street, invariably the "mountain of money on the sidelines" argument is being put forth by more than a good number of Street seers and pundits as a rationale for bullishness on financial assets, and equities specifically. We've heard this same argument again and again for decades now. Invariably these seers and pundits are referring to money market fund balances in their so-called analysis. Don't get us wrong, over the last few decades we have seen record money market fund balances be created. But the fact is that if you go back to the early 1980's and move forward, there has virtually never been a down year for money fund balances straight through to 2002. Point-to-point from 2002 through 2006, money fund balances experienced no growth. But you also know that during this exact period, we experienced both a cyclical bull market in equities and a coincident multi-generational residential real estate bubble of incredible proportion. It's no wonder money fund balances did not grow as it's simply not often that we get a double barreled asset class movement as was the case from '02 through '06. But off to the races with growth in 2007 and beyond has once again been seen in money funds until just recently, punctuated by the safety trade movement of last year and early this. Of course once Bernanke and friends moved the Fed Funds rate to academic zero, dragging money fund rates with it, mom and pop investors have dutifully moved into bond funds in record amounts. Just as the Fed wanted, but ultimately to investor's detriment when generational low interest rates are no more. The point is that the theoretical "mountain" of money has been on a path of growth for three decades now. The mountain simply grows ever higher and analysts again and again point to it in each cycle as a rationale for yet ever higher financial asset prices (of course completely disregarding the issue of valuation in the investment decision making process using this logic). As we see it, if the mountain of money argument held significant water, we would never have experienced two instances in the same decade where the equity market was cut in half. The so-called mountain of money in money funds should have cushioned such an extreme historical outcome...but they did not.
The fact is that money funds have grown in popularity with a broad constituency of "players" as the decades have evolved. Conservative folks that two or three decades ago would only put their money in banks "found" the sometimes higher yielding money fund complex and shifted investment exposure. But for many former CD buyers who moved to funds, it's a good bet that money is never destined for equities. The corporate crowd found the fund complex long ago in terms of parking short term cash/working capital assets, etc. as money funds fit the bill - yield, liquid and often safety (govt. funds). You get the picture. The growth in multiple constituencies in money fund owners means there is a ton of money in the fund complex that is never destined for equities. But the analytical community treats money funds as if their owners were homogenous. They are not and that says to us generically pointing to money fund balances and suggesting it is fodder for equities is very poor analysis at best, and disingenuous at worst.
Anyway, we promise the remainder of this discussion will be long on graphics and short on commentary as the pictures tell the story. As opposed to looking at the money fund complex generically and drawing conclusions about fuel for potential equity investment, we'd rather take an analysis of "cash" by investor constituency. Just who are buyers of equities? Households, institutional investors, corporations (buy backs), etc. We want to look at them. Where are levels of cash by constituency relative to current market values? Relative to historical context?
One last quick comment before pushing off from shore. In terms of institutional cash levels, this week the Investment Company Institute reported equity and bond fund cash levels. Near 3.8% at present, equity fund complex cash rests at a level last seen in October of 2007. Relative to total historical context (data going back to the 1970's) it's a low number both in relative and absolute terms. The low in October of 2007 was 3.48%. Not quite a mountain at the moment, no?
Although we just got through telling you that we wanted to focus on constituencies, per se, we'll quickly start with a look at the macro. What you see below is the analytical "mountain of money" argument the Street conveniently uses. It's money fund balances as a percentage of the market value of equities. Again, so you know where this data came from, we've used the Fed's own Flow of Funds numbers for equity values and money fund values also as reported by the Fed. It's no wonder many a seer and strategist is so bullish, no?
Increasingly money fund balances have spiked in equity market corrections, the spike just becoming larger with each bear market (early 1990's, 2000 and over the past few years) episode. But we need to remember that with the recent spike in fund balances, many folks were simply seeking the apparent safety of government asset protection, clearly regardless of nominal yield concerns. And that continues to this day. Let's face it, how does one get close to a zero yield on 3 month T-bills unless safety was still a primary concern for at least a fair amount of investors? So we see the recent spike in fund balances and the ratio of money funds to equity values very much being driven by a run to safety from all asset classes over the October 2007-March 2009 period. That does not mean it will all flow back into equities. Not by a long shot.
Another meaningful macro in our minds is very simple - M2 relative to the value of the equity market. See the recent spike? That's both equities declining and our friends at the Fed juicing the liquidity (and their balance sheet, of course). But despite both of these anomalistic sets of circumstances, this ratio currently rests below its half century average of 75%.
Um, where's that mountain of money again?
It has been many a moon since we have looked at some of this data, so a quick definitional comment. You may remember that when we have historically calculated household "cash", per se, we've included every bank account, CD, money fund, and every single household bond holding (corporate, Treasury. Agency, muni, etc.). We stretch the strict definition of cash a good bit, but we are essentially trying to give the cash argument all the benefit of the doubt possible. Forget money funds, we're essentially assuming in this view of life that households would also be willing to liquidate all of their bond holdings (despite record current inflows to bond funds) in a heartbeat to theoretically plow into equities. And what we get as a historical ratio using this methodology is as follows.
We currently rest at approximately a 65% ratio when the average for the entire period for which we have data is 105%. Not exactly a mountain, but a very strong contender for a molehill. Over the last two years (since YE 2007) the combo of household cash and bond holdings is almost flat. The recent spike in the ratio seen above from under 50% to over 70% was driven by the decline in equity values, NOT a major increase in household cash/liquidity/bond holdings.
And why no spike in household cash in absolute dollars as of late? Simple. The household balance sheet deleveraging cycle, which is still in its early stages. Households are paying down and defaulting on debt in addition to increasing savings. We know by looking at the inflows to equity funds this year the numbers are negative, as there has been a net outflow. Flows into ETF's have been very positive, but on a net basis we believe it's fair to say the public has not been piling back into equities, despite the near meteoric rise off of the March lows to this point. Although it may sound a bit melodramatic, in an environment like the present where labor market conditions are unsettled at best, wage growth is zero to minimal and household balance sheets remain "offsides", so to speak, in terms of existing liabilities relative to a big decline in assets, it's only a natural that households husband liquidity. And even if households are unable to raise significant cash (liquidity), they at least forgo spending what cash resources they have. We believe this thought process is actually playing out as represented by the chart below. We're looking at household cash relative to total household assets. Remember the broad definition we have brought to the term "cash". Again, the recent big spike is due specifically to household asset value deterioration (financial assets and RE).
Interesting, no? Clearly from the late 1940's to the early 1990's, this ratio was incredibly stable within a roughly 2% point band. This band of experience was broken to the downside in the early 1990's, reaching its nadir at the top of the residential real estate and equity market cycle a few years back, but has recently returned to that forty year band of experience with the decline in equity and housing values. Does this really represent households raising significant cash balances? Of course not. It's the drop in the asset side of the balance sheet that has driven the reversion to the mean journey. Does this represent a return to some type of normalcy (although we hate that word)? For now let's just call it a change back to what was traditional household asset allocation historically. So implicitly analysts are suggesting perhaps households will allocate precious liquidity resources of the moment back to equities? That seems to be the argument. Personally, we just don't buy it given total household balance sheet circumstances playing out in the here and now. But that's our opinion.
You know from our coverage over the years that corporations have been meaningful buyers of equities. Of course this activity is caught up in both buyback and cash driven M&A activity. First, you may be familiar with the fact that recent corporate insider selling has been literally swamping buy activity. Personally, corporate insiders seem anything but bullish as we've seen recent weekly experience of 30:1 sell to buy ratios, or more depending on the week. But how are they treating corporate cash? If equities are in the bargain bin, shouldn't buyback activity logically be off the charts? In a period where top line growth is clearly a struggle, doesn't buyback and M&A activity make sense in terms of trying to advance the bottom line ball past the next first down markers? One would think so. Unless, of course, one is part of the current corporate sector. The following is simply an update of a chart we have shown you in the past. In the bottom clip we chronicle US corporate equity issuance and buyback activity stretching back three and one half decades. Just look at what has happened so far this year. And as we describe in the chart, this activity DOES NOT include the financial sector (who have been prolific equity issuers this year).
Of course the top clip of the chart chronicles the same equity issuance or retirement, but this time alongside is the rhythm of corporate debt issuance or pay down. Up until literally the last quarter 2009 marked the first year in many a moon where on an aggregate basis, corporations have issued both equity and debt. They are raising cash, per se, as opposed to spending it. It was just in the third quarter that corporate debt in aggregate began to contract for the current cycle.
And this is very much dramatic change in terms of corporate influence relative to the size of the equity market itself historically. You can see this in the next graphic depiction the historical magnitude of net equity retired by the corporate sector over time as a percentage of total equity market value. At market highs in 2007, corporations retired 3% of the total value of the equity market. Talk about a meaningful price support mechanism. Too bad they could not have waited just a few years when a lot of these equities could have been purchased at the 50% off sale, right? Admittedly, a meaningful portion of this prior period equity retirement is also attributable to the mini mania in private equity at the time.
As we see it, for now corporations are husbanding liquidity much as appears to be the case with US households. All one has to do is look at the current dynamics of corporate cash flow to get a sense for what we are talking about in terms of corporations acting to protect liquidity. Below is yet another chart courtesy of the historical Fed FOF data. Here we are looking at corporate internal funds generation less capital expenditures. A close proxy to net corporate cash flow? Yes, close enough to get the point across. The issue here is that corporations are not spending on cap-ex. No surprise at all as we have been chronicling this fact all year long whether looking at business surveys or the raw numbers in non-defense and non-aircraft corporate spending. Again, logical. Corporations would be spending if they saw investment opportunities that would exceed the cost of capital. The message is they don't. And wildly enough for the many, the cost of debt capital is near generational lows. That's a loud message.
Without trying to reach for melodrama, we've never seen anything like the above. On a hopefully positive note, does this tell us pent up demand for corporate capital spending will be a reality somewhere in the period ahead? 2010? We think so, but we'll just have to take it one step at a time as for now the corporate purse strings are largely closed for both cap spending and equity buybacks. Quite the opposite is occurring as we are seeing net equity issuance.
A final view of life in terms of "cash" at the corporate level lies below. This go around we're looking at the longer term ratio of cash at the corporate level as a percent of the total value of the equity market. The long term average rests at 68% and we're current sitting at 82%, comfortably above that average. But one more time, the change in this ratio over the last few years is a result of equities declining in value. The increase in the actual nominal dollar level of corporate cash since year end 2007 is an overwhelming 2.1%. Peanuts. Remember, we are including corporate fixed income holdings/assets as cash.
Okay, there you have it. You get the picture at this point. The "mountain of money" argument is certainly not completely without some merit, it's just it seems clearly not to be the big bull argument the Street makes it out to be. Although these are our personal opinions, some of the constituents of equity buyers that are households and corporations are not sitting on "mountains of money". Moreover, they are showing us directly in the data they are not in the spending mood, whether for capital expenditures, retail sales (currently resting at 2005 levels, as we have been chronicling), or equities. And in the bigger picture of broad money in the system that is M2, the numbers just are not that impressive relative to historical context. What does all of this tell us? There simply does not seem to be huge "pent up demand" for equities that would be funded by existing cash balances among many constituencies of equity buyers. That's the message. And what does this mean to the near term equity market outlook? To us it means more of a structural support that would be money potentially headed to equities simply isn't realistic. And as we see life, this says Fed/Government sponsored liquidity has been and continues to be the most important structural support. That and institutional momentum. As we move into the new year it's simply this that we follow. Simple enough? A gloomy view of life? We're simply searching for realism and trying our best to implicitly ask the age old question, "who's the next buyer?".