Flow of Funds Data Indicate Underwhelming Sentiment Towards Equities and Overwhelming Towards Fixed Income
A Tale of Two Asset Classes
“Just as we have two eyes and two feet, duality is part of life.” - Carlos Santana
The stock market has continued to post new highs ever since 2013, when the S&P broke out of what had been up until that point a sideways move since 2001. In order to qualify the rally and uncover potential excessive levels of exposure by the public we look beyond the obvious culprits of buybacks and analyze the public’s exposure to stocks and bonds as well as the flow of new cash into pooled investment vehicles. We find counterintuitive evidence that supports the thesis that signs of excess or a late cycle bullish phase of euphoric public participation are lacking.
According to the balance sheet of US households and nonprofit organizations, provided by the Federal Reserve, 6.5% of their financial assets are accounted for by credit market instruments as of Q2 of this year, of which 2.2% is in US treasuries.
Also, stocks account for 20% of this constituency’s financial assets at the end of Q2. Putting this number in a historical perspective, we find that household ownership of stocks in 2000 was higher at 25% of their financial assets. Before then, that share reached a high of 28% in 1968, which was before the onset of the stock market rout of the 1970’s that saw the S&P go nowhere that decade and decimated sentiment (the so called Nifty Fifty market environment of the seventies). As of 1979 directly held stocks accounted for only 10% of US households’ financial assets. Finally, the share of US households with ownership of stocks has been stable since 2000 at around 50%.
Apart from stocks, bonds and cash, which as of Q2 stood at 14.5% of financial assets, mutual fund shares accounted for 10% of said assets, a marked increase from 7.8% at the start of the decade. The ubiquitous nature of such pooled investment vehicles in both the equity and credit markets represent indirect forms of ownership of both asset classes. We attempt to gauge how public sentiment is leaning vis a vis the asset classes and turn to the Investment Company Institute (ICI), which provides the disaggregation of investment flows into funds in each asset class.
The ICI, a global association of investment companies that promotes adherence to high ethical standards and financial literacy, compiles authoritative data on flows and assets under management for most of the offerings by investment companies (open ended mutual funds, closed end funds, unit investment trusts, etc.). Chart 1 shows the flows of net new cash for all funds with mandates in the two main asset classes: domestic equities (US) and taxable bonds. Funds whose mandate is to invest in domestic (US) equities have experienced net outflows which stands in contrast to the bullish bias the stock market has had during that same time frame. Net new cash flows for long-term (active) mutual funds from Q1 2010 to last October amounted to -$1.5 Tn worth of outflows. Further disaggregation of the ICI flow data shows net new cash flows for these funds’ brethren: the (mostly passive) exchange traded funds (ETF’s).
This is where things start to look salacious.
Net new cash flowing into US equity ETFs from Q1 2013 to October 2019 have been resolutely positive: $1 Tn worth of inflows, contributing to a 259% increase in their market value from $402 Bn in 2010. These US equity ETF inflows are of a comparable level of magnitude to the outflows from long term (active) mutual funds. In fact, their corresponding flows are almost a mirror image of each other, with a sign inversion (Chart 2). It is therefore safe to surmise that a reallocation of financial assets has taken place within the equity asset class, from long term (active) mutual funds to ETFs. No doubt market action had a lot to do with the increase in mutual fund ownership of households as per the number form the Fed cited earlier.
The ICI flow data for bond mutual funds tells a different story. If one were living in a desolate island and the only news that arrived from the mainland came in the form of a note in a bottle that read that flows into bond mutual funds AND ETFs since 2013 were positive and of the order of $1.1 Tn, one would think that interest rates were on a tear and a massive treasuries rally was underway (Chart 3). Well, there has been a rally but to say that it has been massive would be an overstatement. In fact total returns for Bloomberg Barclays US Treasuries index have been dwarfed by the returns from the S&P 500 (see chart 4).
The conclusions we can distil from our analysis are two fold (and points towards potential future areas of further research). Firstly, households have undertaken an aggressive repositioning between long term mutual funds (active) and ETFs. This repositioning has, in turn, not been commensurate with high inflows into equity funds (mutual funds and ETFs combined) or higher ownership of stocks. In other words, the share of the pie has been divided up differently between mutual funds and ETFs, but the size of the share has not changed. Secondly the market participants seem to have discovered the virtues and benefits of fixed income markets: investors seem to have found solace in the fact that bonds, barring major sovereign defaults, pay back the principal, a simple lesson learned the hard way and continues to resonate in the post Great Recession world. Moreover, households have benefitted from the convenience and efficiency offered by dedicated fixed income funds as a way of gaining a foothold in the asset class.
But with the S&P 500 total returns index up 346.5% since 2010 vs. 136.8% for US Treasuries, the question of whether US equities are at the proverbial “ninth inning” or are yet to see their day in the sun is a non-trivial one. Sentiment based on the preceding flow of funds analysis would indicate that the game is far from over and stocks are poised to continue to surprise to the upside over the medium term. But it is worth noting that this was an exercise focused on the asset side of households’ balance sheet.