Regular readers know that we routinely differentiate between cyclical market trends based on the business cycle fundamentals and investor sentiment (~2-5 years) and secular market trends (~10-20 years) based on longer-wave factors such as demographics, normalized valuations, and inflation.
This month’s Sitka Strategy & Research Insight will illustrate the difference between investor sentiment which helps to drive shorter-term cyclical bull and bear markets, and sentiment’s secular market counterpart: investor propensity to own stocks.
By tracking the propensity of investors to own stocks, we can gauge where we are in a secular market cycle and whether we have a tailwind of rising participation and greater prevalence of stock ownership ahead or a headwind of declining participation and a greater indifference toward stocks.
Lastly, will check in on two important markets and see why the secular bear market in U.S. stocks likely has more bite and why the secular bull market in yen-hedged Japanese stocks is just getting started.
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.
That is why, in the U.S., there is a well-documented relationship between market valuations (P/E ratio), and the ratio of 40-somethings (savers and stock buyers) to 60-somethings (spenders and stock sellers), called the M/O ratio. And because many demographic trends are already “baked into the cake,” it is highly likely that the generational shift coming with the retirement of the baby-boomers will create a secular headwind for stock prices by way of declining valuations.
It is also instructive to look at current allocations among households and pension funds (in which households hold a significant portion of investment assets) in stocks, bonds, and cash and how that allocation might change over time. A high (and likely to decline) allocation to stocks is a negative indicator of future returns as there are fewer incremental dollars to be allocated toward stocks and a low (and likely to increase) allocation to stocks represents an opportunity for future investment and returns.
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%. This is the direct result of a secularly diminished appetite for equities due to a lower propensity to own stocks.
Those who fail to see secular cycles are always comparing sentiment and valuations to the prior peak (i.e. this is not like 1999 or 2007, so it must not be a peak) and will routinely miss that intervening cyclical bull and bear markets experience a series of “lower highs” and “lower lows” in sentiment AND valuations– largely a result of a decreased propensity to own stocks across a large share of the public. For evidence of how low this willingness can get, let’s look at the Japanese experience.
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 decline in sentiment looks like.
While Japanese households ownership of equities has remained low for most of the last decade, it is important to note that according to the OECD, allocations in Japanese pension funds fell from over 27% in 2001 to approximately 9% in 2011, surely the sign of a more advanced secular bear market driven not just by demographics, but by a two decade-long response to a credit bubble and the resulting real returns to various financial assets.
These returns, and the diminished appetite for Japanese stocks, have created a different dynamic for the choices facing Japanese households and pension funds over the coming decades. As Japan also continues to age and faces a net loss in its working population, the immense household savings which have fed the Japanese bond market will soon turn into dissaving. That dissaving will not be coming from stocks, but instead from the Japanese bond market.
Well aware of these challenges, the Haruhiko Kuroda-led Bank of Japan, now set free under the aggressive 2-2-2 plan (create 2% inflation by growing the money supply 2x in 2 years) set forth by the election of Prime Minister Shinzo Abe will use its newly created money to pick up where the private buyers of JGBs will be leaving. The resulting inflation and potential capital losses in bonds, may force the remaining non-retiree Japanese investment class and pension funds to seek other options like equities, which not only yield more than the JGBs but are trading not much above book value and at average P/E multiples on depressed earnings. With the Nikkei showing some signs of life as the yen has declined, causing real losses to holders of JGBs, it won’t take much for the slow moving Japanese pension funds to start reallocating to equities. Additionally, global equity managers have been long underweight Japan, which itself only represents around 7% of global market cap.
However, this demographically driven change in asset allocation has even bigger implication for the yen and for nominal prices for all sorts of things, including stocks. As we’ve laid out in previous letters, we believe that Japan simply cannot afford materially higher interest rates given its debt and deficit position. Interest payments alone will quickly consume all revenues. Accordingly, the BOJ will be forced to print more yen to buy every JGB issued or in existence. The result will be a collapse in the value of the yen. So we need to consider Japanese stock prices and the yen in the context of other currency collapses, and look at how markets historically have responded.
In a nutshell, when a currency loses most of its value, i.e. an economy enters hyperinflation, equities tend to act as a claim on real assets (land, plant and equipment, foreign-denominated assets, etc.), which retain most, but often not all, of their value when a currency loses most of its value. So when a currency loses most of its value, equities can nominally rise in dramatic fashion even if business suffers, because the real assets of the companies retain most of their currency-adjusted value.
This is why Mexico’s stock market rose so dramatically in the 1980s as the peso lost most of its value, and it’s also one reason the Venezuelan stock market has quintupled over the last two years. During the 1970s and 1980s, as Israel’s consumer price inflation rate soared to 500%, stock prices rose by 6500 times. This rise was not nearly enough to keep up with inflation, as Israeli consumer prices rose by 10,000 times between 1972 and 1987, but it is another example of how nominal stock prices can rise dramatically during hyperinflation, even if they lose substantial inflation-adjusted value.
In other words, while the Nikkei trades near its underlying book value today, it likely trades at a substantial discount to the future yen-denominated value of its underlying assets, once the effects of the inevitable monetization of Japanese government debt is factored in. This is likely the main reason for the rise in Japanese stock prices over the past 6 months, and we think this trend of re-valuing the yen-denominated value of Japanese stocks has a long way to go.