A Most Unsettling Chart
Americans Have Never Been Longer Stocks
As I write, the SPX is sitting near all-time highs. Economic data has proved resilient, forcing doomsayers to either throw in the towel, or for the stubborn, project economic and market weakness further out. Throughout the most recent Federal Reserve rate-hiking cycle, the U.S. stock market has shown notable resilience despite facing multiple headwinds.
Beginning in March 2022, the Fed embarked on one of its most aggressive tightening campaigns in decades to combat the highest inflation in 40 years. The SPX peaked in January, and by October 2022 was down around -30%. From there, we’ve seen a blistering rally to reach today’s level, up around 60% from the lows. Much of this has been driven by exuberant hype surrounding the advent of Artificial Intelligence (AI), despite the fact some analysts think it’s overblown. But as they say, “never let the facts get in the way of a good story,” and stock markets rarely do. It doesn’t matter if a large part of the spending will be wasteful, the money is flowing, and the hangover is deemed a long way away.
Market hype gets overblown, many miss the boat, then chase, and once they’ve dragged in the last holdouts, there’s a huge selloff. So what? We’ve seen this movie many times before. But that’s not what we’re talking about today. If you were waiting for me to bust out the ugly chart, here it is below. (Chart 1)
Chart 1: Household Equity Ownership as a Percentage of Financial Assets
Chart 1 shows what percentage of household financial assets equities account for in investor’s portfolios in the aggregate. Some may have 100%, some may have 10%, but this is the average. As you can see from the chart, we are sitting at all time highs right now (42%), which is higher than the tech bubble 25 years ago. To any investors who lived through that, it should be a screeching alarm bell!
As I have mentioned before, extremes in positioning can set a market up for large moves. In the short run, this happens pretty frequently. However, major long term inflection points tend to take time to play out, like turning an aircraft carrier. As well, the catalysts are much more consequential.
Surely, there are those who will explain away this record allocation with comments like, “well, people are just comfortable owning more stocks than they used to be.” That may be true, but it’s unlikely to illuminate reasons for current positioning. Surveys on the economy, such as the University of Michigan Consumer Sentiment Survey (Chart 2), don’t exactly paint a joyous picture. Not only are recent readings well below the average, but they’re also closer to the early days coming out of the 2008 Financial Crisis than to periods where we had booming economies and stock markets. Are people choosing to carry higher equity allocations despite this grim sentiment? Seems a little hinky, don’t you think?
Chart 2: University of Michigan Consumer Sentiment
There’s no real mystery here though - we’ve covered this before. Chart 3 is the same as chart 1, but it also shows the Federal Reserve’s Balance Sheet. You can see that since 2009 there has been a strong correlation between the Fed’s Balance Sheet and what percentage of people’s portfolios reside in equities. The trend has been upward for both since 2009, with a few exceptions. The Fed started to shrink its balance sheet a bit around 2018, which coincided with a slight deceleration in economic data. But the Fed was already in expansion mode again by late 2019, even before Covid shut the world down in March of 2020. During Covid, the central bank quickly tripled its balance sheet, which caused the SPX to break to new all-time highs in late 2020 while the global economy was still reeling.
Chart 3: Household Equity Ownership as a Percentage of Total Assets with Fed Balance Sheet
Since inflation spiked close to double digits in 2022, along with rate hikes, the Fed has been letting maturing Treasuries roll off the balance sheet, causing it to shrink. But with $7 Trillion still there, which is double where it was pre-Covid, it’s safe to say the economy isn’t lacking liquidity.
Recently, the story being told is one of a resilient U.S. economy driving stocks higher despite rate hikes, because investors are feeling better about economic prospects. While that may be accurate in recent months, on a longer-term basis that narrative doesn’t mesh with reality. It’s unlikely people are actively choosing to make stocks a larger portion of their portfolios, but more likely stock prices have been driven higher by another mechanism, which is raising equity allocations passively. Otherwise, why are the percentages at record highs even though Americans have a dim view of the economy?
The answer lies in the mechanics behind QE. As the Federal Reserve is buying Treasuries in the open market, they are removing assets from the investable universe and replacing them with new money. Since investors now have a smaller amount of assets to buy relative to the amount of money in circulation, asset prices go higher. Bond prices go higher (interest rates lower), and in general, investors move out the risk spectrum as assets with lower risk (bonds) pay less and less. Ultimately, all asset prices go higher, including stocks. This happens outside of the normal interest rate policy which uses the Fed’s Target Interest Rate. It’s a direct infusion of liquidity, whereas the Fed’s Target Interest Rate only changes the marginal cost of borrowing.
All of this explains the record high allocation investors now have to stocks, but does it make the situation more benign? Maybe - maybe not. Some might argue all the Fed needs to do is just expand the balance sheet in times trouble. However, if long term inflation expectations rise, we could have a problem. 1970s style stagflation (low growth, high inflation) may materialize.
Monetary policy typically works with about a 9-month lag, and it’s been 2 years since Quantitative Tightening (QT) started. That would imply that only half of the tightening has taken effect. Of course, now the Fed has recently lowered rates, and signaling there could be more. But - they’re still doing QT!
So, it remains to be seen whether the balance sheet drawdown will start to bite at some point, or if the Fed has finally found the magic formula for soft landings. But at some point, probably not in the far distant future, markets will hit a rough patch, and volatility will start to pick up. When that happens, investors may start to look at their portfolios and think maybe their stock allocation is way too high. This doesn’t have to mean an imminent crash, but if the aftermath of the 90s tech bubble is any indication, it won’t be pretty.