I’ve been captivated for days by the chart below, which illustrates household equity allocation. What puzzles me most is the simplistic conclusion that this allocation signals the end of the equity rally. I, however, have a different interpretation—one that I believe offers a more robust explanation.
The chart shows that the equity allocation of US households has risen towards 60 percent. The last time stocks had this much weight in the average retail portfolio was during the ‘Dotcom’ bubble. Based on that one red circle, there is now a massive conclusion that a stock market crisis is imminent.
But that, of course, is nonsense. First, the equity allocation has been at these levels before, and for a period of some 10 years. Between 1955 and 1965, households invariably had 55 percent of their portfolio in equities. You know, the outdated 60-40 principle. During those ten years, the S&P500 Index rose by just over 6 percent a year, excluding dividends. Those are not returns that come with a crisis.
And that’s not all. During 1965-1985, when households structurally lowered their equity holdings, stock prices rose by over 5 percent a year, again excluding dividends. So predicting a stock market crash on the basis of one red circle is, to put it mildly, ‘bold’.
Yield, baby!
The reason why equities were largely sold off between 1965 and 1985 is simple: interest rates. The average 10-year US interest rate was above 8 percent during this period. Moreover, interest rates rose steadily, from 4 percent in 1965 to peaks above 15 percent in the early 1980s. Why invest in risky stocks when you can get 8 percent on ‘safe’ government bonds?
Interest-free
And that brings me to my alternative explanation of why household equity weights are historically high even now. At the time of writing, the 10-year US Treasury Yield stands at 3.83 percent, not even half the average interest rate over the 1965-1985 period. Given the recent inflation spike, it is impossible to argue that interest rates are currently high.
Good vs. bad capital
What is high, however, is the amount of debt. The US debt (government) ratio currently stands at 122 percent. Between 1965 and 1985, the same ratio was less than 35 percent. Over the past 40 years, the mountain of debt has more than tripled. And while MMT adepts stubbornly maintain that Treasuries are a nice asset on anyone’s balance sheet, the reality is more stubborn. At current interest rates, who wants those bonds on their balance sheet?
Besides an inflated debt ratio, the US budget deficit is invariably above 5 percent of GDP. Government bonds are extremely abundant, while stock buybacks are at record levels.
So you have an overwhelming amount of debt, while companies are buying back their own shares (read: capital). This translates into a form of Gresham’s law - bad money drives out good - but with the focus on capital. Equity becomes relatively scarcer, and investors start ‘hoarding’ it, although that may not be quite the right word. In any case, this relative scarcity is reflected in households’ rising equity allocation.
Leaving aside the fact that you cannot draw conclusions based on one internet bubble, it seems obvious to me that equity is rapidly becoming more attractive relative to debt, or debt. And it seems equally evident to me that investors are capitalising on this. For example, I have exactly zero bonds in my fund portfolio.
Jeroen Blokland analyses eye-catching, topical charts on financial markets and macroeconomics in his newsletter The Market Routine. He is also a manager of the Blokland Smart Multi-Asset Fund.