The all-time closing high for the Dow Jones Industrial Average was reached two years ago today at 14,165.53. While we remember it well, the memory is more likely to fade between now and the lengthy period of time it will probably take to return to that level. Structural changes to the economy, a shift in risk attitudes across entities, and demographics that favor ownership of less-risky asset classes mean that any move back to the all-time high will more likely be a grind than a leap.
This is hardly a challenged prognostication given all that has happened in recent years and in light of the fact that investors have shown for nearly a decade that their days of irrational exuberance are over.
In its place is a more practical and thoughtful style of investing, one that fits both the times and the needs of individual investors. This means that households will be more long-term minded than they’ve been the past quarter-century and they will avoid casino-style investing and the many pitfalls that go with it. Investors will do this by placing greater emphasis on both the secular forces that shape economies and markets, and on personal financial goals.
Since 2000, Households Have Steered Clear of Equities
When the stock market peaked two years ago, the household sector had less to celebrate than it did in 2000 when stock prices saw their last major peak. Households in-between the two peaks had learned lessons that generations of investors had learned since Tulip Mania in the 1630s. Investors realized after the financial bubble burst in 2000 that investing a large portion of one's assets in one asset class was not wise, especially after having done so with little regard to long-term fundamentals. Data to support this claim are plentiful, and they show that investors on the aggregate have matured, both literally and figuratively. Specifically, data from the Federal Reserve's Flow of Funds report show that since the financial bubble burst in 2000, households have shrunk their stock holdings as a percentage of their financial assets. In addition, households have become a far smaller share of the total value of equities outstanding.
To be more precise, data from the Federal Reserve’s Flow of Funds statistics indicate that at the end of 1999, the household sector directly held $10.050 trillion of corporate equities, or 51.7% of the total market value of stocks. When the bubble burst, the household sector fled, such that two years later the tally was down to 43.6%. In 2004, the figure fell to 39.5% and the tally has not gone back above 40% since then, hovering around 37% the past three years and at the end of the first half of this year.
As a share of the household sector’s financial assets, equities are also playing a smaller role. In 1999, 20.3% of the household sector’s $34.5 trillion of assets were directly held in corporate equities. Two years later the tally was down to 13.5%. At the end of the first half of this year it was down to 9.3%.
These data clearly show a more conservative style of investing, which was evident in the decline in the price-to-earnings ratio of the Standard & Poor’s 500. It steadily declined after the financial bubble burst, to between 15.0 and 17.0 in the several years leading up to the recent financial crisis, from the upper 20s in the years before the financial bubble burst. Irrational exuberance moved from the equity market to the housing market, it seems.
The idea that households will invest more conservatively in the years ahead is strongly supported by the above and by the fact that the U.S. population is aging. On my first point, I ask rhetorically: doesn’t it seem likely that if households because of the shock they received in 2000 stayed nimble about investing in equities (even as equities rallied into 2007) that they will remain nimble following recent events? Moreover, won’t the aging of the U.S. population play a role in keeping it this way? Aging Baby Boomers certainly seem likely to be more conservative about their investment approach and construct a portfolio that is both diversified and one that contains fewer risky assets than in years past.
None of this is to say that equities won't rise in price; they probably will--as usual, in-line with the growth rate in corporate profits, which in the first half of 2009 was 10%. Cost-cutting was the driving force behind the earnings gain, and such could drive earnings for a bit longer, which leads to a question of sustainability. Ultimately there need be a handoff from inventory- and fiscal-led stimulus to more sustainable sources of demand. Gains in equities and other risk assets can through endogenous forces provide a spark and ignite more sustainable sources of demand, but the winds working to prevent the fire from catching on remain formidable.
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Tony Crescenzi is Senior VP, Strategist, Portfolio Manager Pimco. Crescenzi makes regular appearances on financial television stations such as CNBC and Bloomberg, and is frequently quoted across the news media. He is also the author of "Investing from the Top Down," "The Strategic Bond Investor," and co-author of the 1200-page book "The Money Market."