Household Equity Ownership: Direct vs. Indirect

In my post yesterday I said that retail investors are basically "out" of this market, at least directly, i.e. outside of their pension and other funds. One reader asked what the trend has been over the past few years, so here are a couple of charts. Data comes from the Fed's Z.1 Flow of Funds quarterly report.

Households' direct holdings of stocks peaked in 1999 and are now running at around half that level, while their indirect holdings through pension funds, insurance companies and various mutual funds are much higher and rising.

The total amount of equities currently owned by households is the same as in 1999, but direct ownership has dropped from 57% to 33% in 2006. The relative importance and decision-making power of institutional investors has increased greatly.

One consequence of this capital allocation shift is the phenomenal rise and empowerment of hedge funds ($1.5 trillion in assets), which now account for as much as 2/3's of daily volume in some markets. Such funds make great use of leverage through margin borrowing and derivatives, explaining in part why derivatives and "carry" trades have become so popular in the last few years.

There is also another, more qualitative, aspect to this development: institutions have very different investment behavior characteristics from individuals. First of all, it's not their money: if the ultimate owner wants his money back they have no choice but to liquidate positions. Second, they must always be invested: no one gives money to a manager to keep it in cash. Third, they are mostly driven by relative performance: jumping the gun on the competition is crucial. Put these traits together and you can see why institutions are always subject to the herd mentality.

The much maligned individual investor, on the other hand, is a very different kind of beast. Except for those rare delusional instances when they form a "crowd" (e.g. dotcom day traders in 1999-2000, China today), individuals actually act as shock absorbers to the institutions' excesses, exactly because they can decide and act on their own volition. They have the ability to zig when professionals must zag.

The individuals' much reduced direct exposure to the stock market perfectly explains what has happened since 2003 - the institutional herd got bigger and stronger and now rules the field. But this also points to something very worrisome: the individual's absence increases the risk of sharply higher volatility if/when market sentiment turns negative and the institutional herd runs for the exits. This lack of shock absorbers creates a systemic risk that no one is considering right now.

P.S. Today the PBoC did a monetary policy trifecta: It raised interest rates, raised bank reserve requirements and widened the yuan daily FX trading range. It's trying to cool down its economy, discourage rabid speculators and forestall US political pressure to impose trade sanctions. This is certainly much more than a warning shot across the bow, but will China's Golden Pig Year entrepreneurs and speculators pay any attention? They better, because it is becoming increasingly obvious that the authorities mean what they say.