Friday, May 18, 2007

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.


  1. H -

    Thank you so much for your answer to my question from yesterday. I admire your acumen, diligence and your ability to see through all the noise and to teach well.

    You have helped with the first part of my question about what the trend line has been for the individual investors.

    But the second part of the question is still there. Namely, what are your thoughts on why the pack of individual investors has given their money to the big boys.

    Is it an awareness that that's where the best returns are? Or that they recognize that it may all be a rigged game ultimately and because of that they can't effectively compete?

    If so, will they be the proverbial canaries in the mine...when they withdraw their monies to much more conservative funds it will be a powerful message. That's providing they are monitoring their funds, etc.


  2. One answer may be the burning individuals got in the 1999-2000 mania made them turn to pros for managing money.

    Another is more complicated and I think closer to the truth: as pension funds get increasingly underfunded vs. actuarial requirements they assume more risk, i.e. buy more stocks, thus increasing the portion of equities attributed to them.

    I think corporations are part of this game, too. In order to boost their stock prices they get their pension funds to buy their stocks. Not always their own, as in the case of Enron, but crony capitalism is very strong across all corp. boards. You scratch my back, etc etc

    One more reason: as you saw in the post that broke down stock ownership across wealth classes, most stock is owned by the very top 5-10%. They are the wealthy investors that provide the money for hedge and private equity funds. This is a form of pooled "crony investing".


  3. Again, thanks for your thoughtful input.

    Nastiness within nastiness, even when well hidden, is so sad...sigh.

    Be well and I hope you have a good weekend


  4. Reality always intrudes on fantastic realities, and the day of reckoning for all markets, the U.S. and China's will arrive in this most aptly named, year of the pig.

  5. It is pretty clear that the run up in housing values was an effect, or an outright method, of maintaining the economy after the tech bust. Now stocks and t bills are being pumped up by central banks to compensate for the house boom. Next boom after stocks bust? Commodities? The effect? Foreclosures, ruined pensions and inflation. The yuan floats - our imports get expensive again and China can afford to buy more commodities. It is looking very grim in the medium term for the middle class. Health care will be an obvious target for anger over rising costs, as will gas and diesel/heating oil. People will be stuck out in the suburbs driving their ford expedition on $5/gal gas, and prices at Walmat have gone up 20%, while wages have stagnated.

  6. ok for all of your arguments except this one : in Q1 GDP growth was about 0.8 % and Q2 should be about the same. however profits for the companies listed in the SP 500 were up by 9 % in Q1. Why not expect another quarter of 5 - 9 % profit growth sufficient to support the SP 500 ?