By looking at money flows, you can often discern investment opportunities that aren't always obvious otherwise. We all know what happens when a theme becomes widely embraced and followed by the herd: It almost always ceases to become valuable. Perhaps money can still be made, but not without a much higher degree of risk and concomitant volatility.
I prefer getting in when the investment climate is serene and there's ample time for decision-making. Most important, I want to be able to avail myself of the low-hanging fruit, so to speak, then sit back and watch when the crowds inevitably begin scampering to those fragile, shaky, high branches, grasping for whatever's left. In those times, I know that my fruit has become a lot more valuable.
Which way is the tide turning?
As a contrarian, I look at the concept of money flows a little bit differently. You've probably heard the old adage "Go with the flow." Well, to some degree, that's good advice, but let me delve into the saying a bit by describing flows in terms of the ocean and the tides.
At slack tide, the water level on the beach is at its lowest point, although it had been receding for six hours before that. To put it in an investment perspective, slack tide is analogous to the bottom of a market cycle or a period of extreme disinterest in an asset class on the part of investors, as measured by how much money they're willing to commit to it.
In contrast, high tide is just the opposite. At high tide, the ocean is heaving waves far up on the beach. Spray, foam, and roaring sounds are everywhere. The calm, tranquil, and serene environment of slack tide has given way to the raw power and chaotic fury and energy that is high tide, but this didn't occur instantaneously -- it happened over time.
Think of the stock market in 1999 until the ultimate peak in 2000. That would be an investment market version of high tide. Or perhaps you could ascribe that example to commodities today.
I like investing when the tide is slack. It gives me time to reflect, and that makes my decision-making less prone to error. I can also get in before the crowd, and that means I'll encounter lower volatility and risk. I just have to be patient.
Analyzing the flows
Recently, I combed through historical data from the Federal Reserve's Flow of Funds Report, also known as the Z1 report. This report is released every quarter and contains an absolute wealth of information on the overall financial position of this country -- covering households, businesses, the government, and the financial activities of foreign visitors.
The goal of my research was to try to see what investors have been doing with their money over the past 10 years. I took a look at money flows into and out of the three major asset classes: stocks, bonds, and real estate. All three tend to compete with each other for investor dollars to some degree. In other words, when some are hot, others are not -- and vice versa. Moreover, if you understand that most investors go with the flows rather than anticipate them, you can design a long-term investment strategy that gets you into an asset class when it's cheap and out when it's dear.
Let me mention one caveat before I break out the numbers: Timing is still everything, and if you're a value investor, it's almost an absolute certainty that you'll see these developing trends and hitch your cart to them before they start to turn in your direction. The good news is you'll be buying extreme value, and the risk to your portfolio is therefore likely to be very low. The bad news is that you may have to be patient and wait awhile.
A financial snapshot of America
Here are the numbers that you've been waiting so patiently for. First, let me give you a sort of big-picture financial snapshot of American households. They're doing fine and dandy, thank you very much. Their total net worth, which, of course, is assets minus liabilities, is a staggering $54 trillion. This is an all-time record and more than $10 trillion above the previous high-water mark set in the first quarter of 2000 when the stock bull market hit its peak. (It also takes in account the equity in people's homes rather than just declared or presumed market value.)
Now, let's consider the investment flows for the three major asset classes. First, I'll begin with real estate. The data shows that households held $9 trillion worth of real estate in 1996. That climbed to $11.5 trillion by the end of 1999, coinciding roughly with the time the stock bull market was peaking. When stocks finally did their about-face in the first quarter of 2000 and things began to get ugly, investors ran as fast as they could and put more of their money into real estate. Purchases soared. By the first quarter of this year, real estate holdings had nearly doubled to $22 trillion! In other words, over the past six-year period, nearly $11 trillion has gone into the real estate market, compared with just $4 trillion that went in during the entire decade of the '90s. (Let me ask you a question: Do you think this is a high tide or low tide?)
Contrast this with stocks, which have become the second-largest asset holding of households. In 1996, investors held $9 trillion in corporate equities either as a result of direct ownership or through shares of mutual funds. You may recall that 1996 was the year that former Fed Chairman Alan Greenspan uttered his now-infamous "irrational exuberance" remark. However, the Dow Jones was only at 6,700 and still had a long way to climb. And climb it did, as investors poured another $8 trillion into the market over the ensuing three years. At the peak in 1999, American households owned $17 trillion worth of corporate equities -- $3 trillion more than the amount they had invested in real estate.
And not surprisingly, by 2002, when the Dow was bumping along at 7,400, households had reduced their stock holdings to a paltry $995 billion. (How's that for slack tide?) More than $7 trillion had exited the stock market, and most, if not all, went into real estate. (I was buying stocks like crazy in 2002.)
As these violent convulsions between stocks and real estate played out, investor attitudes toward bonds can only be described as apathetic (for American investors at least). At the beginning of 1997, households held $900 billion worth of U.S. government securities (bonds, notes, bills, savings bonds, etc.). Today, that number is down by nearly half to $464 billion, and in 2002, American households held a paltry $290 billion in government securities.
Curiously, the Fed funds rate at the beginning of 1997 was 5.25% -- the same as it is today. But the yield on the 10-year Treasury note was 6.6%, or more than a full percentage point above the current yield. That could explain some of the tepid demand for bonds at the moment.
So, what does it all mean? My analysis tells me two things: First, by any measure, a massive tidal wave of money went into real estate when the stock market bubble burst back in 2000. This has been ongoing for the past six years and may just now be subsiding. So while real estate should always be considered as part of an overall investment portfolio, it appears to me that it will be an underperforming asset for some years to come.
Second, while the stock market's recovery can by no means be described as still in its infancy, it has the potential to go further. As real estate languishes and as long as interest rates and unemployment remain relatively low, I fully expect that we'll see the prior high-water mark of equity holdings by households ($17 trillion) surpassed. That's another $3 trillion or more that should go into stocks, and I think that could push the Dow up another 1,000 to 3,000 points. When that happens, you'll know it's high tide.
Oh, yeah, while bond holdings have come up a bit since 2002, I think the best opportunity is in shorter-dated maturities. Not only have they been hurt by the Fed's 26-month rate hike campaign, but they also appear underowned relative to historical levels.
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