All You Had To Do Was Wait (Grant)

Tuesday, July 10th, 2012

From Mark Grant, author of Out of the Box

All You Had To Do Was Wait

“What makes people so impatient is what I can’t figure; all the guy had to do was wait.”

-Ken Kesey

It was approximately twelve months ago that I called for a U.S. ten year at 1.25%. The yield back then was around 2.25%. We are a scant 26 bps from my prediction now and we have seen a 75 bps drop in yield during this time period. This has been fueled by the continuing “moments” generated in Europe and the demand for anything having some sort of safe haven status. We now have a second driver which is the recession in Europe and the substantial slowdown in the economy of China which I predict will place America in recession by either the fourth quarter of this year or the first quarter of the next.

The American stock market, always myopic in its view, is about to be hit by what it does pay attention to which is earnings. Europe represents 25% of the global economy and the recession there is about to have a very substantial impact on the revenues and profits of many American corporations. It was inevitable, as hindsight will expose, and now as our earnings season gets underway it will get documented in the numbers. If you don’t delight in losing money you will find that the yields of many senior and subordinated corporate bonds far outpace the returns of dividends and certainly the depreciation in value will be far less. Further, in times of economic stress, it is far safer as has been proved time and time again to be towards the top of the capital structure in bonds rather than in the bottom of the capital structure which is equities.

I can report a wide array and a great diversification of viewpoints on just what will take place in Europe but what also can be said with certainty is that most institutional investors all agree that there is a lot of risk on the table now. As part of this process I also wish to congratulate the media. Many commentators in the Press or on television are no longer willing to take the official press releases as fact. There are more people who are not only questioning the headlines but who are looking past them in trying to decipher not only their accuracy but there meaning. I suppose this has occurred by one announcement after another coming from the Continent that was so shaded and so misleading that eventually people woke up to the fact that inaccurate data was being provided and being provided in a systemic fashion. Then there is the timeline issue where plans are tossed out, do not materialize and are being held to account as mollifying statements that somehow never seem to achieve their goals. Whether it was the statements of the IMF and the EU that the new structural plan for Greece would produce a debt to GDP ratio of 120% or the giant firewall that would prevent Spain or Italy from ever needing to be bailed out or the bailout for Spain which their Prime Minister called “A Great Victory for Europe;” the cries of “wolf” are falling on less and less accepting ears.

“The secret of being a top-notch con man is being able to know what the mark wants, and how to make him think he’s getting it.”

-Ken Kesey

It may work, for a moment, to rally equities after the next new piece of sliced white bread is announced but then the reaction flattens out and then the market declines as reality sneaks back in and finds its rightful place at the table. From the very beginning with the first European bank stress test which counted what Europe wanted to be counted and ignored what should have been counted to the second one which was falsified by its methodology; results begin to occur and calamities begin to happen, such as with Dexia, as the real data forced what the phony data reported tried to hide. Europe may cook the books and allow for risk-free assets or the Spanish central bank may allow for “smoothing” and carrying Real Estate at levels with no reflection of reality in them but when mortgages are not paid and commercial loans are delinquent; the lack of revenues and profits tell the accurate tale whatever was allowed to be ignored or not.

All of the time wasted on firewalls and great deceptions worked in the short term but the height of a fence does nothing to help a horse or a nation which is sick inside them. Europe has vastly overspent and tried their best to whitewash the financials of the countries and the European banks and now, and each quarter out for some time; we are going to see a worsening financial landscape for the European nations and their banks. This will not be Armageddon or the end of the world but it is going to be quite painful and have a decided impact on the United States and perhaps the scaring may be deep. In Europe that have mouthed so much nonsense for such a long period of time that they have come to believe in what they have manufactured. This is not uncommon historically but the depth and breadth of it is without comparison. Germany says one thing to placate France and Italy believes the drivel that is touted by the Netherlands and now Greece wants the ECB to forgive their $238 billion in Greek debts on the basis of a united Europe, which would bankrupt the ECB, and then it becomes clear that someone has to pay for all of this and countries start banging on the doors of the asylum to get out. Listen carefully; the banging has begun and will grow loader and more raucous during the balance of the year.

“The world news might not be therapeutic.”

-One Flew Over The Cuckoo’s Nest

Tags: American Corporations, American Stock Market, Bps, Capital Structure, Commentators, Corporate Bonds, Depreciation, Diversification, Earnings Season, Economic Stress, Economy Of China, Global Economy, Having Some Sort, Hindsight, Institutional Investors, Mark Grant, Recession, Safe Haven, Slowdown, Substantial Impact
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The Pros and Cons of Preferreds (Koesterich)

Tuesday, May 22nd, 2012

Given the universal hunt for yield, many investors are asking me what I think of preferred stocks.

I believe that this asset class certainly has a place in yield oriented portfolios, but I wouldn’t overweight preferred equity funds at this time and would instead remain neutral. Why? While preferred funds are certainly providing a healthy, relatively high yield in a low yield environment, the extra yield comes with a lot of volatility.

Currently, preferred funds are offering a yield similar to that of a high yield bond fund, but preferred funds are also offering about 50% more volatility. For instance, the yield on the iShares S&P U.S. Preferred Stock Index Fund (NYSEARCA: PFF) is now approximately 6.5%, roughly in line with the yield of the iShares iBoxx $ High Yield Corporate Bond Fund (NYSEARCA: HYG). But at the same time, PFF’s three-year trailing volatility is more than 15% compared with less than 10% for HYG.  Past performance is no guarantee of future results.  For standardized performance for PFF, please click here.

To be sure, preferred stocks are generally more volatile than bonds and this makes sense given their lower place in the capital structure. However, there is another reason for the heightened volatility of preferred funds today.

The S&P U.S. Preferred Stock Index is composed of mostly financial companies. In fact, today, more than 85% of the issuers in the index are financials. This heavy concentration in the financial sector is also contributing to preferred funds’ volatility — the financial sector is now the most volatile sector in the market.

As such, preferred funds modeled on the index are essentially acting as proxies for financial stock funds, but with equity-like risk and bond-like returns. For those with a positive view on financials, this may be an acceptable risk-reward tradeoff. But as I currently hold an underweight view of global financials, I’m advocating a neutral allocation to the preferred stock asset class for now.

Source: Bloomberg

Russ Koesterich is the iShares Chief Investment Strategist and a regular contributor to the iShares Blog.  You can find more of his posts here.

The author is long PFF and HYG.

The performance quoted represents past performance and does not guarantee future results. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when sold or redeemed, may be worth more or less than the original cost. Current performance may be lower or higher than the performance quoted. Performance data current to the most recent month end may be obtained by calling toll-free 1-800-iShares (1-800-474-2737) or by visiting www.iShares.com.

Index constituents are subject to change.

In addition to the normal risks associated with investing, narrowly focused investments typically exhibit higher volatility. Preferred stocks are not necessarily correlated with securities markets generally. Rising interest rates may cause the value of the Fund’s investments to decline significantly. Payment of dividends is not guaranteed. Removal of stocks from the index due to maturity, redemption, call features or conversion may cause a decrease in the yield of the index and the Fund.  Bonds and bond funds will decrease in value as interest rates rise. High yield securities may be more volatile, be subject to greater levels of credit or default risk, and may be less liquid and more difficult to sell at an advantageous time or price to value than higher-rated securities of similar maturity.

Tags: Acceptable Risk, asset class, Capital Structure, Corporate Bond, Equity Funds, Financial Sector, Financial Stock, High Yield Bond, High Yield Bond Fund, Hyg, Ishares, Pff, Preferred Equity, Preferred Stock, Preferred Stocks, Preferreds, Risk Reward, Stock Funds, Stock Index Fund, Volatile Sector, Volatility
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Are Record ECB Margin Calls Impairing Gold?

Wednesday, March 14th, 2012

In what could prove to be the most critical unintended consequence, [last week] of the ECB’s LTRO program, we note that as of March 2, the ECB has started to make very sizable margin calls on its credit-extensions to counterparties. While the hope was for any and every piece of lowly collateral to be lodged with the ECB in return for freshly printed money to spend on local government debt, perhaps the expectation of a truly virtuous circle of liquidity lifting all boats forever is crashing on the shores of reality. This ‘Deposits Related to Margin Calls’ line item on the ECB’s balance sheet will likely now become the most-watched ‘indicator’ of stress as we note the dramatic acceleration from an average well under EUR200 million to well over EUR17 billion since the LTRO began. The rapid deterioration in collateral asset quality is extremely worrisome (GGBs? European financial sub debt? Papandreou’s Kebab Shop unsecured 2nd lien notes?) as it forces the banks who took the collateralized loans to come up with more ‘precious’ cash or assets (unwind existing profitable trades such as sovereign carry, delever further by selling assets, or subordinate more of the capital structure via pledging more assets – to cover these collateral shortfalls) or pay-down the loan in part. This could very quickly become a self-fulfilling vicious circle – especially given the leverage in both the ECB and the already-insolvent banks that took LTRO loans that now back the main Italian, Spanish, and Portuguese sovereign bond markets.

This huge increase in margin calls can only further exacerbate the stigma attached to LTRO-facing banks – and as we noted March 7, (somewhat presciently) both the LTRO-Stigma-trade, that we created, and the potential for MtM losses on the carry-trades that LTRO ‘cash’ was put to work in could indeed start a vicious circle in European financials, just as everyone thought it was safe to dip a toe back in the risk pool.

What should also start to worry the Germans is the fact a 37x levered hedge-fund central bank with EUR3 trillion balance sheet that has extended credit in a ‘risk-managed’ approach on what appears to be an ever dwindling supply of performing collateral is starting to see dramatic ‘gaps’ in its asset-liability exposure (but rest assured Bernanke told us that our FX Swaps are safe as houses).

One last point should be noted – the hopes of an LTRO3 or some such are surely now out of the window as clearly banks have run dry of any and all reasonable collateral or can the sovereign bonds purchased using LTRO1 and LTRO2 funds be lodged once again in a rehypothecated miasma circling the drain?

Since last week, the ECB has increased its margin calls on European banks by EUR162 million this week to another record high of over EUR17.3 billion. While our pointing out of this huge jump from ‘average’ historical margin calls last week was met with – it’s temporary/transitory due to temporary/transitory ineligibility of defaulted (and since undefaulted) Greek bonds (which given the rise this week has now been proven incorrect) or the more prosaic “don’t worry, be happy”, we remain concerned at both the velocity and now sustained size of these margin calls (as clearly collateral quality has dropped rapidly and remained weak). This is concerning since it would appear we had a good week for collateral (risk assets) in general, so we can only imagine what garbage is clogging the ECB’s balance sheet. The side-effect of this appears to be (as we pointed out here) that Gold (the banks’ remaining quality collateral) is being sold to cover these margin calls just as it was in September 2011 (though lease rates have not squeezed as much this time). We can only imagine the size of these margin calls should we happen to have a week where AAPL stock drops or BTPs don’t rally (broad collateral actually loses value), but that seems impossible anyway.

ECB Margin Calls to European Banks rose once again to record highs…

And Gold remains offered as the need to fund these margin calls means finding money under every mattress and selling whatever banks have to meet the central banks demands…

Interesting that gold lease rates did not drop (soar from the other side) in a squeeze this time – as they did in September 2011.

Charts: Bloomberg

Tags: Asset Quality, Bond Markets, Capital Structure, Collateral Asset, Dramatic Acceleration, ECB, Government Debt, Insolvent Banks, Kebab Shop, liquidity, Mtm, Papandreou, Profitable Trades, Rapid Deterioration, Risk Pool, Shortfalls, Stigma, Unintended Consequence, Vicious Circle, Virtuous Circle
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Credit Plunge Signals “All is Not Well”

Tuesday, February 14th, 2012

European (like US) stocks remain in a narrow range just above the cliff of the unbelievably good NFP print of 2/3. US and European credit markets have lost significant ground since then and it seems equity investors just want to ignore this ‘uglier’ reality for now. The BE500 (Bloomberg’s broad European equity index) is unchanged from immediately after the NFP ‘jump’, investment grade credit is +10bps from its post-NFP tights, crossover (or high yield) credit is around 50bps wider, Subordinated financial credit is +50bps off its post-NFP wides at 382bps, and senior financial credit is an incredible 36bps wider at 225bps (by far the largest on a beta adjusted basis). The divergence is very large, increasing, and a week old now and perhaps most importantly as we look forward to LTRO Part Deux, LTRO-ridden banks have underperformed dramatically (40bps wider since 2/7 as opposed to non-LTRO banks which are only 10bps wider) – how’s that for a Stigma? Some ‘banks’ have suggested the underperformance of credit is due to ‘technicals’ from profit-taking in the CDS market – perhaps they should reflect on why there is profit-taking as opposed to relying on recency bias to maintain their bullish and self-interest positioning as the clear message across all of the credit asset class is – all is not well.

European financial credit is at over a two-week wide here and across the board credit markets have underperformed since the NFP print – perhaps they saw through the headline numbers?

European financial stocks ignored credit last week and then caught up, we now see the divergence growing dramatically. If nothing else, its an arbitrage opportunity but the drift in spreads is much more than technicals here and we suspect is a realization of the growing impact on the capital structure of banks of the ECB sucking up all the collateral supporting it (while capital is not exactly being raised hand over fist).

The most glaring divide remains the ‘stigma-trade’ where we have seen LTRO banks underperform dramatically (wider by 40bps) over non-LTRO banks (wider by only 10bps) and this is perhaps the key for why banks overall are underperforming.

Either way, it should be drastically clear to any and all (that choose to look and not ignore relaity in the interest of a fiat-currency-numeraire-based stock market ‘hoping’ for more printing) that all is not well in the Euro-zone. It is also not just Europe (as we have discussed for a week now) as high-yield credit in the US is also sending warning signals.

Charts: Bloomberg

Tags: Adjusted Basis, Arbitrage, asset class, Bias, Capital Structure, Credit Markets, Crossover, Divergence, Drift, ECB, Equity Index, Equity Investors, European Equity, financial stocks, Hand Over Fist, Investment Grade, Plunge, Realization, Self Interest, Stigma
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The Biggest Urban Legend in Finance (Arnott)

Wednesday, March 30th, 2011

by Robert Arnott, Research Affiliates

Stocks ought to produce higher returns than bonds in order for the capital markets to “work.” Otherwise, stockholders would not be paid for the additional risk they take for being lower down the capital structure. It comes as no surprise, therefore, that stockholders have enjoyed outsized returns for their efforts for most—but not all—long time periods.

Ibbotson Associates, whose annual data compendium¹ covers U.S. stocks and U.S. bonds since January 1926, shows the S&P 500 Index compounding through December 2010 at an annual rate of 9.9% vs. 5.5% for long-term government bonds, an excess return of 4.4%. This return compounds exponentially with time. A $1,000 U.S. stock investment in 1926 would have ballooned to $3 million by December 2010 vs. $92,000 for an investment in long-term bonds, a 32-fold difference.

Emboldened by the 1980s and 1990s (when stocks compounded at 17.6% and 18.2% per annum, respectively), “Stocks for the Long Run” became the mantra for long-term investing, as well as a best-selling book. This view is now embedded into the psyche of an entire generation of professional and casual investors who ignore the fact that much of those outsized returns were a consequence of soaring valuation multiples and tumbling yields. In this issue we examine historical U.S. equity performance from a larger perspective and find that today’s overwhelming equity bias is built on a shaky foundation, reliant on a short and unrepresentative time period.

Let’s Talk Really Long-Term

For those willing to do the homework, longer-term stock and bond data exist for the United States. But that picture isn’t quite as rosy as from 1926–2010; therefore, it doesn’t receive as much attention from Wall Street optimists. From 1802–2010, U.S. stocks generated a 7.9% annual return vs. 5.1% for long-term government bonds.² Our realized excess return was cut to 2.8%—a one-third reduction—by adding 125 years of capital markets history!

Of course, many observers will declare 19th century data irrelevant. A lot has changed! The survival of the United States was in doubt during the early part of the century (War of 1812) and during the debilitating Civil War of the 1860s. The United States was an “emerging market”! The economy was notably short on global trade and long subsistence agriculture. Furthermore, there were three major wars and four depressions—two were deeper than the Great Depression—between 1800 and 1870, a span when data on market returns were notably thin.

By the following century, the United States and its equity markets enjoyed good fortune. It was not invaded and occupied by a foreign power. It did not suffer a government overthrow… just ask Russian investors their return on capital after the Bolshevik Revolution! As Ben Graham might caution, beware the difference between the loss on capital (a drop in price, from which we can recover) and a loss of capital (100% loss, from which we cannot). Russia’s stock market wasn’t alone in the 20th century as three additional top 15 markets in 1900—Egypt, Argentina, and China—suffered a 100% loss of capital while Germany (twice) and Japan (once) came very close.³

Whether we use 200+ years or 80+ years, how many people are pursuing an investment program of that duration? No one, of course. Even “perpetual” institutions such as university endowments aren’t exempt. As the late economic historian Peter Bernstein commented, “…this kind of long run will exceed the life expectancies of most people mature enough to be invited to join such boards of trustees.”⁴ Relevant horizons for all “long term” investment programs are significantly shorter—10 years or 20 years, maybe 30.

Shouldn’t a span of one, two, or three decades be sufficient for investors to be rewarded for bearing the risk of holding stocks? As displayed in Table 1, trailing returns for stocks haven’t come close to earning the excess returns that we’ve all come to expect, even after stocks worldwide doubled from the early March 2009 lows during the Global Financial Crisis! We’ll save an exploration for how the Fundamental Index® concept radically reshapes this picture for another time.

Where is the wealth creation implied by the Ibbotson data? Stock market investors took the risk—riding out every bubble, every crash, every spectacular bankruptcy and bear market, over a 30-year stretch. How much were they compensated for the blood, sweat, and tears spilled with all this volatility? A measly 53 basis points per annum! Indeed, investors who have incurred the ups and downs over the past decade have lost money compared to what they could have earned from long-term government bonds. They’ve paid for the privilege of incurring stomach-churning risk. Not only did Treasury bond investors sleep better, they ate better too!

A 30-year stock market excess return of approximately zero is a huge disappointment to the legions of “stocks at any price” long-term investors. But it’s not the first extended drought. From 1803 to 1857,5 U.S. equities struggled; the stock investor would have received a third of the ending wealth of the bond investor. Stocks managed to break even only in 1871. Most observers would be shocked to learn there was ever a 68-year stretch of stock market underperformance. After a 72-year bull market from 1857 through 1929, another dry spell ensued. From 1929 through 1949, stocks failed to match bonds, the only long-term shortfall in the Ibbotson time sample. Perhaps it was the extraordinary period of history—The Great Depression and World War II—and the spectacular aftermath from 1950–1999, that lulled recent investors into a false sense of security regarding long-term equity performance.⁶

The Odds

Fortunately for the capital markets and equity investors, an examination of history shows that, yes, stocks have a high tendency to outperform government bonds over 10-year and 20-year periods. Figure 1 illustrates rolling 10- and 20-year “win rates” for equities versus government bonds. We break the data into Ibbotson (1926–2010) and Total (1802–2010). The Ibbotson timeframe confirms investor behavior in the 30 years since Ibbotson and Sinquefield published their groundbreaking study.⁷ For the vast majority of periods—86% for 10 years and 96% for 20 years—equities outperform bonds. But the longer term data are less convincing. For 10-year periods, equities outperform in 71% of the observations, rising to 83% for 20 years.

A 70% or 80% win rate still offers pretty good odds. In professional basketball, those are average to above-average free throw percentages. But the relatively small probability of failure masks the magnitude of a miss. Just as a single missed free throw can cost a basketball championship, so too can an equity “miss” lead to drastic consequences, as the past 10 years have shown. There is no guarantee of superior equity returns, which begs the question: Why does our industry act like there’s one? More important, why take all that risk for a skinny equity premium?

Conclusion

We aren’t saying that we should expect bonds to beat stocks over the next 10 or 20 years. Rather, this brief history lesson illuminates that the much-vaunted 4–5% risk premium for stocks is unreliable and a dangerous assumption on which to make our future plans. In our view, a more normal economic environment would suggest 2–3%, which is the historic risk premium absent the rise in valuation multiples in the past 30 years. But these are not normal times. Today’s low starting yields, combined with the prospective challenges from our addiction to debt-financed consumption and aging population, would put us closer to 1%.

It would be foolish to act as if the past 200 years is fully representative of the future. For one thing, the United States was an emerging market for much of that period, with only a handful of industries and an unstable currency. In the past century, we dodged challenges and difficulties that laid waste to the plans of investors in many countries. Nassim Taleb points out that “Black Swans”—unwelcome outliers that exceed the bounds of normalcy—are a recurring phenomenon; the abnormal is, indeed, normal. Our own stock market history is but a single sample of a large and unknowable population of potential outcomes.

Peter Bernstein relentlessly reminded us there are things we can never know, that prosperity and investing success are inherently “risky”; they can disappear in a flash. Uncertainty is always with us. The old adage puts it succinctly: “If you want God to laugh, tell him your plans.” Concentrating the majority of one’s investment portfolio in one investment category, based on an unknowable and fickle long-term equity premium, is a dangerous game of “probability chicken.”

Endnotes

1. Ibbotson® SBBI® 2011 Classic Yearbook: Market Results for Stocks, Bonds, Bills, and Inflation 1926–2010, Morningstar.

2. For much of this section, we rely on the data that Peter Bernstein and I assembled for “What Risk Premium is ‘Normal’?” Financial Analysts Journal, March/April 2002. We are indebted to many sources for this data, ranging

from Ibbotson Associates, the Cowles Commission, Bill Schwert of Rochester University, and Bob Shiller of Yale. For the full roster of sources, see the FAJ paper.

3. See Arnott and Bernstein (2002).

4. See Peter Bernstein, “What Rate of Return Can You Reasonably Expect… or What Can the Long Run Tell Us about the Short Run?” Financial Analysts Journal, March/April 1997.

5. 20-year bonds were used whenever possible but the longest maturities tended to be 10 years for much of the nineteenth century. Also, in the 1840s, there was a brief span with no government debt (we should be so lucky!),

hence no government bonds. Under these circumstances, the equivalent to today’s Government Sponsored Enterprises, railway and canal bonds, were used as these projects typically had the tacit support of the government.

6. For more on this, see Robert Arnott, “Bonds: Why Bother?” Journal of Indexes, May/June 2009.

7. Roger G. Ibbotson and Rex A. Sinquefield, “Stocks, Bonds, Bills and Inflation: Year-by-Year Historical Returns (1926–1974),” Journal of Business, January 1976.

©2011 Research Affiliates, LLC. The material contained in this document is for general information purposes only. It relates only to a hypothetical model of past performance of the Fundamental Index® strategy itself, and not to any asset management products based on this index. No allowance has been made for trading costs or management fees which would reduce investment performance. Actual results may differ. This material is not intended as an offer or a solicitation for the purchase and/or sale of any security or financial instrument, nor is it advice or a recommendation to enter into any transaction. This material is based on information that is considered to be reliable, but Research Affiliates® and its related entities (collectively “RA”) make this information available on an “as is” basis and make no warranties, express or implied regarding the accuracy of the information contained herein, for any particular purpose. RA is not responsible for any errors or omissions or for results obtained from the use of this information. Nothing contained in this material is intended to constitute legal, tax, securities, financial or investment advice, nor an opinion regarding the appropriateness of any investment. The general information contained in this material should not be acted upon without obtaining specific legal, tax or investment advice from a licensed professional. Indexes are not managed investment products, and, as such cannot be invested in directly. Returns represent back-tested performance based on rules used in the creation of the index, are not a guarantee of future performance and are not indicative of any specific investment. Research Affiliates, LLC, is an investment adviser registered under the Investment Advisors Act of 1940 with the U.S. Securities and Exchange Commission (SEC).

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Tags: Annum, Best Selling Book, Bond Data, Capital Markets, Capital Structure, China, Currency, Emerging Markets, Excess Return, Government Bonds, Ibbotson Associates, Investment Bonds, Optimists, Research Affiliates, Robert Arnott, Russia, Shaky Foundation, Stock Investment, Stockholders, Term Bonds, Term Investing, Term Stock, Time Periods, Urban Legend
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Liquid Assets Are at a 37-Year High on Corporate Balance Sheets

Wednesday, July 7th, 2010

This article is a guest contribution from American Century Investments.

Market and stock analysts have recently taken note of an interesting development that began in the depths of the Great Recession. Just prior to its start (i.e. the third quarter of 2007), total liquid assets on the balance sheets of non-farm, non-financial corporations equaled $1.5 trillion and represented 5.3% of total corporate assets. In the fourth quarter of 2008—one year after the recession began and (in hindsight, at its nadir)—liquid assets dipped to $1.4 trillion or 5.1% of total corporate assets. But in the five quarters since (through the first quarter of this year), total liquid assets increased dramatically to $1.8 trillion (an increase of $400 billion) while liquid assets as a percent of total corporate assets—on a market value basis—increased from 5% to 7%.

That means that seven cents of every dollar of total corporate assets (the sum of the market value of its capital structure consisting of short- and long-term debt plus shareholder equity) is now invested in the equivalent of a corporate “piggy bank” as opposed to investments in its long-term productive capital (expected to earn a return in excess of a company’s cost of capital). As the chart below illustrates, while the long-term trend over 144 consecutive quarters from the first quarter of 1973 to the fourth quarter of 2008 has been an increase in liquid assets as a percent of total corporate assets—increasing from 4% to 5% (see the dashed line labeled LT Trend)—the sudden jump as the economy emerged from a severe recession is well above what the 35-year trend and five prior recessions would predict.

Notes:    (1) Liquid assets on corporations’ balance sheets consist of foreign deposits; checkable deposits and currency; time and savings deposits; money market fund shares; commercial  paper;  Treasury, agency and GSE-backed and municipal securities; and mutual fund shares.

(2) Business assets are measured at market value.

(3) Non-financial corporations exclude banks, thrifts, mortgage financing corporations where the primary business is lending money or extending credit.

(4) “LT Trend” (Long-Term Trend line) illustrates the linear rate of growth for liquid assets as a percent of total business assets between the first quarter of 1973 and the fourth quarter of 2008 (144 quarters).

(5) Shaded areas represent recessionary periods.

A Bullish Sign?

A number of analysts have concluded the sudden increase in liquid assets on the balance sheets of corporations is a bullish sign for the equity markets.  One rationale is based on a possible increase in corporate mergers and acquisitions (M&A) activity. History has shown that corporations with large amounts of cash will pursue acquisitions, either of competitors or as extensions of their corporate strategy. With interest rates for prime corporate borrowers at attractive historical rates and the current modest rates of overall economic growth, the argument for increase in M&A activity as a means of growth is a persuasive one. If a company can’t achieve its long-term growth targets via internal growth, M&A (especially acquisitions) can become an attractive alternative.

Tags: American Century Investments, Capital Structure, Consecutive Quarters, Corporate Assets, Corporate Balance Sheets, Financial Corporations, Fund Shares, Money Market Fund, Municipal Securities, Piggy Bank, Productive Capital, Recessions, Seven Cents, Shareholder Equity, Stock Analysts, Sudden Jump, Term Trend, Total Liquid Assets, Treasury Agency, Value Basis
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