All those equities nobody owns are so bullish

One of the many things I will never understand is why analysts so often imply that there can be “flows” out of an asset class unrelated to buybacks or retirements.

All assets are held by somebody, so the idea we can measure a net “flow” that is not zero by definition (once issuers are included) is incoherent from the get go.

Ex ante supply and demand imbalances determine price change. I get that.  Moreover, there may be some profit in identifying these ex-ante imbalances ahead of time and imagining the price changes that will force them to close.  Tudor has a business in that.

But the flow data are ex post, by definition. And if they show an imbalance, then that means only that they are incomplete or wrong. And yet the flow approach approach remains very popular and is taken quite seriously.

Business Insider reports this morning that analysts at Deutsche Bank are excited about equities in part because they anticipate a continued “rotation” out of fixed income and into equities.

That’s an odd claim.  If people want to hold more equities, then their price will go up and the share of equities in the typical portfolio will indeed rise. But that is not what Deutsche Bank is arguing. They seem to believe that net flows into bonds have trounced those in equities in recent years and that some sort of mean reversion looms out there.   Here is their main bit of evidence.

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And here is BI summarizing DB’s interpretation:

To Parag Thatte, Rajat Dua and Binky Chadha, strategists at Deutsche Bank, the move since the US election is likely a sign of things to come, suggesting that while the flows seen last week were extremely large, they “still represent only a modest turn after many years of rotation out of equities and into bonds”. 

Perhaps retail has sold equities to institutional, which might be bullish if the institutional hands are the stronger. I would be receptive to that argument, although I have never seen it demonstrated.  But the aggregate allocation to equities has surely risen steeply, if only because the stock market has been rallying.  So it would seem to be quite misleading to imply that allocations to equities are depressed because of “flows.”

By my lights, the proper way to consider this issue – which does not break simple accounting identities – is offered by Jesse Livermore at Philosophical Economics.  He measures the market value of equities outstanding vs the market value of fixed income and finds that when the average allocation to equities is high, as it is now, subsequent returns to equities tend to be relatively low.

There are two important caveats here. First, Jesse’s claim that his average allocation measure predicts is a bit tongue in cheek.  It is a snarky way of saying that when equities rally, of course, the allocation to them goes up. And over long horizons, valuation has tended to be mean reverting. He does not really believe that the allocation is causal, although he buries the point, I think for rhetorical effect. That aside, he is actually approximating the aggregate allocation, unlike adding up those partial flow data.

Second, his piece was written at the end of 2013 and so is a bit stale.  By late 2013, the powerful rally in equities had taken the average allocation up to slightly-above average levels which implied a slightly below-average excess return over the coming years. He has been right about returns slowing, particularly in the past couple years. But since 2013, returns have actually been slightly above-average, mainly by virtue of 2014.

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I once replicated his work and it was a bit of an effort, so I am not going to do that here, although you can see data updated to Q2 if click on the relevant link in his post.  The important thing, in my view, is to internalize his point about what can cause the aggregate allocation to shift: net issuance and revaluation effects and that is it. Forget “flows.”  Separately, the average allocation has very probably continued rising, simply because the stock market has rallied (dominating buybacks).

Here is the money passage from Philosophical Economics:

Financial markets function on the following principle.  For every unit of every financial asset in existence, some investor somewhere must willingly hold that unit in a portfolio at all times.  By “investor”, I mean whoever owns wealth.  There are intermediaries–hedge funds, mutual funds, pension funds, financial advisors, etc.–that help investors allocate wealth.  But these entities are not the actual investors–their clients are.

The financial market is the place where investors decide–via trades–who will hold what units of what assets.  Note that cash, as an asset, is special in that respect.  It is the medium through which trades occur.  Investors can only switch from one stock or bond to another stock or bond by going through cash.  The going rate of exchange (bid or offered) between a unit of an asset and cash is the market price of the asset.

At the margin, if no investor can be found that wants to hold a given unit of a given asset at the prevailing market price, then the market price will fall until a willing holder is found.  With respect to shares of a stock or bond, the application is straightforward.  If no one wants to hold a given share at $100, then we try $95.  Still no takers?  Then we try $90, then $85, then $80, and so on.  We continue until some investor emerges that finds the share sufficiently attractive to hold at the offered price.  The concept applies analogously to cash–if no investor wants to hold cash, then the price that is bid on everything else will rise until everything else becomes so expensive and unattractive that some investor somewhere capitulates and agrees to hold cash instead.  Measured in terms of other assets, the price of cash falls.

The “supply” of an asset is the total market value of it in existence–the total number of outstanding units times the market price of each unit.  Put differently, supply is the amount of the asset available to be held in investor portfolios–the amount available for investors to allocate their wealth into.  In aggregate, investors have to want to hold the total supply of each asset in existence in their portfolios.  If there is too much supply of a given asset relative to the amount that investors want to hold in their portfolios, then the the market price of the asset will fall, and therefore the supply will fall.  If there is too little supply of a given asset relative to the amount that investors want to hold in their portfolios, then the market price will rise, and therefore the supply will rise.  Obviously, since the market price of cash is always unity, $1 for $1, its supply can only change in relative terms, relative to the supply of other assets.

Separate from the caveats, there is also an awkward point here. The strategists at DB have been adamant that equities would rally post the election and they have been right. So, there is that.  For those of you who merely want to make money, I suppose you would appreciate their helping you. 😉

Maybe the share of the net flow that they are seeing is for the weaker hands, which may be is predictive. I have never seen that argument demonstrated, but the possibility is not excluded on logical grounds, and maybe I am missing something. Alternatively, they have been right for some other reason. But the aggregate allocation to equities has gone up, not down.