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Equity Indicators - Updates and Extremes

Pension Fund Asset Allocations

The Wall Street Journal ran an article over the weekend stating that pension funds were "fleeing" stocks and moving toward more-conservative investments, which is curious given how far many of them must rise in order to meet their obligations to employees.

Pension funds are herds of elephants roaming the plains - they don't change direction all that much, and when they do they all go together.  As we'll see in a minute, they'd probably best be served by doing the opposite of what their brethren are doing.

According to the Federal Reserve, pension funds have allocated 65% of their total assets to the stock market.  For the first time in history, they now hold more money in mutual funds than they do in individual equities (more evidence of herd behavior).

Bonds, meanwhile, get just 20% of their attention.  That's up from what it was near the stock market peak in 2007, but not by much.  They allocate just 5% of their funds to "cash", which I've taken to include all extremely short-term and liquid investments.  Another 10% is allocated to a mish-mash of other investments, a big chunk of which the Fed just calls "miscellaneous".

From the chart above, we can see that funds had a very high allocation to stocks in the early 1970's when the S&P 500 peaked.  During the ensuing bear market, funds fled stocks and dropped their allocation down to about 40%...and never really lifted it despite a resurgent stock market.

That changed in the 1990's as they put more and more money into stocks (or, more accurately, mutual funds).  Finally, they were at their highest stock allocation ever in 2007, with 76% of their funds invested in the market.  They got thumped hard during 2008, and reduced stock market exposure to 62% - still historically high, but the lowest in over a decade.

It's hard to see from that chart, but on a shorter-term basis, the funds do not act in their contributors' best interests.  They flee stocks en masse, then get back in in the same manner.

The chart below shows the year-over-year percentage change in their stock market allocations.  Generally, anything beyond +/- 10% can be considered extreme.  Currently we're at +1%, so nothing notable.

The table below shows the S&P 500's future returns 1, 2 and 3 years following quarters when pension funds fled stocks to an extreme degree.  For comparison, the table looks at both -5% and -10% year/year changes.

The results are impressive...if one had done the exact opposite of the pension funds.  Three years later, with even a -5% change in their stock allocation, one would have enjoyed a median return of nearly 43%, and would have had a positive return after all but two quarters.

If the funds had really dumped stocks and went below that -10% marker, then the returns were even more impressive, but of course the number of incidents drops as well.  The returns were especially notable one year later, which were astronomical.

Now let's flip it over and look at those times the funds had to get back into stocks in a hurry.  Almost inevitably, this was after stocks had already rallied.

Predictably, the returns were much poorer than the ones from the table above.  They were still positive owing to the long-term trend of the market, but they were much less impressive than if the funds would have simply done the opposite of what everyone else was doing.

The fact that funds are apparently fleeing stocks now, at least according to the Journal and Bloomberg, then that may bode well for the long-term outlook for stocks once these funds turn tail yet again and chase the market higher.

This data is released quarterly, with the most recent data covering the 2nd quarter of 2010.  The third quarter's data will be released in early December, when we'll get to see just how much of a change the funds underwent during the summer months.

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