Households save and invest in equities

Reading time: 8 – 14 minutes

Why did US equity prices rebound in 2009?  What do the flow of funds accounts tell us?

The Federal Reserve flow of funds accounts for US Households (Table F.100) reveal the forces that drove the recovery in equity prices in the first half of 2009.

See if you agree.

A dramatic shift in behavior

By comparing the flow of funds in the year 2007 (at the top of the bubble), with the flows in Q2 2009, a remarkable shift in investor behavior is evident.

Household savings rise in 2009

Briefly, continued high levels of personal income, with lower taxes and extremely low interest rates, combined with a fear of hard times that encouraged increased savings, has led to a shift of funds from cash and bonds into equities.

The data seems to contradict popular expectations that increased unemployment would lead to a drop in income and less money to spend.

The Fed flow of funds statistics  suggest what has influenced equity prices in the first half of 2009.

Stimulus measures encourage saving

Both the Bush and Obama administrations pushed small amounts of money into the hands of consumers in an attempt to revive the economy in 2008 and 2009.

The theory, apparently, was that the public would spend these tiny payments, which in turn would cause businesses to produce more to meet demand, leading to increased employment.

The public, frightened by the rapid collapse of securities and real estate markets in 2008, and by warnings from the White House of worse days ahead — with references to the Great Depression — words of politicians not constrained by  historical accuracy — caused many to conclude that the prudent course would be to hold off spending and to save for worse days ahead.

Congress scares investors

The Federal Reserve, for its part, decided that lowering interest rates to almost zero would somehow lead businesses to invest and create new jobs — ignoring the terrifying behavior of a Congress that approved trillion dollar spending bills, without reading them, while favoring programs that would impose higher taxes on small businesses — the principal creators of jobs in the United States.

Rather than hiring, businesses became more productive, getting rid of marginal workers and holding on to the best.

Despite the success of the economic fear-mongers in getting the Democrat Party into the White House — the first president without any palpable executive experience — the over-whelming majority of Americans were not as bad off as claimed.  Most still had jobs and were willing to work hard to keep them.

Congress increased the minimum wage —  sky-rocketing unemployment for young people.

In the case of young black males, most of whom voted for Obama, unemployment reached 50%!

The collapse of credit markets in the last semester of 2008 and the need for banks and other financial intermediaries to de-leverage as quickly as possible, restricted the flow of capital to business — despite low interest rates.

Taxes fall, savings rise

Here are figures that show household income, taxes, and savings in 2007 and Q2 2009:

Here we see that tax savings doled out in various stimulus packages did not result in greater spending, but in greater savings.

Only about 10% of the tax stimulus went into consumption — the rest was saved.

Furthermore, despite rising unemployment, household income did not shrink as compared to 2007.

Switching from debt to equities

Not only did individuals save more in Q2 2009, but they shifted funds away from fixed income assets into corporate stocks.

This table shows a remarkable change in the behavior of ordinary investors between 2007 (before the Crash of 2008) and in Q2 2009 (after the Crash of 2008 and the introduction of Obamanomics).

The demise of stock buybacks

The investment behavior in 2007 can be explained, since it fits a pattern observed since 1982:

1. In 2007, corporate executives were selling huge amounts of stocks (over $794.2 billion, annual rate) in order to take profits on stock options. The main buyers were corporations with buyback programs approved by the executives themselves. See: The Great Misleading, a critical essay on the stock buyback movement.
2. After the Crash of 2008, stock buybacks dried up due to lack of corporate funds. Stock prices fell to the point that most executive stock options were under water. Consequently, equity sales relating to the exercise of options virtually ceased. There were individual purchasers of equities, even in the buyback era, but the amount of such purchases was hidden in the net statistics by massive sales relating to executive options. By Q2 2009, without executive options, $288.1 billion in net equity purchases became visible. The flow of funds accounts don’t indicate whether this amount was greater or less than underlying equity purchases in 2007.



3. In 2007, individual investors still trusted Standard & Poor’s and believed that money market funds were safe. The table shows that in 2007, investors were taking money out of demand deposits and cash to buy longer term credit instruments.
4. In Q2 2009, investors no longer trusted the credit standing of longer term issuers, moving money out of agencies, municipals, corporate bonds, and money market funds, into government guaranteed bank deposits and cash. Extremely low short-term interest rates encouraged this transfer.
5. Massive, undisciplined spending authorized by the Obama administration in January 2009 cast serious doubts on the future of the US dollar, with a high probability of inflation. Individual investors acted rationally by moving away from medium and long term debt, in anticipation of the coming inflation.
   In this article:

   • A dramatic shift in behavior
   • Stimulus measures encourage saving
   • Congress scares investors
   • Taxes fall, savings rise
   • Switching from debt to equities
   • The demise of stock buybacks
   • Is the 2009 bounce sustainable?
   • Related Posts
   • Comments (2)

   Powered by SEO TOC 1.7.3
6. Individual investors, having suffered massive paper losses in equities in the Crash of 2008, held on to their long-term mutual funds, moving additional money from fixed income into equities in the expectation of a market recovery. In part, this reflected continued belief in the Common Stock Legend, and in part a speculative reaction to the extreme lows of the Crash of 2008.

Note: The flow of funds accounts do not  show the behavior of hedge accounts — institutions that are known to have a significant impact on the market.  Since the “households” item in the accounts is not measured directly, but indirectly as the remainder after all the other measured accounts, it could be that hedge accounts flows are included with flows of individuals in households.  It is also possible that, since many hedge funds are organized as foreign partnerships or corporations, this amounts are included in the statistics for the “rest of the world”.

Increased savings, plus the above factors, go a long ways towards explaining the stock market bounce in the first half of 2009.

Is the 2009 bounce sustainable?

The flow of funds accounts for Q2 2009, extracted above, also suggest reasons why the early 2009 bounce is not sustainable.

1. The Obama healthcare and cap-and-trade programs contain elements that will result in substantially higher taxes, direct and indirect, on the American people. This will lead to higher unemployment and perhaps greater incentives to save.
2. Sooner or later, the “spending is stimulus” programs of the Obama administration will result in inflation, raising interest rates on short-term money market funds and crashing medium and long-term bond markets. Inflation also tends to justify lower price-earnings ratios in equity markets, leading to falling stock prices.
3. Corporate executives are still sitting on huge quantities of stock options that may become valuable if stock prices rise. If stock prices reach pre-Crash levels, executives will sell stocks into the market. If credit continues tight, corporations won’t have the cash to support executive options with stock buybacks. This places a ceiling on equity price recovery.
4. Baby boomers, with equity portfolios already severely damaged by the Crash of 2008, will be eager to sell stocks as soon as prices begin to reach pre-Crash levels.
5. The anti-capitalist bias of the Obama administration and the Democrat-controlled Congress, is not conducive to a long-term rise in stock prices. Obama shows no indication, so far, of “moving to the center”. Although the President’s popularity is falling rapidly, the earliest date at which the current administration can be out of office is 2012.

If the Obama administration  continues current policies, portending high inflation and increased unemployment, the United States may indeed be in for a Great Depression.

Fortunately, unlike the 1930s, a US President is now subject to term limits and the majority of voters are not union members.

What do you think will be the outcome of current economic policies?