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In this Economic Research Paper, I wanted to focus on the Federal Reserve’s Sep 21, 2020 Z.1 Financial Accounts release.

The Z.1. release is a quarterly report by the Fed that accounts for the assets and liabilities for entities throughout the United States, including households, businesses, and governments. It comes out with a bit of a lag, but the abundance of information makes it a great data set for monitoring long-term trends.

Record Net Worth

U.S. household net worth reached an all-time high in Q2 2020, both in nominal dollar terms (red line below) and in CPI-adjusted terms (blue):

Total household wealth reached nearly $119 trillion in nominal dollar terms by the end of the quarter. This new high in net worth is due to the sharp rebound in equity prices that occurred through Q2, the continued increase in housing prices, and the rapid growth of the broad money supply.

Some people are confused at why markets and overall net worth could have done so well this year so far, despite such a bad environment for employment and GDP.

The reason, of course, largely has to do with trillions of dollars of government transfer payments from April through July of this year. Due to record levels of stimulus checks, unemployment benefits, PPP loans for businesses that largely turn into grants, and corporate bailouts, personal income on a nationwide scale went up rather than down in this recession so far:

More important than absolute household net worth, and a key ratio to be aware of, is household net worth as a percentage of GDP. This ratio is shown in blue on the left axis of the chart below, with short-term interest rates in red on the right axis for context:

This ratio of household net worth as a percentage of GDP shot up to new record highs of over 6x or 600% this quarter (largely due to a sharp decline in GDP), after already being at record highs of nearly 550% in recent years.

All else being equal, low interest rates put upward pressure on real estate and equity valuations, which puffs up net worth relative to income and relative to GDP. As we have reached lower and lower interest rates over time, asset valuations have pushed upward. However, momentum and other factors tend to exaggerate this move in certain asset classes over time.

During the 2000 peak, real estate was reasonably priced compared to historical norms, but equities briefly shot up to record high valuations, which pushed up household net worth to about 450% of GDP.

During the 2007 peak, it was the opposite, with equities at historically reasonable valuations while real estate briefly soared to record high valuations, which pushed up household net worth even more to nearly 500% of GDP.

In recent years, both equities and real estate have been historically highly-valued together, as interest rates have hit lower lows, and that combination of high equity valuations and high real estate valuations has allowed household net worth to break out to record highs as a percentage of GDP, even compared to 2001 and 2007. We were getting close to 550% household net worth to GDP in recent years, and the decline in GDP in Q2 as asset prices went up, has briefly taken that ratio to over 600%.

Normally, a big economic shock would dislodge that and start to deflate asset valuations to some extent, but so far in this recession, record amounts of stimulus have been able to keep personal incomes and asset prices levitating through this year. And the four-decade trend of lower interest rates has been beneficial to asset price valuations.

Since August, fiscal stimulus has not been in effect, so uncertainty and volatility have returned to equity markets.

Equity-Heavy Household Allocations

The majority of household net worth consists of financial assets like cash, bonds, real estate, and stocks.

We all know by now that by most metrics, equity valuations are historically high. For example, based on the S&P 500 average price-to-sales ratio, or the cyclically-adjusted price-to-earnings ratio, or market capitalization as a percentage of GDP, the stock market is more expensive than most times in history. By some of those metrics, like the price-to-sales ratio, it is the highest in history, while in other metrics, like the cyclically-adjusted price-to-earnings ratio, it is the second-highest after the 2000 dotcom bubble peak.

On the other hand, the one key metric for which stocks are not particularly expensive, is the equity risk premium, meaning the earnings yield or dividend yield of the S&P 500 compared to an interest rate benchmark, like the 10-year Treasury rate. By that metric, the valuation advantage still leans a bit towards the stock market, especially if you filter out a handful of particularly bubbly stocks.

And that is what makes this environment so hard for investors. Back during the dotcom bubble 20 years ago, 10-year Treasury notes were yielding a very attractive 6%. Not only were stock valuations extremely high, but the equity risk premium was also at a record low compared to those high-yielding nominally risk-free bonds, so Treasuries were a no-brainer better alternative to stocks that smart investors could shift into.

With interest rates around the developed world all near-zero currently (or even nominally negative in some cases), and thus sovereign bonds set to produce extraordinarily low returns over the next decade, many investors are left scrambling for assets, including equities and real estate even at rather high prices.

In other words, many investors accept the prospect of long-term low returns that stock indices are likely to offer at such high valuations, because those returns could still be comparable to, or better than, the return they’ll get from Treasuries over the next decade, in exchange for more volatility. Both will likely be low-returning areas, especially in inflation-adjusted terms, but which will be better is an open question.

I prefer good-quality stocks from a long-term perspective, but I do use Treasuries for some counter-cyclical defense, to buy dips and sell rips in equities and other asset classes via tactical rebalancing.

However, we must be cautious because equities are very popular among investors at this time. Besides the traditional stock and bond valuation metrics, one ratio we can look at is the percentage of U.S. household assets that consist of equities, from the Fed’s Z.1. report.

As of Q2, 23.5% of household assets consist of equities (in red below), which is near the high end of the multi-decade historical range. I also included household real estate as a percentage of assets on this chart as well, which is currently at a more historically average allocation:

When equities were over 20% of household assets in the late 1960’s, the result over the next 10 years was about 2-3% annualized returns, which is not even adjusted for inflation. Then, when equities fell to cheap levels in the 1970’s and 1980’s, down to well below 10% of household assets, the annualized forward returns were over 15%, which even after adjusting for inflation were great.

The dotcom bubble, where equities briefly reached 25% of household assets was the worst time in modern history to buy equities, as they produced slightly negative 10-year annualized returns from there. The 2008-2010 period was a great buying opportunity, and now from 2017-2020, equities have been backing up to around 25% of household assets.

This inverse correlation between household equity allocation and forward equity returns is roughly what we would expect to happen from a rather crowded trade.

To summarize here, U.S. household assets and net worth are at a record-high percentage of GDP and earned income, and equities currently represent a historically high portion of those highly valued household assets. This combination historically does not bode particularly well for ten-year forward returns, especially if we adjust for inflation. As a long-term trend, however, it is not a trading signal, but rather just a “big picture” observation.

Equity-Heavy Capital Structures

Despite being highly indebted based on various metrics, such as corporate debt as a percentage of GDP, corporate capital structures are tilted more towards equity than average, as of Q2 2020. That is because, as previously described, equities are so highly valued.

Specifically, at the end of Q2, total corporate equity (excluding banks) was worth $33.5 trillion, while total corporate debt (excluding banks) was worth just under $11 trillion. In other words, total corporate debt was worth about 1/3rd as much as total corporate equity shares at market value.

If we add corporate equity and debt together, the total is about $44.5 trillion, with equity accounting for about 75% of that total, and debt accounting for the other 25%. That is the current capital structure of U.S. nonfinancial corporations in aggregate: three quarters equity and one quarter debt.

Compared to history, this ratio is currently on the high end, meaning that equity value outweighs debt value by more than average. This chart shows market-value equity as a percentage of the total sum of equity and debt since 1945:

During the booming 1960’s, corporate equity remained in a 70-75% band for capital structures for most of that period, with debt representing the other 25-30%.

Then, during the inflationary 1970’s and 1980’s, equity valuations were much cheaper, and so equities made up just 50-60% of corporate capital structures. Corporate debt was relatively low as a percentage of GDP, but corporate equity was also unusually cheap.

The 1980’s began a disinflationary trend and a mega stock boom into the 1990’s, with corporate equities reaching a record 78% of the total capital structure at the peak of the dotcom bubble by the end of the 1990’s decade.

Then, this ratio went down and chopped along for a while after the dotcom bubble burst, and then during the 2009 market bottom, equities were very briefly back to just 60% of the corporate capital structure before quickly shooting back up.

For the past several years, since around 2014, corporate equities have once again been hovering at around 75% of the corporate capital structure, which is near the top end of the historical range.

The big caveat for this comparison of corporate capital structures, is that it is currently more top-heavy than usual. The handful of mega-cap tech and internet stocks, like Amazon (AMZN), Microsoft (MSFT), Apple (AAPL), Facebook (FB) and Alphabet (GOOGL) represent several trillions of dollars in equity market capitalization but have comparatively very little debt. Most of their combined capital structure consists of equity.

As we move down into medium and smaller companies, however, their tilting towards debt becomes a lot bigger, with lower equity valuations and higher debt loads.

Both corporate debt levels and equity valuations have been sharply rising, so corporate debt and corporate equity have both grown faster than GDP. This chart shows nonfinancial corporate equities (blue) and debt (red) separately, each as a percentage of GDP:

Equity value peaked in the 1960’s at around 90% of GDP, bottomed at below 40% of GDP in the 1970’s and 1980’s, soared to 160% of GDP during 2000, bottomed at around 70% of GDP in 2009, and now is at a record high of over 170%.

Meanwhile, corporate debt used to be as low as 20-25% of GDP but has since nearly tripled to the 55-60% range.

Partially this trend increase is from globalization, especially if we compare the 2010’s to the late 1960’s. The S&P 500 is a lot more global today than it was 50 years ago, both in terms of earning revenue from abroad, and cutting expenses by building things in cheaper countries.

However, it is not all (or even mostly) from globalization. The S&P 500 used to earn a bigger percentage of its revenue from overseas ten years ago than it does lately, for example, even though the stock market capitalization to GDP ratio doubled during that time due to increases in equity valuation.

In fact, globalization as measured by global trade as a percentage of global GDP, peaked in 2008 according to World Bank. This mirrors what we see from the S&P 500 foreign revenue percent table above that also peaked in 2008.

So, changes in valuation play the key role for the value of the stock market as a percentage of GDP, especially over a given decade, but that can be amplified by structural trend shifts like corporate tax cuts, globalization, and large publicly-traded companies taking market share from non-public small businesses.

Final Thoughts

My theme is that with the economy in the state that it is currently in, whenever fiscal stimulus is shut off, rising insolvency and normal recession characteristics could begin playing out.

The reason this current economic environment is tied to fiscal stimulus in an unusually tight way, is because of where we are at in the long-term debt cycle.

The amount of leverage and wealth concentration in the economy are both historically high, so any disruptions to broad personal income can more easily lead to systemically poor outcomes both in terms of civil unrest and broad insolvency than those disruptions could cause in a normal, healthier environment.

That will likely make the 2020’s into a particularly “macro heavy” decade, because this could very well continue to play out differently than a normal business cycle depending on how fiscal stimulus or lack thereof impacts the economy. My long-term macro is for very heavy fiscal spending, but the timing is tied to politics.

My overall process continues to be to focus on good individual stocks, with a side order of real estate. I am using fiscal stimulus as one of my tactical risk-on and risk-off indicators, but the underlying theme is to focus on quality businesses. Unfortunately, we must factor stimulus or lack thereof into fundamental business earnings estimates, especially for the more cyclical industries.

Personal incomes and many risk assets have so far defied the recession due to fiscal stimulus. But whenever stimulus goes offline, the natural tendency for an economy so indebted and impaired, is to sink into a period of disinflation and a weakening recovery. Whenever stimulus goes online (which at this point is significantly funded by permanent central bank monetization of the Treasury’s bond issuance), nominal GDP growth can be improved and risk assets have a better shot at pushing up, at the cost of higher inflation expectations and currency devaluation.

Most asset classes these days are correlated to one big theme: rising or falling inflation expectations. And these expectations are tightly tied to fiscal policy.

So, depending on their time frames, investors have that tango, of being more tactically aggressive or defensive based in part on fiscal stimulus being on or off, combined with whatever other indicators they prefer to use, such as fundamental valuations, oversold/overbought conditions, and technical indicators.

Conclusion

Embrace your subscription here with Pries Capital. As you work your way through your subscription, remember that this is not all-encompassing. It is a 40,000-foot view of how day trading/investing works & is designed to give you the basic information to get past the all-important question of how to get started. As time goes along, make note of any questions or highlights, & then come back to Jason, whether email or by phone, & ask questions to learn more about anything on your mind. Pries Capital is a community of all diverse types of day traders and investors, so begin participating, learning, & growing.

With that said, “We have great challenges & great opportunities, and with our help we’ll meet them together!” – Jason Pries

In the world of finance, we have a huge clash right now between the largest economic shock in generations contrasted with the largest ever government response both monetary and fiscal, and that impact between such massive things is causing all sorts of interesting behavior in the markets.

On one hand, we have the biggest global economic contraction of the modern era, the highest unemployment level in post-WW2 American history, and a virus that continues to affect consumer, business, and government behavior. The world went into this crisis with record debt-to-GDP levels, which made what could have been a manageable situation into a more extreme situation. This is an incredibly heavy economic anchor that was built over decades and triggered by a random event.

On the other hand, we have the biggest-ever collective fiscal injection by countries around the world including in the United States, and rapid debt monetization and asset purchases by central banks to facilitate those sovereign deficits and smooth out volatile markets. The Federal Reserve has crossed the Rubicon into buying individual bonds including some junk bonds, as well as muni bonds, in addition to the Treasuries and mortgage-backed securities they already have a long history of buying. This is the ability to use an infinite balance sheet to print money and buy assets.

The result is that we have very large dislocations, like the stock market soaring on heightened liquidity, and junk bond spreads lower than they would be in a natural market, while the economic situation remains stressed.

As this chart shows, employment levels in the United States have crashed to levels not seen since previous recessions in 2003 and 2009, and yet the stock market itself has reflated nearly back to all-time highs.

Now, there are various ways that the above chart could be scaled. But the point is, if someone had told you last year that in 2020, we would have a global pandemic, and a global economic shutdown in response to that pandemic, that resulted in the biggest surge in unemployment in the modern era and the most negative quarter for GDP on record, that the stock market would only fall 30-some percent and then be back near all-time highs in three months?

Probably not, right?

As this next chart shows, the stock market’s rebound and the Fed’s balance sheet rise have been in almost perfect harmony. This lockstep behavior even includes the recent local plateau we have been in since mid-June, as the Fed has tapered liquidity and the market took a step back from its upward trajectory:

The Extent of Economic Damage

While the market enjoyed a nearly V-shaped recovery from late-March to mid-July, the underlying economy is not really showing signs of such a strong comeback. This will take time to work through.

The number of initial jobless claims keep coming down each week, but continued claims are proving to be a bit “stickier”:

Even after this big decline in initial jobless claims per week from almost 7 million at the worst point to under 1.5 million per week lately, they’re still more than twice the weekly peak of the 2008/2009 crisis, which remained below 700k at the worst point.

In other words, 3 months after initial COVID-19 shutdowns, we are still shedding existing jobs faster on a weekly basis than we were at the peak of the Great Recession:

As millions of people continue to lose jobs, millions of other people are getting some of their jobs back or finding new jobs. So, the number of continued claims that has been hovering around 20 million, which is about 3X as high as the level that was reached during the Great Recession, which did not touch even 7 million at its worst point:

As of April and May data, the United States already has much higher unemployment rates than our advanced peers such as Japan, northern Europe, and Australia, and I contend that this divide is likely to continue for quite some time. This is happening for a variety of reasons.

A surface reason is simply that we have different unemployment policies and a greater ease for employers to lay workers off compared to a number of other countries, which can make for a more dynamic economy but can also cause higher peak unemployment levels during crises.

However, perhaps a larger reason is that due to having the global reserve currency for decades in the post-WW2 era, the U.S. has had to run major structural trade deficits decade after decade, and as a consequence of that, has exported a large portion of its industrial capacity to the rest of the world. Economists Robert Triffin and John Maynard Keynes both warned during the Bretton Woods era that the system as constructed would eventually lead to this sort of problem, and they were right in this regard.

In other words, having the global reserve status has created a consistent demand for the U.S. dollar from a global perspective. This is because most commodities are priced in dollars worldwide, and countries need commodities (and have a lot of dollar-denominated debt), and thus need dollars. This keeps the dollar strong and pushes up the import power of Americans and reduces our export competitiveness, so we gradually stopped making things over the years, not just compared to emerging markets but also compared to wealthy peer regions like Japan and northern Europe.

This has left the United States more reliant on the services sector as a share of our economy than most of our peers, and the services sector is disproportionally harmed by COVID-19 and related shutdowns by businesses and governments to slow the spread of the virus. It also means we are reliant on things like masks, pharmaceuticals, and military components from China and similar regions. In other words, it feels good for people in a country to have extra import power, until it hollows out the country’s manufacturing base, which is what has happened.

Most wealthy folks and white collar workers have been insulated from this trend for a while, enjoying many of the benefits of a strong dollar without directly feeling most of the drawbacks, while blue collar workers have generally been more negatively affected, because although their dollars are strong, their jobs have shifted overseas and/or their wages were more pressured downward by foreign competition.

The U.S. has a lower median net worth than a significant portion of our peers despite a higher mean net worth than many of them, which means that we have a greater percentage of people on the brink of insolvency, that can’t afford lost income streams. In addition, the United States has the highest per-capita healthcare costs in the world, and for many people, their health insurance is tied to their employer. Plus, the U.S. went into this crisis with the highest government deficit as a percentage of GDP than most other advanced countries in 2019.

For these reasons, my overall opinion is that the U.S. will be forced to have larger fiscal deficits and central bank balance sheet expansion than many of our advanced peers over the next 3-5 years, even though most nations will also face high deficits and monetization of those deficits. It is a question of relative magnitude relative to GDP.

I will monitor this situation over time to see how it develops.

Equal Weight vs Market Weight

I am watching a few indicators lately, and one of them is the ratio between the S&P 500 equal weight index and the S&P 500 market weight index.

Most major stock market indices are weighted by market capitalization, meaning that the bigger the market capitalization of a stock (the total value of all shares), the bigger its weighting in the index.

For example, Apple Inc (AAPL) has a weighting in the S&P 500 that is more than 100 times as big as Nucor Corporation (NUE), even though they are both S&P 500 members. Nucor is a mid/large cap steel producer, while Apple is one of the largest mega-caps the world has ever seen.

As another example, even compared to other top-100 S&P 500 companies, like Union Pacific Corporation (UNP) or Texas Instruments (TXN), the software titan Microsoft (MSFT) holds a slot in the index that is more than 10X the weighting of either of them.

This market capitalization allocation method is mainly for low costs. Index funds were created decades ago when trading costs were high, and this market-weight momentum strategy maintains minimal turnover. Nowadays, trading costs are way lower, but that is still how many index funds are weighted.

On the other hand, there are some equally weighted indices. An equal weight S&P 500 index, for example, weights each of the 500 companies equally. So, rather than Apple representing over 5% of the index and Nucor representing 0.05% of the index, they would both represent 0.20% of the index. An equal-weight index must rebalance regularly (usually quarterly) to maintain that equal weighting.

Here is how the S&P 500 market-weight-vs-equal-weight data compare from inception of the data in 1989 to the end of June 2020:

However, we can see that there are periods where the market-weight index does way better (such as the 2000 tech bubble), and periods where the equal-weight index does way better (such as the 2007 housing bubble).

Here is a chart that I lighted back in May. The top five stocks in the S&P 500 (Microsoft, Apple, Amazon, Alphabet, and Facebook) now make up over 20% of the 500-company index, which surpasses the amount of concentration that occurred even at the height of the Dotcom bubble:

Historically, the equal weight version tended to go on to perform worse than the market-weight version for the next several years after periods where the top 5 companies had a smaller share of the index, such as the mid-1990’s and the mid-2010’s. Inversely, it tended to outperform significantly from periods where the top 5 stocks had very high concentration, such as the early 1980’s and early 2000’s.

We are currently in the biggest period of concentration in over 40 years.

If we view it as a ratio, meaning we take the S&P 500 equal weight total return index and divide it by the S&P 500 market weight total return index, we can see more clearly periods where one or the other outperforms. Whenever this line is rising, it means equal weight is outperforming, and whenever it is falling, it means market weight is outperforming:

There, a strong pattern appears. During the later stages of a business cycle, and particularly during recessions when the market sells off sharply, investors flock to the biggest and strongest companies, and therefore the market weight version outperforms. On the other hand, during the earlier portions of a new economic cycle, when growth is accelerating, the equal weight version outperforms. At that point, previous market leaders tend to be overvalued, and new leaders spring up to take their place in terms of equity returns.

And then this pattern can be overlaid with the previous point that the equal-version tends to do well over a cycle from a starting point of high-concentration, while the market-version tends to do well over a cycle from a starting point of low-concentration.

If history is of any guide, if a new business cycle begins, we should likely see the equal weight version outperform in the years ahead, after under-performing for the past several years, and particularly under-performing during this crisis. In other words, some of the more troubled names like banks, miners, industrials, and so forth would likely need to rebound more sharply, if there is to be a true broad-based recovery from the March and April lows.

Both the stage of the cycle we are in (mid-recession), and the degree of concentration we have in the S&P 500, would suggest that the next several years are more favorable towards the beaten-down equal-weight version.

On the other hand, investors should always be aware of the possibility of a major structural change, i.e. that “this time is different”. Maybe we’ll enter a new era of mega-cap dominance, where Apple (AAPL), Microsoft (MSFT), Amazon (AMZN), Facebook (FB), and Alphabet (GOOGL) continue to outperform, going from over 20% of the 500-company index to over 30%. That is not my overall opinion, but it is an outcome to consider in terms of risk management.

This could depend in part on antitrust decisions for how much acquisition and consolidation that the U.S. government wants to let happen in the corporate sector, which makes it difficult to predict. Alternatively, it could shift in equal-weight’s favor if there is a sustained trend change from disinflation (which disproportionally benefits “growth” names on average) towards reflation or stagflation (which would more likely benefit “value” names on average).

There has been an interesting development in the past couple weeks of multiple major advertisers, from Unilever (UL) to Coca Cola (KO) to Verizon (VZ) to Honda (HMC) to Diageo (DEO), dropping or pausing their Facebook (FB) ad campaigns, and some other social media advertising plans as well. Will it be temporary and blow over, or will analysts need to adjust their bullish forward consensus estimates a bit?

Meanwhile, Alphabet is apparently shifting from secular grower to cyclical mega-cap now that it has such a large market share of the (cyclical) advertising industry, with an anticipated decline in 2020 adjusted EPS, which would be its first adjusted EPS decline as a public stock since the early 2000’s, while it is trading at a more than 32X multiple of analyst-consensus 2020 earnings per share.

Slow-growth blue-chip Apple, at the same time, has been closing stores due to a rise of COVID-19 cases in the United States, and has significant supply chain exposure to China as the economic war between the two great powers continues to heat up, but has been bid-up to rather high valuations.

Long-term Portfolio Updates

I have several investment accounts, and I try to provide updates on my asset allocation and investment selections in each “Economic Research” article.

These investment accounts include a primary passive/indexed retirement account, two actively managed brokerage accounts at TD Ameritrade and Infinity Futures, and the model portfolio account specifically for our Investment Clubs.

Changes since the previous issue:

• Opened a 2% stake new position in Nucor (NUE).
• Added 3% stake in JP Morgan Chase (JPM), now up to 5%.
• Sold 5% stake in Aberdeen Gold Shares ETF (SGOL), now down to 10%.
• Sold 5% stake in Aberdeen Silver Shares ETF (SIVR), now down to 9%.

In other words, I reduced precious metals exposure a bit and increased equity allocation.

This was for a variety of reasons. Precious Metals in my opinion has become overvalued after such a strong rally, it became clear that the stock market was pricing in a V-shaped economic recovery.

I would be happy to shift that 5% stake back into precious metals “if” I start to see the major markets start to roll back over and negative sentiment come back in.

Final Thoughts

The stock market has been bid-up by the combination of fiscal and monetary policy response, while the raw economic indicators remain in a troubled state.

I shifted some equites into precious metals in March (a bit earlier than ideal, rather than right at the bottom), and rode up this rally, but I’ve been putting on the brakes a little bit since mid-July. I am going to keep a close eye to see whether the spring fiscal stimulus is running out of steam or not.

I continue to view assets that do well in an inflationary environment (or negative real interest rate environment) in a positive way for the long run from current levels, as part of a diversified portfolio. This includes certain types of real estate and real businesses, high-quality commodity producers of copper and oil, and quality gold miners.

I also continue to like a diverse batch of global equities as part of a portfolio, but am cautious about the heights that the S&P 500 and Nasdaq have reached in recent months amidst so much fiscal and monetary stimulus, and thus use a counter-cyclical Treasury management policy of taking some chips off the table in overbought conditions, and getting a bit more aggressive in oversold conditions.

Conclusion

Embrace your subscription here with Pries Capital. As you work your way through your subscription, remember that this is not all-encompassing. It is a 40,000-foot view of how day trading/investing works & is designed to give you the basic information to get past the all-important question of how to get started. As time goes along, make note of any questions or highlights, & then come back to Jason, whether email or by phone, & ask questions to learn more about anything on your mind. Pries Capital is a community of all diverse types of day traders and investors, so begin participating, learning, & growing.

With that said, “We have great challenges & great opportunities, and with our help we’ll meet them together!” – Jason Pries