The Decumulation of Equities Will Provide Future Support to Bonds

the great rotation

the great rotationThe recent retreat from all-time highs for the Dow Jones Industrial Average (DIA), S&P 500 (SPY), and Russell 2000 (IWM), likely caused more than a few investors to buy the dip.  After all, throughout stock-market history, buying the dip has been a strategy that eventually makes people money.  Despite virtually every piece of financial literature distributed to investors including language similar to, “Past performance is not indicative of future performance,” financial advisors and investors far and wide believe that over the long run, past performance will indeed be indicative of future performance.  From wealth accumulation strategies to withdrawal strategies, the financial world is built upon the foundation of an ever-rising stock market that can return high-single-digit to low-double-digit compounded gains over a person’s investing lifetime.

With that in mind, it seems like an appropriate time to remind investors of something Morgan Stanley Research published in late 2013.  It concerns baby boomers and what Morgan Stanley terms the “decumulation phase” that could strain the financial markets beginning just a few years from now.

The Morgan Stanley Research piece in question is its October 8, 2013 Blue Paper entitled, “Global Asset Managers – Great Rotation? Probably Not.” On page 20, it says the following:

“Ageing demographics mean regular income, capital preservation and lower volatility are key

We expect that ageing demographics will subdue the strength of this rotation relative to history and will drive convergence between the Retail market and the retirement market. The reduction in equity allocations for the >60 age bracket over the past decade (based on ICI data for the US market) plus the ageing demographic (consultants estimate that within five years nearly 75% of Retail assets will be owned by retirees or those close to retirement) clearly call into question the sustainability and strength of this rotation back into equities. By the end of the decade, the weight of Retail money will be in decumulation phase, as it is in Japan today. We expect that regular income, capital preservation and lower volatility outcomes will be the key focus of this investor group. Moreover, while US Retail equity allocations at ~50% are below the peak levels of the late 1990s of ~59%, they are above the longer-term average of ~45% since 1965” [emphasis added].

If just four years from now (the study is one year old, hence four years to go) 75% of retail assets will be owned by retirees or those close to retirement, it creates several problems for the stock market.

First, financial commentators can scream and holler as much as they want that investors should be nowhere near bonds.  But as many people enter retirement, their investment focus shifts to stability and income.  And, for better or worse, bonds are still the asset class people think of first when it comes to stability and income.

Second, unlike some of the fortunate dividend-growth aficionados in the blogosphere, most people in the baby-boomer generation will not be able to live off the dividends their investment portfolios currently provide.  This will put selling pressure on equities, as baby-boomer portfolios are drawn down over the next couple of decades.  Additionally, baby-boomers are unlikely to be willing to stomach the 30% to 50% decline in equities that is likely to occur at least once during their retirement (when a bear market pops up).  The need for capital preservation will be enough to push money into “lower volatility outcomes” creating additional selling pressure on equities.

Third, if the Fed actually goes ahead with a rate-hike cycle in the coming years, as so many investors expect, it will only push more baby boomers into bonds, as higher yields become too attractive to pass up (especially when one has become accustomed to the lower yields of recent years).

Fourth, as Morgan Stanley noted, U.S. retail equity allocations are still about 500 basis points above their longer-term average.  If mean reversion is indeed in our future, it would create selling pressure on stocks.

If you will be part of the group that will own 75% of all retail assets a few years from now, you will have significant competition in your search for yield.  Those who are truly concerned about capital preservation should start learning about the benefits of investing in individual bonds, instead of following the herd into bond funds.  There are retail brokers that now charge just $1 per bond (1 bond = $1,000).  There are also dealers that offer minimums as low as one bond per purchase.  That even makes it entirely possible for investors with smaller portfolios to diversify across a variety of companies for a reasonable commission.  Concerning the topic of individual bonds, you may find a few of my prior LearnBonds articles of interest.  The ones I am referring to can be found here and here and here.

More from The Financial Lexicon:

The 5 Fundamentals of Building a Retirement Portfolio
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