I may be a little early discussing this at the end of August, but I believe that pension funds will be buying stock over the the next few months. In a year that can be characterized as marginal given how the S&P 500 has traded in a +/- 10% range around its year-end close of 1115, perhaps this improvement in demand at the margin is just the boost the market needs to get back on track. For the record, I think we move to new highs over the balance of the year, but it sure hasn't felt good recently!
I am no pension expert, but I understand how they work. Their major challenge is to manage a pool of assets against their liabilities. While a lot of this retirement type of money has moved from defined benefit plans to defined contribution plans (i.e. IRAs and 401-k plans), public and private pension funds are still a big factor in the market. We know that John Q. Public has been dumping stocks all year, especially lately, in order to chase bonds, as this shows up in the mutual fund data (which covers a lot of this non-pension retirement bucket). But what about the more rational, actuarial-driven pension fund investor? First, take a look at this chart, courtesy of Towers Watson in their recent Capital Market Review from 6/30:
The pension fund managers are on a treadmill, with their assets unable to keep up with their liabilities. The low interest rate environment inflates the value of the liabilities, but it probably reflects demographic trends too. So, already, we know that they need to grow their assets. We could see companies, which are pretty flush with cash, kick in contributions to mitigate the underfunding, and perhaps we might see some shifts in the assets towards higher yielding (and riskier) asset classes. All of this would seemingly be good for stocks.
The real crux of my argument, though, goes to simple rebalancing. Pensions manage against a model. When asset prices change, they adjust their holdings. This is done typically I believe on a quarterly basis or perhaps when the market has moved in extreme fashion (not the case today, but certainly in 2008-2009), but some of it is done more frequently or less frequently. I expect that rebalancing in October (or earlier) after the recent sharp run-up in bonds could favor stocks. While I think that looking at this quarterly makes the most sense (and the least compelling argument), I want to share a monthly, quarterly and YTD example. My illustration is very simplistic, as it includes only stocks and bonds, thus leaving out private equity, international stocks, commodities, real estate or any number of other asset classes. Let's assume, though, that the long-term model is 60% stocks and 40% bonds. Here are the returns for stocks (S&P 500) and bonds (Barclays Aggregate):
If we start each period rebalanced to "60/40", here is what the allocation looks like now:
- Monthly Rebalance: 59% Stocks, 41% Bonds
- Quarterly Rebalance: 60% Stocks, 40% Bonds
- Annual Rebalance: 57% Bonds, 43% Stocks
While it may not seem so large, if they rebalance monthly or less frequently than quarterly, then pension funds need to sell bonds and buy stocks. This could be magnified by any strategic moves to increase expected return. I also should point out that I have used the broad bond market, but pension funds use long-duration Treasuries to cover their longer liabilities. Thus far, according to Barclay's, 20+ year maturity Treasuries are up 20% in 2010 and over 5% in August. It seems likely that they will at least reduce exposure to long Treasuries as part of their rebalancing.
Going back to this dynamic of the growth in liabilities outpacing the growth in assets, I wanted to see if there was any sort of quarterly rebalancing impact apparent in the past several quarters. I believe it is fairly evident that despite the market being pretty flat over the past year, the previous 5 quarters show a bias towards rising stock prices:
While there are many factors that will influence the near-term direction of stocks, I do believe that the presence of a buyer (pension funds) could help boost stocks. The recent decline in interest rates bodes well not only for rebalancing but also because it further widens the asset/liability gap. Defined Benefit funds are facing significant challenges that I think could force them to reach for return to some degree. Additionally, I have heard many companies discuss plans to make contributions, which will also feed into demand for stocks. At a time when we hear almost non-stop of the sellers (mutual fund redemptions), I think that it is important to keep in mind that there are many buyers too, including the defined benefit plans but also companies that have begun to redeploy their cash by buying their own stock or making acquisitions. My guess is that we will see the pendulum swing from too much supply to too little in coming weeks.
Disclosure: None
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