Why pension fund managers are reducing stock market exposure…
Brendan Greenwood, CFP, CIM, B.Comm | May 10, 2023
What is happening with the economy?
The global economy has been in a state of flux in recent years, and one of the primary drivers of change has to do with shifting monetary policies of central banks and growing government debts. These changes have had a significant impact on the world's financial markets.
Loose monetary policy accelerated consumption and the amount of money chasing assets contributing to higher than normal inflation and higher stock market prices. Governments reversed course last year and began raising interest rates, increasing borrowing costs, slowing down economic activity. This, in turn, can lead to a decline in stock prices, as investors become less optimistic about the future prospects of corporate earnings. State street measures the risk sentiment amongst institutional money managers and notes it hasn’t seen three consecutive months of negative readings since 2015.
Are stocks overpriced?
Let’s look at the S&P 500, a major US stock index as our proxy for the stock market. The S&P 500 tracks the total market capitalization (share price) of 500 of the largest companies in the US. The cyclically adjusted price earnings (CAPE) ratio of the S&P 500 can help us gage whether the stock market is over-valued. CAPE looks at the 10-year average real earnings of all the companies in the stock index and compares them with the current stock price of all companies that make up the index. The higher prices are relative to 10-year average real earnings the more expensive stocks are. Currently the CAPE ratio is around 29 compared to a long run average of 15 going back to 1957.
The current CAPE ratio highlights a stock market that is still richly valued, trading near valuation levels that preceded the 2007-2008 financial crisis. Elevated market valuations and rising interest rates have led to a fall in the equity risk premium, a measure of the excess return the stock market provides above the risk-free rate. The risk-free rate represents the interest an investor can expect from a risk-free investment over a specific period.
The equity risk premium has fallen dramatically leading asset managers to start considering alternatives that provide a better risk-reward trade off.
Where is the smart money going?
Pension fund managers typically are more vigilant in how they manage money because of their promise to deliver a defined benefit. Over the past several years due to falling interest rates they’ve had to take on increasing risk to generate enough return to meet their pension liabilities. In the current higher interest rate environment pension fund managers can reduce their risk and earn just as much. In the face of a looming recession pension managers are reducing their stock market exposure. In some cases, to 50% and in more extreme cases much lower. AON a global management consulting firm that advises pension fund managers, in it’s modelling of possible stock market outcomes included a scenario involving a 50% decline in stock values over 3 years without an immediate rebound.
Most notably pension fund managers are increasing their exposure to inflation sensitive holdings such as commodities and private infrastructure. Allocations are also being increased to publicly traded bonds as well. Institutional managers believe higher interest rates are likely to persist for the intermediate term. It would serve your portfolio well to evaluate the percentage held in stocks and the types or stocks held. For example, in higher interest and inflationary environments value has historically outperformed growth stocks that tend to have valuations dependent on future cash flows. If you’re reducing the percentage of money allocated to stocks, you need to assess what alternatives make the most sense.
Brendan Greenwood is an Investment Advisor and Financial Planner with Worldsource Securities Inc. specializing in tax advantaged personal pension strategies and low volatility investing for professionals, incorporated individuals, business owners, retirees and their families.
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