INSIGHTS

On September 29, 2014

Viewpoints from AAM – Analyzing the Federal Reserve’s Flow of Funds Report

Human dynamics and all the irrationality brought to individual assessment of opportunity – or lack thereof – never ceases to amaze me. Consider that in the last few years as the market has grown consistently and measurably, we haven’t witnessed a substantial correction. This is in light of Russia’s invasion of Ukraine, the rise of the Islamic State, European recession, China ghost towns and real estate bubble fears, quantitative easing by 58% of the global GDP and the fears of tapering; yet we haven’t seen a drop of 10% in a long time. Our director of Money Management, Mike Boyle, CFA, has detailed this at length and I would recommend reviewing his previous blogs. However, an event last week brought about a short correction that mirrored some of the previously listed events. Who would have guessed that the flexibility of the iPhone 6 Plus would concern markets to the point of rivaling the geopolitical crises that seem to escalate daily.

Though said in partial jest and embellishment, it continues to bring to light that logic in the short run has little to do with market gyrations. Instead, we are constantly bombarded by little-to-great externalities that, given time to incubate, can become large concerns. One subtle, but potential, note that may fit this area is the shocking announcement of Bill Gross leaving PIMCO to go to Janus. There are several stories as to why; however, the shift of a key figurehead and founder moving is substantial in what occurs to current assets held by PIMCO; and what will the fallout be? One thing we know about shifting assets from one asset manager to another is: underperformance and manager change. This will be one to watch closely as we are talking about substantial amounts of assets at risk of transferring. Then again, it may prove to be like all the other events, a non-event.

One note that did come up was the current release of Flow of Funds report from the Federal Reserve. Over the last few years, this has proven to be much like the statements from the FOMC (Federal Open Market Committee): predictable and regrettable in that so much focus was placed upon it only to be let down by its sterile direction. However, the Fed Flow of Funds report had a little twist.

First, the household profile showed little change to overall net worth and cash deposits. The more important takeaway is the maintaining of the swell of liquidity on a macro scale.

The big shift was the disappearance of revisions in the corporate funding gap. We’ve discussed the timeliness of the figure showing companies’ ability to fund their operations and potential expansion spending internally, or the need to utilize capital markets.

When the line above is below 0, companies are generating enough cash from operations. Over time this has only been the case approximately 20% of the time. When the line is above 0, the need to access capital markets and various other forms becomes necessary. Notice the two high water marks and their closeness to recent market tops. Prior to the current release (before revisions), we were well below zero. After revisions and including recent data, we are back to the point when companies have to utilize external funding. The chart below shows the revision shift.

What this chart above tells us is that while this is more problematic to the bullish case, it isn’t quite a ringing for the warning bell. It does tell us to be a bit more mindful. We also want to be mindful that the Federal Reserve, as with every other economic statistic released, is initially released in pencil with an eraser nearby.

One side note on the corporate picture is expectations for earnings. It appears we are running at 3% GDP for the third quarter. Though that might be slightly bullish, consider what has occurred with corporate profits under a much more benign growth.

Though continuing our mindful approach, there continues to appear to be a bias toward the upside through the end of the year in equities…though it is never in a linear fashion.

CRN: 2014-0905-4395R 

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