The Merrill Lynch World Wealth Report
(October 12, 2006)
Dear Subscribers and Readers,
As of Wednesday evening, October 11, 2006, the Dow Industrials is up 1.92 points while the Dow Transports is up 32.67 points for the week. Meanwhile, the S&P 500, the NASDAQ Composite, the Russell 2000, and the Philadelphia Semiconductor Index are up 0.36, 8.28, 1.90, and 9.25 points respectively. While the “lack of breadth” argument is by no means over yet (although it substantially improved late last week), the market is still on an uptrend. More importantly, there still has not been any significant divergences, and nor have we seen an overbought condition in our sentiment indicators just yet – which means that the current uptrend is definitely not over yet.
As for commodities, readers may recall that I have been calling for investors to stay away from “investing” in commodities in general since earlier this year. More specifically, I had mentioned that natural gas prices were hugely overbought at the end of last year (when it was trading at over $15/MMbtu). As for crude oil, I had stated in our June 11, 2006 commentary based on the latest NOAA projections at that time, an active hurricane season should be the last thing on investors' minds. Coupled with a slowing U.S. economy, the increase in spare oil production capacity in 1Q 2007, and an ever-tightening ECB, I had also argued that crude oil prices have also effectively topped out for this cycle in our August 3, 2006 commentary. Since that time, the spot price of crude oil has dropped from over $75 a barrel to slightly less than $59 a barrel today. Even so, we had argued in our September 17, 2006 commentary that the current cyclical bull market in commodities in general or energy cannot be called “over” unless the Canadian dollar (which has an over-50% correlation with both the CRB and the CRB Energy Index over the last 16 years) starts to roll over. At that time, it was trading at nearly US$0.90. Today, the cash price of the Canadian dollar has declined to below US$0.88. My guess: Even though both oil and natural gas prices are now oversold and should bounce at any moment, this author is not going to touch them with a ten-foot pole – cut or not cut from OPEC. Moreover, given that natural gas inventory levels are over 400 Bcf greater than last year's inventories at this time, and given the demand destruction of many industrials users that we witnessed last winter, Spring 2007 prices for natural gas (at nearly $8/MMBtu) is still too high unless we have another historically cold winter this year.
The huge multi-month technical breakdown in oil can also be witnessed in the following chart of the AMEX Oil Index (the XOI):
While the oil bulls can argue all day that the absolute level of the XOI is still on an uptrend given that it hasn't broke the 1,000 level (even though the XOI is below both its 20-week and 40-week moving averages) – it should be noted that on a relative strength basis (vs. the S&P 500), the XOI has already suffered a significant breakdown. Coupled with a slowing U.S. economy, historically high inventory levels, and an increase in world spare capacity starting in three months, there is a good chance that the cyclical bull market in crude oil prices has ended – for now.
However – even though the cyclical bull in crude oil and natural gas prices has ended – I would still argue that both of these commodities are still in a secular bull market. As I have argued before, the most bullish scenario for oil prices in the intermediate and longer-term (next three to five years) is for the price to settle within the $45 to $50 level for at least 9 to 12 months – long enough to discourage VC funding in the alternative energy industry and to encourage the purchase of SUVs again – before it again embarks on a new uptrend. Technically, this is called “forming a base” and is one of the most bullish patterns in stocks charting simply because the folks that are still holding oil or the same stock after 9 to 12 months of inaction are inherently “strong hands” and would not sell unless there is some kind of “blow off” in prices. As for some of the oil service companies such as HAL – I realize that on a P/E basis, the stocks are screaming “buy” but keep in mind that these are historically cyclical companies and actually tend to exhibit low P/E ratios near the top of the cycle rather than near the bottom (when P/Es are actually usually very high).
At this point, I want to spend the rest of this commentary discussing the 2006 Merrill Lynch World Wealth Report – which was released a little bit over three months ago. To quote Merrill Lynch, the purpose of this report is to “explore the investment behaviors of the world's wealthiest people — who in so many ways shape the attitudes and financial service demands of individual investors everywhere.”
In this report, Merrill focuses on the investment behaviors and demands of high net worth individuals (HNWIs) – those will financial assets of over US$1 million. To quote further: “In summary, 2005 was marked by decelerated growth — in line with our year-ago forecast — largely driven by two economic forces: GDP and market capitalization. HNWI portfolios remained fairly stable during the period yet revealed a slightly more aggressive approach with increased allocations to alternative investments and equities. While their overall asset allocations are similar to ones HNWIs employed in 2004, they are markedly different from those seen in 2002, further evidence that HNWIs do monitor market shifts and reallocate as appropriate. This year's Spotlight section focuses on growth through globalization and the upcoming generational transfer of wealth. Over the next few years, these powerful market forces will reshape HNWIs' portfolios and, ultimately, wealth-management service offerings.”
Other significant developments include:
- 8.7 million people globally hold more than US$1million in financial assets — an increase of 6.5% over 2004
- HNWI wealth totals US$33.3 trillion, representing an 8.5% gain since 2004
- Wealth generation was driven by real GDP gains and continued market capitalization growth
- Emerging markets registered strong advances in market capitalization, aiding wealth creation in regions such as Latin America, Eastern Europe and Asia-Pacific
- South Korea, India, Russia and South Africa witnessed the highest growth in HNWI populations
- HNWI financial wealth is expected to reach US$44.6 trillion by 2010, growing at an annual rate of 6.0%
More importantly, readers should get a good sense that – based on both this report and our previous commentaries discussing the historical trend of US households' balance sheets – unless 1) The Central Banks of the world commit a significant policy mistake, or 2) There exists a significant rise in protectionist sentiment around the world, or 3) The developed countries of the world raise income taxes significantly, or 4) the world engages in World War III – the trend of increasing wealth among both HNWIs and the general population should continue going forward. This historical trend is highlighted in the following figure straight from the Merrill Lynch World Wealth report:
As one can see from the above chart, the amount of wealth held by HNWIs experienced only a slight dip in 2001 and 2002 – even in the midst of the events of September 11th and the biggest collapses in U.S. corporate history – all in the aftermath of the great technology and telecom bubble. If there was ever a post WWII financial anomaly, this was it. As shown by the Fed's Flow of Funds data, the destruction of wealth of US households during the years 2001 and 2002 were in fact significantly greater (on a percentage basis) than the destruction of wealth during the 1973 to 1974 bear market. Again, the lesson to be drawn is this: The world economy continues to be more robust than most people think – unless one or more of the four above-mentioned events occur, which is not likely anytime soon according to my research.
According to Merrill's projections, the amount of global wealth among HNWIs will continue to rise – on average - $2 to $2.5 trillion a year for the rest of this decade. Assuming a mere slowdown in the U.S. economy for the next six to nine months, there is no reason not to expect a continuing uptrend in the U.S. stock market, especially given that both U.S. large caps and U.S. growth stocks are among the most undervalued asset classes in the world today (as exemplified by both private equity funds and corporate insiders who are buying U.S. shares at an unprecedented pace). For illustration purposes, the U.S. economy experienced the highest GDP growth out of virtually all the developed economies in the world last year and yet the U.S. stock market also experienced the worst performance at the same time. Given that the UK FTSE 1000 returned 16.7% and given that the Paris-based CAC 40 returned 23.4% last year, there is every reason to believe that the S&P 500 could gain in excess of 12% to 15% for 2006 even as the U.S. economy experienced sub-par growth (for the record, the French economy grew only 1.4% in 2005).
Now, for readers who are financial planners, private wealth managers, hedge fund managers and private equity managers – I encourage you to read this report in full, as it not only discusses the behavior and beliefs of high net worth individuals, but also discusses other issues that are close to the hearts of high net worth individuals, such as the effects of bequeathing assets to their children, the ability to track their net worth and risks with simplified reports, as well as having a “warmer” client/wealth manager relationship as opposed to a manager that only cares about delivering absolute performance. To illustrate the first point, the following chart shows some of the beliefs of current relationship managers as it pertain to the HNWI heirs:
Managing the relationship across different generations will continue to gain importance going forward, given the fact that baby boomers are significantly wealthier than their parents are and given that many of them are now retiring or close to retirement. To make it harder on the wealth manager, their heirs of the HNWI clients also promises to be more pro-active and more financially educated than their parents ever were. In other words, one better starts thinking about how to communicate various investment options and strategies to the folks in the Generation X and Generation Y group right now!
Henry To, CFA