Money & Finance - The Great Rotation

The bull continues to run as January posted some of the best gains in the stock markets in decades. Our equity portfolio has kept a “risk-on” long position since our behavioral model turned bullish back in mid-December. Needless to say we are pleased to be on the right side of this market move but continue to be extremely cautious with how long we intend to stay exposed.

As can be seen in figure 1, when running the various U.S. sectors and indices through our model, we are getting bullish readings for most of them. We will remain long and enjoy the benefits while it lasts. 

 

The Great Rotation

Given the myriad of risks with the ability to derail this freight train of a stock market, we have been reading excessively about the “great rotation”. On 1/22/13 we wrote a newsletter that outlined increasing fund flows into U.S. stocks and heightened investor confidence.

Expanding upon the points in that letter, we continue to see large sums of investor money flow into equities. According to some figures that have been produced and making a few assumptions on our part based on past trends, the month of January probably saw north of $70 billion make its way to the stock market. This is occurring as the ten-year treasury yield has risen to roughly 2.0%. 

This is a potentially important observation given that money has heavily gravitated to fixed income securities since the 2008 economic crisis. Whether corporate, high yield or sovereign, investors have found peace of mind in bonds and have avoided the stock market at all costs.

To highlight this trend, we have modeled a comparison between fixed income and stocks. To do this, we are taking the historical twelve-month forward earnings estimates for the S&P and creating an earnings yield (basically the inverse of the P/E). This is for ease of comparison.   

When plotted against the ten year treasury yield, it’s easy to see the misallocation of asset classes, as the yield differential between to the two are two standard deviations away from the norm. The S&P 500 earnings yield is 7.5% vs. 2.0% for bonds. This clearly highlights the dangers of a coming collapse in U.S. Treasuries should investors decide stocks are the better investment vehicle.

Five years later it now seems the risk averse have become risk tolerant and many market professionals believe this great rotation out of bonds into stocks will propel the market to new highs and beyond.

We are fine with this explanation as long as we are capitalizing on it.

That said, there have been a few great notes that have come out debunking the great rotation theory and claiming that the liquidity driven rally will come to an end expediting a major market correction (that is long overdue in our opinion).

 

 

Myth Busting the Great Rotation

According to Citi analysts William Katz (via Matthew Boesler at Business Insider), if the great rotation is truly upon us, they have not seen any indication of concern from earnings calls with the three major players in the fund space. After reported earnings and conference calls with T. Rowe Price, Waddell & Reed and Affiliated Managers Group, Katz has determined there is no threat of the great rotation as of yet. 

In fact, after listening to Bill Gross from PIMCO funds on Bloomberg radio the other day, his views corroborated what Katz has determined. If there is a great rotation happening, PIMCO is not seeing it. This makes sense in our view considering bond fund flows. If there truly was a great rotation then one would expect money being PULLED from bond funds and PLACED into equity funds. According to Boesler, for the first three weeks of January, bonds funds pulled in $9.4 billion, $10.6 billion and $8.0 billion, respectively. Hardly evidence of a rotation.

More Evidence against the Rotation

Gerard Minack from Morgan Stanley (again courtesy of Matthew Boesler at Business Insider) put together three “must-see” charts for anyone anticipating a great rotation from bonds to stocks.

http://business.financialpost.com/2013/02/01/anyone-hoping-for-a-great-rotation-into-stocks-must-see-these-charts/

 

 

“This illustrates that the size of the outflow from equities in the past five years doesn’t explain the massive inflows into bonds. The big redemptions from money market funds over the same time period may be the missing link: the rotation in recent times may be more aptly described as one out of cash and into debt.

Regardless, it’s not even quite fair to say that money has just poured out of stocks in recent years. In fact, even though equity mutual funds have sustained hundreds of billions of dollars in outflows, the truth is that equity ETFs have seen even bigger inflows over the same period, as the chart below reveals.” 

 

 

“The next issue Minack raises is U.S. pension funds’ current allocation to equities. Right now, it’s hovering just above its long-term average of 50 percent. It is thus hard to see how the big, “real money” investors could provide much impetus for big marginal flows into equity funds.”

 

 

“While one would expect these to display a positive correlation, the fact is that there have been long periods – in the late 1980s, for example, or the mid-1990s – when returns displayed an inverse correlation with flows.

Even though the economy appears to be on the rebound, economic fundamentals are still the biggest open question, according to Minack: More to the point, while investor sentiment has clearly improved over the past half-year, it’s not clear that sentiment could withstand material bad news. We’ve seen this upbeat equity mood before over the past three years. Likewise there have been significant set-backs to debt.”

 

Fed Power

Let’s not forget that it is the desire of our leaders in Washington to keep interest rates as low as possible. Chairman Bernanke wants to keep monetary policy as easy as possible in hopes of stimulating a sluggish economic policy and the Obama Administration has used this cheap money to finance Keynesian fiscal policy to achieve the same outcome. In all, as look as Washington retains control of its influence in the markets*, we doubt there will be considerable movements in yields.

* We say retains control because the day will come when they lose control than all bets are off. (But that discussion is for another day).     

 

Bottom Line: We are long this market and have enjoyed early gains for 2013. If this great rotation proves to be correct, we would expect the market to continue to climb and for our investors to capitalize on this momentum. Should the great rotation prove to be false, the market will quickly run out of liquidity and in our opinion head lower into what can be a major correction.

We do not have an idea which scenario will most likely play out. What we can be certain of is that we will “follow our model” and attempt to profit by capturing the trend either way.

 

References

http://business.financialpost.com/2013/02/01/anyone-hoping-for-a-great-rotation-into-stocks-must-see-these-charts/

http://www.telegraph.co.uk/finance/comment/jeremy-warner/9837996/Enjoy-the-stock-market-rally-while-it-lasts.html

http://www.businessinsider.com/citi-seasonality-not-great-rotation-2013-1

http://www.businessinsider.com/el-erian-explains-the-great-rotation-2013-2

http://www.businessinsider.com/bond-god-the-world-is-changing-and-bonds-are-the-most-overbought-ive-seen-in-my-55-year-career-2013-2

- Joseph S. Kalinowski, CFA

Twitter: @jskalinowski

 

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