Tuesday, February 19, 2013

What Great Rotation?

Over the past few weeks, we have been hearing a lot about the concept of "The Great Rotation." Its theme revolves around the fact that investors who have been putting money into the bond fund for the last decade will now start to rotate that money into the U.S. stocks funds. This rotation will create significant buying pressure in stocks, pushing the market to all time new highs.

However, there are several flaws in this argument.

First: In order to reach price equilibrium market requires buyers and sellers. If significant number of U.S. bond investors decide to sell their bonds, we will need enough investors to buy this supply. Otherwise, bond prices will crash. If bond prices crash, yields will rise sharply. This will very negatively impact the U.S. economic growth, as businesses and individuals will not be able to purchase properties and/or big ticket items on lower interest rates.

Furthermore, once interest rates significantly increase above stock market dividend returns, they will force prudent investors to seek higher returns in the less volatile Bond market. This would also put a burden on the upward rising trajectory of the stock market, and will provide a support for the Bond prices.

Second: In order to justify higher yield, we need the economy to grow at a faster pace. This rise will trigger inflation concerns, and will force the FED to increase interest rates, which will in turn result in bond price decline. But please keep in mind that the economy is not robust yet, even after years of extraordinarily easy monetary policy by the FED. And with recent payroll tax increase & Sequestration cuts, U.S. economy will not become robust for the foreseeable future. Therefore, it is hard to imagine Bond yields rising sharply.

Third: According to a recent survey individual investors are currently almost 65% invested in the stock market. This number is in line with historical averages, suggesting that investors are not substantially under invested in stocks right now. Therefore, they cannot really reallocate into stocks if they are already in stocks.

Based on the above reasons, the Great Rotation argument does not posses merit.

At the same time, historically when individual investors have started putting money into stock funds in droves (as they have done in January and February), it has been a good time to exit the market. We have not only seen this behavior before stock market tops in 2010, 2011 and 2012, but also in the 1980s. Individual investors started to put money back into the stock market in the 2nd quarter of 1987 but the market topped out in the 3rd Quarter of 1987, just before crashing in October 1987.

Therefore, if history is any guide, one should be worried not happy about recent pessimistic sentiment towards bonds and News Headlines about the Great Rotation. In the next update, we will analyze the bond market from a structural and sentiment point of views.

1 comment:

  1. In my view, the only rotation is money that has been in the market (pro traders) is being replaced by the retail investor. That is also a dangerous sign. But what kills me is that the overbought condition in the SP500 and the extentsion of the rally don't jive. I realize that this condition can go on for weeks, but when the two do line up and the pullback starts, it could be deeper than anticipated - more than 5% but no more than 15%. I don't see 20% yet - but it may get there if the rally continues to defy gravity. Be careful out there, this is a dangerous area to be in. Brad


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