A new Great Rotation?
By James Saft
(Reuters) – One of these days, and it might start soon, investors are going to begin to reverse their multi-year rotation out of stocks and into bonds.
We are now fully 30 years into perhaps the greatest bond bull market in history, as interest rates have slid from the high teens to a level that feels like it’s change for a Coke. As well, equities have returned virtually nothing for a decade for most investors. To make matters for equity bulls worse, these lousy returns have come along with huge volatility as the market worked its way through first the dotcom bubble then the housing bubble and now very possibly the social media bubble.
The last 30 years have been marked by two related trends. Inflation has fallen, benignly at first but painfully after the bursting of the housing bubble. At the same time debt levels surged, first in private hands before the crash and now in public ones.
This has all combined to entice, and sometimes force, investors to move money from stocks into bonds, a trend which itself has helped to reinforce the underlying fundamental forces of falling inflation and growing debt levels.
Michael Hartnett and Kate Moore, equity strategists at Bank of America Merrill Lynch, call the coming move to stocks “The Great Rotation” and argue it will affect profoundly what does well and what poorly. Thinking in five-year increments they argue that the rotation, when it comes, will largely up-end where the winners in markets can be found. Rather than creditors, debtors should outperform while equity will outperform credit and cash do better than gold.
The huge question is when does it start and what will be the signals?
“The Great Rotation argues for a complete shift into the assets that have underperformed in recent years, a move that would clearly compromise the leadership of growth, yield and quality,” they write in a note to clients.
For now, the catalysts for such a rotation are missing: an end to the era of deleveraging and a normalization of real estate, labor, and monetary policy (i.e., no QE3 and a Fed rate hike), the strategists wrote.
“Only if the Fed is willing and able to raise rates in the next 12 months should investors consider radically altering their asset allocation, in our view,” the note said.
WATCH THE FED
In some ways, this is all no more than wondering when the great recession will actually end, and there lies the danger. It is absolutely true that should we find ourselves in a position where housing is doing well again and the Fed is ready to raise interest rates, then of course equities will outperform bonds and of course investors will begin to shift asset classes.
The difficulty of the situation is that it is extremely difficult to know how long it will take housing to right itself and when an improving jobs picture will actually spark inflation. For a lesson on how easy it is to get this wrong in a balance-sheet recession, one characterized by the destruction of debt, just look at Japan. There have been any number of false dawns over Tokyo in the past 20 years and each one of them has burned investors who turned prematurely bullish.
To be sure, the Great Rotation will be a powerful trend once it is established, and like the move out of stocks will be self-reinforcing.
A look at the size of the move out of stocks gives a flavor of exactly how powerful the trend will be.
Bonds and bond funds held in portfolios of U.S. individual investors have grown markedly, especially in recent years. Bond allocations have gone from a low of 7 percent in August of 2000 up to 19 percent today, according to data from the American Association of Individual Investors.
Over the same period equity allocations have decreased to 61 percent from 71 percent. Allocations among state and local government pension funds show a similar move, with especially sharp moves into bonds and out of stocks in recent years. As well, a lot of the institutional money that has gone into hedge funds in recent years has come out of equity long-only holdings. Some of that will have gone back into equities but much ended up in credit- and debt-based hedge funds.
Given that pension fund assets are 73 percent of GDP, a reversal of this trend will be both powerful and, very likely, slow moving.
The best strategy may well be to try to be a little late and a little smart rather than be the genius who calls the turn. Let others take the big early gains, and be satisfied with joining in once the trend is well established.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at email@example.com and to see previous columns by James Saft click on SAFT/)
(This has been corrected in paragraph 5 to read “the coming move to stocks”, not “the coming move to bonds”)