Wednesday, January 23, 2013

Has "The Great Rotation" from Bonds to Stocks Begun?

According to Credit Suisse, more than $1.1 trillion has flowed into bond mutual funds since 2008, while equity funds have experienced $415 billion of outflows.  Even the low level of interest rates which has prevailed over the past several years has not changed the enthusiasm for bonds among retail investors.

There's been a lot of talk in the financial press about when we will start seeing a significant move from bonds to stocks, a.k.a. "The Great Rotation".

And they are not alone.  Credit Suisse also notes allocation to equities among US and UK insurance companies and pension plans are at 50 year lows.  Institutional investors have not only been adding to bond positions, but to investments in alternative asset classes such as hedge funds and private equity.

At some point, some analysts believe, bond investors will face the unhappy prospect that their investment positions are not even earning the rate of inflation, and begin to rotate back to stock positions.  When interest rates rise, the thinking goes, investors in bond mutual funds will find the value of their funds declining, and move back to stocks.

All of this, of course, is a very bullish long term forecast for stocks.

While we are starting to see some signs of a shift in asset allocation, it is too early to state that we have begun to see any significant changes, in my opinion.  But the press, at least, has begun to pick up on any signs of change.

Here, for example, is an excerpt from a Reuters article published this morning:

According to Lipper, net flows to U.S.-based equity funds in the first two weeks of 2013 was, at $11.3 billion, the biggest fortnightly inflow since April 2000. Including exchange traded equity funds (ETFs), the number tops $18 billion - well over twice the flow to equivalent bond funds.

What's more, fund-tracker EPFR said some $7 billion of inflows to emerging market equities alone in the first week of the year were the biggest on record and these have outstripped demand for emerging bond funds five weeks running.

In a note published this morning, Merrill Lynch chief equity strategist Savita Subramanian wrote the following:

Despite relatively consistent net buying of US stocks by our pension fund clients since 2008, Small Cap Strategist Matt Trapp recently noted in his US Pension Analysis report that pension equity allocations have generally been decreasing over this period as flows into bonds have been much larger than equity inflows. If we begin to see a Great Rotation from bonds into stocks, pension funds may increase their equity allocations, suggesting inflows could begin to accelerate. As Matt notes, every 1ppt increase in equity allocations for private defined benefit pensions could yield additional equity inflows of $23bn. Given the longer time horizon of pensions vs. other institutional and hedge fund clients, pensions may also be better positioned to take advantage of the attractive valuations of US equities. 

Whether the recent trends are the start of a significant asset shift, or merely a blip in fund flows at the beginning of a new year, remains to be seen.

In my opinion, the real test will be when we get a market "correction".  If there is truly pent-up demand for equities, this will present investors an opportunity to buy at prices cheaper than today.