Speculation Of A 'Great Rotation' Is Premature

The S&P 500 Index closed above 1500 for the first time since 2007 on Friday, January 25, 2013, after rising for eight days in a row—the longest streak of daily gains since a nine-day run ended in 2004. Speculation has emerged that the long-awaited rotation by investors from bonds into stocks may finally have arrived and is powering the rally and, if so, that it has a long way to go. While we are also awaiting the rotation of investment flows from bonds into stocks, we think the latest speculation is premature and that the stock market rally may be due for a pause or a modest pullback.

Lipper, the fund flow tracking service, has reported inflows into stock mutual funds each week so far this year, providing some evidence that investors are finally favouring stocks after years of selling. However, the details of the data reveal that the money is not going to U.S. stock funds and not coming from bonds:

  • U.S. stock fund outflows. While U.S. stock mutual funds have seen inflows, during the past two weeks, the combined total of U.S. stock mutual funds and exchange-traded funds (ETFs) have been outflows. While ETFs only account for about one-tenth of the assets in mutual funds, they often account for most of the weekly flows.
  • Bond fund inflows. At the same time, taxable bond funds and ETFs have seen inflows.

The details of the data reveal that there is no evidence of a rotation from bonds into U.S. stocks, yet. The only rotation that appears to be taking place is out of money market funds into international stock funds, which continue to see steady inflows.

Another reason not to get overly excited about this development is inflows to U.S. stock mutual funds have been a good contrarian indicator for the stock market in recent years. For example, the last time U.S. stock mutual funds experienced a monthly inflow was April 2011—just as stocks peaked for that year on April 29, 2011 [Figure 1]. Prior to 2011, the inflow in April 2010 took place just before a stock market slide that began on April 23, 2010.

lpl rotation

Photo: LPL Financial

The inflows we have seen this year are likely part of the normal pattern of inflows in the early part of the year that have been followed by outflows during the rest of the year. The real test of investors’ appetite for U.S. stocks will be later this year, as we see if the flows to U.S. stock mutual funds can buck the seasonal pattern that typically shifts to outflows.

Many individual investors consider the risk in investing to be the likelihood of suffering a loss during a quarter or a year, rather than the risk of missing longer term investment objectives. This is why they have shifted out of stocks and into bonds so consistently in recent years despite solid, but volatile, stock market performance. Investors have sought the perceived safety evident in the steady but relatively low return of bonds at the expense of potentially undershooting their long-term goals.

A long-term rotation from bonds to stocks is likely to begin sometime this year, as yields finally start to rise following a 30-year decline that boosted bond market total returns and pushed bond valuations to highs. High-quality bonds may begin to suffer losses, and the growing dividends per share coming from stocks become more attractive with stock market valuations near 20-year lows. However, those claiming that it is already underway are premature and may be in for disappointment if they expect the stock market rally to continue each week in the months ahead.

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