A lot was said recently regarding the Great Rotation. Unfortunately, much of what was said was based on misunderstandings of what the Great Rotation actually is or can possibly be. The purpose of this article is to clarify what the Great Rotation is and can possibly be and how it matters to investors.
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Per the February 2013 edition of the Merrill Lynch RIC (Research Investment Committee) Report, the concept of the Great Rotation was introduced in the February 2011 RIC Report. The RIC Report is a monthly investment strategy report. Per the February report, over the last six or seven years, $823 billion net has moved into bond funds and $562 billion net has moved out of long-only equity funds. This equates to a shift of about 5% of all fund assets or about 6% of all mutual fund assets from long-only equity funds to bond funds. The Great Rotation stipulates that this shift will reverse. That is, the same 5% or 6% that moved into bond funds and out of long-only equity funds will move into long-only equity funds and out of bond funds. To quote from the February report: “We now believe 2013 will be the year that the Great Rotation begins in earnest, although this will likely be a multi-year and sometimes bumpy transition.”
Per the February report, the stated to-be drivers of the Great Rotation were “normalization” in GDP (gross domestic product) growth and the return of risk taking post the U.S. recession and financial crisis. It was qualified that the markets needed “to become less fearful” first, as they have become more recently, as many fears regarding things such as the EU (European Union) debt crisis and U.S. budget negotiations have now been addressed or lessened.
In the February report, it was stated that “two major risk scenarios” are seen in relation to the Great Rotation.
(1) “A sharp rise in interest rates, perhaps in response to much better than expected macro data, that prompts massive outflows from bond funds and a widening of credit spreads. 1994 and 1999 stand as two examples where the 10 year Treasury yield rose more than 250bps over the course of a little more than a year, resulting in losses in bond funds and sizeable outflows. Credit Strategist Hans Mikkelsen thinks we will still be able to see an orderly rotation out of bonds if the 10-year yield were to rise to 2.5%. But a rise above 3% in a short period of time could result in a disorderly rotation.”
It is important to note that this was expressed as a “risk”. This means it is seen as a possibility, not a probability. I would also like to note that the “widening of credit spreads” aspect of what was said is, at least, questionable because Treasuries and RMBSs (residential mortgage-backed securities) interest rates figure to increase the most, as these securities have been, and continue to be, the subject of U.S. QE (quantitative easing) buying that should end in the not-too-distant future. (In this context, “credit spreads” should refer to the spread between U.S. Treasury interest rates and non-U.S.-Treasury interest rates for securities with the same time to maturity.)
(2) “A ‘tail-risk’ type event that sends bond yields sharply lower and increases risk aversion. With governments increasingly intervening in currency markets, we view this as one potential source for such an event.”
“Tail-risk”, as used here, simply means an unusual, negative event, like some of the events that were associated with the EU debt crisis. Since February, we had such an event; but it did not increase risk aversion. The Bank of Japan’s decision to buy a rather large amount of securities, thereby flooding the market with more Yen with the goal of increasing Yen inflation to 2% in two years, was such an event. This decision had the knock-on effect of lowering non-Japanese government securities interest rates because Japanese securities are paying very low interest rates that do not make sense with Yen inflation rising to 2%.
Although people often say that money has moved, is moving, or will move from bonds to stocks or stocks to bonds, in relation to the Great Rotation and otherwise, it usually has not, is not, or will not. Basically, the S&P 500, the S&P 400, the Russell 2000, many other indexes, and the stocks therein have a consistent net money inflow or outflow of exactly zero. For example, all other things being equal, when people buy shares in an S&P 500 mutual fund, the fund then buys S&P 500 stocks with the money. For every purchase of shares in an S&P 500 stock, there is a seller at the same exact price. The net related flow of money in and out of the S&P 500 stock is zero. There may now be more mutual fund money invested in the S&P 500, but not more money.
Stocks have a net inflow to the extent additional stocks are offered (via IPOs [initial public offerings], for instance), increasing the stock market capitalization in which one can invest. Stocks have a net outflow to the extent some stocks are no longer offered (due to privatizations, for instance), decreasing the stock market capitalization in which one can invest. Rising and falling stock prices are one of many influences on whether more or fewer stocks are offered.
It, of course, works the same way on the bonds side of the equation. For example, all other things being equal, when people sell shares in a U.S. Treasuries mutual fund, it does not directly lead to there being less money invested in U.S. Treasuries. In fact, it may not lead to this at all. The U.S. government has done and will do a certain amount of borrowing. If Treasuries interest rates rise significantly, the government may or may not be influenced to do less borrowing, as there are other factors involved. Also, the government has done so much new borrowing recently that a net inflow is all but guaranteed for some time to come because, practically, this new borrowing can only be whittled down a little at a time.
Regardless of what anyone says, including people from Merrill Lynch, the Great Rotation, if it occurs, is not about money flowing from bonds to stocks. It is about the subset of bonds and stocks investment money invested in funds shifting more toward stocks.
The vast majority of bond and stock fund money is individual investor money. Individual investors very largely are not pros. The main reason individual investors are invested in funds is for future or current retirement. Individual investors tend to be a trailing, versus a leading, indicator in that they tend to sell after prices have fallen and buy after prices have risen. It is likely that interest rates will have to increase significantly and/or stock prices will have to increase significantly more before the Great Rotation, if it occurs, begins to occur. The Great Rotation will likely not be an initial driver, but a later effect and influence instead. This means you should be paying greater attention to interest rates and stock prices than bond and stock fund money flows.
Moreover, in the context of the big picture, the amount of money involved is not large. Best I can figure, the U.S. stock markets currently have a market capitalization of about $19.5 trillion. $692.5 billion, which is the average of the $823 billion (bond fund inflow) and $562 billion (stock fund outflow) figures mentioned above, is only 3.55% of $19.5 trillion. The size of the U.S. bond markets appears to be about $37 trillion. $692.5 billion is only 1.87% of $37 trillion. The Great Rotation may be better called, simply, the Rotation.
The Rotation, if it occurs, will likely be significant in two ways. First, an already-in-progress upward movement in interest rates and upward movement in stock prices will be fed and increased by the Rotation. This influence on interest rates and stock prices will occur because of a greater overall desire to sell bonds and buy stocks. This influence will not be very significant because this sort of late-to-the-game influence by not-as-smart-money individual investors is usual.
Second, the Rotation, as it completes itself, will serve as a contrary indicator. The shift of fund money from stocks to bonds that occurred in the last six or seven years is signaling that you should own fewer fixed-income investments and more stocks than you normally would, and that your fixed-income investments should be to-maturity-then-cash investments. Once the Rotation is complete enough, an opposite signal will be sent.
It will be difficult to know when the Rotation is complete enough though. There is no certainty that the Rotation, if it occurs, will involve about $700 billion. The actual figure could be much less or much more. No one says being a good investor is always easy.
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