Beware the Great Rotation
Commentary: It might be time to pull back from stocks, not dive in
new
Feb. 18, 2013, 3:15 p.m. EST
By Mark Hulbert, MarketWatch
CHAPEL HILL, N.C. (MarketWatch) — The most cited bullish argument these
days, at least among the couple of hundred investment advisers I
monitor, is that the stock market will “melt up” as investors sour on
bonds and transfer the trillions they have in fixed-income mutual funds
into stock funds.
I suppose it is conceivable. But a careful review of historical fund
patterns doesn’t provide much support for this so-called Great Rotation
argument.
Consider the share of all mutual-fund assets (excluding money-market
funds) that are allocated to either stocks or bonds. According to data
provided by the Investment Company Institute in Washington, the equity
share at the end of 2012 stood at 65.7%. That is only marginally lower
than the 71% average of all comparable monthly readings since 1970.
Given that pattern, it is difficult to make the case that average fund
investors are allocating an abnormally low share of their assets to
stocks — or that they are about to increase that share.
Other mutual-fund data cast doubt on the Great Rotation as well.
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Consider 1987, arguably the period over the past three decades most
relevant to the Great Rotation argument today. Then, as now, a bull
market was getting long in the tooth. Beginning in April of that year,
following more than 60 months in which fund investors had invested an
average of nearly $4 billion a month of new money in bonds, they
reversed course in a big way. Over the next six months, according to the
ICI data, fund investors withdrew an average of $3 billion a month from
bond funds.
As market historians recall, the stock market that year topped out in
August, four months after that trend reversal. And the 1987 crash — the
worst one-day drop in U.S. stock-market history — occurred two months
after that. Far from inaugurating a new bull market for stocks, that
reversal in fund investors’ opinion about bonds came right before a
major stock-market top.
Another reason to question the Great Rotation argument is that any
positive impact on the stock market is likely to be short-term at best.
That, at least, is the finding of a study, “Measuring Investment
Sentiment with Mutual Fund Flows,” published last May in the Journal of
Financial Economics.
The authors found that even though the stock market often rises as
investors shift assets from bond funds to stock funds, almost all of
that increase is reversed within four months’ time.
The Great Rotation stock-market melt-up hypothesis also would have to
fly in the face of well-documented seasonal trading patterns. A study
presented in December at the Australasian Finance & Banking
Conference in Sydney, “Seasonal Asset Allocation: Evidence from Mutual
Fund Flows,” found that U.S. fund investors on average transfer assets
from stock to bond funds during the winter months — and do just the
reverse in summer.
As followers of the famous “Sell in May and Go Away” seasonal pattern
will recognize, the implication of this new research is that the stock
market on balance has performed better when the direction of fund flows
between stocks and bonds is in precisely the opposite direction of
what’s presumed by the Great Rotation argument.
Even if a Great Rotation out of bonds comes to pass, it doesn’t mean investors will move all of that money into stocks.
In fact, they probably would put much of it in boring old money-market
funds, according to Claude Erb, a former fixed-income fund manager at
Trust Co. of the West.
Investors are reluctant to transfer funds between one asset class and
another, Erb says. Since they typically consider money-market funds to
be in the fixed-income asset class, money funds most likely would be the
primary beneficiary of bond-fund redemptions, he says — especially
since the higher interest rates that make bond funds less attractive
would make money funds more so.
If these patterns are any guide to the future, now might be the time to
pull back from stocks rather than dive in. As Russ Wermers, a University
of Maryland finance professor and one of the authors of the research
presented at the December conference, puts it: “For most investors, the
more proper response to the fund flow premise of the Great Rotation
argument is probably to reduce equity exposure rather than allocate new
sums to equities.”
Mark Hulbert is the founder of Hulbert Financial
Digest in Annandale, Va. He has been tracking the advice of more than
160 financial newsletters since 1980. Follow him on Twitter
@MktwHulbert.
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