The Great Rotation, or not

Cross-posted from FTAlphaville.

The ‘great rotation’ from bonds into equities: a few weeks ago it was looking like itmight be seriously on. Even Albert Edwards sort of kind of said equities were cheap. And Ray Dalio said it is happening, too.

But there are a bunch of reasons why it doesn’t seem to be quite such a sure thing, at least for now.

First, definitions. What is the Great Rotation? It depends on who you’re listening to. It can either be a generalised RORO-type rising preference for risk assets, or a more specific “tilting of pension and insurance funds’ strategic, long-term asset preference back towards equity from extreme positioning in bonds”. That latter definition was from a Reuters story, which goes on to describe it thus:

The gist of the argument is that investor holdings of now expensive, ultra-low yielding government debt – following a virtually unbroken 20-year bull market in bonds – are ripe for rebalancing. The attraction of relative and absolute valuations in equity will coax the outflow to stocks.

Leaving aside the fact that stock markets in the past day or so have demonstrated they can still get quite jittery over the eurozone, there are many arguments that the great rotation was overplayed.

One likely area of over-exuberance was the suggestion that US deposit outflows were related to the TAG unlimited insurance on deposits over $250,000 at the end of 2012, and therefore people were moving from bank deposits to equities. For several reasons (including the obvious question of why one would substitute totally non-guaranteed equities for totally guaranteed bank deposits) this theory doesn’t pan out so well.

But the simplest and most obvious anti-TGR argument is just that there hasn’t been a corresponding flow out of bonds. In fact, bonds are still rather popular.

Another counter is that the whole concept is misguided: equities can’t have been “underowned” all this time because *someone* has to own them, right? Ditto bonds being ‘overowned’, or whatever.

However we think this is a little nitpicky. Yes, that terminology of ‘underowned’ etc is silly. But the ‘great rotation’ argument is, at least in some places, about pension funds and insurers moving their long-term asset allocation mixes into more equities and fewer bonds. There are other types of investors, after all, who might be taking the other side. You could also point out that there’s a bunch of asset classes that aren’t stocks or bonds. Let’s look at a bit of what Ray Dalio said at Davos:

The returns of cash are terrible. So as a result of that, what we have is a lot of money in a place — and it needed to go there to make up for the contraction in credit — but a lot of money that is getting a very bad return. That, in this particular year, in my opinion, will shift. And the complexion of the world will change as that money goes from cash into other things.

So that’s the broad-brush theory, or theories. Some, such as BofA, think it’s already happening as asset managers begin to regain an interest in the likes of European bank stocks; others such as Dalio see it as a more subtle shift, connected to monetary policy and liquidity, that hasn’t necessarily begun yet.

But the key anti-TGR argument of the past few days is that the evidence from January flows data just isn’t that supportive of net flows out of bonds and into equities.

Morgan Stanley’s cross-asset strategist Gerard Minack is among those who’ve pointed this out. In fact, he says there wasn’t an anti-rotation out of equities to unwind in the first place:

First, the idea of a ‘great rotation’ from debt into equity presupposes that there has been a massive rotation from equity to debt. It’s not clear that that has happened. The great rotation of the past few years appears to have been from cash-like assets into debt, not from equity to debt. Exhibit 1 shows US mutual fund flows. The big trend from early 2009 has been out of money market mutual funds into debt funds (and bank deposits).

Moreover, he says if one looks at equity fund flows, there are no signs of a mass exit — though there is a big shift towards ETFs:

Also, he points out that if one were to place faith in big shifts by, say, pension fund managers into a particular asset class as supporting said asset class, history does not bear this out:

Flows from funds are not the only flows, of course, but Minack says this does indicate that long-term funds moving into an asset class isn’t enough to sustain gains in that class — an idea that seems to be behind the argument that the great rotation is bullish for equities. It seems unlikely, at least, that equities are becoming more attractive on fundamentals alone.

Also, says Minack, aggregated asset mixes by pension funds vary wildly between different countries. Look at the US, Finland and Australia — whose pension funds’ equity weightings were all somewhere around the 40 per cent mark in 2010, and bonds were as little as 10 per cent in the case of Australia. By contrast Poland, Mexico, Sweden, Spain and Denmark all had well over 50 per cent of assets in bonds.

Other arguments are that it’s just seasonal flows, or a one-off related to the wave of pre-cliff dividend payments of late 2012. Matt Boesler at Business Insider has been documenting these theories in the past few weeks.

So, maybe nothing happened and we can all go home now.

We can’t quite call it quits on the subject, however, without looking at a genuinely bearish view on this.

Then again, fund manager John Hussman who calls himself a reluctant permabear, says it’s not only not a great rotation; it’s actually time to get defensive:

These conditions represent a syndrome of overvalued, overbought, overbullish, rising yield conditions that has emerged near the most significant market peaks – and preceded the most severe market declines – in history:

1. S&P 500 Index overvalued, with the Shiller P/E (S&P 500 divided by the 10-year average of inflation-adjusted earnings) greater than 18. The present multiple is actually 22.6.
2. S&P 500 Index overbought, with the index more than 7% above its 52-week smoothing, at least 50% above its 4-year low, and within 3% of its upper Bollinger bands (2 standard deviations above the 20-period moving average) at daily, weekly, and monthly resolutions. Presently, the S&P 500 is either at or slightly through each of those bands.
3. Investor sentiment overbullish (Investors Intelligence), with the 2-week average of advisory bulls greater than 52% and bearishness below 28%. The most recent weekly figures were 54.3% vs. 22.3%. The sentiment figures we use for 1929 are imputed using the extent and volatility of prior market movements, which explains a significant amount of variation in investor sentiment over time.
4. Yields rising, with the 10-year Treasury yield higher than 6 months earlier.

The blue bars in the chart below identify historical points since 1970 corresponding to these conditions.