It’s one of those catchy terms coined by a major Wall Street firm: the “Great Rotation,” which describes the possibility of a major asset allocation shift by investors from bonds into stocks. Specifically, it is the concept of the reversal of the dramatic shift out of equities into cash and bonds during the 2008financial crisis. In 2008, investors pulled approximately $80 billion dollars out of equity funds as fears of the next great depression grew.
Adding to the argument that the “Great Rotation” into equities will occur is the fear of price declines in bond values as interest rates rise. Certainly, one of the biggest financial topics this year has been the Federal Reserve’s plan to eventually taper its aggressive monetary stimulus programs. Just the threat of tapering sent many bond funds price down five to ten percent this year. J.P. Morgan produced a study on historical price declines for various bonds for every one percent increase in interest rates. The following are the losses that historically have occurred in bonds:
5 year Treasury Bonds: -4.9%
10 year Treasury Bonds: -7.4%
30 Year Treasury Bonds: -18.8%
Floating Rate Bonds: -.01%
High Yield Bonds: -4.3%
Investment Grade Corporate Bonds: -6.8%
Three groups of investors comprise most of the market activity daily. 1) Professional Managers (Mutual Funds, Hedge Funds & Investment Advisors), 2) Pensions and Endowments and 3) Retail Investors. Which investors have started rotating out of bonds back into stocks? We can start by looking at the professional managers, whose actions tend to have the most effect in the short-term on markets.
Professional Managers: The latest survey by Bank of America Merrill Lynch covered 172 managers managing over $500 billion in assets. It showed a 7½ -year low in bond positions relative to the funds’ benchmarks. However, the professional managers still are not fully invested in equities. According to Investment Company Institute data, the equity share of all mutual fund assets (excluding money market funds) was 65.7% at the end of 2012; which is below the 71% average of all comparable monthly readings since 1970.
Pensions & Endowments: There is a cohort of investors that could represent a more meaningful shift back toward traditional equity exposure. The source of those funds may come not from traditional fixed income, but from the “alternative” space that has garnered so much attention over the past decade. A recent study by Strategas shows that the “Yale Model” has been all the rage among Pensions & Endowments over the last decade. The Yale model focuses on broad diversification and an equity orientation in different forms. The model holds that liquidity is extraordinarily expensive to purchase and that a greater exposure to asset classes like hedge funds and private equity will boost returns. For example, Yale’s public equity exposure is only 5%, while Princeton’s is only 7%. For pensions & endowments, in 2002 the average weighting in equities was 50% and their alternative investment allocation was 24%. In 2012, their equity allocation was only 31% and their alternative investment allocation was 54%. As you can see traditional equity exposure has plunged as a percentage of these plans’ allocations and the money has been concentrated in alternatives.
Pension & endowment boards are now under a great deal of pressure due to the poor performance and much higher fees associated with many of the alternative investments (like private equity and hedge funds). The focus on risk-adjusted returns, especially since 2008, has prompted many volunteer boards to structure portfolios that are designed more to avoid embarrassment than maximize future returns. The high fees and poor performance of alternatives is likely to lead many boards to go back to more traditional investment allocations which could lead to a large inflow of funds into equities in the coming years.
Individual Investors: The latest data shows individual investors are still sitting on record amounts of cash. Retail bank deposits at the end of October were approximately $9 trillion and they have another $2.5 trillion sitting in money market funds. These accounts are earning little or no interest. The latest data also shows that household wealth invested in stocks is currently around 38%, which is down from the 2000 high of about 53%; but up from its 2009 low of under 25%. Household wealth invested in bonds is at 20% which is up from its 2000 low of about 13%; but down from its 2010 high of over 23%. Retail investors are still nervous about the political dysfunction in Washington and many simply will wait until they are “comfortable” with U.S. economic growth before they are willing to become investors again.
Our view is that when interest rates do gradually rise, the media and “manic” short-term behavior of the markets will lead to overdone selling of bonds and inflows into equities
that may push valuations up to multiples that are above historical averages for an extended period of time. Currently the S&P 500 is trading at 15 times forward earnings which is reasonable based on a 15 year average price to earnings multiple of 16.3. The focus on value and dividends will continue to reward investors in our opinion as all this plays out.
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