The Great Rotation?

The financial media loves a catch phrase and, with the apparent emotional hook of the ‘fiscal cliff’ diminished, we needed a new one.  The current best candidate is the so-called ‘Great Rotation.’  The idea here is that investors, finally and completely fed up with the dismal returns from bonds, are going to move heavily back into equities.  This is the ‘Great Rotation.’  When I Google the term, there are 820,000 search results.  Not bad for a phrase that was invented in October 2012 (in a research note from Bank of America, apparently). 

The big stock market rally in January 2013 helps to bolster the proposition that money is finally switching from ‘risk-off’ to ‘risk-on,’ but how deep does the evidence really go?  There are a series of arguments about why the current rally happened, and why it should continue.  The real question for investors, however, is how often they are willing to fall for a slick marketing pitch.  An escalating frenzy in any investment makes for lots of exciting TV commentary and when people get emotionally charged up, there is money to be made.  But who will the winners and losers be?

The basic narrative should be familiar now.  There is a major opportunity, and you better get on board to avoid missing out.  Don’t worry about the data to the contrary.  Don’t worry about the fact that this new trend seems to defy the experience of history.  Move quickly (Act now, while supplies last!).  This reasoning has been used to create innumerable bubbles.  Most recently, this narrative has been applied to tech stocks and the ‘New Economy’ (one of the great catch phrases of the past), real estate, and yet another batch of IPOs that have turned out really well for founders and venture capitalists but not so well for investors who bought in around the IPO (e.g. Facebook (FB), Zynga (ZNGA), Groupon (GRPN), Yelp (YELP), and Pandora (P)).

Perhaps the most dangerous thing about every ‘big idea’ like the ‘Great Rotation’ is that they contain grains of truth.  There is no question that bond yields are dismally low and that investors seek alternatives with higher potential return.  It is also true that there is a huge pool of money sitting in investments that yield little or nothing.  The problem is that the narrative of the ‘Great Rotation’ implies that people should and will radically re-allocate from fixed income assets to equities.  The reality is that stocks are not especially cheap on the basis of their earnings and stock prices are ultimately anchored to earnings, not the fact that investors want higher returns.  It is true, of course, that stock prices can and do decouple from the earnings of the firms in which they represent ownership and can stay decoupled for years at a time.  We saw price-to-earnings ratios skyrocket in the Tech bubble and remain high for years, before they ultimately returned to what are considered rational levels.

The challenge that I would pose to investors who want to get in on the ‘Great Rotation’ is to have a concrete set of metrics for how they choose to invest and how they will know when to ‘rotate’ out again.  During the creation and subsequent collapse of the real estate bubble, investors who established concrete entry and exit criteria based on price-to-rent ratios, for example, would have gotten in early and would have known to get out as the bubble inflated.  Those who simply bought in because prices had gone up a lot (and would hopefully continue to go up) are less likely to have emerged whole.  One of the key metrics that I use for ‘timing,’ to the extent that I do it at all, is dividend yield.  The yield on the S&P 500 in March 2009 was 3.6%.  Today, the yield is down to 2.1% due to the massive surge in the price of the S&P 500 over recent years.  This does not mean that prices may not continue to rise.  The yield on the S&P 500 was at or below 2% for an entire decade through 2007, which demonstrates that yields on equities can certainly get lower (e.g. prices can go higher even with no growth in earnings).  My point here is that stock prices are not especially low on the basis of earnings.  An objective belief in the ‘Great Rotation’ must rest on some other criterion.  The standard narrative is that the enormous quantity of money sitting in cash and money market funds will drive an extended stock rally, but this prediction is just that—a forecast with unknowable probability of playing out.

For those people who do not have objective criteria and who are just following the crowd in timing a major shift from bonds to stocks, I am afraid that the outcome of the ‘Great Rotation’  (as with most ‘next big things’)  is mainly going to be a transfer of money from naive investors to sophisticated ones.

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