What Great Rotation? The Stock Market is Still Incredibly Risky

The epic bond rally that began in the early 1980s seems about to end, as the Federal Reserve eyes raising interest rates. So investors keep hearing about a so-called Great Rotation out of bonds into stocks. Well, it’s not happening, due to lingering leeriness about equities after the horrendous market slide that the financial crisis created – memories that this month’s slide have reinforced.

The notion of a Great Rotation first surfaced in a 2012 Bank of America Merrill Lynch research note. The idea was that low interest rates would push investors into stocks, also known as “risk assets” because their values fluctuate much more than those of bonds. A corollary was that rates would start inching up, which hurts bond prices, giving investors even more of an impetus to tilt to stocks.

For several years following the cataclysm, the perceived safety of bonds gave them the upper hand (see chart below). From 2007 through 2012, $1,021 billion flowed into bond funds, while retail investors withdrew $619 billion from U.S. equity funds.

Then the rotation seemed to kick in – for a while, at least. The big catalyst likely was the sterling performance of the Standard & Poor’s 500 in 2013, when the benchmark stock index advanced almost 30%, not counting dividends.

That year marked a reversal of the pattern of bond funds gaining at the expense of stock funds, with almost $18 billion coming into equity funds and $21 billion leaving taxable bond funds. In the first quarter of 2014, $18.6 billion moved into domestic equity funds, according to the Investment Company Institute.

But roll forward two quarters and take another look at the numbers. At the end of the third quarter on Sept. 30, inflows into domestic equity funds became outflows once more. For the year, stock funds have recorded a negative $20 billion. The stock market’s October bloodbath has deepened this. Taxable bond funds enjoyed inflows through the third quarter of $50 billion.

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The refuge that investors see in bonds persists despite their meager interest income. In 2006, when money began to flow out of the stock market and into taxable bond funds, a $100,000 investment in a six-month Treasury bill generated annual income of $5,150. Lately, this bill yields $50, down some 99%.

Amid memories of the 2007-2009 bear market, equity investors clearly are not exuberant. In fact, they are downright skittish. Although stocks have set record highs this year, they periodically get slammed when a piece of bad news appears, whether it’s a tepid manufacturing report or turmoil in Ukraine. October’s downdraft apparently owes a lot to fears about Europe’s ongoing economic weakness.

During the third quarter, equity investor anxiety began to gain momentum – the period had the bulk of equity mutual fund outflows this year. The damage ranges far beyond the large-capitalization S&P 500:

  • The Russell 2000 small cap index declined 7.4% versus S&P 500 advance of about 1%. The exchange-traded fund that tracks the Russell benchmark, iShares Russell 2000 (IWM) is trading below its 200-day moving average. Relative underperformance of small-cap stocks signals investors are moving toward a more defensive stock exposure.
  • The S&P 400 mid-cap stock index, whose ETF is iShares Core S&P Mid-Cap (IJH), and the Consumer Discretionary Select Sector SPDR (XLY) have broken below their 200-day moving averages.
  • The S&P 500 CBOE Volatility Index, or VIX, which measures how much stocks jump around, increased by over 50% from June through September. This indicates turbulence in the market.
  • The New York Stock Exchange cumulative advance-decline line has mostly moved downward since the start of July.
  • High-yield debt spreads began to widen, a signal that lenders are becoming increasingly worried about credit risk. The chart below shows the difference between the riskiest junk bonds (CCC) and comparable Treasuries. Fear in the corporate credit market often precedes fear in the equity market.

Rising investor anxiety over the past few months triggered two whipsaw selloffs in the S&P 500, one at the end of July and the other starting at the end of September and worsening this month.

Regardless, being out of equities over the past two years has been a mistake. Pullbacks were short and consistently followed with new highs. These sudden jolts, combined with the narrowing of stock leadership in a decreasing number of large-cap stocks, has been a significant challenge to successful tactical investing all year long.

The good news is with generally dispirited equity investors, there does not appear to be an equity valuation bubble. A healthy market pullback may be a refreshing opportunity to put money to work after more than two years of an advancing S&P 500 without a 10% correction.

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Written by Nicholas Atkeson and Andrew Houghton, who are the founding partners of Delta Investment Management, a registered investment advisory firm in San Francisco, and authors of the new book, Win by Not Losing: A Disciplined Approach To Building And Protecting Your Wealth In The Stock Market By Managing Your RiskAdditional market commentary and investment advice is available via their websites at www.deltaim.com and www.deltawealthaccelerator.com

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