Domestic stock funds garnered a whopping $21 billion in the initial four weeks of 2013, according to Lipper. This was the best four week period for inflows since early 2000 and caused analysts to debate the issue of a ‘mini’ or ‘great rotation’ from bonds to stocks. Market mavens therefore wonder if we are at the verge of a landmark inflection point. Even if we are not, the Great Rotation has an element of truth.
A scenario of outflow from the traditional bond market into the stock market is not difficult to conjure. Bond prices have reached the stratosphere thereby no longer compensating owners adequately. It is feared that to extrapolate the generous bond returns from the past three decades into the future may smack of hallucination. In contrast, equities are available at reasonable P/E multiples in line with historical norms and offer compelling value despite the run up in prices since The Great Recession.
However, rather than money solely flowing from bonds to stocks, money moving into the stock market appears to be coming from cash on the sidelines (and money market funds), hedge funds as well as new money earned by individuals. Investors are also rotating funds from the European bourses to the domestic market.
Multiple factors point to concurrent inflows into both stocks and bonds rather than a sole bond outflow/ equity inflow situation. Firstly, as millions of baby boomers near retirement age they will likely place a heavier emphasis on fixed income securities. Overall, they may be expected to hold diversified positions including both stocks and bonds, but probably weighted in favor of bonds.
Their behavior in turn, influences pension fund managers and annuity managers who become less supportive of a Great Rotation from bonds to stocks. Equity exposure at pension funds and endowments are at low levels in the U.K. and U.S. as these institutions favored bonds during the last few years. In this regard, bookkeeping rules and regulations in the U.S. and solvency requirements in Europe encourage pension funds and insurance companies to hold bonds.
Even if the bond market was to take a hit and Treasury yields rise, it may still not be reason for systematic outflows from bonds to stocks. Instead, investors could plausibly be expected to buy on dips and take fresh bond positions through dollar cost averaging.
In the end, pundits suggest that investors consider a continuum of stock and bonds to derive the best combination of liquidity, safety, returns and diversification. A mixture of stocks and bonds has beaten 100% stock index funds in several of the past few years.
To the extent there is a migration from bonds to stocks that money may flow into defensive equity sectors such as consumer staples, utilities and pharmaceuticals. Some prospective plays include Colgate-Palmolive Co. (CL - Analyst Report), Unilever plc (UL - Analyst Report), Procter & Gamble Co. (PG - Analyst Report), Johnson & Johnson (JNJ - Analyst Report), Merck & Co. Inc. (MRK - Analyst Report), Eli Lilly and Company(LLY - Analyst Report), AT&T, Inc. (T - Analyst Report), American Electric Power Co., Inc. (AEP - Analyst Report) and The AES Corporation (AES - Analyst Report). A dividend stream in some of these companies may offer a stable income besides the possibility of capital appreciation.