The Great Rotation Or The Greater Fuel Theory?
One of the rationale's we've heard from time to time for market bullishness since we were babe's-in-the-wood investors is the "mountain of money" argument. "Cash on the sidelines", as it's also known. We've heard it at major market peaks and major market troughs. It's convenient, it sounds good and every once in a while may even be true. But there are so many economic dynamics affecting cash holdings and how invested positions are analyzed, that no one macro argument dominates one way or the other.
A new concept chant for 2013 on Wall Street is what has been called "The Great Rotation". The argument runs that money is finally leaving the bubble that is bonds and is and will continue to find its way increasingly into equities. Now before venturing even one step further into this discussion, let us be clear. Starting from where we stand today and looking over the truly longer term (say 5-10 years), the mathematics of bonds leave a good deal to be desired. Personally, we think bond "mathematics" border on scary looking over the long term, especially set against ongoing Fed balance sheet and US Federal debt expansion. Alternatively, the mathematics of equities argues more positively for stock investment on a relative basis for anyone with even a modicum of time, patience, and a tolerance for short term price risk. Having said this, we want to look at a few metrics that suggest it may be a bit too early to argue the stampede is on in terms of this so-called "great rotation" from bonds to stocks that has gone mainstream as of late. We'll get there eventually, and who knows, maybe in the not too distant future. But the starting gun has not gone off yet, despite what you might hear on the "news".
To set the stage, since 2009 equity mutual funds have been under consistent selling pressure. The common thinking is that the public has been liquidating their equity mutual fund holdings as stock prices have moved higher. In like manner, investment inflows into US bond mutual funds have registered record numbers, giving rise to the thinking that the general public has moved to bond investments en masse after experiencing two gut wrenching 50% stock bear markets in less than a decade's time from 2000-2009. The reason for the "new new thing" mantra? Well, inflows to US equity funds so far in 2013 have been of a magnitude not seen in years.
Let's go to the metrics. Investment flows into equity mutual funds so far this year have seen a dramatic turnaround relative to comparable year-to-date inflows from 2012. But what seems left out of the discussion at present is the like period YTD flows into bond funds. The following chart documents YTD flows for both 2013 and 2012 into US equity funds and ETFs (Exchange Traded Funds) on a combined basis as well as collective investment flows to US bond funds and ETFs.
If we consider flows into US equity mutual funds and equity ETFs on a YTD basis, we're looking at a 135% increase in 2013 numbers relative to last year. Impressive, right? Yet when looking at the combined US bond mutual fund and US bond ETF flows, the year over year increase we're looking at totals a paltry 2% increase. Put differently, YTD 2013 flows into US bond funds and ETFs are 61% larger than flows into US equity funds and ETFs as of mid-February. So the question becomes clear as per the data - where is the great rotation from bonds to stocks? Yes, equity funds are receiving greater investment inflows year over year in absolute terms, but flows into US bond funds YTD remain larger than into equities, and haven't subsided. An inconvenient fact left out of a lot of recent "analysis"? It sure appears so.
Again, to ourselves the current "mathematics" of bond investment doesn't make a lot sense when looking out over any reasonable time frame. But, we need to remember that in the very near term flows we are seeing into equity mutual funds today are in large part driven by tax anticipation behavior we saw in Q4 of last year and specifically in December. In very interesting behavior, YTD 2013 flows into US equity ETFs are actually down substantially relative to 2012 YTD experience. Odd in that US equity ETFs have been attracting positive flows at the expense of US equity mutual funds for years now. Why would this switch be happening? Again, it may have roots in Q4 2012 and December '12 events.
Remember that in Q4 2012 and December specifically we experienced a massive anomaly in accelerated dividend payments by many corporations. From Las Vegas Sands to Costco and well beyond, billions were paid out to equity investors in "special" common stock dividends, and of course a portion of this clearly floated through equity mutual funds winding up as money market fund cash in mutual fund accounts. As we move into 2013, are we simply seeing this money return to its rightful home in equities and equity funds, exactly where it was invested a few months ago? We think so. Combine this with 2012 end of year bonuses, earned income accelerated into 2012 to beat the taxman, early year qualified plan contributions, etc. and all of a sudden the newfound resurgence of money flows to equity funds looks a lot more explainable. Moreover, the very numbers themselves do not show bond fund/ETF liquidations - quite the opposite. So, this great rotation from bonds to stocks may come to be, but it has not started yet.
Tangentially related to current period "analysis" and this great rotation thinking (which we would suggest has been less than thoughtful or thorough), is commentary regarding the positioning of large institutional pools of capital. It was a month back that we saw an article in Barron's proclaiming large pension funds to be only 34% invested in stocks. We again saw a similar number thrown out by a fund manager in Barron's again just a few weeks ago. Of course the implication is that 65% of institutional pension assets are invested in bonds. Nothing could be further from the truth, but it sounds good in printed media and on TV, right?
Just where are these numbers coming from? Luckily, you can find them quite conveniently in the quarterly Fed Flow of Funds report published on the Fed's own website. So let's have a look at the raw data and see if perhaps there are a few "unanswered" questions these analysts have forgotten to include in their commentaries. Below is the current asset class breakdown of US Private (think corporate) Pension Fund investments.
|Private Pension Fund Total Assets (billions)||$ 6,598.7||% Of Total Assets|
|Cash (Money Fund)||226.4||3.4 %|
|Credit Market Instruments||1,166.4||17.7|
|Unallocated Insurance Contracts||491.0||7.4|
As you can see, right there is that 34.2% allocation to stocks, exactly as these commentators have described. Private pension fund bond holdings are broken out in detail under "credit market instruments". The numbers further are broken down explicitly among Treasuries, corporate bonds, Mortgage Backed Securities and Government agency bond holdings. This apparent low allocation to equities actually has been consistent for over a decade now. It did not all of a sudden drop post 2008. The real issue being that the Fed Flow of Funds report does not delineate just what is inside the "mutual funds" categorization. The superficial analysis you have been treated to as of late implies/assumes it's in bonds, just waiting to "rotate" into stocks.
Let's remember that private pension funds have been much more aggressive than their public pension fund counterparts over the decades as they shifted allocations to "alternative investments" (e.g. private equity, commercial real estate, venture capital, etc.). Moreover, private pension funds pay well below bond mutual fund fees to have their individual bond allocations managed, so they wouldn't have a large investment allocation to bond mutual funds. The quoted analysts touting this great rotation thesis have been using selective statistics.
While not broken out, private pension funds have been and continue to be heavily invested in private equity "funds", hedge "funds", commodity "funds" and institutional commercial real estate "funds", among a number of other alternative asset class categories. In large part, is this what we are looking at in this category of pension fund mutual fund holdings? Of course it is. Are these really the type of assets just waiting to "rotate into stocks"? Of course not. In many senses they are already there. So it's obvious where the superficial analysis of the moment breaks down, despite that "rotation" story and those institutional asset allocation stats appearing in headlines and sound bites. As Steven Colbert would suggest, it's analytical truthiness. It sounds like the truth. It could be the truth. But.....it's not the truth.
Before wrapping up, let's look at Public Pension fund (think States and municipalities) asset allocations. You will not see the aforementioned analysts quoting these numbers. Why? Because they show the Public Pension funds are already 61% invested in equities. That also does not support the great rotation thesis.
|Public Pension Fund Assets (billions)||$ 3,093.0||% Of Total Assets|
|Cash (MMF)||59.4||1.9 %|
|Credit Market Instruments||850.2||27.5|
The numbers tell the story. And of course public pension fund assets are also exposed to alternative investments such as private equity, hedge fund, commercial real estate, commodity, etc., just to a lesser extent than their private pension fund brethren. The public and private pension assets in the US "rotated" a long time ago.
So there you have it - just a few facts to contemplate amidst the cacophony of daily "noise" that is often financial market commentary. As always, we have to look under the hood in financial market and economic analysis. In summary, as our President would say, let us be clear. Current bond investment mathematics border on scary if you buy today and look long term. Equities have a relative advantage in a world where central bankers have eliminated the return component from principal safe investments. Central bankers having flooded the global system with unprecedented conjured liquidity that could easily spark an equity "melt up". We remember an analyst I respect saying a few years back that the public will not come back to equities until they make a new high. We concur. The public always chases the inflating asset....until it stops inflating, of course. Remember the old Wall Street adage - never confuse brains with a bull market. And here's a new one for you - never confuse asset class rotation stories with central bank asset reflation (one of the Fed's primary goals of quantitative easing is to get stock and real estate prices higher).
Can we characterize our current circumstances as the "The Greater Fuel Theory"? Time will tell.