The Great Rotation or Reflation?
One of the rationales I’ve heard for bullishness on the financial markets since I was an investment babe-in-the-wood is the “mountain of money” argument. Cash on the sidelines, etc. I’ve heard this 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 dynamics involved in the issue of cash holdings throughout various factions in the economy and how invested positions are analyzed, that there simply is no one macro argument one way or the other.
Recently, a new chant on Wall Street as we’ve entered 2013 is “the Great Rotation”. 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 me 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 heck of a lot to be desired. Personally, I think bond “mathematics” are scary, especially set against ongoing Fed balance sheet and US Federal debt expansion. Alternatively, although I’m not shouting from the highest rooftops quite yet, the mathematics of equities argue strongly for the asset class on a relative basis for anyone with even a modicum of time and patience. Having said this, I want to look at the reality of a few numbers that suggest it may be just a tiny bit too early to argue the stampede is on in terms of the so-called “great rotation”. We’ll get there at some point, and who knows, maybe in the not too distant future. But the starting gun has not necessarily gone off quite yet.
Let’s go right to the numbers. The stat that is clearly driving the great rotation thinking is the flow into equity mutual funds YTD. Very much a dramatic turnaround relative to YTD flows in 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 on a combined basis as well as US bond funds and ETFs.
On a YTD basis if we combine flows into US equity mutual funds and equity ETFs, we’re looking at a 135% increase in 2013 numbers relative to last year. Impressive, no? And 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. But of course YTD 2013 flows into US bond funds and ETFs are 61% larger than flows into US equity funds and ETFs. So the question becomes clear as per the data – what rotation from bonds to stocks? Yes, equity funds are receiving greater flows year over year in absolute terms, but flows into US bond funds YTD are much stronger than into equities, for now. An inconvenient fact left out of a lot of recent “analysis”? Sure appears so.
Again, in my own mind the current environment “mathematics” of bond investment doesn’t make sense looking over any type of meaningful time frame. But, in like manner we need to remember that 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 the fourth quarter of last year and last December specifically. 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 4Q2012 and December 2012 events.
Remember that in 4Q and December specifically we saw a massive anomaly in terms of accelerated dividend payments by many a corporation. From Las Vegas Sands to Costco and well beyond, billions were paid out to investors in individual equity securities via common dividends, and of course a portion of this clearly floated through equity funds. 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? At least for now, this is exactly what I believe we are seeing. Combine this with 2012 end of year bonuses, earned income accelerated into 2012 to beat the taxman (and woman), early year qualified plan contributions, etc. and all of a sudden the newfound resurgence of flows to equity funds looks a lot more explainable and much less the optic anomaly. Moreover, the very numbers themselves do not show bond fund/ETF liquidations, quite the opposite. Again, this rotation may be to come, but it has not started yet as per the actual numbers. We have allocation, but not rotation.
Tangentially related to current period “analysis” regarding this great rotation thinking has been what I would suggest is less than thoughtful, to say nothing of thorough, commentary regarding the positioning of large institutional pools of capital. It was a few weeks back that I saw an article in Barron’s proclaiming large pension funds are only 34% invested in equities. I saw a similar number thrown out by a fund manager in this week’s Barron’s. 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 and everyone else can find them quite conveniently in the quarterly Fed Flow of Funds report. 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 data breakdown of US Private Pension (think corporate) Fund assets.
As you can see, right there is that 34.2% allocation to equities, exactly as these commentators have described. By the way, credit market instrument numbers are broken down explicitly among Treasuries, corporate bonds, MBS and agency holdings specifically. The trick, of course, is that this apparent low allocation to equities has been consistent for half a decade to a decade now. It did not all of a sudden drop post 2008. The KEY issue being that the Fed Flow of Funds report does not delineate just what is inside what they categorize as “mutual funds”. And the superficial analysis you have been treated to as of late implies/assumes it’s in bonds, just waiting to “rotate” into stocks. Remember, the private pension funds in this wonderful world have been much more sophisticated than their public pension fund counterparts over the decades as these were the folks that first ventured into the world of alternatives. Moreover, do you really think pension funds would be willing to pay bond mutual fund fees as opposed to much lower individual account institutional bond management fees? Please. These analysts touting these apparent stats clearly have little to no understanding of institutional fund management.
Although not broken out, institutional 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 at worst, is this what we are looking at in this category of 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 sense they are already there. So it’s obvious where the superficial analysis of the moment breaks down, but again that “rotation” story and those offside institutional asset allocation stats being cavalierly quoted sure sound good 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, a very quick look at Public Pension fund asset allocation of the moment. You will not see these analysts quoting these numbers. Why? Because they show the Public Pension funds are already 61% invested in equities. That does not support the great rotation story.
The numbers are clear. And of course these folks are also exposed to alternatives such as PE, Hedge, Commercial RE, 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 financial market commentary. Again, let me be crystal clear, bond mathematics are scary using today as a starting point. 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. Moreover, I remember Martin Armstrong saying a few years back that the public will not come back to equities until they make a new high. I completely agree and we are there for all intents and purposes. The public always chases the inflating asset….until it stops inflating mind you. You’ll remember the old saying, do not confuse brains with a bull market. Here’s a new one for you, do not confuse rotation with central bank reflation. Can we characterize our current circumstances as the “The Greater Fuel Theory”? Time will tell.
About Brian Pretti CFA
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