One of the concepts I’ve discussed over the past couple of years has been the flow of funds into bonds, a result most notably tied to demographics and two bear markets. It appears that with the leading economic indicators turning around, causing rates to rise, that after five years investors are finally starting to believe in the U.S. The exodus out of bond funds in June may have slowed down, but the trend appears solid as risk appetites have returned for investors.
Since the stock market bottomed in 2009, it has clearly been the best investment class. Jim Puplava likes to tell the story of how investors didn’t want to have anything to do with stocks after the ‘87 crash. It was the hardest subject to broach with investors at the time. The financial market is the one business where nobody wants to buy when products come for sale. Below is a performance chart showing the S&P 500, Pimco’s Total Return fund, gold, the CRB commodity index, and a European stock index. If you could have set your portfolio in 2009 to the various asset classes, it would have been best served to weight U.S. stocks over the past five years.
However, after two bear markets, investors so far have been much more concerned about protecting their retirement than growing it. After 2008, their 401(k)s became 201(k)s with an S&P 500 down 50%. Scared by the correction in stocks, they moved their portfolios into cash and bonds. 2010, 2011, and 2012 has seen some of the lowest infusions of cash into stocks, while bonds have seen the most new cash flows, as seen below.
Source: www.ici.org
As I mentioned before, a lot of the shift into bonds has to do with the population aging and risk tolerances changing through the span of a 10-year secular bear market. Not to mention investors have been plagued with one crisis after another: housing bubble, financial bubble, Japanese Tidal Wave and Fukushima, Greece, Debt Limit Debates, European Sovereign Debt Crisis, Flash Crash, and Sequestration. The chart below shows, as of 2011, that investors in their 50s and 60s have dramatically lowered their exposure to stocks in their 401(k)s compared to their peers a decade before.
Source: www.ici.org
Retail investors chase returns. Data from ICI shows that new cash flow to bond funds is related to bond returns. That’s important because for the first time in years, long-term yields have begun to rise, causing bond prices to fall.
Bond investors are getting worried enough that they’re pulling out billions out of bond funds. That money is going to cash and equities – more specifically – foreign equities.
Source: www.ici.org
Three months don’t make a “great rotation” out of bonds and into stocks, but the writing is on the wall. Long-term, rates have nowhere to go but up. Yes rates can go sideways a little longer, but if the Fed plans to taper its purchase and end them by mid-2014, and emerging markets and the developed economies continue to improve, then yields are likely headed higher. Leading economic indicators are finally trying to put in a long-term bottom. Given that the economy seems to be on surer footing, I’m sure the Fed wouldn’t mind reloading its chamber with bullets as soon as it can in case there’s another crisis around the corner; however, with two failed QE attempts at jump starting the economy, the Fed’s doves are wanting to let this version linger a little longer.
Source: Bloomberg
With the major stock indices up double digits this year, it is likely that investors will begin to move more money into equities as investors chase returns. We see it now with the outperformance of small cap and momentum stocks these past four months. After so many months pouring into riskier assets, it may be time for a break in stocks over the next couple of months as we consolidate, but it is a welcomed sign that this bull market may finally be coming into its own. There’s a lot of money in bonds and it will need to be reallocated as rates rise on less accommodative monetary policy and stronger economics.
Next week should be exciting on the 18th when the Fed announces its policy along with its supplemental meeting with Bernanke. The markets are looking to the 18th as the next catalyst to move the markets in a given direction. The news isn’t what’s important, it will be the reaction of the market in stocks and bonds.
