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Stock investors are like Vladimir and Estragon waiting under the tree for Godot. But, instead of two days, stock investors have been waiting for nearly eight years now. Day after day, year after year, they keep waiting and hearing from little boy analysts about how the “great rotation” out of bonds and into stocks may not happen today but surely will happen tomorrow. Yet, outside of the Pozzo and Lucky like distractions, such as the daily rise of S&P 500 Index beyond any reasonable explanation on many trading days, the “great rotation” of money flowing out of bonds and into stocks never actually takes place. Are stock investors today merely players in the capital markets theater of the absurd?
Why We Need To See Godot
The arrival of the great rotation by investors out of bonds and into stocks is critically important to stock investors for the following reasons.
A defining characteristic in capital markets through the post financial crisis period has been the fact that stocks have soared to new record highs at the same time that bond yields have fallen to historical lows. Many investors have viewed only one of these two outcomes as sustainable. Either the economy would accelerate into a sustained growth phase accompanied by higher inflation that would eventually send investors out of their bond allocations in pursuit of opportunities in stocks, or the economy would eventually fall back into recession, causing stocks to fall back to earth with investors moving to the relative safety of bonds.
The bias among investors has been heavily tilted toward stocks eventually prevailing as the winner and adding to its gains while the bond market will eventually relent. A primary flaw has continuously existed with this stocks-over-bonds narrative throughout the post-crisis period, however, which is the fact that domestic equity stock mutual funds and ETFs have been consistently hemorrhaging money flows throughout the post-crisis period – they have seen a net reduction of nearly $1 trillion since the outbreak of the financial crisis – while taxable bond mutual funds and ETFs have seen steadily strong inflows throughout. Put simply, retail and small- to mid-sized institutional investors have been selling their stocks and buying bonds for about a decade now since the outbreak of the financial crisis.
OK, so this explains why the cumulative returns on long-term U.S. Treasuries (NYSEARCA:TLT) are more than +100% over the past decade. But how could it possibly be that the stock market has tripled from its March 2009 lows if its retail and institutional participants have been cumulative net sellers over this time period? It has been primarily due to two factors: central bank liquidity flows and share buybacks by corporations with access to low cost debt.
Such is the dilemma facing stock investors today, and why they find themselves waiting under a tree day after day for the great rotation from bonds to stocks to finally take place. For the flow of central bank liquidity is increasingly drying up, as the U.S. Federal Reserve is now raising interest rates and the People’s Bank of China has been tightening policy since 2015. The Bank of Japan appears to be approaching its limit along with the European Central Bank, whose long-term existence may increasingly come into question in the coming years. Moreover, while corporate share buybacks did rebound from their slowing pace in 2016 Q4, the fact that corporate debt-to-total capital ratios are running historically high at a time when liquidity conditions are now tightening and the pace of economic growth remains lackluster suggests the pace of corporate buybacks may prove more difficult to sustain going forward. In short, stocks desperately need a new source of demand to maintain stock prices at their historically high valuations today, and waiting on the great rotation Godot is their best hope in finding this support.
Not Today But Surely Tomorrow…
Perhaps this helps explain why lately when listening to analysts in the media that the anticipated great rotation is not just discussed as a possibility but simply assumed as a given. Surely bond yields will rise as investors move out of bonds and into stocks.
The only problem is that it simply is not happening. According to data from the Investment Company Institute, domestic equity mutual funds and ETFs experienced net outflows of -$217 billion from January 2015 to October 2016. At the same time, taxable bond mutual funds and ETFs experienced net inflows of +$161 billion. In short, the exact opposite of the great rotation.
At first, it appeared that the stock market Godot might finally have arrived in November 2016. From November 2016 to March 15, 2017, domestic equity (NYSEARCA:SPY) mutual funds and ETFs experienced net inflows of +$82 billion.
But these recent net inflows into domestic equities (NASDAQ:QQQ) may end up being nothing more than a Pozzo and Lucky like distraction for several reasons.
First, this was also not a great rotation out of bonds and into stocks, and bonds not only did not experience net outflows during this time period, but also actually experienced net inflows at +$94 billion that were $12 billion greater than the net inflows into stocks.
Second, since March 15, taxable bond mutual funds and ETFs have received another +$33 billion in net inflows. Put simply, still no rotation.
Lastly and perhaps most importantly, the net inflows into domestic equity (NYSEARCA:DIA) mutual funds and ETFs appears to increasingly be grinding to a halt. For since March 15 through April 12, domestic stocks have seen net outflows of -$22 billion, thus wiping out more than a quarter of the net inflows they had accumulated since November.
The Bottom Line
Stock investors are waiting for Godot in assuming that the great rotation out of bonds and into stocks is somehow coming right around the corner. And despite having suffered the abuse of several dramatic and stressful drawdowns in recent years, today’s stock market participants appear able to blindly look past weak economic growth, historically high valuations, and such absurd narratives as “bad news is good news” and “fundamentals don’t matter anymore” in trusting that the stock market is going to be able to keep its portfolio values moving steadily higher and without too much to get worked up about along the way.
Unfortunately, all of these forces are increasingly meaningful risks of which investors should be concerned. For just because the market is bored to death with historically low volatility, is seemingly almost asleep sometimes in its upward drift, and is trapped in a nihilistic loop that may continue for several more years before it’s all said and done, it still does not remove the fact that the cycle will eventually be broken and the unpleasant reality will finally return to the U.S. stock market.
And just as we reflect back on both the tech bubble and the housing bubble with remarks like “how could we have not known better”, one suspects a day may come in the future where investors are wondering the same about the markets today.
Of course, the U.S. stock market continues to rise in the meantime. But just because investors all around you are waiting endlessly for Godot does not mean that you must do the same. Don’t just go blindly into passive investment products assuming that everything will just work out fine over time, for next time the bear strikes, the bounce back may take much longer than it has in the recent past. Instead, build a broadly diversified asset allocation strategy that includes stocks that are selected with particular valuation, return and risk control objectives in mind. And complement these stock holdings with other asset classes such as bonds (NYSEARCA:AGG) and precious metals (NYSEARCA:GLD) that have a low to modestly negative correlation to stocks that can do their own thing from a return and risk perspective regardless of what the stock market may be doing at any given point in time.
Stop waiting under the tree for stock market narratives that are never going to play out. The second longest bull market in history is not going to last forever. Look to continue to participate while the upside returns still last, but do so within the framework of a strategy that can also perform once stock investors finally come to the realization that the great rotation Godot and the many other Godots both before and after are simply never going to arrive.
Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.
Disclosure: I am/we are long TLT, PHYS.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am long selected individual stocks as part of a broadly diversified asset allocation strategy.