Weekly Market Commentary - Still Waiting for the Bonds-to-Stocks Rotation

WMC_WP2Stock mutual funds have seen inflows each week so far this year, providing some evidence that investors are finally favoring stocks after years of selling. However, the details of the data reveal that the money is not going to U.S. stock funds and not coming from bonds. A long-term rotation from bonds to stocks is likely to begin sometime this year, but those claiming that it is already underway are premature and may be in for disappointment if they expect the stock market rally to continue each week in the months ahead.

 

 

Still Waiting for the Bonds-to-Stocks Rotation

 

The S&P 500 Index closed above 1500 for the first time since 2007 on Friday, January 25, 2013, after rising for eight days in a row — the longest streak of daily gains since a nine-day run ended in 2004. Speculation has emerged that the long-awaited rotation by investors from bonds into stocks may finally have arrived and is powering the rally and, if so, that it has a long way to go. While we are also awaiting the rotation of investment flows from bonds into stocks, we think the latest speculation is premature and that the stock market rally may be due for a pause or a modest pullback.

Lipper, the fund flow tracking service, has reported inflows into stock mutual funds each week so far this year, providing some evidence that investors are finally favoring stocks after years of selling. However, the details of the data reveal that the money is not going to U.S. stock funds and not coming from bonds:

 

1-29-2013 chart 1

mutual funds and exchange-traded funds (ETFs) have been outflows. While ETFs only account for about one-tenth of the assets in mutual funds, they often account for most of the weekly flows. ƒƒ Bond fund inflows. At the same time, taxable bond funds and ETFs have seen inflows.

The details of the data reveal that there is no evidence of a rotation from bonds into U.S. stocks, yet. The only rotation that appears to be taking place is out of money market funds into international stock funds, which continue to see steady inflows.

Another reason not to get overly excited about this development is inflows to U.S. stock mutual funds have been a good contrarian indicator for the stock market in recent years. For example, the last time U.S. stock mutual funds experienced a monthly inflow was April 2011 — just as stocks peaked for that year on April 29, 2011 [Figure 1]. Prior to 2011, the inflow in April 2010 took place just before a stock market slide that began on April 23, 2010.

The inflows we have seen this year are likely part of the normal pattern of inflows in the early part of the year that have been followed by outflows during the rest of the year. The real test of investors’ appetite for U.S. stocks will be later this year, as we see if the flows to U.S. stock mutual funds can buck the seasonal pattern that typically shifts to outflows.

Many individual investors consider the risk in investing to be the likelihood of suffering a loss during a quarter or a year, rather than the risk of missing longer term investment objectives. This is why they have shifted out of stocks and into bonds so consistently in recent years despite solid, but volatile, stock market performance. Investors have sought the perceived safety evident in the steady but relatively low return of bonds at the expense of potentially undershooting their long-term goals.

A long-term rotation from bonds to stocks is likely to begin sometime this year, as yields finally start to rise following a 30-year decline that boosted bond market total returns and pushed bond valuations to highs. High-quality bonds may begin to suffer losses, and the growing dividends per share coming from stocks become more attractive with stock market valuations near 20-year lows. However, those claiming that it is already underway are premature and may be in for disappointment if they expect the stock market rally to continue each week in the months ahead.

 

IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.

The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Stock investing involves risk including loss of principal.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise and bonds are subject to availability and change in price.

Municipal bonds are subject to availability, price, and to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rate rise. Interest income may be subject to the alternative minimum tax. Federally tax-free but other state and local taxes may apply.

International and emerging market investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.

Investing in mutual funds involves risk, including possible loss of principal.

An investment in Exchange Traded Funds (ETFs), structured as a mutual fund or unit investment trust, involves the risk of losing money and should considered as part of an overall program, not a complete investment program. An investment in ETFs involves additional risks: not diversified, the risks of price volatility, competitive industry pressure, international political and economic developments, possible trading halts, Index tracking error.

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INDEX DEFINITIONS

The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.