Newtons cradle

Content provided by Rusty Vanneman, CLS Chief Investment Officer

There is a popular notion that money flowing out of bonds and into stocks will significantly propel the stock market higher in the year(s) ahead. This is called the “Great Rotation,” a term first introduced by Bank of America Merrill Lynch analysts back in 2011.

How bankable is this notion?  Not very. As the money manager Jeffrey Gundlach recently mentioned, “The great rotation is a ridiculous notion. It’s utterly illogical.”

There are multiple problems with this idea.

First, if massive flows from one asset class to another drives performance, why did the “great rotation” from stocks to bonds since 2008 not translate into stellar relative returns for bonds? In fact, through the end of September, the annualized 5-year return for the Barclay’s Aggregate Bond Index was 6 percent. The annualized return for the U.S. stock market was 16 percent. If massive investor inflows didn’t create outperformance for bonds then, why would one automatically assume that outflows would create underperformance?

Second, there is the notion that investors are currently holding less in stocks now than they historically have. That’s not true either. Current stock ownership (looking at equities divided by total financial assets) is significantly higher than the long-term average ownership and in fact has only been higher a few times: around the year 2000 and in 2007. Not awesome times to be overweight stocks!

Indeed, there have been massive outflows from bonds to stocks in recent months. And stocks have outperformed bonds recently.  While the connection between flows and relative performance seems obvious and tells a story, don’t take the bait. The Great Rotation may sound great, but it’s not a theme to bet your financial objectives on.