The 'Great Rotation' theme and investor psychology

David Peartree, The Daily Record Newswire

The opening investment theme for 2013 is all about the “Great Rotation” among asset classes. As an Internet meme the metaphor may have gained some traction, but as an investment theme it’s going nowhere.

Still, a look at this topical issue is instructive for the broader insights it provides about how markets work and investor psychology.

The idea is that individual investors are finally, finally shifting out of cash and bonds and into stocks. The great bull market in bonds is over and a monumental shift is now under way, at least so goes the argument, as investors collectively rotate away from cash and bonds and into stocks.

The thinking, or the hope, is that this rotation provides the impetus for the next leg of market momentum and perhaps even marks the start of the next great bull market.

Barron’s on Feb. 4 flashed the headline, “Stock Alert! Get Ready for a Record on the Dow.” Their enthusiasm is based, at least in part, on the Great Rotation theme: “There’s a huge amount of money that could shift into stocks because individuals until recently have favored bond over equities, based on mutual-fund flow data.”

“Is now the time to dive into the stock market?” The Wall Street Journal posed that question on Feb. 5 in a Web forum of industry experts and “thought leaders.” The question was prefaced with the observation that January broke the pattern of 20 consecutive months in which investors pulled more money out of the U.S. stock market than they put in.

A simple Web browser search for “great rotation” will yield pages of relevant hits. Along with some notes of skepticism, you’ll find plenty along the lines of: “Market on ‘cusp of great rotation’ from bonds to equities, say fund managers,” “Great rotation to stocks from bonds gains traction” or “How to Profit from the Great Rotation.”

It’s a tempting theme, until you stop and think about what’s being described and what’s actually going on. For long-term investors, it offers no justification for changing one’s strategic asset allocation.

First, it’s not clear that any sizeable or persistent shift by retail investors is under way. Investors did indeed shift over $20 billion into stock mutual funds in January. It’s the first break in the trend of stock mutual fund outflows since April 2011, but one month does not make a new trend.

Second, even assuming such a trend is under way, it’s not necessarily a good thing for stock investors. Remember the strong inflows into stocks in early 2000 and how that turned out. The market now is nowhere as euphoric as back then, but the point is that there is no necessary link between fund flows and asset class performance.

The more fundamental question is how exactly does the market rotate away from an asset class (cash or bonds) and into another (stocks)? On an aggregate basis, at the market level, such a thing is not possible.

This is not an original observation, but it is worth repeating because it clears up a lot of mixed up thinking about the markets. John Hussman, an economist and fund manager, has discussed what he calls The Iron Law of Equilibrium: “Every security that has been issued must be held by someone until it is retired.”

Restated, the exact quantity of stocks, bonds or cash outstanding is the exact quantity being held by someone. In the case of stocks, it’s not as if there are lots of orphaned, unloved stocks sitting on a shelf somewhere waiting for someone to buy them.

It’s true that institutional market markers hold some inventory but it’s a limited supply. The point remains: someone already owns all the stocks out there.

Similarly, cash, in aggregate, can never ‘come off the sidelines’ for the simple reason that in a security transaction the buyer’s cash is exchanged for stock and the seller’s stock is exchanged for cash. The amount of cash on the sidelines is unchanged. The net change in asset classes is zero.

If retail investors collectively move into stocks, then institutional investors have to sell. The overall ownership of stocks will not have changed. The only thing that changes is the owner. Investors are merely trading places.

Talk of the Great Rotation creates the impression that something technical but very profound is under way, a shift in the markets that no intelligent investor would want to miss. In fact, all we are talking about is investor psychology and what their buying and selling preferences tell us about their appetite for risk.

Ignore the Great Rotation. Adopt a strategic plan for how much you should own in the basic asset classes. Resist the urge to chase momentum and avoid becoming “the greater fool” who overshoots his or her personal allocation range and allows the previous fool to get out.

By the way, the best response to the question posed on The Wall Street Journal Web forum (“Is it time to dive into stocks?”) came from the creator of the Dilbert comic strip. Says Scott Adams, “absolutely.” His reasoning is simple and honest: “I own stocks and I want you to drive up their prices.”

Dilbert gets it.

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David Peartree, JD, CFP® is the principal of Worth Considering, Inc., a registered investment advisor offering fee-only investment and financial advice to individuals and families. Offices are located at 160 Linden Oaks, Rochester, N.Y. 14625; email david@worthconsidering.com.

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