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Aug 5, 201311:39 AMFinancial Perspectives

with Michael Dubis, CFP

The ‘Great Rotation’ is a silly, nonsensical investment trend

(page 1 of 2)

Have you heard about the “Great Rotation” of investor money out of bonds and into stocks? Google it and you will come up with thousands, if not millions, of hits. According to the Great Rotation theory, investors will eventually tire of (or no longer accept) the low yields in the bond markets and rotate their investments to stocks.

The concept was originated by a brokerage firm. It has become a media darling. It’s very catchy and simple — perfect ingredients to inspire reaction. Brokerage firms and the media profit when concepts that are catchy lead to transactions. 

The concept implies that investors will be better served by owning stocks instead of bonds. This concept is silly for many obvious reasons. Let’s briefly review the issues and get you focused back on what matters.

First of all, you simply cannot have investors exit bonds and buy stocks in disequilibrium. There is ALWAYS a buyer and a seller in the public markets. If someone sells a bond, there will be a buyer. If someone buys a stock, there will be a seller. There is a limited supply of stocks and bonds, and there is always a buyer and seller. It is why we call them “markets”! So the whole concept of “rotating” out of one and into the other is mathematically impossible. 

Secondly, if one believes that quantitative easing has influenced historically low bond rates (which I personally believe it has) then one must understand that QE has also influenced all riskier assets through the bidding up of investment value.

All investments base their value on a premium to the risk-free investment, which in the U.S. and most of the developed world we consider the Treasury bond. If bond yields fall, other investment assets rise because investors look for other investments to get similar returns, thus bidding them up in price.

They take on additional risks by doing this, though. If bond yields rise, there is a natural arbitrage for investors to grab the new higher yield, and they do this by selling other investments (usually stocks or other types of bonds) to get this new investment yield. Those other investments usually fall in value. Because bonds are more stable in yield and more reliable in return (albeit often a much lower return), bonds adjust less than stocks. In other words, if we see a massive rise in interest rates, not only will bonds suffer, but stocks will suffer more. There is no free lunch. 

Finally, the worst potential impact of following the Great Rotation is that investors will start chasing returns: buying high and selling low. Wall Street profits when investors react emotionally. The Great Rotation inspires this epic turning point in the market where if you don’t “rotate” you’ll be left behind.

News flash: Stocks have been on a tear for four years now. If you haven’t been a long-term investor in stocks in at least part of your portfolio, you missed a lot already. Bull markets don’t go on forever. Four years after it leaves the terminal is generally not a good time to start chasing the train. 

(Continued)

Aug 8, 2013 08:09 am
 Posted by  Scott Frazee

Michael,

A couple of points of contention:

1) "There is a limited supply of stocks and bonds, and there is always a buyer and seller." This true in the short term, but not in the medium or long term. Most corporate and treasury bonds are for a specific period of time, so they exit the market, while new bonds are issued (assuming people buy them), causing a constant flux in the total available bonds. If there were in fact a decrease in new bond purchases, there would be rotation out of bonds. There is not quite as much flux on the stock side because stocks only exit the market when the issuing company buys them back or the company goes bankrupt or is otherwise liquidated.

2) "Stocks have a greater potential for loss than bonds." This is patently untrue. Stocks and bonds both have the potential for complete loss. If a company defaults on its bond you could be out everything (less the interest already received). Similar a stock can become worthless is a company folds (again less any dividends already received). The difference between them is the probability for loss and gain and of what magnitude. As mentioned bonds tend to be more stable (and even have preferential treatment in bankruptcy proceedings) in earnings, though tending to provided lower long term gains than stocks.

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About This Blog

It is an understatement to say the world has experienced a radical shift in capital markets. There are more layers of information and opinions on the direction of the world than we've seen in decades. The internet and the media do not always make it easier, but Michael Dubis' contribution through IB blogs will help you sift through the noise and give you some perspective. You can find his company online.

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