What to expect in 2013 – Great rotation time?

The S&P 500 has resumed its climb after the Fiscal Cliff negotiations and optimism that the Debt Ceiling negotiations will be resolved

What to expect in 2013 – Great Rotation Time?

A few weeks into the New Year and stock markets are in positive territory.  As of this writing, the S&P 500 index is up and, companies that have reported quarterly earnings have been mostly positive with positive surprises around 68%.   While it is early in the period for company reporting, additional profits over expected have set a firm tone.  Other favorable indications of market confidence are strong volume levels and a very low reading for the VIX index.  Also known as the “fear index,” the VIX spikes up when investors dump stocks and recedes when stocks advance.  The VIX closed yesterday at 12.46, its lowest level in over five years as the S&P 500 has approached its all time high.[1] [See chart of S&P above.  Source: Bloomberg]

What is the Great Rotation and when will we see it?

Since the global financial crisis in 2008, investors’ preferred habitat has been bonds to stocks for their perceived safety.  In particular, investors have favored US Treasuries in the face of extreme uncertainty and have forgone the potential growth prospects of stocks, deemed risky assets, even as they have become cheaper (while stocks have sold for an average price to earnings ratio of 16.7 over the last fifteen years, they are currently valued at around 12.5!)  Moreover, the dividend yield on many stocks has become comparable if not greater to bonds since the Federal Reserve has whittled the discount rate to less than 1% to stimulate demand.

So with attractive valuations and dividends, it is reasonable to expect that investors would be tempted to sell their bonds in favor of stocks.[2]  This movement from bonds to stocks or vice versa is known as the Great Rotation and strategist have debated its timing since the Global Financial Crisis.  In 2012, the S&P returned over 17% last year, far greater than even the riskiest bonds.  Moreover, the US economic backdrop is improving with growth, lower unemployment and rebounding residential real estate.

Individuals still hesitate

2012 money flows show that individual investors have not been believers in the stock market and have forsaken almost $200 billion in potential profits.[3]  Data reported by the Investment Company Institute concur.  While equity markets were hitting their highs of the year, equity mutual funds saw huge withdrawals totaling over $156 billion in 2012, more that the net outflows of $128 billion in 2011.  As the market improved, individuals yanked more out of equities to chase bonds!

Chart #2 shows net outflows accelerating throughout 2012.  Source:  ICI.org

What could disrupt the momentum?

The initial week in January is the first period since April 2011 to demonstrate a preference for equities at $14.8 billion compared to almost $9.8 billion for bonds.  And while the US economy continues to repair from the Great Recession, the fiscal backdrop in Washington DC has yet to be resolved.  Lawmakers avoided the Fiscal Cliff by January 2^nd but still have the debt ceiling, automatic spending cuts to discretionary and defense spending (delayed for two months) to resolve.  Look for continued coverage here in the Huffman Broadsheet.

Takeaway

The US economy is expanding and the stock market’s recent high (reflects renewed vitality.  While the Fiscal Cliff resolution may mute growth with renewed increases to Social Security and taxes on the top 1% of earners the Debt Ceiling drama will determine whether lawmakers are willing to risk fledgling growth with ideological grandstanding.  If they cause a growth scare or recession, this economic wound would be self-inflicted.

This week lawmakers seem eager to resolve the debt ceiling – for three months.  Whatever the outcome, the Huffman Broadsheet will be here to report the implications.  In any event, my perception is that the Great Rotation is here.