Are We Watching a ‘Great Rotation’ Into Stocks?

Money is flowing into stock funds this year. Skeptics abound but others believe that the Fed's determination to rekindle an appetite for risk will produce a shift from bonds into stocks over the next few years and drive prices higher.

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Good news has a predictable cycle. Initially there is only the surprising information, positive on its face. Then comes a period of skepticism and a suggestion that the news is not so good after all and may even be bad. Finally, with the good and the bad aired (and individuals thoroughly confused), the story languishes for months as truth emerges.

We’re in the languishing period now on what may be the most important development for investors in half a decade. Inarguably, money has been piling into stock mutual funds this year and steering the market higher. January likely will end 22 consecutive months of mutual fund investors exiting the stock market.

For the week ended Jan. 16, U.S. investors moved a net $3.8 billion into stock mutual funds. That followed $7.5 billion of inflows the previous week, along with another $10.8 billion that was directed to exchange-traded stock funds. This is the fastest two-week pace of inflows since 2000 and, on its face, welcome news indeed.

There is ample reason to suspect the trend has staying power. Housing and the economy are recovering. Interest rates are so low that fixed income seems a lousy alternative. The Fed has all but declared its intention to hold rates unnaturally low until investors rediscover their appetite for risk.

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Yet the skepticism that has met the bullish turn on fund flows suggests that things in the market are far from rosy. Writing for Forbes, fund flow expert Charles Biderman reported that the money behind this early year surge of stock buying came from three fleeting sources—all of which may already have dried up: normal year-end rebalancing, the unusual sale of stocks ahead of higher capital gains taxes this year, and the unusual early payout of corporate bonuses ahead of higher income taxes.

Piling on, the website Seeking Alpha notes that the inflows this year “barely begins to repair the damage done over the past three calendar years” and that the last time stock fund inflows were near this level in April 2000 “came a month after the all-time high on the S&P 500 in March of that year—not exactly a smart money move.”

All true. So what’s an individual steering her own financial future to do? Keep your eye on the long view. Stocks come in and out of favor, and each big swing can last for a decade or longer. The average stock has roughly doubled off its financial crisis bottom but remains below the high reached 13 years ago. This rally has come despite a general loathing for the market. If sentiment turns, prices could trend higher for years.

Bank of America strategists believe a “great rotation” is coming from bonds to stocks. The theory is that institutions are so heavily invested in bonds, which sport obscenely low yields and will be terrible investments if rates rise, that managers have only begun shifting toward stocks. Reuters reports that this possible rotation has “some of the most persistent global equity bears of the past two decades” rethinking their position, afraid of missing “the cheapest equity prices in a generation.”

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There would be hiccups, of course—and possibly soon, given the market’s recent surge. There is no reason to steam back into stocks all at once, and any move in that direction should be done with an eye on global diversification. Consider bumping higher the amount of your future 401(k) contributions that goes into stock funds. If you are way under-exposed, consider moving money in each quarter over the next year. A decent target for equity allocation — the percentage of your assets that is invested in company stocks — is your age subtracted from 110. If you are 40, that means having 70% in stocks.

Nothing is certain with the stock market, especially in the short term. But a steady pension- and insurance-led rotation out of bonds into stocks, coupled with renewed individual investor interest, could lift prices even if the economy fails to gather much steam. And if you think bond yields under 2% are painful, wait until you see the losses that pile up for investors who hold bonds if rates rise.