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Demystifying the 'Great Rotation'

Zacks Equity Research

It has been reported that there were very large net inflows into equity mutual funds in January, which reversed a nearly two-year trend. As a result, equity inflows surpassed purchases of bonds by a wide margin last month.

However, for there to be a meaningful rotation, funds need to flow from bonds to stocks. Bond funds still garnered tens of billions of dollars in January, which (though less than before) is counterintuitive to the notion of a Great Rotation. 

The ‘dash from cash’ theory is also plausible but similarly weakened by continued accumulation in money market funds. Instead, investors appear to be allocating more for stocks, less for bonds and trimming their cash reserves.

The economy-wide allocation for equity in December 2012 was not terribly shy of normal levels, thereby stifling theories that investors have been keeping away from equities (and are therefore now more likely to embrace stocks).

For those still seeking shelter in bonds, expecting the generous returns from the past three decades would not be wise. Investors who consider the current government bond yield of lower than 2% a bad deal wouldn't like it a bit to see interest rates pick up again. Financial markets were temporarily roiled last week on rumors that the Fed would gradually reduce its multi-billion-dollar monthly bond buybacks which have kept rates rock bottom thus far.  

The chase for yield is therefore increasingly pushing investors to embrace higher levels of risk, be it in the form of junk bonds or emerging market bonds. Even the most bearish of equity pundits are re-evaluating their 'wait and see' position, as they are concerned about missing out on reasonable domestic stock valuations.

The S&P 500 is trading at a P/E of about 14x, which is well within its historical range. Equities, therefore, still offer compelling value despite the run-up in prices since the Great Recession. Not only are equity valuations favorable, but many offer a better yield than government bonds. 

Exxon Mobil (XOM) provides a dividend yield of about 2.58%. General Electric Company (GE) offers a yield of 3.45%. Johnson & Johnson (JNJ) and Wells Fargo (WFC) stand at approximately 3.36% and 2.51%, respectively. We are not even considering share buyback programs of some of these income-oriented stocks, which may drive up their composite yield by as much as a couple more percentage points.

Using our value-oriented approach, we found gazebo stocks in other sectors as well. Verizon Communications Inc. (VZ) offers a strong dividend yield of 4.96%, consumer-staple giant Procter & Gamble Co. (PG) is at 3.07%, Microsoft Corporation (MSFT) provides 3.3% and Wal-Mart Stores Inc. (WMT) is at 2.26%.

Comparisons of the current robust inflows into the bourses with those way back in September 1987 -- when investors poured large sums into the stock market just prior to its collapse -- may be eerie, but the current scenario is not all that similar.

Do we then have a bubble in fixed income securities or is every dip a buying opportunity? Even if the bond market was to take a hit for some reason and Treasury prices fall as a result, that may still not be reason for systematic outflows from bonds in favor of stocks. Due to the regulatory framework coupled with demographic trends, pension fund and insurance company managers may be less supportive of a Great Rotation than they were earlier.

Read the Full Research Report on PG

Read the Full Research Report on WMT

Read the Full Research Report on MSFT

Read the Full Research Report on WFC

Read the Full Research Report on JNJ

Read the Full Research Report on XOM

Read the Full Research Report on VZ

Read the Full Research Report on GE

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