18th January 2013
Analysts are talking about a 'great rotation' from bonds into equities. But are markets falling prey to another bout of irrational exuberance?
The latest BofA Merrill Lynch Fund Manager Survey showed asset allocators directing more money towards equities after a long-term preference for bonds. The report said: "The new year sees asset allocators assigning more funds to equities than at any time since February 2011, while their confidence in the world’s economic outlook has reached its most positive level since April 2010." Source: Bank of America news room
The research showed risk appetite at its highest for nine years. Fund managers believe that equities are under-valued, particularly in Europe and are reducing cash holdings to invest. The key to this bullishness has been the partial resolution of the fiscal cliff, which many believe will spur the world's largest economy to stronger economic growth.
This has been reflected in fund flows reported on Marketwatch.com. It says: "Equity funds, including exchange-traded funds, took in $18.3 billion for the week ended January 9, the fourth largest net inflows since Lipper began calculating weekly flows in January 1992. Some $10.8 billion poured into equity ETFs, while mutual funds took in more than $7.5 billion, their largest inflow since the week ended May 2, 2001."
The shift in sentiment should not be underestimated. JP Morgan points out that in 2011 and 2012, investors put over $1trillion into global bond funds, and pulled $9bn away from equities as the Wall Street Journal reports. The S&P is up over three per cent since the start of the year, while bond markets have gone into reverse.
It certainly seems that momentum is with equities and as such, it would be a good time to buy. However, as the Wall Street Journal article points out, we have been here before. It writes: "2010, 2011 and 2012 all saw an optimistic start before crisis fears reasserted themselves. Take the S&P 500 in 2012: By April 2, it was up 12.8 per cent, but in the following two months it fell 10%. For now, money isn't leaving global bond funds."
Equally, the fiscal cliff is not fully resolved. If President Obama struggles to deal with the second half of the problem, it could send markets into disarray once again. The removal of supportive quantitative easing programmes may also dent sentiment towards equities. Then there is the valuation argument: stock markets are now at their highest point since the credit crisis and, intuitively, that feels like a bad time to be switching back into equities.
That said, the experts are going with the flow: In his latest research note, Goldman Sachs Asset Management's Chairman Jim O'Neill, says: " The S&P 500 finished its fifth trading day of the year with an accumulated gain of close to 2.2%. According to the rule, this means an 85% probability of another “up-year” for the S&P 500, and probably most other stock markets. It also has meant a stronger than overall average gain, in the vicinity of 14%, perhaps a touch more. This evidence goes back to 1950, and while I can’t think of a particularly sensible economic rationale behind it, I wouldn’t ignore it, especially when so much more “fundamental” evidence suggests the same."
Most agree that in spite of these early gains, equities do not look expensive. Investment expert Sam Liddle, partner at Albemarle Street Partners, says: "We are not at all surprised by the sudden interest in equities. Everyone had become so focused on protecting the downside. It came to the point where someone led, and everyone followed." However, he says that the pace of the shift is worrying and the market may have got ahead of itself in the short-term with the fiscal cliff not yet fully resolved.
The yield argument may be the clinching one. Once corporate bond prices have risen so high that the yield is unattractive and there is increased potential for capital loss, equities may be the only logical option. This point is surely close. Liddle says: "Investors are in many cases getting a better yield from equities than from corporate debt and with more upside potential."
Markets climb a wall of worry, so the cliche goes. For the time being, it is reasonable to see the market rally as a snap-back after a decade in the wilderness rather than a bout of irrational exuberance, but further volatility is likely as the next round of fiscal cliff negotiations approaches.