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What is the Great Rotation?

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The term “Great Rotation,” which came to prominence in late 2012, refers to the widespread prediction that record-low bond yields will prompt investors to rotate out of bonds and into stocks during 2013 and beyond. But is the Great Rotation a legitimate concern, or just another unfounded worry propagated by the financial media? The most likely answer: A little of both.

What is the Great Rotation?

The Great Rotation is a term coined by Bank of America Merrill Lynch in its research note from October 2012 titled “The Bond Era Ends.” In the piece, the authors laid out the case for why bond investors are likely to being rotating cash into the stock market – a trend that would boost equities but depress bond prices.

The original logic behind the Great Rotation was as follows:

1) Bond yields had fallen so far (as their prices have risen), that yields couldn't fall much further. As a result, it had become inevitable that yields would rise (and prices would fall) in the years ahead.

2) Two important reasons for the decline in yields in 2010-2012 were the “flight to quality” – as fear about various macroeconomic issues has prompted investors to gravitate to lower-risk bonds and away from stocks – and the Federal Reserve’s policy of ultra-low interest rates. With the global economy gradually picking up steam and the major risk factors (such as the European debt crisis and the fiscal cliff largely removed from the equation, this flight to quality was bound to reverse.

In addition, the Federal Reserve would eventually need to raise interest rates and taper its policy of “quantitative easing,” events that would remove the most important pillars of support for the bond market.

3) With these issues in mind, and seeing more limited opportunities and unattractive yields in bonds, investors would rotate cash away from the relative safety of fixed income investments to take advantage of the more attractive long-term total return prospects of stocks. Since the 2010-2012 rally in bonds was driven in large part by massive inflows of investor cash, a reversal of these inflows would exacerbate the downturn in the bond market and lead to serious losses for fixed-income investors.

That’s the essence of the Great Rotation. And it’s an idea that gained a great deal of credence through late 2012 and early 2013, as evidenced by the flood of headlines devoted to the topic through the first quarter of 2013.

Has the Great Rotation Already Started?

The events of 2013 indicate that the fears of the Great Rotation have some credence. Bonds have performed poorly - particularly in the second quarter - while stocks have rallied to 20%-plus gains. However, during the period of the bond market's worst performance - May and June - stocks flatlined, indicating that the outflow from bond funds didn't lead to a direct benefit for stocks in that time. But at the same time, the year as a whole has been characterized by strong outflows from bond funds and equally strong inflows into stock funds.

This indicates that while there has indeed been a rotation in the market, which has undoubtedly contributed to the gain in stock prices, it's difficult to ascribe a direct causal link between the weakness in bonds and the strength in equities.

Further, this shift in money flows could be derailed at any point by an unexpected slowdown in the U.S. economy, a revival of Europe’s debt crisis, adverse economic developments in China, or any other surprise that would cause investors to seek the relative safety of bonds.

In other words, don’t make decisions based on expectations for a Great Rotation. While the upside for bonds is indeed limited at this point, making investment decisions on concerns about the Great Rotation isn’t advisable. Pundits are frequently wrong, and it’s rare for an event that has received as much attention as this one has to unfold exactly as the consensus expects. And in this case, it doesn’t hurt that the issue in question has been given a catchy name. As always, investors are better served by designing their portfolios to meet their own objectives rather than reacting to the headlines.

Disclaimer: The information on this site is provided for discussion purposes only, and should not be construed as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities. Be sure to consult investment and tax professionals before you invest.

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