Is A “Great Rotation” Underway?

The following is an excerpt from a recent Orcam Investment Research piece:

Thoughts on the “Great Rotation” 

It’s been difficult to escape discussion about the “great rotation” in recent weeks.  In case you’ve been hiding underneath a rock, the idea of the “great rotation” is that investors are presently in the process of “rotating” out of bonds and into stocks.  There are three big misunderstandings being made behind this thesis:

  • First, investors don’t “rotate” out of stocks and into bonds.
  • Second, the end of the bond bull implies an end to easy Fed policy.
  • Third, the bond bull has been weaker than most presume.

The first point is a very fundamental fact about secondary markets.  We must understand that all securities issued are always held by someone.  There is no such thing as “getting out of” stocks or bonds.  You can sell to someone else who exchanges you their cash position, but in the aggregate there is no such thing as “getting out of” stocks and moving into bonds.  All securities issued are always held by someone.  It’s better to think of money as moving through securities and not into them.

Ultimately, what determines the price of these securities is the desire of the buyers and sellers to acquire or dispose of those securities.  But the idea of a “great rotation” is a great misnomer.  It implies something similar to switching from Makers Mark to Jim Beam as your preferred form of whiskey.*   But stocks and bonds are not consumer products that we can switch in and out of.  They are savings vehicles issued as liabilities of the entities who issue them and they are always held until retired.

The second point revolves around the idea that government bonds are no longer an attractive asset class.  This might make sense were it not for such an accommodative Fed policy.   Ultimately, Treasury Bond prices are pegged to economic conditions and the Fed’s perception of economic conditions.  Bond traders will adjust their holdings of Treasury bonds based on their perception of future Fed policy.  But future Fed policy is contingent upon future economic conditions.

Thus far, the Fed has been very clear about future policy due to the continuing weak economic environment.  They will not ease off the accommodative pedal until they see 6% unemployment.  That means we’re staring at a 0% Fed Funds Rate for the foreseeable future.  Since long rates are an extension of short rates I wouldn’t expect huge deviations in t-bond prices unless we see a roaring economy in the coming years (IF we see a roaring economy at all).  And while I’ve long been optimistic about the economy I would not peg high odds on the sort of growth that would lead to 6% unemployment in the coming 12-18 months.

It’s also helpful to put this into perspective by looking at the current guesses of those bond traders trying to front run the Fed.  At present the Fed Funds Futures curve is much steeper than it was just a few weeks ago (see figure 1).  Traders are now pricing in a rate hike as soon as early 2015.  I think this is probably optimistic.

(Figure 1 – via Orcam Investment Research)

The risks to the US economy will remain many in the coming years as the Balance Sheet Recession lingers and government spending slows.  It’s also highly unlikely that the unemployment rate will drop below 6% before 2015.  That likely means the bond market is overly optimistic about future rate hikes and we’re likely to see that curve shift to a flatter position.

Lastly, I think it’s important to keep the bond bull market in perspective.  Since 1928 the average annual return on Treasury Bonds was 5.4%.  Meanwhile, the trailing 10 year returns on Treasury Bonds has been 5.76%.  In other words, the recent returns have been far lower than most presume and much more in-line with the average annual return.  While it wouldn’t be surprising to see this rate of return revert further to the mean I think it’s a stretch to imply that the bond market is as deeply into “bubble” territory as we constantly hear about.

(Figure 2 – via Orcam Investment Research)

In sum, I think it’s important not to get too caught up in these dramatic sort of concepts that imply we are presently in the middle of some sort of paradigm shift.  Bonds aren’t going away.  They’re not going to become a less important part of people’s portfolios.  Investors aren’t “getting out” of bonds.  And while the next 10 years are not likely to be as favorable to bonds as the last 10 years I wouldn’t fall victim to the idea that you need to dramatically shift your portfolio to account for what sounds more like a marketing ploy than sound advice.

*  While we are not in the business of providing specific investment advice to clients, we would highly recommend against ever making this “rotation”. 




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Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  1. It’s amazing many people think money is flowing out of bonds and into stocks.

  2. “Traders are now pricing in a rate hike as soon as early 2015. I think this is probably optimistic.”

    While I don’t disagree with this, I must point out that Ben Bernanke is saying he’ll retire in January 2014. Chances are that the next chairman will be a dove, but perhaps it is unwise to discount the tail risk of a more hawkish chairman.

  3. If an individual investor moves from 100 percent bonds to 50 percent bonds, on the micro level would you say that he had ‘rotated’ into bonds.
    When we talk about such rotations, aren’t we saying that the individual investor is switching to stocks — presumably buying them from institutions and hedge funds and major players and selling his bonds back to the same.
    As a trading tool, some believe this would indicate we’re getting close to a market top.

  4. Cullen,

    if you include roll-over returns, the bond bull market has been very strong. Yes, the yields from holding a bond to maturity have averaged 5.76% (upwardly biased by the 70s). However, the capital gains from a constant maturity strategy could have been significant. This explains in part why risk parity strategies appear to have been so successful in the recent past (i.e. more by accident than by clever design).

    I agree about the “great rotation” story and the related “money on the sidelines” arguments. I am amazed that so many believe in it.

  5. “Traders are now pricing in a rate hike as soon as early 2015. I think this is probably optimistic.”

    I would caution from viewing a rate hike as an optimistic development by definition. Remember that rate hikes can occur as a result of two motions: rising real GDP, but also falling or leveling off potential GDP.

  6. Those are total returns….Everyone seems to think the bond market has been on some unstoppable tear in recent years. It really hasn’t. Aside from a few really stellar years the 10 total returns have been sort of average. Starting from 2002:


  7. “Housing has bottomed” and “interest rates will rise later this year” have been repeated quarter after quarter after quarter for years now. People just don’t understand how long real estate and interest rate cycles really are.

  8. Reminds me of a conversation my business partner and I had last week about “all the cash on the sidelines”. He pointed out (rightly) that the cash wasn’t going to go away, it just might be given to somebody else in exchange for a stock or a bond — but the cash will still exist. Same for the bonds, as Cullen points out. It’s interesting how some “experts” keep cautioning us (financial advisors) about fund flows, often comparing the peak in equity fund flows in early 2000 to recent peaks in bond fund flows. I understand how they might be trying to point out a bubble in the making, but I tend to agree that they’re promoting some misunderstandings about the mechanics of the financial markets.

  9. Even with the sell off today, it’s hard to deny that capital is flowing into stocks. I think cash, low-yielding, short-term bonds & tsys, CD’s, and precious metals are less attractive. It’s more of a rotation out of the safety and fear trades. If there is a bubble in anything it is in cash.

  10. My recollection was that easing could slow/end if unemployment went to 6% OR inflation/inflation expectations became a problem. I think it’s a reasonable speculation that the easing could end because of inflation not unemployment.

  11. The rotation in the stock market is who is buying in.
    Allocations to equity funds are going up. So retail funds are rotating in but someone else is rotating out. Maybe it’s the people rotating out of the stock market who are bidding up the price of houses. Maybe they’re the smart money.