Is there a “Great Rotation,” Virginia? Yes, sort of…

ConvergEx Group's chief market strategist takes an investor's look at the famous editorial

Dec 24, 2013 @ 12:01 am

By Nicholas Colas

equities, stock market, valuation, money flows
+ Zoom

“Is There A Santa Claus?”, a piece which appeared in the New York Sun in response to a letter from a little girl named Virginia, is the most republished editorial in American newspaper history.

The basic outline of the story behind this yuletide classic is well known. Eight-year-old Virginia O'Hanlon asks her dad if Santa Claus really exists – her increasingly jaded friends claim he doesn't. In an inspired move, father lays off the delicate problem on someone else. He tells his daughter to write to the New York Sun, with its reputation for solid reporting in a town increasingly devoted to tabloid-ish “Yellow journalism.” The now-famous response from the paper's editorial board: “Yes, Virginia, there is a Santa Claus.”

And now, for the rest of the story…The sentiment behind the Sun's endorsement of Santa Claus is heartwarming, full of love and warmth. But as with so many legends, its path to Christmastime fame is more circuitous than most people realize. A few lesser-known facts of the case:

• The Sun's now-famous editorial first ran on Sept. 21, 1897, long before the traditional Christmas season.

• It was not the “featured” editorial of the day, but ran seventh. More important topics included chainless bicycles and the vagaries of Connecticut's elections laws.

• Little Virginia had to wait quite some time for her response. She mailed her question to the paper during the summer of 1897.

• Despite popular request, the Sun refused to reprint the editorial until December 1902. The reason for the delay seems tied up in the paper's own reluctance to embrace public opinion as a valid input to determine content. No Twitter or Buzzfeed or Drudge back then, after all.

• The next reprinting was in 1906 upon the death of the author, Francis P. Church. In the 10 years that followed, the paper carried it another six times. It became a Christmastime staple in the 1920s and the Sun reprinted every year until the paper failed in 1950.

As we approach the end of 2013, the investing analog to Virginia's query might well be: “Is there a Great Rotation?” It is a matter of faith that investors will sell their bonds in coming years as yields rise and prices fall and replace those holdings with stock investments. This will buoy equity prices to new highs while exacerbating losses in fixed income. “Beat the rush and rotate early” is the message from many an investment strategist. But is this faith-based approach to asset allocation correct? A few points to consider:

• It assumes all is right with the world, or close enough for government work at least. And it is government, through fiscal and monetary policy, that may drive the outcome. Federal Reserve tapering of bond purchases has begun, even as job growth in the U.S. remains below recovery-period norms and inflation is below their targets. Economic recovery in Europe is more like an EKG flat line than a vibrant pulse. Withdrawing stimulus too early is just as much a historical hallmark of central bank playbooks as any other unforced error. Will this time be different?

• Equity valuations in the U.S. range from fair to egregiously overvalued, depending on the metric. Historical P/E multiples on trailing earnings would have you run for the hills to learn how to husband animals and grow your own artisanal wheat. Even forward looking P/Es only look OK — 15 to 16 times next year's $115 estimate for the S&P 500.

• Bond market volatility is an overlooked speed bump for bullish equity investors. The “Great Rotation” theory relies on increasing investor confidence as the tinder for the blaze of equity flows to come. What if bond portfolios see a 5% pullback in the first half of next year? Is that the recipe for bravery among the investor class? Not so much…

Money flows in the mutual fund and exchange traded fund world through 2013 can give some useful “Tells” about the Great Rotation to come. Consider the following, sourced from the Investment Company Institute and The latter is our go-to source for all things ETF-related, while the former is the industry group with the most complete mutual fund information:

• Mutual fund investors are leaving bonds, but their destinations all require passports. For the year-to-date, they have withdrawn some $69.4 billion from fixed income mutual funds, with $29.4 billion in the last six weeks alone. Much of this diaspora comes from municipal bond funds, at $52.0 billion of redemptions YTD. On the equity side, the inflows are solidly international, at $135.7 billion year to date and $21.9 billion in the last six weeks. Domestic U.S. stock funds fall a distant second. Their inflows are just $22.5 billion YTD and $1.8 billion in the last six weeks.

• ETF investors are equity bulls and commodity – not fixed income – bears. Of the $187.9 billion into ETFs this year-to-date, $131.3 billion belongs to U.S. stock funds. Granted, a piece of this is likely hedge fund shorting of products like the SPY ETF, but this is usually a hedge against single-stock long positions and is therefore still overall U.S. stock-positive. The largest outflows are from gold funds – GLD and IAU, specifically – with $26.8 billion in redemptions year to date. Bond fund redemptions are a relatively trace amount of the ETF fund flow picture at just $2.6 billion for the quarter-to-date and still positive $11.6 billion for the year-to-date.

• Putting the mutual fund and ETF pictures together into one collage, the “Great Rotation” is more like a leaky faucet than a torrent of money. Equity is the favored investment class, to be sure. Mutual fund investors head overseas, and ETF owners stay closer to home with about $130 billion in each pocket. Exclude the exodus from munis, and mutual fund owners look much the same as their ETF cousins. They are not redeeming fixed income as much as they are putting fresh money into stocks.

In short, the trade in 2013 has been out of munis and gold, and into the world's stock markets. Look a little deeper, and the headline becomes “Mutual fund buyers are finally back.” Just two years ago, U.S. mutual fund investors were net sellers of financial assets, to the tune of $27.5 billion. The year 2012 saw them tiptoe back, with positive flows of $117.6 billion, but still redeeming stocks for bonds. This year, inflows are $164 billion with two weeks or so remaining and substantially all of that into stocks.

So is there a “Great Rotation,” Virginia? Yes, sort of… But like Santa Claus, it isn't where you expect to find it.

Nicholas Colas is chief market strategist at ConvergEx Group, a global brokerage company based in New York.


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