Watch Out! Reversal of the 'Great Rotation' Coming: Study
Talk of a "great rotation" out of bonds and into equities is misleading according to investment strategy group Lombard Odier, which argues that 2013 could see the reverse happen.
Global equity markets have thrived on the back of increased risk appetite since the start of the year, with major indices including the Wall Street's Dow Jones Industrial Average and Tokyo's Nikkei 225, breaching multi-year highs in recent weeks.
Meanwhile traditional safe haven investments have sold off. Benchmark 10-year Treasury yields have climbed over 50 basis points since the start of the year to over 2 percent.
But Geneva-headquartered Lombard Odier says in its latest Investment Strategy Bulletin that investors should not get too comfortable with the current rally in equities.
(Read More: The Great Rotation: A Flight to Equities in 2013)
"A theme for 2013 might well actually be the rotation out of equities and back into bonds," Lombard Odier writes in the report.
"Far from envisaging a sustained and large equity rally on the back of a 'great rotation' our best case scenario would be for the equity rally to lose some steam, and the worst case scenario for it to experience a significant sell-off. Protect your portfolio and be ready to move out of equities back into government bonds when yields normalize."
According to Lombard Odier, the theory behind the "great rotation" is intrinsically flawed because it is driven more by supply rather than by demand. The reason investors have owned more bonds than equities over the past few years is because of a huge increase in leverage over the past decade. On the other hand, the equity market has been shrinking as companies use proceeds from debt issuance to buy back their own shares.
(Read More: Why Talk of a 'Great Rotation' May Be Overblown)
Lombard argues that as supply/demand levels continue to shift in this direction, equities could become increasingly overbought, pushing investors back to fixed income. It added that U.S. 10-year Treasury yields at 2.25 percent would provide an ideal entry point.
The group drew parallels between the current trading environment and the dot-com bubble of 2000 and to the start of the financial crisis in 2007. It warned of several "red flags" indicating a potential market shock.
"We would caution that the two latest episodes of large net debt issuance to finance stock buybacks corresponded to market extremes: 2000, 2007. This adds to other red signs, particularly for U.S. equities, such as investor complacency, rich valuations and talks of a QE (quantitative easing) exit strategy by some Fed members."
(Read More: Bernanke's Challenge: Prime Markets for End of QE)
However, Jonathan Pain, author of global market commentary The Pain Report, put forward an opposing view on CNBC Asia's "Cash Flow" on Tuesday, saying that markets are continuing to see a mass migration out of fixed income assets into equities, a trend which he argued was still in its infancy.
"Investors have been in a state of hibernation since the crash of 2007. The market might have a pullback in the short-term but in the medium to long term the equity outlook is looking attractive. The market has further to run. I urge investors to sell government bonds and buy equities," said Pain, who was optimistic on the U.S., Asia and Africa equity markets.