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Are investors belatedly undertaking the "great rotation" from bonds into stocks that Wall Street loudly heralded three years ago?
For those who don't recall the vaunted great rotation theme, the popular idea in late 2012 and into 2013 was that the 30-year bond bull market was ending, the presidential election passed, quantitative easing underway, the "fiscal cliff" standoff settled and the public was underexposed to stocks — so a mass shift into equities should help drive the market higher.
It was a cute and plausible idea, but it didn't bear out. Investors still felt burned by the financial crisis meltdown that had halved the value of U.S. stock indexes for the second time in eight years.
While cash did begin to trickle back toward equities in 2013, it was scarcely a true rotation and certainly wasn't great. According to the Investment Company Institute, a net $538 billion exited stock funds (including exchange-traded funds) from 2008 through 2012. Only about $120 billion has since returned, and this year more money has departed equity funds than entered.
The 's first boost in short-term interest rates since 2006 and the closure of a speculative high-yield debt fund apparently scared a wave of retail cash out of bond funds. In the week ended Wednesday, a net $15.4 billion was pulled from fixed-income funds, according to Lipper, with the $5.1 billion exiting investment-grade bond portfolios qualifying as the largest on record.
There is no immediate indication that this money made its way straight into equity mutual funds. To the contrary, these funds shed $17.3 billion in the same week, the third-heaviest weekly outflow ever.
Yet circumstantial evidence suggests that investors now fearful of bonds — rationally so or not — are looking to replace them with higher-yielding stocks. The S&P Utilities sector surged by 4 percent from Friday's close through Thursday, while the Vanguard REIT ETF gained 3 percent and Vanguard High Dividend Yield ETF added 1.9 percent. This compares to a 1.4 percent lift for the broad S&P 500 over the same four days.
If indeed investors were to begin grudgingly replacing bonds with dividend-rich stocks, it would be another unfortunate example of the public's tendency to react with a long lag to turns in asset values. Over the past three years, total returns for the S&P 500 are above 15 percent, versus about 1.5 percent for the aggregate U.S. investment-grade bond market.
That said, the dividend yields on stocks is quite competitive with bonds now, leading many strategists to suggest they offer good value for the income-seeking investor. The S&P 500 now yields about 2.2 percent, almost exactly the same as the 10-year Treasury yield.
For nearly the entire period since the late 1950s, stocks have yielded a good deal less than bonds. Only for brief periods since 2008 have equity yields nosed above Treasury yields, and at those times it has generally indicated that the stock market was getting attractively valued and was poised to rebound.
Many strategists and investment advisors have been promoting the idea that stocks could serve a bond-like purpose in this environment. Dividends tend to rise over time with company profits, and at least right now are taxed at a lower rate than bond interest payments are.
Tom Lee, founder of Fundstrat Global Advisors, has been plying this theme, in particular sifting for large companies whose shares yield more than their own corporate bonds. This screen surfaced such beaten-down stocks as Caterpillar Inc., International Business Machines Corp., HP Inc., ConocoPhillips, Procter & Gamble Co., Exxon Mobil Corp. and Wal-Mart Stores Inc..
In recent history, this yield setup has served as a signal that the market is unduly skeptical of an issuer's equity relative to its debt. But of course, from a theoretical angle, there's nothing inherently odd about a company's stock yielding more than its bonds. Those bonds come with a promise that the principal will be repaid and often hold a priority claim on corporate assets.
Russ Koesterich, global chief investment strategist at BlackRock, argues that investors should be wary of casting yield-oriented stocks in the role of bonds. "They're highly rate sensitive. You've got a lot of hidden duration in your portfolio when you own a lot of defensive high yielding stocks," he says.
In other words, those "bond substitute" stocks come with risks similar to plain, old bonds.