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Pro Analysis

Santoli: The ‘Great Rotation’ into equities and out of bonds finally begins

DOW, 18k - 19k and climbing, NYSE traders
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There's no doubt that investors quickly rotated into stocks since the election, spun around by a steep drop in bond prices. The key question is whether this is a good thing - both for the stock outlook and for those investors suddenly shuttling into equities at this stage of a market cycle.

Three years after Wall Street was singing in unison of a coming Great Rotation from bonds into stocks, investors started to dance to this tune with a dramatic shift in this direction the past couple of weeks.

Bank of America Merrill Lynch calculated that the first week following Donald Trump's election saw the largest rush into equity funds in two years, the biggest withdrawals from fixed-income funds since the early 2013 "taper tantrum" in bonds, and the widest spread between stock and bond flows on record.

The rapid jump in Treasury yields – with the 10-year hustling from 1.86 percent on Election Day to a new 2016 high of 2.34 percent Friday – chased income-fixated investors out of bond funds as inflation expectations perked up.

And the rally in bank, small-cap, commodity and industrial stocks has prompted a new "cover story" for renewed bullishness on stocks: deregulation, tax cuts and a debt-enabled fiscal spending boost will, we're told, make American grow fast again.

By most accounts, this sudden pivot into stocks is a belated response by retail investors who have been more skeptical of the equity market than one might expect after it has more than tripled in value over some six-and-three-quarter years. Sluggish underlying economic growth, the heavy perceived influence of central banks and periodic global shocks have all kept investors back on their heels.

Meantime, the worldwide scarcity of yield has kept fixed-income products and yield-centric stocks in steady demand. The categories of funds showing the heaviest inflows this year as a percentage of their total assets are emerging-markets debt, investment-grade bond and real estate investment trust products – all creatures of the mad chase for yield. The heavy buying of "low-volatility" stocks on the theory that "stocks are the new bonds" this year also reflects this impulse.

The jagged market moves favoring riskier, more cyclical assets over "safe" ones has been a stiff challenge to investors' collective positioning, and it set off a mini-panic in the other direction as traders grabbed for exposure to what's working now.

The outstanding share count for the SPDR Financial Sector (XLF) and SPDR Industrial Sector (XLI) ETFs surged 30 percent since early November, reflecting massive excess demand over supply. The torrent of cash into XLF, in particular, is more than double the peak level from any similar period in recent years, and suggests that bullishness for the bank stocks is running quite hot right now.

So, a supposedly "hated" bull market – or at least one that didn't elicit trust and excitement from Main Street – gaining favor among small investors must be a good thing for the market, right?

This is the general view among Wall Street handicappers, it seems. Tom Lee of FundStrat Global Advisors, says, "We are finally seeing a rise in inflation expectations…to trigger the virtuous rotation into equities."

Virtuous, in this case, means self-reinforcing, as the outperformance of stocks draws in more cash to equities and, presumably, helps fuel a further rise in stocks.

This might indeed play out for a while. Heavy public participation in stocks is sometimes a feature of a late-bull-market "exuberance" phase, when good economic news is acknowledged more broadly and equity valuations expand toward some higher peak.

The "Trump trade" could be a decent trigger for such a move, even though the election response has mostly just accelerated and magnified market themes that began working over the summer (rates rising, cyclical stocks leading, inflation expectations awakening).

But there are a few caveats to keep in mind before assuming a public embrace of stocks is here, and is only a positive.