Theories of the Great Rotation

For years now, investing professionals have been waiting and waiting for the individual investor to get back into good old-fashioned domestic equity mutual funds. People have withdrawn more than $400 billion from such funds since the stock market crashed in 2008–09, and no amount of rising on the part of the S&P has been enough to bring them back.

Until, perhaps, now. The month of January presented a shocking turnaround, with as much as $90 billion flowing into domestic stock funds. For at least the first three weeks of the year, stock funds took in more new assets than bond funds, which is highly unusual. This situation is so unlike the fund landscape for the past few years that pundits have taken to calling it the Great Rotation. The conceit is that we are witnessing a grand shift from bond funds into stock funds.

There are two basic questions here: Is this really a shift that's going to last for longer than a month? And if so, is it a good thing?

The first question is probably tougher to answer than the second one. While there have been many theories as to why January saw so much new money in stock funds, none of them are close to definitive. Here are some of the strongest rationales:

Because of the threat that tax rates on dividends would spike in 2013 as a result of the fiscal cliff, many companies released "emergency" dividends before the end of the year. The idea is that these dividends are being reinvested in stock funds. But that doesn't make complete sense: Dividends get automatically reinvested, so there wouldn't be any lag time between when they're issued and when they're put back into stock funds, but the inflows continued through all of January.

January is always a big month for investing, what with year-end bonuses and everything. Investors put $28.6 billion into stock funds in January 2006, and $23.9 billion into them in January 2011. In neither case did the trend continue for the rest of the year.

With the FDIC ending its insurance on bank deposits of more than $250,000, investors have transferred that money from savings accounts into stock funds. This idea was floated by PIMCO CEO Mohamed El-Erian, but it doesn't make much sense. How many people keep more than $250,000 in a bank account?

It's just a fluke, and anything can happen within the space of a month.

Investors are finally coming to terms with the fact that Treasury bills are at historic lows and don't show a lot of signs of rising above 2 percent any time soon. People are rebalancing their portfolios with an eye toward recognizing that many fixed-income instruments are unlikely to even beat inflation.

The likelihood of the Great Rotation continuing depends on which of these theories you believe. If it's the last explanation, we might see the money continue to pour into stock funds. If it's any of the first four, probably not.

If that money does continue to flow into stock funds — if indeed we have embarked on a Great Rotation — is that good news for the market as a whole? There are two basic theories here:

The Good: All that money will help prop up the stock market rally for the next few years. After all, if there is more money chasing after stocks, it will help drive the prices of stocks up. When all that money flowed into stock funds in January, the S&P 500 was up 5 percent. Remember those two earlier Januarys when stock funds took in so much money? The S&P was up more than 2 percent in January 2006, and up 4 percent in January 2011.

The Bad: A huge influx of individual investors is often considered a sign of a market top. There was one other January that saw a big rush toward equity funds: January of 2000, when the dot-com fever was just about to boil over. There was $42.7 billion invested in domestic equity funds that month — and as of March, the tech bubble was ready to burst.

At any rate, we are probably due for a bit of a correction. People who were scared off by the 2008-2009 plunge must be kicking themselves for missing out on the doubling we've seen in the market since then. Those investors will, slowly but surely, come back to equities over time. Whether that's in this Great Rotation or in some sort of slow-motion Great Evolution remains to be seen — but that money will be back.

For more from Tom Nawrocki, see:

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