Money has been pouring into stocks globally over the last few weeks, as investors have grown more comfortable taking risk—and less comfortable missing gains. It’s not hard to see why they might feel this way. Several key sources of worry have receded, including the dreaded possibilities of going over the so-called fiscal cliff and of failing to raise the U.S. debt ceiling, which could have placed the U.S. at risk of default. Plus, rising markets tend to coax hesitant investors into taking on more risk—herd behavior at work.
And it’s not just the absence of bad news that’s at work. U.S. economic data have generally been benign, and fourth-quarter corporate sales and earnings results have mostly topped expectations. China is reaccelerating, and even in the eurozone, which continues to struggle economically, sentiment has become more sanguine since the European Central Bank stepped in last summer with a promise to do “whatever it takes” to prevent a meltdown.
Receding risks and positive macroeconomic news are well and good, but questions are building as to whether this rally represents something more than just another temporary bout of bullishness in an otherwise sideways market. Specifically, market watchers are wondering whether we’re seeing another round of New Year’s optimism, destined to morph into summer doldrums or the beginning of the Great Rotation—a mass re-allocation from bonds into equities that could drive stock prices to new heights. If the latter prevails, the gains we've seen in recent months may be part of a broader, longer secular bull market.
Before addressing this question, I would point out that while the long-term, fundamental picture does appear bullish for stocks, technical indicators—statistical attempts to measure supply and demand balance in financial markets—point toward the possibility of a modest correction in the near term. As Jerry Garcia, the noted financial economist (or was it Grateful Dead front man?) warned, “When life looks like easy street, there is danger at your door.” Various measures of investor sentiment do seem to have become excessively bullish lately, reminding us not to expect recent good news to be the only type of headline we’re liable to read.
Over the longer term, however, market fundamentals, in my view, support the prospect of a bull market with considerable time left to run. Central banks’ extraordinarily accommodative policies continue to lend asset prices support, for example, and in the absence of rip-roaring growth or inflation in most of the developed world, easy monetary policy should be with us for some time to come. Demand for goods and services seems to be on the upswing (or at least stabilizing) in many regions, whether it be for industrial commodities in China or for autos and housing in the U.S. Even in troubled Greece the government now professes that additional austerity measures won’t be necessary provided that currently planned spending cuts actually come to fruition—a big “if,” I admit.
Prices the market now requires us to pay for stocks appear reasonable or even attractive for many equity indices even though stocks clearly are not as cheap on an absolute basis as they were even two years ago. Many equity indices appear especially undervalued compared to bonds, which have been many investors’ perceived safe haven for the past several years.
Beyond these factors, reports on net “flows”—a Wall St. term for the mass of money constantly washing into and out of asset classes—offer among the most powerful arguments that the Great Rotation may be under way. Starting in the fall of 2008, panicking investors sold off investments of all kinds at a staggering rate. September of that year saw hundreds of billions of dollars flow out of equity, fixed income and even money market funds, according the Investment Company Institute. When shell-shocked investors began returning to financial markets in late 2008, they began overwhelmingly investing in bonds, while equities continued to suffer quarter after quarter of net outflows.
The exodus from stocks wasn't limited to individual investors. According to a recent Bank of America Merrill Lynch study, as of the end of 2011 (the latest full-year data available), equity allocations had fallen to their lowest percentage of corporate pension assets since 2002 (41.8 percent vs. a 10-year average of 56.1 percent), while bond allocations were at their highest levels (40.2 percent vs. 33 percent). Given that assets in such pensions total about $2.3 trillion, a shift back toward more “normal” pension asset allocations could have a profound effect, with a 10 percent increase in pension equity allocations potentially driving $228 billion back into the stock market.
Recent flow data suggest the Great Rotation may have only just begun. After seeing $600 billion in net outflows over the preceding seven years, January has seen at least $35 billion return to domestic equity markets, most of which came from money market funds. Even peripheral Europe attracted about $125 billion in net inflows, according to news reports.
Investors appear finally to be coming off the sidelines and perhaps reassessing their allocations to investment-grade fixed income. This is just as well. As I've been arguing for some time, with interest rates often below the rate of inflation, high-quality bonds offer precious little value in today’s market—and the potential for serious losses when and if interest rates start rising again in earnest. In contrast, I believe stocks’ solid run in recent months may have laid the groundwork for a modest, near-term pullback, but they are likely to continue to reward patient investors over the coming years.
Jerry Webman is the author of MoneyShift: How to Prosper from What You Can't Control and Chief Economist at OppenheimerFunds.