Last week in Money and Markets I told you about a fundamental force that has been lifting stock prices in recent years: buybacks. They were a big reason why the S&P 500 Index gained 32 percent last year, while earnings grew less than 5 percent.
In the 12-month period ending September 2013 (the latest data available), corporate America invested $445.3 billion repurchasing their own shares. The record is $589.1 billion in 2007.
But there’s something else propping up the stock market: the great rotation out of bonds and into stocks. A growing number of investors, both large and small, will be making this asset-allocation move in their portfolios, which collectively adds up to an enormous amount of buying power for the stock market.
|A growing number of investors are shifting their asset allocation from bonds to stocks.|
The three-decade secular bull market in Treasury bonds had to end sometime, and 2013 marked the inflection point between bull and bear.
In 1981, the benchmark 10-year U.S. Treasury yielded a mind-boggling 14 percent. But the next 30 years witnessed steadily falling inflation expectations and with it a sharp decline of interest rates — to a low of just 1.4 percent in July 2012.
During this period, fixed-income mutual funds enjoyed a heyday of inflows. And why not; investment-grade corporate bonds returned an average of 10 percent annually over the entire 30-year period, just a hair less than the 12 percent average annual gain for stocks.
That led many fund investors to shun the volatility of stocks — especially after two epic bear markets less than 10 years apart — in favor of the perceived safety of bonds. At the end of 1984 all mutual funds, including bond funds, held just $16 billion in corporate bonds. By the end of 2012, funds held nearly $2 trillion in bonds.
Following the financial crisis, retail investors poured nearly $1.4 trillion into bond funds from 2009 to 2012 in a frenzied flight to safety. Bond funds had positive inflows, and equity funds suffered steady outflows for five years straight.
Typically, investors are slow to react at key market turning points with a major shift in their asset allocation. Generally, fund flows follow performance. Past performance is what drives investors into and out of asset classes.
So 2013 began in similar fashion with bond funds attracting net inflows through June, but then came the turning point.
With the S&P 500 already up 14 percent by the end of June, and bond investors worried about the impact of Fed tapering on bond prices, the great rotation out of bonds and into stocks began.
Bond funds suffered $111 billion in outflows during the second half of 2013 (through November), while equity funds attracted nearly $200 billion. It was the first year of positive money flows into stock funds since 2007! And with 2014 under way, bonds are still under selling pressure as interest rates rise.
So the question is: Will this great rotation out of bond funds and into equities continue?
At some point it’s inevitable. After all, there remains almost $3.6 trillion in bond mutual funds and ETFs earning very low yields today. That’s a lot of potential buying power that can keep stocks moving higher, but this asset-class rotation may not accelerate right away. The reason: institutional investors and their balanced asset allocation.
A great many pension and retirement plans strive for balance in their investment portfolios using:
* Stocks — for long-term capital appreciation potential, and
* Bonds — to lessen volatility and provide current income to pay retiree benefits.
Ten-year Treasury bonds lost 7.8 percent in value last year while the 30-year Treasury, which is more sensitive to interest rates, fell 15.1 percent. And with stocks up 32 percent, many pension and retirement plans are no doubt out of balance entering 2014.
They will need to shift their asset allocation by taking some profits and trimming their equity exposure, while adding to bonds. As a result, investors may witness a short-term trend reversal early in 2014, before the great rotation resumes driving stocks higher in the process.