Is the 'Great Rotation' Theory a Myth?

By ETFguide.com  FEB 21, 2013 4:35 PM

We don't see any evidence of a flight to equities at the expense of bonds, and actually see a high probability opportunity to buy bonds.

 


The “Great Rotation” from bonds to stocks is underway... or is it?

There is no doubt the investment world is confident that we are still in a bond “bubble” that is sure to pop, but that opinion is now a few years old and has largely been incorrect. 

Regardless of what the mainstream thinks, we remain skeptical of any bond bubble and are actually looking at a bond buying opportunity. Let's analyze some of the reasons.

The Great “Fake” Rotation

Once the money flow data was released for January, showing decade high mutual fund (MUTF:VFINX) and ETF (NYSEARCA:VTI) inflows, Wall Street went crazy with reports that the “great rotation” was in full swing as it justified buying equities (NYSEARCA:VT) at the expense of selling bonds (NYSEARCA:BOND).

“Have we entered the Great Rotation” – Charles Schwab 2/6/13

“Are we watching a Great Rotation into Stocks – Time Magazine 1/28/13

“Trading the Market’s ‘Great Rotation” – MarketWatch 2/7/13

The great rotation argument implies a zero sum game where money is either in stocks (NYSEARCA:SPY) or it is in bonds (NYSEARCA:TIP) and the two asset classes jockey for investors’ dollars.  When investors put money into stocks, it must come from bonds. When money is put into bonds, it is at the expense of stocks.

But the facts simply don’t support such a scenario of recent rotation.

In order to justify January’s equity fund inflows as part of the great rotation, the money that flowed into equity funds should have come out of bonds. But bonds also had inflows of $30 billion. Not exactly a rotation out of bonds.

In reality, the Great Rotation was a “fake” as most of the money flowing into equities (NYSEARCA:EEM) came from savings and money market accounts that were ballooned by the accelerated pay that occurred in December as a result of the non-recurring fiscal cliff episode.

At times like these, it often helps to step back from the day-to-day headlines and see what is really going on in the bigger picture. One of the best ways to do this is by examining the charts.

Seeing the Forest through the Trees

One simple question: Does this chart of the iShares Barclays 20+ Year Treasury (NYSEARCA:TLT) look bullish or bearish?



Source: ETFguide

The long-term trend in bonds has been up in price and down in yield. Although long-term Treasury prices have recently pulled back from their highs (what all the fuss is about), it barely even shows up in the chart above. Bonds are firmly in a bullish uptrend.

A Recent Example of Overly Bearish Sentiment

On July 1, 2012, bonds were also experiencing a plethora of bearish sentiment as prices dipped to $125 on the iShares Barclays 20+ Year Treasury. Along with the shorter-term technical picture, the sentiment background helped us stay long treasuries. 

In a post to our readers, we wrote:

Continue to disregard the media and talking heads that say bonds are overvalued and inflation is around the corner. Until we see it in price, it is not happening. Price is the only true leading indicator, and we will rely on it to tell us when inflation is here. Until then, we continue to stay long the longer duration treasury bonds. We are set up for all three time frames pointing in the same direction (up).

As we alerted, US Treasuries continued to rally and we swiftly exited on July 20, 2012 when iShares Barclays 20+ Year Treasury was $130 and sentiment flipped to extremely bullish levels.

For more on our analysis of bonds last summer, see some of our past articles here and here.

Reasons to Buy Treasuries

The technical setup for iShares Barclays 20+ Year Treasury is intriguing right now for a few reasons. With price around $116, the recent pullback is now at a level near numerous support zones, which should keep the downside risk minimal. 

Some of these support levels surround Fibonacci retracement levels, last year’s $107-$113 support zone, as well as a long-term uptrend support line.

A sizable decline in the equities (NYSEARCA:IWM) market also would only help increase bond prices as investors flee to bond safety.  Couple this with the pessimistic sentiment surrounding bonds and the recipe is in place for another Treasury bond rally.

Editor's note: This story by Chad Karnes originally appeared on ETFguide.com.

To read more from ETFguide, see:

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No positions in stocks mentioned.