Forget the 'Great Rotation': The Prudent Move Today Is Into Alternatives
Talk of the 'great rotation' out of bonds and into stocks needs to be much more focused on alternative strategies going forward.
– Jeremy Grantham on US equities, November 2013 Letter
Much has been made this year of the “great rotation” from bonds to stocks. The theory was that after years of pulling money out of equity funds and putting it into bond funds, investors were finally going to start doing the opposite. Year-to-date gains of over 26% in the S&P 500 (INDEXSP:.INX) and negative returns in bonds seem to finally have lit enough of a fire under investors for a reversal to take place. After all, nothing is a more powerful motivator than recent performance. Through the first 10 months of this year, investors have poured money into stock funds at a faster pace than at any point since 2000. At the same time, we have seen the largest redemptions from bond funds in years.
The supposed rationale behind this “great rotation” is the historically low yields on bonds. For example, even as interest rates have risen over the past six months, the Vanguard Total Bond Market Index Fund (MUTF:VBMFX) is still yielding only 2%. Unless you are expecting rates to decline from here, these bond funds are not going to provide a return much above 2% over the next few years. Where is an investor to go, then, to achieve a reasonable rate of return or even to keep up with the rate of inflation?
Given the strong returns in the S&P 500 this year, many have migrated to US equities. As the upward path in US stocks has been unusually smooth, some investors are even viewing equities as a safer alternative to bonds. But looking out longer term, the rotation to equities only works if we can assume that equities will have strong returns with lower volatility going forward. Many investors are arguing just this, stating that because bond returns and interest rates are low, equity returns will be high and volatility will remain muted. Unfortunately, this assumption is incredibly flawed.
The low returns on bonds today are largely a reflection of a lower return environment for all asset classes going forward. There is no free lunch. Much like the cash-for-clunkers program, which simply pulled demand forward, what Fed chairman Ben Bernanke has achieved through zero interest-rate policy and quantitative easing is higher short-term asset prices and returns that have been pulled forward. When the Fed stimulus is inevitably withdrawn in the coming years, all of the assets that benefited from these policies will suffer just as demand for autos dropped sharply after the cash-for-clunkers program ended.
As the venerable Jeremy Grantham of GMO said in his most recent letter, the “US [equity] market is already badly overpriced – indeed we believe it is priced to deliver negative real returns over seven years… In our view, prudent investors should already be reducing their equity bets and their risk level in general.”
GMO has a fair value estimate for the S&P 500 of 1100, or 39% below today’s close of 1800. So while I would certainly agree that bonds are likely to underwhelm in the coming years, investors are likely to be equally disappointed in their purchases of US equities at current prices.
The more prudent rotation for many investors to consider given the current environment is out of traditional strategies and into alternative ones. These tactics do not offer constant equity beta and have therefore underperformed US equities over the past year, but that is precisely the point. The only way to achieve true diversification benefits is to add an asset class with a low correlation to the existing assets in a portfolio. And unlike long-only equity and bond funds that rely on fundamentals and rising prices with a “convergence” to fair value, these strategies are “divergent” in nature and have the ability to generate profits during periods (including shocks/crises) when fundamentals do not matter.
Given the outlier year to the upside we have had in 2013, I don’t expect the average investor to be concerned with his or her US equity holdings; most are not envisioning an environment where equities experience more than a three-day decline. If anything, investors are likely wishing they had more exposure to equities. As we approach year-end, though, the more savvy investors are not likely to be betting on another outlier year in 2014. They are also likely to be following Grantham’s advice in reducing “equity bets” and overall risk.
The bottom line is that with all the talk of the “great rotation,” investors have missed the most important question: Are US stocks a meaningfully better alternative to bonds? At current levels and on a risk-adjusted basis, this is a difficult case to make. As such, at a time when both equity and bond funds are poised to deliver below average future returns, the prudent investor should be considering a rotation into alternative strategies.
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