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The choices investors face: stocks, options, bonds, futures, forex, cash. (iStockphoto.com)
The choices investors face: stocks, options, bonds, futures, forex, cash. (iStockphoto.com)

Expert’s Podium

More signs of a ‘great rotation’ out of bonds Add to ...

There’s been a lot of talk in the financial press about whether 2013 is the year of the “great rotation.” That is, a re-allocation into equities after years of overweighted inflows into bonds. It’s an intriguing question, a question that may have significant implications for portfolio performance now, and for many years to come.

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We’ve already seen a recent beginning move out of bonds and into stocks over the past three or four months. Common sense suggests that it’s about time for this rotation to happen in a bigger way.

Last year, outflows from U.S.-based equity mutual funds totalled $215-billion in spite of double digit returns from the U.S. stock market. Over a longer time frame, this trend is even more pronounced. Consider the attached chart, here.

Being a contrarian investor, I think this is a pretty compelling argument for the “great rotation”. With everyone (still) marching into bonds, it seems a good time to do the opposite.

In addition, government bond yields are pitifully low (at least in the developed world). By comparison, dividends in some high-quality blue-chip names may be quite attractive – often higher than the benchmark 10-year bond yield. So there’s another incentive to invest in equities: because they offer a competitive yield in a low-interest rate environment.

Also, corporate balance sheets are strong right now, with many companies running lean and sitting on piles of cash. As such, there’s a lot of “dry powder” out there. Not that this guarantees a strong stock market performance, but it does place a limit on downside risk.

Among high-net-worth individuals, the “great rotation” has been happening for a while now. In fact, the rotation is nine to twelve months old. Over the past several quarters, many HNWIs have been moving out of fixed income and cash in an effort to purchase equities (both public and private).

No one has a crystal ball, but yes, I think it’s very likely a “great rotation” is turning. Will it all happen in one year? Definitely not. From what I can see, there appears to be a reluctance among investors to jump back into equities – call it a fear of “getting burned” again. I think we’re still in the (very) early innings of a gradual shift back into equities. This is a process that will take years, not weeks.

How can you position yourself for this “great rotation,” particularly if you’re wary of equity markets? Here are some ideas:

Think singles and doubles

The “great rotation” will likely be an over-arching theme for the next three to five years. In such an environment, picking broad sectors will probably be easier than individual stock picking. For example, North American small caps, technology and/or dividend paying stocks (a common-sense alternative to bonds) are all sectoral plays that are easily accessible via funds and low-cost ETFs.

I think now is not the time to try and hit investment home runs – stick to singles and doubles instead, particularly if you’re just getting back into the equity space. It’s something that many HNW individuals have been doing as they re-allocate to equities, buying quality while cutting back on “high-risk, high-return” speculative investments.

Long AND short

The “great rotation” will likely take some time to play out. It will be a tug-of-war in the markets. There will be fits and starts, pauses and re-starts, corrections and bull runs. We’re likely to see a good deal of volatility along the way.

That’s not necessarily a bad thing, mind you. You may be able to turn volatility into profit by “going short,” that is, selling borrowed securities in the expectation they will soon fall in value.

I’ve always believed the best way to “go short” is with a professional investment manager, someone skilled and experienced in such strategies. But for those who’d rather do it on their own, there are multiple choices.

By writing covered call options, for example, or by writing puts – both can be an excellent way of generating income in times of volatility. There are also passive ETFs that can offer the same exposure.

Look to the U.S.

Since the great downturn of 2008, the U.S. economy has suffered exceptionally. But here’s the good news: five years later, the U.S. has gradually recovered and is ready to lead the global market recovery further.

There’s a good combination of value and opportunity in the U.S., as opposed to Europe, where there’s value, but less opportunity – that’s not to say that Europe’s time won’t come. However, I’d be cautious about jumping in just yet, particularly if you’re just starting your own rotation. European markets surprised lots of folks to the upside in 2012, and performed much better than expected, so may be due to a “pause” here.

Over the past several quarters, many HNW individuals have increased their exposure to U.S. assets; this is particularly pronounced among Canadian HNWIs, who tend to view the Canadian dollar as slightly overvalued. I think it may be a good idea to follow their lead.

Diversify your fixed income portfolio

If you must be in fixed income – and make no mistake, many of us do as balanced investors – then it makes sense to do it smarter. As I’ve said before, the old “set it and forget it” portfolio of government bonds is looking increasingly risky right now.

Even HNW individuals haven’t completely “cleaned out” their fixed income portfolio. What they’ve done is diversify. Instead of loading up on government bonds, they’re shortening their duration to help limit interest-rate risk. Just as importantly, they’re diversifying into emerging market bonds and investment quality and high yield corporate bonds.

Fixed income is an important diversification tool in any portfolio, but the relative weight of fixed income assets, versus other asset classes, does not need to be fixed. After years of money inflows and outperformance in bonds, rotation into other asset classes is inevitable.

Thane Stenner is founder of Stenner Investment Partners within Richardson GMP Ltd., as well as Portfolio Manager and Director, Wealth Management. Thane is also Managing Director for TIGER 21 Canada (www.tiger21.com/canada). He is the bestselling author of ´True Wealth: an expert guide for high-net-worth individuals (and their advisors)’. (www.stennerinvestmentpartners.com) (Thane.Stenner@RichardsonGMP.com). The opinions expressed in this article are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP Ltd. or its affiliates.Richardson GMP Limited, Member Canadian Investor Protection Fund.

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