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Let the great rotation out of bonds and into stocks begin! Add to ...

What’s it going to take to get investors moving out of bonds and into stocks? Bank of America’s global equity strategist Kate Moore believes she has an answer: Bond prices will fall this year, making the steady returns from dividend-yielding stocks look more attractive.

“Global government bond yields are forecast to rise modestly as the global economy slowly recovers,” she said in a note. “Despite potential for near-term volatility and policy noise, we continue to think investors should look for opportunities to add to risk assets during periods of weakness.”

It is easy to shrug over this line of thinking. For one thing, the idea that bond prices are doomed to fall, lifting yields, doesn’t sound very radical given that observers have been predicting the death of the 30-year-old bond bull market for years.

For another, investors burned by the bear market of 2008 seem reluctant to return to stocks despite the allure of the recent rebound. I pointed out earlier this week that investors continue to shy away from stocks, as reflected by money flows out of equity mutual funds and into bond funds – even though past performance should suggest money flowing the other way. Global equities returned 17 per cent in 2012, more than triple the gain on bonds. In particular, U.S. equities returned 16.1 per cent last year, while U.S. Treasury bonds returned just 2.2 per cent.

Stock performance aside, though, Ms. Moore argues that we are in the midst of a gradual economic recovery at the same time that central banks continue to provide massive policy stimulus. Bond yields have fallen to historic lows, leaving little room to fall further. If they rise even a little, the impact could be big, damaging investor infatuation with bonds as risk-free investments.

“If the 30-year Treasury yield, which is currently 3.1 per cent, were to rise above 3.32 per cent, the return over the next 12 months would be negative,” she said.

If the bond market starts to push investors away this year, the equity market is going to need to pull them in. And here, Ms. Moore points to the allure of dividend-yielding stocks as a replacement for low-yielding bonds. Indeed, global dividend yields are larger than global corporate bond yields for the first time in at least 16 years.

What’s more, corporate cash balances are at record highs, giving companies an incentive to buy back their own stock, which is another way of returning capital to shareholders and will only add to the incentive to rotate out of bonds and into stocks.

Bank of America strategists are calling this process “The Great Rotation,” and believe that last year’s strong performance by U.S. financials, homebuilders and peripheral European assets provided an early indication that this is already starting.

However, Ms. Moore believes that there is still a long way to go before the rotation is truly “great”: “A longer-run look at positioning shows that investors have simply shunned equities in favour of bonds in recent years,” she said. “Record setting amounts of money went into bond funds in 2012 as investors frantically searched for yield.”

Perhaps that search will send investors into stocks in 2013.

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