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Why Wall Street is wrong about the move into stocks

You can see why 2013 is being called the year of the great rotation: Stocks are outperforming bonds, developed markets are outperforming emerging markets and Japan's benchmark index is on a tear.

Given these monumental shifts, it is tempting to make a rotation of your own by loading up on the hottest sectors – and investment professionals will love you for it.

A better idea? Resist the rotation.

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Many pros, including Wall Street strategists, have long been expecting the investment landscape to shift as sidelined investors, burned by the financial crisis, rediscover stocks and ditch bonds in the process. The notion is that as more investors embrace stocks, the higher major stock market indexes will rise, encouraging even more investors to join the rush, creating some sort of bull market nirvana.

It is an appealing theory, and it is being supported this year by encouraging early evidence: Investors were hot for stocks in January. According to Morningstar, U.S. investors moved a net $15.5-billion into stock funds last month, marking the biggest monthly inflow into equities since 2004 and ending a 23-month stretch of outflows.

This renewed interest in stocks comes as the S&P 500 approaches a record high. Problem is, the benchmark U.S. index has risen 125 per cent over the past four years, and stock valuations are looking less encouraging.

The Shiller price-to-earnings ratio, which looks at the 10-year average of inflation-adjusted earnings, is a lofty 22.8 – or well above the long-term average of 16.5. That hardly looks like an ideal time to fiddle with your portfolio's current asset mix and jump headlong into stocks, chasing returns.

Indeed, for all the talk about a great rotation – and the industry's eagerness to label it as a good thing – the reality is that small investors have a reputation as contrarian indicators. Their late-to-the-party enthusiasm for stocks provides a signal that the bull market is aging.

According to the American Association of Individual Investors, small investors were also enthusiastic about stocks at the height of the technology craze in the late 1990s and again before the financial crisis in 2008, in terms of the equity allocation in their portfolios. This enthusiasm ended badly when major indexes cratered.

Conversely, small investors have shied away from stocks during periods when equities have been bargains – with historically low allocations during bear-market lows in 2002 and 2009.

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True enough, these allocation changes are due partly to rising and falling share prices rather than active moves on the part of investors. Nonetheless, they suggest that investors have a tough time adjusting their asset allocation appropriately by buying stocks low and selling them high, and their portfolio returns suffer because of it.

Today, with U.S. stocks at their highest levels since 2007 and even lagging Canadian stocks up nearly 70 per cent from their 2009 lows, maintaining your current equity allocation should require selling stocks, not buying them.

That doesn't sound like the makings of a great rotation. It sounds more like a consistent approach to asset allocation that ignores the temptations of fear and greed. Hey, it sounds downright reasonable.

Wall Street might not like this approach, nor anyone else who is peddling the great rotation as the next big reason to buy stocks and gain exposure to the improving economy. But ignoring Wall Street has never been a bad idea.

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