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Sitting Out the Great Rotation is the Worst Mistake You Could Make

9 | By Shah Gilani

I wrote an article for Money Morning on Tuesday, “The Great Rotation Makes Stocks a Generational Buy.” This elicited many comments from my readers – some in agreement, others… not so much.

Reader Mike W. wrote, “Last week $22 billion flowed into mutual funds and ETFs. That’s the second-largest weekly flow on record. Of that… $8.9 billion flowed into equity mutual funds… the most since March 2000 and the fourth-largest weekly inflow on record.”

This echoed my statistics in the article.

Mike continued, “What happened after the [largest] inflow of $23 billion in late 2007? The stock market fell off a cliff. What happened after March of 2000? The stock market fell off a cliff.”

But there’s much more to this story.

Mike’s not comparing apples to apples. I’m not advocating buying blindly. Instead, I point out that buying these days should include buying into global diversification, asset class diversification, and buying downside protection. Downside protection alone comes in umpteen different flavors, all thanks to ETFs.

The problem with the “falling-off-the-cliff” argument is that it compares three different time periods and points to what seems likea common factor. That is to say, the markets did collapse after each of the historical inflows he mentions.

But Mike is right in a very real sense. Too often the public enters great bull markets at exactly the wrong time. Contrarians actually use their arrival at the party en masse as a signal to get out of the house because the music’s about to stop.

Back in 2000, the hot money was chasing Internet stocks in a feeding frenzy; there was a new billionaire every minute. Stocks without earnings were doubling – doubling – every month or so in a textbook case of irrational exuberance. There’s a better word for it: craziness.

Then came the blow-off from the reality check – along with the realization that hot-shot star analysts were aiding and abetting one of the biggest pump and dump schemes in history. This sent the latecomers off the cliff and upset the apple cart for just about everyone.

The markets came roaring back in a few years. In 2007 the real estate bubble was about to burst. Again, the latecomers, those perennial Tail-End Charlies, were the tragic actors. Most of them were making money – on paper – and borrowing against their (unrealized) real estate gains. They chased the markets and, wouldn’t you know it, stocks were the end destination. They all piled in, just ahead of the inevitable cliff. We all remember what happened next.

It’s important to note that the market crash was the result of the real estate crash and all that leverage that had built up everywhere. There were margin calls all over the place and people were selling everything to get out of the way. Everyone was headed for the exits while the hedgers and short-sellers sold like their lives depended on it.

When it was all over, what happened? We went over the cliff and came back around to the edge again – with one very important difference. This time around we’re looking at a lot less leverage in the system and no major retail bubble to push us over.

This time, stocks have not risen as a result of bubble-making gamblers throwing money into ridiculously over-pumped companies. There is a bubble-making gambler at work here, to be sure, but that’s the Fed in all of its quantitative-easing, easy-money, double-fisted, hand-pumping glory.

Corporations are not where they were in 2000 – or 2007. They are infinitely better off now.

But there is another side, should the Fed slow down its pumping operations. Interest rates will start to rise and bond prices will start to fall. That’s going to be one of the triggers of the Great Rotation. So, it can be argued that the Fed-pumped markets may be in danger of falling if the Fed stops pumping. But that will mean the money flows into stocks.

The picture I’m painting is this: there will be trillions of dollars coming out of low-yielding bonds. That money needs a place to go, and the destination is the stock market. It will be the beneficiary of the Great Rotation as the money flows in, looking for return, dividend yield and appreciation.

I’m not saying we won’t see a correction; we’re way overdue for one. We could see increasing volatility in the first two quarters of 2013. But still, I’m looking for buying opportunities, especially on the dips. If we get a correction, a particularly big one (which I’m really hoping for), I’m diving in with everything I’ve got – right when it looks the worst.

Why am I hoping for a steep correction in the first half of the year? So I can buy the panic with both hands and reap the rewards from the bounce and massive push that’s sure to follow the wholesale dumping of bonds at their last gasp.

If we don’t get a correction, I’m not going to sit by and watch the market double and say, “I’m gonna get in on the next correction!” No, I’ll get in now and add on the way up, raising my stops the whole way. That way, I’ll stop out if there is a big correction, with profits or without, and I’ll keep buying at lower prices if we go there.

That, my friends, is why we’re at a generational buying point. Besides, I’m always buying insurance so I can sleep at night.

Here’s hoping,

Shah

Editor’s Note: For more about The Great Rotation, and to join the conversation with Shah, visit Money Morning.

9 Responses to Sitting Out the Great Rotation is the Worst Mistake You Could Make

  1. Jay says:

    Yep, it’s different this time (sarcasm intended). Leverage? There is still plenty of it in the derivative markets as I believe you and the other Money Morning writers have discussed. The real elephant in the room that may cause money to leave the markets is the amount of debt (personal, institutional, and government especially) that still needs to be dealt with. Yes, companies are in pretty good shape, but are they spending?

  2. ray says:

    Except, don’t all those pension funds have requirements to maintain certain percentages allocated to bonds and equities. In other words, aren’t there built-in constraints in the system that prevents all this bond money flowing over to stocks?

  3. rem says:

    to Nancy: I think Shah refers to some form of stock portfolio insurance such as puts on an ETF tracking the SP or calls on bearish ETF such as TZA (tracking the Russel 2000 index). In a market crash, stops may be executed below your desired prices, which leaves you with losses greater than you want. That’s rare but it can happen.(Covered) Options allow the holder to be better protected as, at maturity, they realize 100% protection from the threshold (strike) price.

  4. Dom says:

    SG,

    Thank you for this and the prior articel on MM. Since most of your articles I’ve read have been mostly bearish/cautious on equities, this 2 part series if you will caught my eye as an interesting change of opinion due to recent events…

    After reading both of them, I think I see ur strategy/rationale…seems you are saying that bond yields are still super-low, Fed appears to be slowing down QE and also appears like it will start raising rates. Thus bondholders will sell when this happens and likely rush into equities.

    Last week was sign that ppl are already piling back into equities, so thus good time to pile back into equities. Also, corporations are strong right now and able to ‘supply’ consumer demand once consumer feels confident about spending his/her $ again. Finally, no real estate bubble, internet bubble, or other such potential catalyst that could ‘force’ a correction so to speak

    So strategy is to 1, simply get in, 2, invest across different asset classes, and 3 hedge urself with SL’s, ETF’s, etc..

    Sounds good on surface, but my devil’s advocate’s thoughts are…

    Hindsight is always 20/20, after every crash ppl then say we shoulda seen it coming…shoulda seen the real estate cr crunch, shoulda seen that internet stocks with no value were skyrocketing, etc…what about a potential ‘debt bubble’ bursting in 2013/14?

    Yes, the average consumer/homeowner has deleveraged somewhat, but still LOTS of debt floating around at muni and fed gov’t level and also student level…Black Swans/major mrkt drops always seem to materialize without warning…what if China all of the sudden stops buying our debt and we are forced to raise rates, making our debt look more risky? What’s probability we dont raise the debt limit?

    Also, you say corporations are strong. Has top-line growth been really that great? You even say firms are ‘leaner’ in ur last article and have cut unnecessary employment, which tells me they grew on the bottom-line but not on the top-line, revenue, side.

    Does lack of top-line growth really indicate strength? You also said that low interest rates have yielded piles of cash for corporations…not sure about that rationale either, but admittedly, lots are sitting on lots of $$$.

    Also, hasn’t the EQUITY market had a down day, about 1% or so, every time the FED murmors about ending QE and raising rates? Money may also flow out of the CREDIT market, but that doesn’t sound like a sure sign that it will flow out of CREDIT and into EQUITY.
    Are these minor 1% or so pullbacks SIGNAL or NOISE?

    FWIW, I think u make some good points and a fairly good argument for going long. Nonetheless, would love to hear more of your thoughts on why getting in now is not too late despite ‘record inflows.’ Would also love to hear ur thoughts/responses to some of my Questions and other commentors. Perhaps a part 3 article or an extended Q&A article?

    Thanks again,

    Dom

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