The Big Surprise in the Great Rotation Into U.S. Stocks

The Big Surprise in the Great Rotation Into U.S. Stocks

Now that the S&P 500 has reached record highs once more, investors are finally starting to recognize the advantages of U.S. stocks by increasing their investments into exchange-traded funds that own domestic equities. That's not surprising, given long predictions of what's become known as a "great rotation" into stocks.

But the surprising thing about the way the great rotation is taking shape is what investors are selling in order to put more money into U.S. stocks. Although expectations were that investors would take money out of the bond market, it's actually coming from some other sources that most people wouldn't have picked as candidates until very recently.

Where the sales are
The reason most investors expected bonds to be a big funding source for equity-fund inflows is that bond investments have posted huge losses lately. As interest rates rose from their rock-bottom levels, bond prices plunged, with some bond funds facing double-digit percentage losses in just a matter of a couple of months. Given how conservative bond investors typically are, those losses aren't something that many of them were prepared to see, and a mass flight from bond funds would leave some of those investors with little choice but to take money and put it into stocks.

Instead, though, other niches of the investment world are seeing an exodus from investors. A recent blog post at Barron's gave figures from ConvergEx that identified several surprising sources. First and foremost was gold, with the SPDR Gold Trust seeing redemptions of $1.3 billion since the month began. In a classic example of selling only after big price declines, gold investors are apparently tired of holding onto ETF shares that have lost a third of their value from gold's highs over the past couple of years.

The other big loser that's getting sold to fund U.S. stock purchases is the emerging-market stock area, where investors have moved more than $200 million out of ETFs. Higher interest rates have lowered the risk tolerance of many investors, and emerging-market holdings were among the first to suffer, as many emerging markets have actually posted losses for the year compared to the S&P's very strong gains. All told, the iShares MSCI Emerging Markets ETF has performed consistently with many other emerging-market investments, with the ETF having fallen 10% on the year.

The unwillingness to take big bets has also driven money out of leveraged and inverse funds. The big losses in many inverse stock ETFs makes outflows logical, but leveraged bullish ETFs have posted amazing returns. ProShares Ultra S&P , for instance, has posted more than double the rise of the unleveraged S&P 500 so far this year. Nevertheless, short-term traders are apparently satisfied to cash in their profits and take less aggressive positions going forward.

Finally, income-oriented funds in the real-estate and preferred-stock areas have seen outflows. This actually is most consistent with the original great-rotation theory, as these types of investments often behave in line with the bond market. With losses having come from rising interest rates, investors who believe rates will keep going up are selling to avoid further declines down the road.

Will the Great Rotation continue?
As long as macroeconomic conditions keep pointing toward a healthier recovery, it's likely that the same trend toward U.S. stocks and away from these other investments is likely to continue. Bonds might well follow suit as well and eventually provide even more inflows to the stock market, and as long as stocks keep attracting capital, it's possible for the bull market in stocks to continue well into its fifth year.

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