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Is the ‘Great Rotation’ From Bonds to Stocks Under Way?

There’s a ton of talk about a bond bubble, as well as the “Great Rotation” in assets that will move tens of billions out of bonds and into stocks.

To me, these issues are not a question of “if” but “when” — bonds will fall out of favor. And here’s why:

  • Old bonds are ticking time bombs: Rates have been rock-bottom since 2009 and cannot move lower. That means it’s only a matter of time before newer debt yields higher returns, forcing investors to sell older bonds and drive down prices of those investments. Bonds taken on during the depths of the financial crisis — when investors were looking for the safest thing available — will eventually look downright homely given newer debt with better yields.
  • You can’t shun stocks forever: Equities have been seen as risky and volatile, but eventually they will return to favor. Maybe not 2013, maybe not 2014 … but they will. Cash on the sidelines is staggering, too much money is in bonds and “risk-free” instruments like CDs can’t even keep up with inflation. This simply can’t last — especially if the markets continue to hit new highs with idle investors watching enviously from the wings.
  • Growth will return: I don’t fancy myself a Pollyanna, but I do believe the American economy and federal government will get their act together and that brighter days are ahead. Whether it’s steadily improving manufacturing stats or slow mending in the labor market or an end to the continued deleveraging in American households, there are potential catalysts to spark a sustainable recovery. Skeptics say that recovery could still be five years off, but we could see momentum return as early as the end of this year. That will push risk-averse money into equity markets once more — and in a big way.

Those are the reasons for the so-called great rotation out of a 30-year bull market for bonds. But what’s the impact?

Well, the MarketBeat blog over at The Wall Street Journal cites a great Goldman Sachs note on the matter:

Households, mutual funds and pension funds collectively own $12 trillion or about 34% of the bond market. Each 100 bp reallocation by these investors away from bonds and into stocks would equate to roughly 1% of the equity cap of the S&P 500.

Got that? For every 1 percentage point that investors take out of bonds, the S&P 500 gains 1% in capitalization. Even a modest 10% or 15% drawdown would be quite a liquidity event, then.

Obviously, the very best time to dive back into equities was in March 2009. And given the big returns in 2012 for the major indices, even going long 12 to 18 months ago would have served you quite well.

But if you’re not fully invested in this market, it’s time to stake out a position in stocks over the next several months lest you get left behind. And if you’re overweight in bonds, there’s even more of an incentive for you to change your asset allocation — because you risk underperforming big-time if you cling to low-yielding Treasuries and corporates during this market evolution.

I remain convinced the short-term could be rocky for the stock market … but that doesn’t mean it’s safe to hang out in bonds forever.

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Jeff Reeves is the editor of InvestorPlace.com and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at editor@investorplace.com or follow him on Twitter via @JeffReevesIP.

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