The Great Non-Rotation

Have you heard? Stocks are the new bonds! At least, so says anyone who tracks mutual fund flows. Money is pouring out of bond funds and into stock funds—evidence, they say, of a “Great Rotation” between asset classes. A generational sea change! And, evidently, this is über bullish for stocks.

If this sounds too good to be true, well, it is. Sorry folks, but the great rotation is a myth. Yes, stocks seem poised for more bull market, but not because massive amounts of new money are about to pour into equities.

Here’s the thing: Net outflows from fixed income funds don’t equate to money leaving bonds en masse. In fact, the latter is impossible. It’s the same with equity fund inflows. There are two sides to every transaction—buyer and seller. For every seller, a buyer exists. Otherwise, nothing would be sold or bought. When a fund has net outflows, the fund manager simply erases the shares and sells some of the underlying holdings to compensate—and someone else buys them. Similarly, when a fund has net inflows, the manager creates new fund shares and buys more of the underlying assets—from someone selling them. It’s all zero sum. For every investor leaving stocks, another is jumping in or doubling down. If you buy $1,000 in stocks, someone else is selling $1,000 in the very same stocks. Money going in and out effectively cancels.

Which means you can’t have a great rotation. Or a mini rotation. Or any rotation at all. When stocks’, bonds’ or any asset’s prices fall, it isn’t because money is pouring out. And rising prices don’t mean money is flooding in. Instead, prices rise when investors are willing to pay more. This isn’t a function of the number of buyers. The stock market is like a big auction—all it takes is one investor bidding more than the next guy for the price to rise. And that’s a function of fundamentals—all the many economic, political and sentiment drivers that impact investors’ expectations for future profitability. Were it otherwise, stocks likely would have done poorly from 2009 through 2012, when equity fund flows were negative much more often than not.

So if you’ve looked at fund flows, summed all the net equity fund outflows since 2008 and assumed this equals a ton of dry powder on the sidelines, my apologies. Maybe retail investors do have a lot of cash on the sidelines—anecdotally, many who sold out after 2008 never returned. But when and if they decide to buy, stocks won’t automatically pop just because there are new buyers. Rather, stocks will rise if buyers are willing to pay more for a share in publicly traded firms’ future earnings.

Not that fund flows are a useless indicator—they’re extremely telling about investor sentiment. The large number of net equity fund outflows during the bull’s first four year shows just how pessimistic investors were. Reality exceeded those very dim expectations, and stocks rose. Now, with equity fund inflows accelerating some—but still pretty choppy—it’s one more indication sentiment is mixed. Some people remain skeptical, others are getting optimistic—and euphoria is a ways off. This strongly suggests the bull has far to run.

And it’ll run because reality should exceed still too-dour expectations. Today’s global economic picture isn’t great, but it’s better than most think. For example, folks fear the US will crater when the Fed tapers quantitative easing (QE)—not realizing the economy has grown despite QE, not because of it. When QE ends and the world doesn’t, that’s a huge positive surprise—and a big market tailwind. The world is similarly stronger than most believe. Some fret anemic growth, but robust air traffic and freight volumes tell us people and goods are moving around the world at a healthy pace—signs of a humming economy. Add in the likelihood China keeps notching stable economic growth, global trade keeps rising despite the odd tariff tiff and nascent Crimean trade war, and earnings keep beating estimates, and potential positive surprise power abounds.

So by all means, keep a positive outlook for stocks! But center it properly, on fundamentals—not on the notion of sidelined cash just waiting to reenter the market.