It's coming, so they say. Flows will begin to rise and crescendo like a tidal wave, too powerful to ignore. Those too stubborn and unyielding to heed the signs of this sea change will be among the wreckage, with little recourse in its devastating wake. After years of warnings without validation, too many will be unprepared and the scale of destruction will be unprecedented.
No, this is not a warning of a hurricane or some other natural disaster, or the end of the world in any traditional sense. This is about the much-prophesized impending apocalypse for investors in fixed income, which, if you believe the hype, is nigh.
Proponents of this theory of an impending massive reallocation from bonds to stocks have some serious egg on their face, for these predictions have been made in each of the last three years. Instead, equity funds have continued to see outflows, while bond funds have set new records in their asset grab. Indeed, according to the Investment Company Institute (ICI), since January 2009 taxable bond funds have been the beneficiary of more than $850 billion in fund flows and municipal bond funds another $100 billion. During that same time, some $1.4 trillion has left both U.S. stock and money-market mutual funds.
This year could be different, though as the calendar turns to the final quarter of 2012 not much has changed. Although U.S. stock market returns this year have been compelling, with the S&P 500 up over 11% year to date as of this writing, equity fund flows continue to stagnate, and were down almost $70 billion through mid-August. Bond funds have done well in their record low yields, with the Lipper Intermediate Investment Grade Debt Funds peer group gaining 5.9% and the Lipper Intermediate Municipal Debt Funds peer group up 4.0% through July 2012. But these returns are all the more impressive given the staggering $200 billion in assets added to bond funds this year, according to ICI's asset tracking.
With such a massive disparity of flows, the notion of an impending reallocation out of bonds and into equities may not be so far-fetched. After all, our domestic economic growth appears to be muddling through, and while growth is subpar at or below 2%, the threat of another recession is low. The consumer has deleveraged-household debt as a percent of GDP has dropped down to historic trend levels, while household debt as a percent of disposable income is at a five-year low of 110%. Debt service and financial obligations ratios have improved. Employment is slowly recovering, and the U.S. housing market has stabilized in price and turnover.
Furthermore, inflation remains moderate, and other risks to the financial markets-such as the European debt problems or a meltdown in China-seem to be resolving either through policy action or the expectation of it, and that has induced a relative calm, at least for now. Even discussion of the U.S. fiscal cliff seems somewhat surreal, with most investors anticipating some measure of resolution to the simultaneous spending cuts and tax increases set to occur at year-end.
Most compelling of all, valuations in equities look attractive relative to historical standards, with the market's forward P/E estimate just 13.7 in the United States, and even less abroad, while bond interest rates are at historically low levels that offer inferior income to savers and investors unless the riskiest type of debt is considered.
So why then do we continue to see surging investor demand for bonds and what are the prospects for a shift away from bonds into stocks?
Pervasive fear is probably the single most important driver of demand for bonds, with investors still reeling not just from the losses sustained in the market bust of 2008, but from a lost 13 years of investment returns (since 1998). Not helping matters is the 35% drop nationwide in home prices, as well as the continued tax, economic, political and employment uncertainty. Adding to the fear parade are the flash crash of May 2010, whose origin is still unknown, and a botched Facebook IPO, as well as increased volatility created by high-frequency trading strategies and leveraged ETFs. More recently, Libor-gate has erupted, a scandal involving the world's largest banks that apparently falsely deflated the London Interbank Offered Rate (Libor) for their profit during the height of the financial market crisis in 2008.
Even absent these unsettling events, the appetite for risk-taking seems to be in a kind of secular decline. With the baby boom generation reaching retirement age, the impulse to de-risk is high, and these demographics may make lower risk appetites a longer-term phenomenon. Just as that same generation drove a massive market-centered bubble in the second half of the 1990s, in which equities reached new and ultimately unsustainable highs, today they are operating in reverse, forcing bond yields to record lows. As for whether the stock market's good fortunes in 2012 might lure them back into equities, the jury is still out, but it is not looking good. Between greed and fear, fear may be the more dominant emotion. For many of these investors, a return of principal is more important these days than a return on principal.