Shortly before Thanksgiving, I had the privilege of being on an investor panel at Bank of America’s Debt Capital Markets and Derivatives Conference. On the panel before me was a trio of BofA’s chief strategists, among them Michael Hartnett, their chief investment strategist. Mr. Hartnett reminded the audience that he was the man who coined the phrase “The Great Rotation” and after much anticipation, at long last, it was here.
At that moment, a thought occurred to me: What if waiting for the Great Rotation was like Waiting for Godot? I imagine a good number of you have read Beckett’s absurdist classic at some point in high school or college. Those of you who have not may be familiar with It’s the Great Pumpkin, Charlie Brown. Spoiler Alert! For those few of you unfamiliar with either story – surprisingly to me, I found more than one colleague who was! – stop now, read/watch one or both and proceed from this point in the text later.
Looking at Mr. Hartnett’s bio, I saw that prior to being BofA’s chief investment strategist, he was their chief global equity strategist. If you look at the bios of every chief investment strategist on the Street, I would be quite surprised if it takes all the fingers on one hand to count those whose backgrounds do not have prominent equity research titles. In my experience while on the Street and also working with my esteemed equity colleagues at PIMCO, I can tell you there is a different world view. Taken to the stereotypical extreme – and here I am really exaggerating to make the point:
Bonds = Math Savants, perhaps with a touch of Asperger’s
Equities = Storytelling, and in some cases, Mythology or Religion
Both approaches are critically important in society, as is their balance given that they can often be complementary. Like a great salad dressing, too much oil or too much vinegar is a bad thing, as the natural inclination of each is to separate rather than stay harmoniously blended. Equity guys want more oil, Bond guys more vinegar, and each prefers the company of their own rather than the other.
Looking at it from the perspective of someone who has been in an equity seat for the past two or three decades, a reversion to the mean in investor asset allocations makes sense. One friend who has seen more cycles than I, and had a front-row seat to institutional investing in the ‘80s and ‘90s, explained the endurance of the 60/40 policy portfolio. “Those that tilted too heavily to bonds in the early ‘80s missed out on the first big run and had regret. Those that got aggressive later and let the winnings ride pushed on to, and through, 70% equities then got burned in ’87. So the magic number gravitated to around 60%.”
We at PIMCO and a number of like-minded individuals elsewhere think the mean reversion anchor may be overstated, especially during times of major global realignments. Fundamental changes in investor behavior driven by accounting and regulatory changes, demography and individual cohort experience are mitigating factors. I and my colleagues have written extensively about corporate pension plans de-risking over the past decade, but the arguments for it go back to Fischer Black and Irwin Tepper in the early 1980s and others beforehand. The combined catalysts of accounting and regulatory changes in the past decade with twice bitten, thrice shy plan sponsors have cooled the appetite for equities: Thank you very much for a 25% year on the S&P, but we’ll take a number of our chips off the table now, if you please.
Individuals now are more skeptical – and conservative, too – than in the past. Ten thousand baby boomers a day are reaching 65. What do they need in retirement?
1. Stable, predictable income
2. Minimal downside risk in their investment portfolios
Both will become more critical going forward. Especially for the next generation of retirees who will rely principally on their own savings, rather than on the defined benefit pensions of their parents’ generation. Even those younger than me seem to have less appetite for risk. Friends and colleagues in their 20s and 30s came of investing age over the last decade and a half. Their personal experience missed much of the bull run of equities in the ‘80s and ‘90s. Caution and skepticism run high.
A Great Rotation? Not so much. A series of Lesser Rotations? Definitely.
What do I mean by Lesser Rotations? Focus less on movement across major asset classes and more on movements within major asset classes.
In fixed income there has been a very pronounced and deliberate move out of broad, core, aggregate bond portfolios and into investor type, self-segregating styles. This has been happening over the last 3-plus years, but it accelerated dramatically this year as rates began to rise.
Liability-hedging investors, principally corporate pension plans and life insurers, are buying longer maturity investment-grade credit. Everyone else’s unloved, risky asset is, in fact, their natural hedge.
Retail buyers and institutions without duration-laden liabilities are shedding the tether of the aggregate index for objective-focused bond portfolios. Positive fund flows have principally been into absolute-return-focused product and product designed to produce stable, predictable and dependable income. The long-term pull to higher rates and the natural process of aging make these trends that are secular in nature if not super-secular.
The same demographic factors are logical drivers of the lesser rotation in equities. Just like we are seeing a move out of core bonds into income, downside protection, unconstrained strategies, something similar is happening in equities: A move away from the style box (which really just provided exposure to equity beta) and toward outcome-oriented strategies, again – income, low volatility and unconstrained, that is a high active share.
Many equity strategists have argued that low volatility, high dividend paying stocks are overvalued and growth is cheap as investors have overpaid for stability and predictability. Here is a relatively simple thought experiment for the math-inclined who think about equity valuation. Suppose I think of a stock or industry sector with a low beta and a yield of a little more than the 10-year Treasury bond. What should its price-earnings multiple be? One plausible upper bound might be ßxPE(SP500)+ (1-ß)x(1/y), where y is the current yield on the 10-year Treasury. With a current SP500 multiple of 17 and a Treasury yield of a little under 3%, high yielding, low beta, heretofore boring sectors such as consumer staples and utilities may not be overpriced on a relative basis at two to three more turns of the P/E multiple than the broad market. For example, the consumer staples index has a beta of 0.7 to the SP500, call it 3% on the 10-year: 0.7x17 + (1-0.7)x(1/3.0%) = 21.9, implying an upper bound for the consumer staples index of about four turns higher in the current rate environment. If rates were at 4%, the number would be 19.4, or about 2.5 turns higher than the S&P earning multiple.
Indeed, relative valuations for big-dividend payers have come in somewhat as rates have backed up. Even if we handicap this by plugging in a 4% Treasury yield in anticipation of higher rates down the road, the multiple premiums are not unreasonable in a new world where income is king. Especially if we take into account the preferential tax treatment of dividends relative to interest income.
So is The Great Rotation coming? Vladimir and Estragon wait and wait, but despite false alarms and assurances from messengers that Godot is coming, he never shows. Linus van Pelt spends all of Halloween night in the pumpkin patch in anticipation of The Great Pumpkin’s arrival, yet the long-anticipated encounter does not happen for him, either. At the end of the two stories, Vladimir and Estragon are still waiting, and Linus vows to return to the pumpkin patch next year. Hope. Faith. Belief.
Call us skeptics, call us nonbelievers, but we will not look for the equity market under the lamppost where it was last seen, nor the bond market in the pumpkin patch of old. We will look to help meet the needs of today’s 10,000 retirees and tomorrow’s, and those looking to retire in 10, 20 years or more. The lesser rotations have a momentum unto themselves and will someday spiral or morph into some Great Rotation – but not now.