Does The “Great Rotation” Really Exist?

A lot of the chatter you hear in the daily financial news is not useful if you’re an investor with long-term goals like retirement planning. “What’s hot and what’s not” won’t make much of a lasting impact on your road to prosperity.

But there’s one phrase bouncing around the airwaves these days that’s worth giving some attention to –the so-called “Great Rotation.” This refers to a “structural shift” from one asset category into another – in this case, from bonds into equities.

There’s no conclusive evidence that the Great Rotation of 2013 is any more real than the Great Pumpkin of the “Peanuts” cartoon. But it can have a major influence on portfolios for a decade or more to come, and for that reason it’s worth noticing.

Structural Shifts vs. Market Cycles

A Great Rotation is a structural shift. This is not the same thing as a market cycle, and it’s important to know the difference.

Look at a one-year performance chart for the S&P 500. You’ll get a picture of a market cycle that correlates in some way to economic trends like GDP, inflation and unemployment.

Why is that? The stock market is regarded as a leading “economic indicator,” meaning that stock prices tend to tick up before an economic recovery kicks into full gear. Stock prices are likely to trend lower ahead of a recession. This ebb and flow is called a “market cycle”.

Structural shifts, by contrast, extend over a series of market cycles. Here’s an example: In the aftermath of World War II the U.S. stock market, as measured by the S&P 500, grew for many consecutive years. Each time the market would correct (meaning that prices would fall from their peaks by 10% or more), it would rebound and surpass its previous high point. This went on, market cycle after market cycle, until it reached a peak in 1968.

That marked the beginning of another Great Rotation – that time out of stocks and into bonds. The S&P 500 would regain that 1968 level from time to time over the coming decade, but would always fall back below it. That lasted until 1982! Being a long-term investor during those 14 years was painful.

History (Sort Of) Repeats Itself

After that, we experienced  a Great Rotation into equities that lasted for eighteen glorious years. These were the years of globalization, privatization and, of course, the commercialization of the Internet that led to a frenzied late-1990s tech bubble.

Then we experienced 1968 all over again – an extended deep freeze for equities. Technically, this is where we still are. The S&P 500 reached 1527 in March 2000 as the tech bubble peaked. It still has not definitively confirmed and exceeded that level.

Today, in fact, the index is flirting with the 1527 level. That’s why there’s so much chatter about the Great Rotation. To put it in simple monetary terms: if you had bought an S&P 500 ETF in March 2000 you would have had zero capital appreciation through mid-February 2013. (You would have picked up about 2% or so annually in dividends, which is less than what you’d have earned in coupon interest from a U.S. Treasury security held for the same time period). You can see why so many investors hope that this Great Rotation turns out to be real: it represents hope for long-term investors.

What Does It Mean For You?

The basic principle of long-term investing is that equities outperform bonds over long time periods. Investors with long time horizons should maintain strong equity allocations. This will position them for long-term growth and help them meet their goals.

The last 13 years of stock market performance can raise doubts as to whether that basic principle still holds. But if you’re planning to invest for long-term financial goals, don’t lose faith in equities. Whether the Great Rotation happens this year or not, a significant equity allocation in line with your risk tolerance and time horizon is still the best path for reaching your goals.

Is the Great Rotation upon us? Tell us what you think.