The Great Rotation: Stock Picking Versus Promotions?

Great Rotation a myth but stocks still a top pick ... Don't hold your breath waiting for that Great Rotation out of global bonds and into stocks. Even so, go into stocks anyway if you are big enough and tough enough to survive the inevitable volatility ... It also makes intuitive sense given the likelihood of lousy inflation-adjusted returns, even losses, in bonds. The only problem is the world is brimming with old people, rickety banks and foreign central banks , all of whom want and need safe assets almost without regard to the price. The upshot: equities will likely outperform bonds over the medium and long term but returns will be low by historical standards. – Reuters

Dominant Social Theme: Stay in stocks and grow rich over time.

Free-Market Analysis: Predictions of a bond bubble popping are generally accepted now and not so surprising as they were even a year ago. But this Reuters editorial on the Great Rotation out of bonds makes some good points. No matter what happens with the bond markets – especially the US Treasury market – there will likely always be a significant constituency that will stay no matter what.

And the idea that as bond markets subside stock markets will inevitably surge is also, as the article points out, something of a logical fallacy. For one thing, equity markets – especially the US equity market – are already inflated. And for another, the average investor who is not yet involved in the stock market after seeing averages virtually double is not likely to go there no matter what.

The Great Rotation may be a popular topic of conversation these days but it is the Great Contraction that occupies most people's minds. The economic crisis of the past five years has stripped the securities industry of its greatest asset, which is the ability to market equity optimism.

The last time an investment debacle of this magnitude occurred was in the 1930s, and investors didn't start returning to the market for 20 years. Here's more from the article:

"Structural demand for safe havens is likely to remain high and, when combined with the structural scarcity of such assets, is likely to keep interest rates on safe assets low," economist Michael Gapen wrote in the annual Barclays Equity Gilt Study, a long-running series on asset markets and returns. Safe assets are, usually, government debt, which rarely default and are easily bought and sold even in times of distress or market dislocation.

One of the ironies of the financial crisis is that even though government debt is objectively more risky now, demand is higher. That's because, in part, if the safest assets are riskier you need more of them in a mixed portfolio to have the same absolute level of risk. It's also because a lot of assets which were created and bought as "safe" before the crisis – such as asset-backed securities – proved to be anything but.

By the loose definitions of 2007, safe assets equaled about 35 percent of global GDP in 2007. Take out all the faux-AAA debt and now that figure is nearer 25 percent, and expected to shrink in the coming decade. Less supply and more demand equals high prices. Figure in that much of the world's wealth is controlled by people in or approaching retirement, and you have a recipe for strong demand for government bonds, even amid a deteriorating longer-term outlook for government finances.

Okay, we can accept that no matter what happens to Treasuries a significant constituency will remain – perhaps to their detriment. But how about those who see opportunity in equities? Deciding to take the plunge is one thing; figuring out the location is another. Options range all the way from passive asset-allocation to aggressive stock picking.

Asset allocation is seen skeptically on Wall Street these days because allocators didn't receive the full benefits of the early 2000 runup and participated with everyone else in the financial crisis later in the decade. And when one looks at the stock market now, the fierceness of the recovery might give one pause. After doubling in only a few years time, is additional growth going to take place at a similar pace?

With this in mind, we are beginning to see opportunities being mentioned internationally, not in Western countries but in developing ones. This has nothing to do with the opportunities per se and everything to do with a determination to find other sources of government-available income.

Throughout the past three decades the dollar reserve system has been supported first by Japanese and then by Chinese purchases of massive amounts of US Treasuries. But the determination of Japanese officials to inflate domestically and difficulties with Chinese balances of trade mean that the buying from Asia is diminishing.

In its place, we've written that Africa in particular is being groomed to replace Asia as buyer of last resort. We note the various ground wars in Africa that are apparently aimed at shoving Africa in a pro-Western direction. And now that Muammar Gaddafi is out of the way, we would not be surprised to see the idea of an African Union advanced more aggressively.

As difficult as markets have been over the past decade, we would offer the idea that it is the turn of the developing world to be offered as the next great wealth opportunity. Again, this has little to do with the actual opportunity and a lot to do with the need of Money Power itself to prop up the dollar-reserve system as it exists.

The buying has got to come from somewhere and if it is not to be from Asia, then Africa is likely to be developed in much the same manner as China was developed over the past decade. African goods will be promoted to the West and especially in the US. In return, African economies will purchase US debt, funding the US deficit – and providing the raw monetary material that US and Western consumers will turn into purchases of African goods.

This certainly sounds far-fetched but who would have thought that China would have boomed so aggressively – or Japan, for that matter. These are not simply market events but arranged strategies that have to do with international monetary flows.

If one wants to venture abroad investment-wise, the trick will be to determine how to take advantage of the next great shift in monetary assets from Asia to Africa and other countries that don't appear right now to promising possibilities.

One can allocate assets or try individual stock-picking but either way it will not be an easy decision. In fact, investing abroad in developing countries – often corrupt and arbitrary – is not for the faint-hearted. But if one examines the broader investment patters and what is going on in Africa today, the future of the very largest investment flows should be obvious. African countries in particular and developing countries in general are seemingly being groomed – and this well may be the next great investment story of the 21st century.

Conclusion: Whether what we have observed is possible and practical is perhaps not yet clear. But there are plenty of signs that it is coming and that those who figure out a way to position themselves for this next "great promotion" will benefit as it expands.