Beware the Great Rotation

Price-to-earnings multiples are going to get even more excessive as bond investors switch into the Russell 2000.

By Stock Traders Daily Jul 9, 2013 1:29PM

Stock market report copyright CorbisLast week the Great Rotation began, with bond investors transitioning into stocks. That usually means high dividend-paying stocks, but something else has been happening that may be counterintuitive, given the otherwise conservative nature of the rotation.

 

Bond buyers are typically conservative, but that may not be the case with many recent bond fund investors. They may have been chasing performance, and given the total returns most bond funds experienced between 2008 and 2012, who could blame them? 

 

Now, however, the bond funds have turned, with over $120 billion of net worth being wiped out of long-term T-Bonds alone. Investor who were formerly chasing performance in bonds may now be looking to the Russell 2000, and therefore the iShares Russell 2000 Index ETF (IWM), which is largely  comprised of smaller cap stocks.

 

Almost quietly the Russell 2000 has been breaking out, and it is now at all-time highs. Chart patterns show no clear resistance levels, and money flows into small-cap stocks seem more consistent than ever. The catch is that the Russell 2000 has a P/E multiple of over 59, but investors who chase performance do not care about that.

 

Investors swapping bond funds for the Russell 2000 are setting themselves up for an eventual fall.  Some will argue that earnings are expected to be great for small-cap stocks, and that might be true, but even if the Russell had EPS growth of 25% the multiple would still be excessive. 

 

The old adage on Wall Street is that we should not follow the herd, but that only applies when momentum is not a factor. During momentum moves the best thing to do is to go for the ride, but you also must be nimble enough to get off because when the music stops, reversals happen fast.

 

Stock Traders Daily has issued recommendations based on the Great Rotation that suggest exactly this. As bond investors rotate into stocks the equity markets are likely to experience unwarranted buying pressure. That will tame pessimism on Wall Street, and lead to even more excessive P/E multiples. Inevitably there will be a contraction, with the PowerShares QQQ Trust, Series 1 ETF (QQQ), SPDR S&P 500 ETF Trust (SPY), SPDR Dow Jones Industrial Average ETF (DIA), and Russell 2000 all falling back to historically acceptable multiples.

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