Why Equities Will Outperform Bond Funds

For the first 7 months of the year, the Investment Company Institute estimates that $59 billion has gone out of domestic equity funds.  This is on top of the $120 billion that left town in the second half of 2011.

Where did all of that money go?

In some cases, it went to bond funds, which have enjoyed $228 billion in bond fund inflows since July of 2011.   In other cases, it left the investment category altogether.  Clearly, investors have become risk-averse and fearful about losing money.  Unfortunately, for the saps that have put their money in bond funds, that is exactly what is going to happen.  We are in an unprecedented low interest rate environment.  Consensus is that interest rates will have to rise in the not too distant future.  When interest rates rise, the underlying price of bonds, and especially the value of bond funds, drops.

Even novice investors know that investment classes go in cycles.  What is hot today will be cold tomorrow. With a combined $180 billion in domestic equity fund outflows over the past 13 months and $228 billion in bond fund inflows, something is going to give and a reversal, at least on some level, will occur.

The trigger could be higher interest rates, or stock market outperformance, the continued attractive nature of dividend stocks, the Presidential election outcome, etc.  I am not smart enough to identify it at this time.  What I can identify is that as the equity fund inflows return, the market could rally to new levels, and since small stocks have not been broadly participating in the current rally, they may find themselves a very attractive option when the inflow/outflow situation changes.

The tipping point will be driven by higher volume and a clear but subtle appetite for more risk by larger investors. So, look for a rise in the fall.

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