No Sign of ‘Great Rotation’ Among Fund Investors – This article, from Minyi Chen, CFA, Portfolio Manager of AdvisorShares TrimTabs Float Shrink ETF, is brief but worth a read for its very useful for its commentary on Bond Mutual Fund and ETF Inflows.

Thinking About Thinking, by Jeffrey Saut at Raymond James, provides a superficially plausible source for the US equity inflows that aren’t coming from bonds: non-US equity outflows.

Vadim Zlotnikov at AllianceBernstein makes a different, more specific argument in Cyclical Stocks Appeal After Defensive-Led Rally. After noting that the drive in equities was led by defensive (what we at Whitebox have called bond-like) equities, he calls for investors to take a renewed look at cyclical stocks, which even after May’s rally are still trading at a significant discount to defensive stocks.

But what are we to make of those still holding onto their low-yielding bond portfolios with white knuckles? With these investors still so seemingly risk-averse as to have abstained from the recent run in equities, if bond markets begin to show signs of weakness, as Say’s Law might say is inevitable, where will they allocate their capital?

The first and we think most likely is the “pastoral”—our peaceful meadow. In the pastoral scenario, the equilibrium holds. The economy does not implode. More likely we see continued moderate growth—what Brian Wesbury has been calling “the plow horse economy.” In an atmosphere of modest economic optimism we see continued, modest, orderly flows of capital from bonds (and other hiding places) into stocks, not motivated by hatred of bonds but a positive desire to be in equities. With all that going for it, the S&P might well have another strong year.

Consequently spreads might open up a bit to compete with equities. But, in this most serene of all possible worlds, the Fed does not yet lose its credibility. The world continues to buy Treasuries. In a calm rotation from credit to equity, sustained by acceptable to strong economic growth, the downward pressure exerted on equity prices by rising discount rates likely would be balanced, or even overpowered, by the upward pressure of economic optimism and strengthened earnings. Rates rise modestly but not enough to turn the deficit into a death spiral; this gentle rise sustains credit markets rather than derails them.

In the best possible case, growth is strong enough and long enough that the opposing fears that are inflating the bond bubble and threatening to pop it are relieved rather than realized. The real risk- free rate slowly turns positive. Credit and equity markets compete at least as much on greed as on fear. We return to a normal economic world.

In the other two scenarios we are not so lucky. In the “avalanche” scenario, credit markets collapse from high yields on down. As with a real avalanche, this credit avalanche could be triggered either by a big obvious shock—a recession could do it—or it could be triggered by an event so trivial that the world never agrees on what happened…

In the “earthquake” scenario, credit markets collapse from the base as the Fed and Treasury finally lose credibility. Treasury rates soar. Spreads actually widen rather than tighten as they typically do when rates rise because this rise reflects not economic optimism or demand for capital but fear. High yield issuers become unable to roll their debt, credit markets close, the economy contracts, and the fiscal crisis is even worse than under the avalanche scenario.

Again the proximate cause could be almost anything that spooks Treasury investors…

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Oh, you thought I was talking about me? Hah! Well I can understand the confusion. Actually I was thinking of Bill Gross, of PIMCO fame. Gross’s recent letter proclaiming (yet again) the death of equities is getting lots of attention mostly because compared to his usually insightful pronouncements it is extremely silly.

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Each methodology was backtested with two sets of stocks: the largest 1,000 U.S. stocks from 1964­–2009 and the largest non-U.S. stocks from 1987–2009. The authors used a wide variety of metrics in their analysis, including total return, volatility, Sharpe ratio, tracking error, and more.

The authors find empirically that these alternative strategies often outperformed standard benchmarks due to exposure to value and size factors. They caution investors to be aware of transaction costs and suggest it might benefit investors to combine less costly alternative strategies to mitigate exposure, rather than investing in a single fund using a method with higher costs that could diminish return.

This paper was a finalist for the 2011 Whitebox Prize for the best financial research of 2011. To see the top 10, click here.

Using the Thomson Reuters First Call CIG database and CRSP daily stock prices from January of 1996 to December of 2007, along with data from Compustat, IBES, and Thomson Reuters Institutional Holdings 13f filings, the authors calculated abnormal stock returns around company-issued guidance in a manner consistent with similar studies. Then, assuming the information leakage would be related to the information found in the guidance, the authors examine the portion of the abnormal returns made in five or ten days prior to the announcement, theorizing that abnormal returns prior to the announcement would be the result of information leakage. The authors found that this information leakage occurred both before and after Reg FD, that information leakages are more pronounced when the characteristics of the firm, guidance, and industry are subject to more asymmetric information, and the magnitude of the leakage is an effective signal of the content within the forthcoming company- issued guidance.

Using this information, the authors construct a simple trading strategy based on the observed leakage, taking long positions on positive leakage of at least 1% and short positions on negative leakage of at least 1%. In each case, the position is held for just six days, including the day guidance is issued, and then closed. Both saw significant positive returns. The short positions saw an average profit of 11.77%, and the long positions a profit of 9.18%. Though the profits are reduced after the introduction of Reg FD, the profits for both positive and negative leakages remained significant.

This paper was a finalist for the 2011 Whitebox Prize for the best financial research of 2011. To see the top 10, click here.