When the Levee Breaks

Here’s a riddle:

What happens when an extra half trillion dollars that has been shoe-horned into bond funds decides it’s getting a horrific return, sees the 10% rally in dividend-paying equities and decides to switch asset classes?  What happens when this mass asset class transfer happens not in an orderly manner, but in a rush – between say October and the holiday season?  Specifically, what happens to the stock market?

Katrina happens, Esse.  People hanging in tree branches, pickup trucks lying sideways on the rooftops of buildings, Indonesian tsunami stuff.

A biblical flood-tide of misallocated cash leaves the 1.5%-yielding short-term bond market and comes sloshing back over the transom into the equity market.  You may have already gotten a whiff of this hurricane-tide in the first two weeks of October.  Bears are mistakenly referring to it as “just another Risk On moment”.  It is becoming much more than a moment.

The plunge into bond funds over the last two years has been epic; $350 billion in inflows in 2009, 2010 is on pace to see another $300 billion.  This ocean of money predominantly came into these funds at the short-end of the yield curve and is currently earning a sclerotic rate of return that is dwarfed by “real” inflation (you know, like food prices, energy and stuff that matters in real life).

According to Morningstar, the pace of the out-of-stocks/into-bonds trade that has been so dominant all year is slowing.

From Morningstar via the WSJ:

Overall, long-term (bond) mutual funds saw inflows of $14.28 billion during September, lower than August’s $16.81 billion

I would not be surprised to see this trend continue and then reverse itself entirely as investors look at the paltry yields they’ve signed on for and begin reallocating back toward their forsaken stock funds again.  And because we’re Americans, despite our much-mythologized “rugged individualism”, we tend to stampede like a delirious herd.  Because this is the case, I also wouldn’t be surprised to see this move happen en masse.

Just a heads up – the more agile among us may want to start paddling their surfboards in front of the right wave now.