This post is taken from our weekly report dated January 23rd 2018.

We are seeing a rotation into equities and out of bonds at the start of this year. BAML, using EPFR data, noted that equity fund flows over the past 4 weeks are up to $58 billion, the largest ever, and net short positioning in bonds continues to rise. This has led to the stock-bond ratio becoming extremely stretched. In the top-left chart, we can see the long-term RSI of the stockbond is near all-time highs. Longer-term returns in stocks vs bonds are likely to be poor when this measure is so high. The top-right chart shows the 1-year Sharpe for stocks-bonds is much higher than it’s ever been over the last 16 years. Stellar trailing risk-adjusted returns often means poor returns going forward. Mitigating the chances of a full-blown rout in stocks vs bonds is the positioning data (bottom-left chart), which is relatively muted.

It is difficult to see the justification for this flood of inflows to equities, other than momentum chasing. Profit-taking would favour switching out of equities and into bonds, given the superior performance of stocks over the last year and more. Bonds now pay more than the S&P dividend yield, and the gap with the earnings yield is closing (bottom-right chart). Also, on virtually every measure, stocks are more overvalued than bonds. We are watching our Correction Signal for signs of outright turbulence in equity markets, but a stretched stock-bond ratio suggests that equity markets will begin to underperform bonds.

(Click on image to enlarge.)

Charts suggesting that equity markets will begin to underperform bonds

Source: Bloomberg, Macrobond and Variant Perception