For the longest time, the biggest meme in the investment world was the “The Great Rotation.”

The story went that investors, being the fools that they are, have piled into bonds. At some point, they will be pulling out and going into equities. And when that happens, God help us. Bonds are likely to crater and equities will take off.

But along the way something strange happened. All of a sudden the storyline has changed.

The new meme is that equities have done well due to lower cross-asset volatility, and cash allocations to equities have increased. When volatilities rise, investors will flee equities. And when that happens, God help us.

I was deeply skeptical of the flow argument for bonds going down. I remain deeply skeptical of the flow argument for volatilities and equity valuations.

The key point with respect to flows and valuations is that, in a typical market, flows determine valuations. And flows, to some extent, are themselves determined by valuations.

equity

Source: Fed Flow of Funds, 6/30/14. Total Invested assets is defined as directly held mutual funds and indirectly held corporate equities, credit instruments (bonds) and total currencies and deposits (cash).

But that argument does not hold in a deleveraging economy. In a global deleveraging cycle, flows are determined by investor concerns about their leverage position—and are far less sensitive to valuations. In a similar vein, volatilities are determined by transparency and signaling of monetary policy. In a deleveraging economy, sane monetary policy is likely to be stable and supportive, which in turn may lead to lower volatilities and likely melt up in equities. It is really that simple. In the current environment, it is the deleveraging that is determining the direction of monetary policy.

So, if you are looking for a change in the direction of volatilities, flows and therefore equity valuations, look no further than a change in the direction of monetary policy, which in turn is going to be determined by whether or not the deleveraging cycle is over. Don’t pay heed to any other investment meme.