Bye-Bye Bonds? What Fund Flows Say About 2013

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Investors are showing enthusiasm levels near the highs for the year - just in time for the economy to go marching off the "fiscal cliff."

The prospect of higher taxes and tighter government spending seems not to be bothering many market participants, who in December shifted allocation from bonds into stocks.

Whether the bulls will regret their position is a matter for 2013 to decide, but the evidence for the moment shows that the luster finally may be coming off fixed income. (Read More: Vanguard CIO: Beware Bond Bubble)

"What we've done for four years is climb the wall of worry," said Jim Paulsen, chief market strategist at Wells Capital Management and believer that investors fund flows "will reverse" in the time ahead.

"Next year is going to be more of a confidence-driven run, not just climbing despite concerns but really climbing because of rising confidence," he added.

December indeed has shown investors preparing to change asset allocations.

Flows into stock-based mutual and exchange-traded funds have totaled about $8 billion so far, while bonds have taken in less than $1 billion, according to Lipper.

That reverses course from a year in which bonds have taken in about $250 billion and equities have lost more than $130 billion.

Paulsen believes that the change will continue based on two factors: Bond returns will turn negative, and investors will grow more confidence in stocks after the Standard & Poor's 500 passes its historic high of 1,565.

"That will end the lost-decade conversation," Paulsen said. "At the same time, bond players are not just getting a low return but taking a hit. That could be a serious change in that fund flow."

Enthusiasm, in fact, is everywhere on Wall Street despite the hand-wringing over the "fiscal cliff" stalemate that economists think could plunge the U.S. into recession. (Read More: Market's Solid Year Could Soon Fall Off a 'Cliff')

Bullish sentiment on the American Association of Independent Investors survey last week hit a 10-month high of 46.4 percent.

Investors wary of the U.S. simply have pivoted into multinational investments, with global funds taking in $9.3 billion in December as they continue to outperform domestic offerings, according to market data firm TrimTabs.

Rather than focus on the immediate danger of the Washington impasse, more seem to be taking the longer view that bonds finally are running out of steam and the Federal Reserve's money printing is forcing cash into riskier assets. (Read More: Central Banks: How They Are Ruling the Financial World)

"One of today's greatest market inefficiencies may stem from the scarcity of capital devoted toward long-term investing," Savita Subrmanian, equity and quant strategist at Bank of America Merrill Lynch, said in an analysis.

"Investors overly focused on the lack of near-term macro visibility may be failing to take advantage of today's depressed valuations and bearish sentiment, which are laying the groundwork for the next secular bull market in equities," she added.

Subramanian also expects a change in fund flows due to the bond market reversing course.

Along with a 1,600 price target for the S&P 500 in 2013, she expects the 10-year Treasury yield to hit 2 percent.

The higher yield would come about because of a decline in bond prices, a phenomenon that could chase investors who believe the mild coupon won't compensate for the price decline.

At the same time, investment pros continue to tout the stocks-are-cheap theory, reasoning that the current average price of 13 times forward earnings is still well below average.

"While there's no guarantee that history will repeat itself, it does add confidence to our Investment Policy Committee's forecast of a near-10 percent advance in the coming year to the 1550 level," said Sam Stovall, chief equity strategist at S&P.

Of course, the biggest worry when sentiment runs this high is that it will get overdone quickly and investors hopping aboard will do so after the best gains have been realized.

Add in the unpredictability of the fiscal cliff talks, which have kept stocks in a trading range, and it's causing optimistic investors like Paulsen to add at least a note of caution.

"If you go over (the cliff) at the end of the year those bullish numbers could go away," he said. "Short terms is negative right now. Still, the markets are holding up."