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Fund flows away from U.S. stocks spark correction fear

The U.S. market's recent rally comes even as investors are putting far more money in bonds and foreign equities than domestic stocks.

That raises questions about the durability of the move higher and heightens the possibility of a significant leg lower, according to Michael Hartnett, chief investment strategist at Bank of America Merrill Lynch.

"Correction risks will grow in absence of fresh inflows in coming weeks," Hartnett wrote in a note to clients. (Tweet this)

U.S. equity funds saw $6 billion in outflows over the past week, with a $4.9 billion chunk of that coming from exchange-traded funds, according to BofA.

Bond funds saw inflows of $5.6 billion continuing a major theme for the year. Fixed income has raked in $121 billion, while equity funds have attracted just $1 billion in 2015.

Traders work on the floor of the New York Stock Exchange.
Brendan McDermid | Reuters
Traders work on the floor of the New York Stock Exchange.

The moves come as the S&P 500 has gained 2.4 percent in April and the Nasdaq, which consists largely of tech stocks, is up 3.9 percent and the Russell 2000 small-cap index has risen 1.4 percent. Those gains have come even while the SPDR S&P 500 ETF, which tracks the index, has surrendered $1.03 billion over the past week alone, the iShares Russell 2000 has seen $1.02 billion in redemptions and the PowerShares QQQ lost $120.7 million.

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Wall Street has been anticipating a market correction during the latest leg of the bull market, but none has materialized. It has been more than 3 1/2 years since the S&P 500 last dropped more than 10 percent, a streak that is the third-longest in history.

Waiting for fund flows to indicate the next one, though, could be a losing game.

Market watchers have long deliberated whether the metric is a leading or lagging indicator. For much of the early cycle of the current bull, investors had pulled hundreds of billions out of equity funds even as the market kept rising. Expectations for what Wall Street called "the Great Rotation," or an exodus from bonds into stocks, haven't been met either, but that hasn't kept the market from rising.

"Fund flows reflect what's happened already rather than what's going to happen. It's very similar to surveys of confidence to some degree," said Jim Paulsen, chief market strategist at Wells Capital Management. "It's not a very good future indicator. The early years of this bull market made tremendous strides upward with very little flow."

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For his part, Paulsen shares a bullish long-term market view but feels this could be a flat year for the market, with the possibility of a significant drop-off along the way. But he thinks fund investors who share his wariness of U.S. markets are choosing the wrong alternative.

"It just is absurd to me that people would be rushing into bonds," he said. "I don't get it."