US Stock Funds Could Be Back After Sitting Out 2010 Rally

US equity funds, out of favor through most of 2010 even as the stock market was posting double-digit gains, could come back in fashion as investors start peeling money away from bonds and emerging markets in the year ahead.

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Domestic equity mutual funds sputtered into the end of the year with 33 straight weeks of net outflows even though global equity funds recently have seen net inflows, according to TrimTabs market research.

Despite a 12 percent gain in the Standard & Poor's 500 , fund investors this year were putting most of their money into bonds, which until December were seeing inflows of $25 billion a month. Fund flows are generally seen as the best gauge of where retail and institutional investors are putting their money, while individual stocks are more often the playground of short-term traders.

But the trend lately has been for money to come out of bond funds, and some strategists are beginning to position for 2011 with the belief that the flow out of fixed income will lead investors not into more emerging markets but rather back into the U.S. Bond funds are expected to see outflows of $14 billion for December.

"What you've seen is a fairly significant outflow of funds from bond funds, and that's going to have to find a home," says Curt Lyman, managing director at HighTower Advisors in Chicago. "What we're going to see is a flow of funds back into U.S. domestic funds. As an American, where would I rather invest—in Europe where there are increasing concerns over the systemic stability of the euro, or at home in the U.S. dollar?"

The direction of fund flows will be significant if the market performs as well as many strategists expect.

Predictions for the year ahead have the S&P 500 gaining anywhere from 10 to 20 percent, with much of that predicated on accommodative monetary policy from the U.S. government and a continuing recovery for the U.S. economy.

By contrast, the S&P's 2010 gains came largely on the back of a weak dollarthat helped multinationals compete in the global marketplace. But more domestically oriented companies struggled to increase their revenue even as they improved bottom-line performance.

If U.S.-based companies fail to attract investor interest from the start, that could act as a headwind for the recovery and bring some of those bullish forecasts into question.

"January is going to be the real tell-tale sign," says Nicholas Colas, chief investment strategist at BNY CovergEx, an institutional investment advisory firm in New York. "If it doesn't happen in January, I don't know when it will."

Colas points to three factors that could boost U.S. funds: Positive sentiment about the market's direction, a gradual exodus from bond funds, and an uptick in 401(k) contributions when the new year starts. The movement into the U.S. probably will start with broad indexes like the S&P and then into small-caps, he says. The Russell 2000 small-cap index has far outpaced its counterparts, gaining 25 percent in 2010.

"The U.S. investor has poured so much money into bond funds that the trend is bound to change," says Jordan Kimmel, market strategist at T3Live in New York. "The funds that flow out of bonds are going to go in a high proportion right into U.S. large-caps."

In fact, Kimmel thinks the only group among major stock sectors unlikely to participate in the move to U.S. funds is health care.

"The U.S. story is very much alive around the world; the stock prices just don't tell it now," he says. "Most importantly, U.S. employment is starting to come back, and U.S. confidence is coming back a little bit. The last thing you want to do is sell large-cap U.S. short going into 2011."

Investors have to be careful, though, of "feeling like they've got to be with the crowd," says Robert "Hap" Sneddon, president at portfolio manager at CastleMoore in Toronto. The unwinding of government stimulus could temper the economic recovery, and investors have reached a level of complacency not seen since just before the market's historic highs in October 2007.

"All these things are lined up for a possible disappointment," Sneddon says. "This year could at best be kind of a sideways year because we don't have all these policy thrusts behind us."

But the consensus for now is that 2010's global stock rally will come home to the U.S. in 2011.

"Investors are fundamentally risk-averse," Lyman says. "When they reach for returns, do they want to shoot for the moon or swing from the chandelier on New Year's and invest in emerging markets, or invest closer to home? I think they'll invest closer to home."