One Reason Stocks May Stall

Despite taking a small breather toward the end of January, the U.S. stock market appears to have resumed going up. The market is up almost 3% in 2010, and up roughly 70% in the past year from its lows of a year ago. But while embattled stockholders may be celebrating these gains, they would do better to look ahead.

Burning a hole in their pockets
There's a lot of uncertainty surrounding the economic recovery right now, but investors who think the market will continue to produce at the level it has in the past year may be in for a rude awakening. According to recent news from Bloomberg, the market may not be getting help anymore  from one group that has helped support buying in the past year -- mutual fund managers. Equity funds have been on a spending spree, burning through cash at the fastest rate since 1991. Average cash levels dropped from 5.7% in January 2009 to just 3.6%. Some funds have slimmed down even more:

Source: Morningstar Principia. Cash levels as of Dec. 31, 2009.

The concern is that with such low cash levels across the board, most of the money available to fund managers has already been deployed in the market. That doesn't bode well for future returns, as flagging demand may put downward pressure on prices.

Lack of support
I agree that stocks are not likely to put in an impressive showing this year, but I don't think that has much to do with the level of cash in equity mutual funds.

Keep in mind that investors have shuffled billions of dollars into bond funds in the past year or two. These actions were partly in response to the more attractive short-term results bonds were cranking out and partly out of fear of losing more money in the stock market. Right now, bond funds and exchange-traded funds are stuffed to the gills with investor dollars, dollars that likely will eventually find their way back to the stock market once the general level of fear and uncertainty has subsided.

However, I do think we've seen the best returns we can expect from this rebound already, and history has proven that out. Looking back at the nine postwar bear markets before this one, the biggest jump in returns typically came in the one year following the end of the bear market. According to a recent analysis by Broad Reach Wealth Management, while the average bear market brought a 32% decline from peak to trough, in the one year following the trough, the market returned 36%. In the second year of the recovery, the market put up a 12% gain, while the third year brought a mere 1% return. Obviously, the numbers have been a little bit more extreme than average this time around, but the pattern is clear -- the biggest gains are behind us. This is just another reminder of why it makes sense to stay invested for the long run. By getting out when things look bad, you're likely to miss the biggest part of the rebound.

Getting back to business
So if the market has already given us most of the rebound juice that it has to offer, where will further gains come from? Well, from where they should always come from -- earnings growth. Companies will need to start growing, selling more, and increasing earnings to contribute to lasting stock-market gains. And while some sectors are still struggling, we're finally seeing growth on some fronts. Retailers like McDonald's (NYSE: MCD) and American Eagle (NYSE: AEO) recently announced robust profit growth, and more companies are likely to follow suit as the recovery firms up.

Looking ahead, I expect more steady, consistent returns for the market, but nothing that will dazzle, at least in the immediate future. Investors would be wise to stick to high-quality stocks with stable cash flows and low debt loads. These types of stocks haven't been fully rewarded in the market yet, but are likely to gain favor in a slow-growth recovery. Valuations will also be increasingly important because overpaying for growth won't be as likely to pay off in a slower-growing economy.

Likewise, make sure you've got a hefty allocation to foreign stocks. Faster growth in other regions of the globe can help make up for slower expansion here at home. Most investors are woefully underexposed to international companies, because folks tend to invest in what they know. More aggressive investors can handle at least 25% to 30% of their allocation in foreign stocks, while more conservative types can still afford around 10% of their portfolio in this area.

The wild days of 70% annual returns may be behind us, but there is still plenty of stock market power out there for investors who are patient, manage their expectations, and invest for the long term.