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The charts* below (click on each to enlarge) have shown that as the U.S. economy continues to show improvement, overall sentiment toward stocks has turned more positive and investor appetite for equity continues to stabilize. In contrast, bond market’s outflows, especially at the long end of the yield curve, have been driven primarily by steadily rising yields on government bonds (NYSEARCA:TLT) since November.

We believe investors should remain defensive in the bond market and be cautious before committing to any durational risks by buying longer-term maturities. Raw material and commodity prices are slowly creeping up due to robust demand from the emerging markets and the inflationary monetary and fiscal policies. Rising inflation might not be too far down the road and could trigger a sell-off in long term bonds. The uncertainties over an unlikely, but possible, downgrade of U.S. sovereign credit ratings are casting another cloud over the already volatile bond markets.

But there are still opportunities for attractive returns in the fixed-income market. Investors should put emphasis on credit-risk focused fixed-income funds with disciplined risk control. Getting exposure to non-government bonds with high initial real interest rates and safe credit spreads should provide upside if fundamentals remain strong while creating a buffer for potential principal losses in a rising interest rate environment. High Yields (NYSEARCA:JNK) and Investment Grade bonds (NYSEARCA:LQD) have been performing well recently with strong trends and should be a good momentum play.

*Our smart money indicator reports surveyed funds’ aggregate asset exposure to U.S. equities and bonds. It is derived based on comprehensive analysis of top asset allocation gurus' recent asset exposure. We track two separate indicators:

Top 3 Moderate Allocation Funds (Smart Money)
481 Moderate Asset Allocation Mutual Funds (Pro Money)

This is calculated weekly and the chart covers the last one year. For the week ending 1/14/2010, our proprietary model reported equity exposure for the two set of funds was 68% and 66%, respectively.

Top 3 Moderate Allocation Funds (Smart Money)

481 Moderate Asset Allocation Mutual Funds (Pro Money)

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Navigating a Safe Path Through Volatile Bond Markets