One needs to be careful about getting too abstract when talking about investments, but in trying to get a grasp of where the financial markets have gone this year, and where they're headed in 2011, you can't help but sense that at least two realities are at play.

Domestically, the stark reality is that unemployment remains stuck at just under 10%, with corporations showing no signs of expanding payrolls or wages to a degree that would spark robust economic growth. The nation's housing and foreclosure problems, meanwhile, are entering into a fourth year, muting a recovery that is sputtering along at 2% per year. The gloom surrounding the U.S. economy is the primary reason why investors-both individual and institutional-are keeping an abnormally high portion of their assets on the sidelines, despite favorable market returns, earnings outlooks and valuations, according to investment managers.

When you step back and take in a broader view, however, things are happening that give many in the investment community reason for optimism and, in some cases, bullishness. This outlook starts with corporate earnings, which have shattered most analysts' forecasts in 2010 and been perhaps the primary reason the market is yielding double-digit returns year-to-date (the S&P 500 was up 10.7% as of November 9). The earnings picture is one of the most notable silver linings of the 2008 market collapse, as corporations responded to the crisis by cutting costs, reducing debt and aggressively pursuing global markets that are now growing at twice the rate of the U.S. economy. The trend is part of a seismic shift in the investing landscape that has seen a broad cross-section of U.S. managers move their focus overseas-to U.S.-based companies with a sizable presence in foreign markets as well as foreign companies.

These certainly aren't the only factors shaping the outlook of investors. Much concern centers on the Federal Reserve, which is embarking on a plan to buy $600 billion in government bonds-an unprecedented economic engineering initiative designed to stimulate the U.S. economy at the risk, some say, of igniting runaway inflation.

Pockets of activity that provided investors with some relief, such as emerging markets and real estate, will also be closely watched, as will merger and acquisition activity, which managers say has noticeably increased this year. As opposed to the spring, when dire warnings of a double-dip recession paralyzed investors, they note that many indicators are headed in the right direction, albeit slowly.

Yet the prevailing questions heading into the new year seem to be centered on which sentiment will prevail in 2011: the feeling that the domestic market is too weak for equity investing or the argument that, when looked at globally, the equity market is poised for a bull run.
"The claws of the bear are still in the hearts of investors," says David Winters, manager of the Wintergreen Fund. "I think that people are still very much trapped by what happened in 2008 and are not willing to take any market fluctuation. They would much rather have no return than a negative return."

Going Global
The market dichotomy is a reflection of the extent to which U.S. corporations have become globalized, says Douglas Cote, senior portfolio manager for ING Investment Management. If investors were fully aware of how immersed U.S. companies have become in both emerging and developed overseas markets, they wouldn't be sitting on the sidelines as they are now, he says.

He feels that the investor who in past years was 60% equities and 40% fixed income has retreated into an 80% fixed-income position-a posture Cote feels is dangerous, particularly with the Fed planning to further loosen up the money supply.

Given the global economic growth rate, which averages out to about 4%, investors should be at least back to the 60/40 allocation, he says. "If you actually look at the facts, you would be bullish. If you look at the market from a global perspective, you would be bullish," Cote says.
The numbers vary based on the metrics used, but analysts estimate that S&P 500 companies derive anywhere between a third and a half of their revenues from international markets. While investors may not be highly aware of this fact, international managers have been highly aware of it as they've looked for alternatives to the ailing domestic economy over the past few years.

Given the question marks surrounding U.S. economic growth, investors cannot only expect to see managers bulk up on U.S. companies with international exposure, but also on companies that are domiciled outside of the U.S.

At the Prospector Capital Appreciation Fund, about 12% of holdings are blue chip multi-nationals such as Johnson & Johnson, Abbott Labs and DuPont. In previous years, such holdings have been so low "that we never bothered to calculate the percentage," says manager Rich Howard.

What's changed? Valuation for one thing, Howard says. The flow of assets out of the equity market has created irresistible valuations in some cases. "They're much more undervalued than they've ever been," Howard says. But, he says, the exposure these companies provide to emerging markets is another compelling incentive to own them-especially for managers such as Howard, who do not specialize in emerging markets.

"I'm not an expert in emerging markets or their companies and I usually avoid them," he says.

John Augustine, chief investment strategist for Fifth Third Private Bank, has increased the size of his overseas holdings from 8% to 30% since 2001, with the biggest jump in those types of companies occurring over the past two years. The international holdings are about equally split between companies domiciled in emerging markets and those in nations with developed economies.

Whether the focus on international revenues increases will depend on whether the pace of U.S. economic growth catches up to the global growth rate, he says. "When you look at the big picture, we unfortunately are at a speed that is frustratingly slow," Augustine says. "We're recovering at 2% when we should be recovering at at least a 3% GDP growth rate."

At Wintergreen, the portfolio's foreign holdings have gone from about 35% to 70% over the past five years, Winters says. It's simply been a case of the fund chasing opportunity, and finding that the trail leads overseas, to companies such as Switzerland-based Nestle, he says. The world's largest consumer goods company, Nestle yields 3% in Swiss francs, does business all over the world and has achieved 6% organic growth this year, he notes. The company's emerging market revenues have gone from 25% to 35% over the past ten years.
"They make products that people buy everywhere-coffee,  chocolate, baby food. It's a relatively low-risk way to participate in what's going on in the world," Winters says.
Cote feels globalization's impact on the U.S. equity market is not only sustainable, but permanent. Although he predicts the 2011 investment market will be similar to this year's-in the low double digits-he feels there will continue to be a strong connection between U.S. revenues and global markets. He feels the global growth rate will be sustainable because of unbridled growth of the middle class in emerging markets.

"What people don't understand is that the global emerging big eight-China, India, Brazil, etc.-now produce more of global economic growth than the U.S., plus the European Union, plus Japan put together," Cote says.

There are also signs the U.S. economy, while recovering slowly, is poised to pick up the pace, says Jim Swanson, chief investment strategist for MFS Investment Management. Noting that S&P 500 companies are holding more cash than they have since 1955, Swanson says, "These companies have reduced their risk profile and learned how to make money with less cost. Productivity is aligned with profitability."

Other positive signs for the domestic economy are increased corporate capital outlays and a housing market affordability index-a measure of how easily the nation's family can buy a house-that is at a 35-year high, he says.

"All the numbers are adding up to growth," he says.

The Risks Ahead
While the global economy may be giving encouraging signs, investors still need to sort through the risks, which in 2011 could range from potential clashes in Korea or the Middle East, to the repercussions of cotton being at its highest price since the American Civil War.

For instance, one of the running concerns is that U.S. companies won't be able to repeat their earnings performance in 2011 because their extensive cost-cutting measures have run their course. The benefits derived from emerging markets may also run out of steam, with some observers already warning of an emerging market "bubble."

Indeed, given the events of the past few years, many investment managers say they're dealing with more unknowns than they've ever encountered in their entire careers. "With the Great Recession and the tumbling of the stock market, I've never seen anything like this," says David Chalupnik, head of equities for First American Funds and a 26-year investment veteran.

Chalupnik has seen his share of economic slowdowns, but he says the depth of the current decline, and the vexing hole the U.S. economy finds itself in, has left everyone groping for answers. "You have no experience to fall back on," he says. "Everything you believe in and trained on just doesn't help."

The Fed's "quantitative easing" is an example of the uncharted waters investment managers find themselves in. The Fed is hoping to pull levers that will lead to more liquidity, greater risk-taking and, hopefully, the creation of enough momentum to generate job growth. But because it's a brand new initiative, there's been varied speculation on the possible outcomes.

If the Fed's plan to lower interest rates and stimulate borrowing works, it could give the domestic side of corporate ledger sheets a sorely needed boost, observers say. "If quantitative easing helps in any way to spur economic activity, you should start to see companies pick up here in the U.S. that are domestically focused," says Quincy Krosby, chief marketing strategist for Prudential Annuities.

Others are concerned that, apart from its impact on the U.S. economy, the quantitative easing plan could have negative and unintended consequences for other parts of the global economy. Jerry Jordan, manager of the Opportunity Fund, fears that the Fed will end up creating more liquidity in the stock market, leading to a commodity price bubble.

But there's one commodity in particular he's concerned about: food. "Food is a whole different kettle of fish," he says. "When food prices go up, everyone loses except the farmers, and they don't constitute that big a block."

Inflated food prices in 2010 could knock the wind out of economies worldwide because they would come at a time when food supply is struggling to meet demand, he says. Illustrating the point, he noted that China just recently went from being a soybean exporter to an importer.

The emerging markets that have been fueling global growth would be especially hard hit by surging food prices because they are already experiencing inflation of between 4% and 10%, Jordan says. "You'd possibly be facing food riots and government intervention," he says.

On the domestic side, investors may have to find a way to get comfortable with the fact that corporations and the markets can perform well in a slow-growth U.S. economy.

"The elephant in the room is corporate profits," Cote says. "Other things, like quantitative easing, [are] a flea on the elephant's tail."