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LONDON, Nov 15 (Reuters) - Global stocks may be running out of room to rally further after a bumper year as the fragile economic recovery and the prospect of a cut in the Federal Reserve's bond buying discourage big investors.
Equities are the best performing asset so far in 2013, with the benchmark MSCI world equity index rising 17 percent since January. Wall Street and some European indexes have been hitting record highs on a daily basis.
This year's rally is unique because it has been mainly driven by mutual funds and retail investors. They have been able to sustain inflows by reinvesting their income, as cash-rich corporates not confident enough to expand their businesses increase dividends and buy back shares to reward shareholders.
In contrast, institutional investors - who collectively manage $56 trillion, or 70 percent of global investment assets - have yet to fully embrace this year's "Great Rotation" move into equities out of bonds.
Fund managers surveyed by Bank of America Merrill Lynch had a relatively high 4.6 percent of their portfolios in cash this month, while the number of investors saying equities are expensive hit its highest level since January 2002.
Data from JP Morgan shows pension funds and insurers in the United States, Japan, Europe and Britain have actually bought $230 billion of bonds in the first half of this year and sold $20 billion of equities.
"Right now we're sitting in our overweight equity positions. We wouldn't buy more. In the short-term the market will be sensitive to all the tapering questions concerning the Fed," said Benjamin Melman, head of asset allocation at Edmond de Rothschild Asset Management in Paris.
"If you look at valuations, there's a far less room for manoeuvre compared with what we had previously. We probably won't see the same kind of performance on equities next year."
The ratio of equity prices to expected earnings over the next 12 months for the S&P 500 index is currently 14.8 - the highest since 2010 and above its long-term average of 13.9.
The same measure for STOXX Europe 600, at 13.3 percent, is at a four-year peak and notably above its average Of 12.0.
So far this year, global equity funds have drawn $229 billion of inflows or 3.7 percent of total assets under management (AUM), with Europe attracting inflows for 20 consecutive weeks, according to BofA data to November 13.
Bonds drew just $15 billion, or 0.5 percent of AUM, while money market funds had $95 billion of outflows, equivalent to 2.9 percent of AUM.
Respondents to the BofA survey said G7 bank lending growth and Chinese and Asian growth are the missing catalysts for further gains.
"Investors want to be involved in stocks but they are not fully invested," BofA's European investment strategist Manish Kabra said. "What will turn reluctant bulls into raging bulls? We need to see more bank lending growth in the G7."
Bank lending in the United States and Japan is accelerating, but European banks are still shrinking their balance sheets and cutting back on loans.
There is also a long-term incentive for institutional investors to avoid equities because of regulatory changes that require funds to take on extra capital when they increase holdings of risk assets.
"There's more regulatory burden to hold equities for institutions," Rothschild's Melman said.
Renewed discussion about when the Fed will start to scale back its monetary stimulus could prompt selling of equities as it would lead to higher U.S. Treasury yields.
Comments this week by next Fed chief Janet Yellen making plain she would keep the U.S. central bank's easy monetary policy until a job-creating economic recovery was in place have pushed stocks back towards five-year highs.
A string of U.S. data pointing to a stronger recovery had recently prompted markets to revise their expectations of when the Fed will begin to taper to early as December from March.
Societe Generale says U.S. stocks will come under pressure if the equity risk premium - the excess return that investors require to hold stocks over risk-free bonds - normalises to its long-term average of 3.9 percent from the current 4.6 percent and bond yields to rise to 3.9 percent by end-2014.
"Rising bond yields during period of economic recovery are not necessarily bad for equities," SG said in a note to clients.
"However, at a time when earnings momentum remains weak and the consensus earnings growth estimate is expected to moderate, rising bond yields could be a catalyst for a U.S. equity market correction."