By Colin Barr
August 26, 2010

A stampede into government bonds could set up a stock market rally.

It seems far-fetched to say so when market chatter centers on two depressing possibilities, a double-dip recession or deflation — a fall in prices that depresses the economy by increasing debt burdens. Given all the talk about housing market relapses and sovereign debt defaults, the more pressing question seems to be how far stocks might fall.

Yet even those who take a dour view of the economy and of stocks’ long-term prospects say plunging bond yields could drag risk-averse investors kicking and screaming into the stock market.

“There appears to be no other game in town but the stock market for money on the sidelines,” writes strategist Andrew Barber of Waverly Advisors in Corning, N.Y.

This month’s surge in government bond prices means the potential risks for bond buyers are twice as large as the expected rewards, says Matthew Lloyd, investment strategist at Advisors Asset Management in Monument, Colo.

That isn’t an equation he’s willing to risk capital on, given the low returns on highly rated sovereign debt. He said he’d rather try to find better prices on riskier assets such as stocks and real estate, on the assumption that a slow, uneven and ungratifying recovery will proceed.

“People forget that economic recoveries aren’t linear,” Lloyd said. “There’s a propensity to wait for another shoe to drop, but I think people underestimate how much has been flushed out.”

That said, finding can’t miss stocks is hardly like shooting ducks in a barrel right now.

Even after a 15% or so drop from April’s highs and a lost decade since the collapse of the tech bubble, U.S. stocks remain overvalued by certain measures. Complicating matters, policymakers are doing all they can to keep the money spigot open and push investors into risky assets, supporting prices.

“There aren’t fabulous values now anywhere,” said Marc Heilweil, who runs the $34 million Marathon Value Portfolio fund, which owns shares of blue-chip companies such as Tyco

, IBM

and 3M

as well as tech titan Cisco

.

He believes the decade-long bear market in stocks will remain intact for a few more years while the economy deleverages. But he stresses that doesn’t preclude a rally between now and year-end, as always fickle investors reassess the economy and the markets for the umpteenth time.

“The herd has just been moving from one view to another,” Heilweil said. “Anyone who thinks they can see for sure what’s ahead is a fool.”

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