In a rough week for stocks, seemingly every attempted bounce was met with heavier selling, leaving investors with the bitter taste of a correction as the weekend beckons.

Major averages closed modestly up Friday, but are still sharply lower since May 10, when the broad market selloff began. The

Dow Jones Industrial Average

closed down 2% for the week, and is off 4.2% since May 10, closing Friday at 11,143. The

S&P 500

is down 1.3% for the week and 4.2% since May 10, closing at 1267. The

Nasdaq Composite's

eight-day losing streak ended Friday; it rose 0.6% to 2193.88, but it lost 2% on the week and is down 5.4% since May 10.

The stock market's declines this week can largely be attributed to heightened inflation fears atop waning confidence in the

Federal Reserve

and Chairman Ben Bernanke. This is clearly part of the financial zeitgeist at this point, but the prolonged despair is part of a bigger trend -- the reallocation out of risky assets and into safer ones.

The declines in commodities, stocks and emerging markets contrast to rebounds in Treasuries and the dollar. Within the stock market, this was demonstrated by weakness in economically sensitive stocks such as

Phelps Dodge

(PD) - Get Report

and

Caterpillar

(CAT) - Get Report

vs. strength in "recession-proof" stocks such as

Coca-Cola

(KO) - Get Report

,

Procter & Gamble

(PG) - Get Report

and

Colgate

(CL) - Get Report

. Even much maligned

Merck

(MRK) - Get Report

rallied this week after an advisory panel recommended unanimously that the FDA approve a vaccine against a virus that causes cervical cancer.

These dynamics point not only to a reaction to a potentially more hawkish Fed, but also to a changing investment backdrop. The yield-hunters may be heading back to the lodge.

There is no question that hedge funds and institutional investors like insurance companies, pension investors and Wall Street houses would have had conversations with their risk-management officers this week, said one hedge fund principal, who declines to be named. He added that his fund has positioned itself defensively this week by allocating a lot more money to hedges.

"We've cut our commodity-related long positions by 50% to 70%, and we have a lot more puts in place," he says. Many technical types went "massively short," as soon as the S&P 500 got to 1326, nearing 1330 on May 9, he says.

The leadership of the 2006 rally has shifted as well. The small- and mid-cap stocks that led in recent years and early 2006 were declining ahead of the large-cap indices. The Russell 2000 and the Nasdaq have fallen harder since May 10 and were trailing the blue-chip averages for a while, meaning on up days the blue-chips were up more than the Russell or the Nasdaq, and on down days, they were farther down. Lots of traders were short the Nasdaq and the Russell and long the S&P 500 prior to last week, says one hedge fund manager.

The Nasdaq's performance vs. the S&P 500 peaked in January, says John Kosar, director of Asbury Research. The Russell 2000 peaked this year on May 5 at when it hit 781. It closed at 722 Friday, down 7.5%. The Nasdaq is also down 7.5% from its peak this year of 2370 on April 19.

Rumors are also swirling that at least two large institutions are in the market unwinding their long positions in commodities to taking long positions in the Treasuries market. The market's movement bears out this shift to conservatism.

Treasuries ramped up dramatically in the last couple of days and the yield curve is flattening again. The 10-year Treasury note ended unchanged on the day Friday to yield 5.06%, but it had approached 5% throughout most of Friday's session. It yielded 5.19% last Friday. The spread between two and 10-year Treasury yields narrowed by 6 basis points Friday as the two year Treasury yield also approached 5% from the other side. It ended at 4.964%.

Higher yields in shorter-duration Treasuries look quite attractive compared with higher risk assets that don't provide a guaranteed return. The S&P 500 is down 0.1% for the year and the Nasdaq is down 2.2%; the Dow is up 2.7%.

Commodities, long-heralded as a speculative bubble, sold off sharply all week as well. The price of oil fell 5% this week, dropping Friday to a six-week low of $68.53 per barrel. Gold has fallen 10% from its high of $730 per ounce last week. Copper is down 12% from its highs last week, and silver is down 17% since its 25-year high last week.

"Fast money is driving the market," says Gail Dudack, founder of Dudack Research Group. "Hedge funds have been under pressure to provide 30% returns, and that is why copper was up fourfold. That speculative money is moving into cash."

That may be true, but it is hard to measure, and it isn't as if there is a liquidity crunch out there. Dudack compares the recent downturn to declines in April 2005 when

GM

(GM) - Get Report

was downgraded to junk and October 2005, when the

Refco

fraud turned up.

If there is a shift into cash, it would be quite a shift from recent activity. Hedge funds certainly saw inflows in the first quarter this year. Indeed, $27.6 billion of cash flowed into hedge funds in the first quarter of 2006, according to Tremont Capital Management's quarterly asset flow report.

According to Tremont, $21.3 billion flowed into emerging markets, managed futures, long/short equity and global macro strategies. One can see the hedge funds' dominance in the markets from the related

surge in prime brokerage revenue on Wall Street. Prime brokerage represents 29% of

Goldman Sachs'

(GS) - Get Report

net income, 21% of

Bear Stearns'

(BSC)

and 20% of

Morgan Stanley's

(MS) - Get Report

incomes, according to estimates by TABB Group, an advisory firm. Next quarter may show a very different story.

Mutual fund flows show that investors are pulling out of U.S. stocks. Domestic equity mutual funds saw $1.1 billion of cash outflows in the week ended Wednesday, according to AMG Data Services. This was the largest outflow since the week ended Dec. 14. The largest inflows were felt by international equity and debt funds, which saw $694 million of inflows in the week.

This may be a smart move in the long run. While emerging markets sold off sharply this week as well, the global markets are in a secular bull market, while the U.S. is just ending a cyclical bull within a secular bear market, says Louise Yamada, of Louise Yamada Technical Research Advisors. "The globe is in a build-out phase like the U.S. was in 1942 to 1966, when we had our industrial build-out," says Yamada.

She suggests taking some profits, but protecting positions in industrial and materials stocks, among the week's biggest losers, and American Depositary Receipts.

If the liquidity tide is turning to favor safer assets, there must be cash piles building. The question becomes where they will go next week.

In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click

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