Although the extent of the Australian stock market's summer correction surprised everyone, local investment managers cannot be accused of being complacent.

In December, Russell Investment Group's quarterly Australian Investment Manager Outlook (IMO) survey showed 43 per cent of Australian investment managers expected zero or negative returns from Australian shares in 2008. This was the most bearish sentiment the IMO survey had revealed on the local equity market since 2005.

To some extent, this was recognition the strong run of equities was running out of steam, as valuations became stretched. After returns of 27.9 per cent (2004), 22.5 per cent (2005), 24.2 per cent (2006) and 19.3 per cent (2007), the most optimistic projections were for the Australian share market to deliver a return of about 12 per cent in 2008.

Managers were also decidedly pessimistic on international equities on worries about continued volatility in the equity markets. The strong belief expressed in the survey was that the worst of the sub-prime fallout in the United States was still to come.

In net terms (bulls minus bears), cash was the only asset class Australian managers viewed positively heading into 2008.

"I think most institutional investors - especially superannuation funds - who usually take a very long-term view of the share market, had done their homework, their downside modeling and concluded that the share market was going to deliver lower returns this year than it had been producing in recent years," investment consultancy JANA executive director David Holston says.

"They were responding by looking pretty carefully at the managers and sectors they wanted to use. For example, quite a few super funds were giving managers Australian equities mandates that excluded listed property trusts (LPT) because of changes in that sector that made it not uncorrelated enough to hold in its own right. That's certainly not a typical mandate.

"Also, large investors are very cognisant of the long run of growth style, and likewise, they've become aware that their configuration going forward might not want to be overweight to growth-style managers."

Holston says most Australian institutions would still be invested about 30-35 per cent in Australian equities, with resources anywhere up to 25 per cent of that allocation.

"The China/India growth story is acting as a counterweight to the sub-prime/US recession story. The institutions are leaving the resources exposure in the hands of the managers they choose, but it's fair to say that their resources exposure is going up - and at the moment, it's going up by default, as sectors such as the financials get hammered on the back of the sub-prime uncertainty."

The biggest change being seen at institutional level, he says, is the move into alternatives, led by the industry funds. "This is a trend that's been going on for a few years now," he says.

"Five years ago, the industry funds had 5-10 per cent allocations to alternatives, but the mainstream public-offer funds had zero. Now, the mainstream funds often have about 10 per cent in alternatives, while the industry funds can have up to 20 per cent. The alternatives allocation is increasing by definition as the equities allocation is being shrunk by the market."

KPMG superannuation partner Emery Feyzeny says a few managers pre-empted the downturn. "For example, six months ago, Schroders reduced its LPT exposure to zero - that's a pretty radical move," Feyzeny says.

"Prior to the downturn, Schroders was holding 23 per cent cash, Perpetual was holding 28 per cent and Maple-Brown Abbott was holding 18 per cent, plus 21 per cent in highly liquid Australian fixed interest. That's quite high when you're meant to be fully invested.

"All of these managers had large weightings to domestic shares - Schroders and Maple-Brown Abbott had 33 per cent, and Perpetual had 30 per cent - but clearly, they couldn't see any value left in the stockmarket. A flat yield curve meant that they couldn't see any value in fixed interest either - they weren't getting any premium for investing at the long end. So they were tweaking equity exposure downward, but shifting into cash rather than anywhere else." Naturally, that meant relatively poor performance for these managers in the quarterly rankings. But by the December quarter, Feyzeny says it was clear this trend was starting to reverse. "If the market continues to be this weak, they'll be the star performers - because for the moment, cash is king," he says.

"The industry super funds have generally moved about 2-3 per cent of their allocation from Australian equities to cash over the last three to four months, to the point where 15-20 per cent cash weighting is typical. But not many funds or managers practise tactical asset allocation - trying to time the market. The proportion of the industry that does that is less than 30 per cent. The jury is still out on whether tactical asset allocation is worth the effort in terms of any value it might add."

As the dust settles from the January share slump, cash looks like it will be hard to beat as an asset class this year. The return from Australian dollar cash has not beaten the return from shares since 1994, but at 7 per cent and with the prospect of further interest rate rises to come, it must look attractive to fund managers in the short term.

On a longer-term view, managers will be looking to redeploy cash into the equity market. "Most institutions have a fixed strategic asset allocation, and they'll be rebalancing into the current equity market weakness," Russell Investment Group strategist Andrew Pease says.

"If their equity allocation is 40 per cent, it can range between 38-42 per cent. If the share market falls 20 per cent in value, that's going to take the equity proportion of the portfolio below 38 per cent, and they're effectively forced to top up on stocks, in a weak market - which is good.

"Their equities performance might not beat cash to the end of the financial year, but they'll be looking longer-term than that. In index terms, the ASX 200 is 10 per cent lower than where it began the year, and you'd have to say that to get back to where it started would be a good effort. Along the way we could see a lot more of the volatility we've seen in January. In that case, equity investors would have to be content with picking up the 5.7 per cent dividend yield with franking. Depending on the size of the rebound that shares have from the January slump, we could see something better, but the volatility is such that you couldn't predict with any certainty any contribution from capital growth."

But on a longer-term view, Pease contends there is little doubt Australian equities are "pretty good value". "Analysts have been actually upgrading their earnings forecasts recently: for calendar 2008, the consensus is looking for 10 per cent earnings per share (EPS) growth, broken down into 16 per cent from resources, 8 per cent from financials and 9 per cent from industrials. That's not super strong when you compare it to the last four or five years, but it's certainly not a recession outlook either," he says.

Feyzeny describes the market as more fairly valued.

"The position that most managers appear to have taken is that industrial stocks were clearly over-valued on historical price/earnings (P/E) ratios - they were running at about 19 times earnings - so they moved to underweight industrial stocks. Fair value is about 15 times earnings, and that's where the market is now," he says.

"I don't imagine that value managers like Investors Mutual will be piling into this market just yet - if they are buying, I imagine it's tentatively, not in big wads. The market is pretty much at fair value, and the basic problems that surfaced in August 2007 are still there: sub-prime is still working its way through the US economy, it's being propped up by the Fed through interest rates, the market isn't at all convinced by the President's proposed fiscal stimulus package, and sentiment is still pretty sour. For the time being that sentiment looks to be weak enough to more than counteract the China/India sentiment that's underpinning the resources sector." AMP Capital Investors head of investment strategy and chief economist Shane Oliver expects share investors to earn "a bit more than the dividend yield", which, at about 5.7 per cent with franking, represents the highest yield since 1991.

"I still think that shares can generate about 8 per cent this year, possibly 10 per cent with a bit of luck," Oliver says.

"They were very oversold by January 22, and they have come back a fair bit. Further monetary easing from the Fed and US fiscal easing will help them, but the ride for share investors is likely to remain rough over the next six months on the back of ongoing worries about the US downturn, its impact on company profits and its impact on China will also weigh on the Australian share market.

"While investors have to remain relatively cautious over the next six months, Australian shares offer fairly good value for investors prepared to look beyond current uncertainties. The forward P/E on Australian shares has now fallen to less than 13 times, which is its lowest level since April 2003 and well below its 10-year average of 15.3 times, and January's price falls have also put numerous Australian shares trading on dividend yields of 6 per cent-plus. But given the obvious difficulties in timing the bottom, the best way to take advantage of improving valuations is to average into the share market over the next six months."

Investors can probably beat the return from equities in 2008 in direct property and infrastructure, he adds.

"Office property looks fairly attractive, with low vacancy rates and strong rental growth still prevailing there. I don't see much that's attractive in bonds, domestic or global, and international equities is anyone's guess, because the key risk remains US recession," he says.

Pease remains optimistic on the US' prospects of avoiding recession. "The Fed's easing has been pretty aggressive - it's chopped 175 basis points from interest rates, and we believe a further 50-100 basis points is likely - and we know that just as night follows day, recoveries follow aggressive Fed monetary easing. The Fed has put an enormous amount of monetary stimulus through the US economy and it has really set the economy up for a rebound," he says.

But in the short term, Pease cautions that the US non-farm employment figures due on February 1 will be "psychologically critical" for the markets. "If that comes in above expectations, that's great, and if it stays positive, that's even better. That will offset this fear that the US will suffer rapid slippage into recession, and it's that fear that has really gripped world markets. A sign that this particular negative sentiment is overdone would be very helpful," he says.

"Sentiment can shift very quickly, and just as the negative sentiment we saw in January can become self-feeding, so can positive sentiment. We don't think that the US earnings outlook is as bad as the share market is telling us, and to an investor that matters more than US GDP numbers. Investors associate a recession with EPS falling by 20-25 per cent. In any case, given the Fed's aggressive moves on interest rates, we're much more optimistic about the US earnings outlook in 2009."

Ironically, given the differences between the US situation and the Australian at present - where the latter exhibits rising earnings, rising house prices and strong economic growth - Pease expects the corporate earnings situation to reverse in 2009.

"Our economy, and thus corporate earnings, will be under pressure in 2009, because our interest rates have to go up to bring inflation under control," he says.

"At that stage, we expect US corporate earnings to look pretty strong."