U.S. and foreign funds surged higher in March, erasing much of the damage caused by the first two months of the year.

Domestic stock funds rocketed 7.76% in March, cutting the first-quarter loss to 8.92%, according to Lipper Inc. World equity funds soared 8.35% last month, trimming their Q1 decline to 9.68%

Bond funds were also mostly higher. U.S. taxable bond funds rose 1.47% in March, ending with a 1.76% gain for the first quarter. General municipal bond funds fell 0.25% last month, but ended the quarter with a 5.45% gain.

U.S. diversified stock funds' gain in March followed a 9.03% loss in February.

Short-selling funds, which make money from falling stock prices, plunged 16.79% in March, paring the Q1 gain to 2.14% -- the only positive return among U.S. diversified stock funds.

Value Vs. Growth

Value funds beat growth among large caps and small caps, but the tables were turned in midcaps.

Large-cap growth rose 8.38% in March and was down 3.73% for the quarter. Large value leapt 8.75% last month and was down 13.15% in Q1.

Midcap growth rose 8.75% in March, leaving its Q1 return at -3.90%. Midcap value rose 8.50% in March, bringing the first-quarter decline to 10.72%.

Small-cap growth rose 8.25% in March for a Q1 return of -8.11%; small-cap value rose 8.65% last month for a Q1 return of -15.26%.

In March, the Nasdaq rose 9.86%, the Dow 7.73% and the S&P 500 8.54%. For Q1 they were down 3.07%, 12.22% and 11.67%.

Bear Market Rally?

"We have just experienced a bear market rally driven by short covering of the financials," said Kevin Shacknofsky, co-manager of Alpine Dynamic Dividend (ADVDX) with $453 million in assets.

"We are skeptical about whether the (Treasury Secretary Tim) Geithner plan can bridge the gap between buyers and sellers, and are concerned whether populist politics in Congress on taxing bonuses will derail any financial rescue," he added.

Shacknofsky is buying large-cap tech stocks and agriculture, and avoiding industrials and health care because of "pricing pressure from the new Obama administration."

Randy Bateman, president of Huntington Asset Advisors with about $4 billion in assets under management, sees info overload.

"The markets are foundering over an overload of data that is virtually indecipherable," he said. "So many stimulus programs, so much distrust of Wall Street and Washington, too many legislative knee-jerk reactions and too much of a trend toward big government."

Bateman has positioned a large portion of his small-cap Huntington Situs Fund (HSUAX) in cash but wants to be fully invested by the end of April.

He's been buying and selling put- option contracts in Flowserve (FLS), Jacobs Engineering (JEC), Anixter International (AXE), CommScope (CTV), Terra Industries (TRA), Trinity Industries (TRN), Quanta Services (PWR), Watts Water (WTS), Eagle Materials ( EXP) and Albemarle (ALB).

By selling puts, the fund receives premiums for taking on the obligation to buy the stocks at a given price.

"The three billion people in India and China did not go away," said Bateman. "This will create a long-term sustainable demand for materials, energy and industrial equipment. In concert, the U.S. will be throwing money into our own infrastructure."

Bear Market Rally

Going into the second quarter, fund managers anticipate a sizable bear market rally.

"We have noticed the rebound in retail sales, consumer spending, consumer credit, home sales and durable goods," said David James, co-portfolio manager of the five James Advantage funds. "These stories have been underreported but provide a strong backbone for the rally."

James is buying large multinational corporations whose products should be more competitive abroad owing to the weakening dollar, small financial firms and foreign sovereign bonds.

"The foreign currency translation from a depreciating dollar will likely make this a profitable investment on a total return basis and will continue for a time," said James. "Despite protests otherwise, the Fed's actions devaluing the dollar will eventually lead to higher inflation."

Steve Lehman, manager of $1.8 billion Federated Market Opportunity Fund (FMAAX), is buying on weakness and selling into strength using contrarian technical and psychological indicators.

He prefers stocks that are hated by analysts, trading below book value and buying in shares.

"When things run up sharply, we're trimming because this is not a buy-and-hold environment," said Lehman. He's bullish on agricultural, oil and basic materials stocks, which sold off hardest last year and bearish on defensive sectors like health care.