Market Review Fourth Quarter 2010: Strong Finish, Optimistic Prospects for Foreseeable Future

Includes: DIA, QQQ, SPY
by: John D. Frankola

The stock market finished 2010 strongly, with the S&P 500 Index producing total returns of 6.7% for the month of December and 10.8% for the fourth quarter. The S&P 500 rose on 17 of 22 trading days in December, making it the best December since 1991. The strong finish helped to turn 2010 into a very good year for equity investors. As shown in the following table, the S&P 500 Index generated returns of 15.1% for 2010, while the Russell 2000 Index of small companies produced returns of 26.9%. The MSCI EAFE international index lagged with returns of just 4.9%, due to significant problems in a number of countries, most notably Greece, Ireland, Spain and Portugal.

The year-end rally pushed the S&P 500 to its highest level since September 2008, just prior to the Lehman Brothers collapse. The S&P 500 would have to rise another 24.5% to surpass its previous peak reached in October 2007.
The performance of several major equity indices over various time frames is summarized below. qtletter10-q4.JPG
  • Considering that most Americans are wary of government influence in the markets, it is somewhat ironic that the 2010 rally was at least partially fueled by government actions. On August 26, Federal Reserve Chairman Ben Bernanke suggested that the Fed was prepared to take additional measures in order to keep interest rates low and stimulate the economy. At the time, the stock market was down 6% from the start of the year, and many feared the possibility of a double-dip recession. Bernanke’s comments had an almost immediate positive impact on the equity markets. As the November elections approached, the market continued to rally on the prospects that Republicans would gain enough ground in Congress to force an extension of the Bush tax cuts, which were set to expire at year end. The Fed followed through with a second round of quantitative easing and Congress extended the tax cuts. Both actions should have simulative short-term effects, but could exacerbate longer-term problems if the economy does not respond with accelerated growth.
  • Quite possibly, the strong stock market performance also reflected that the Obama administration has come to realize that for the economy to fully recover, a more investment-friendly environment is necessary. For most of the first two years of his administration, President Obama was viewed as anti-business. New health care and financial sector regulations were regarded as having a negative impact on companies within these industries. Lower stock prices resulted in curtailed consumer spending, underfunded pension plans, delayed retirements (fewer jobs for new entrants to the labor force), and less tax revenue from capital gains. The administration’s more recent posture seems to appreciate that, if stock prices return to higher levels, many of the current problems will be lessened.
  • Positive trends in a number of economic indicators also helped to move equity markets higher during the quarter. While unemployment and housing remain stubbornly weak, industrial production, consumer spending (including auto sales), and gross domestic product are all moving in the right direction. Corporate earnings and cash balances are at or near record levels. Strong economic performance in emerging market countries has stimulated growth of U.S. exports and overseas operations. Interest rates remain low, which reduces borrowing costs for consumers and businesses, and encourages spending and investment. Additionally, the level of inflation continues to be within an acceptable range.
  • Despite the market’s recent optimism, there are still many problems that need to be resolved. At almost all levels, governments are running huge budget deficits. Unemployment remains high in the U.S. and most of Western Europe. There are fears that economic troubles in several European countries could drag down the European financial sector and spread to the rest of the globe. In addition, ongoing political concerns related to the Middle East, Afghanistan, Pakistan, and North Korea have the potential to threaten global economic stability.
  • While the stock market had a great fourth quarter, the bond market experienced negative returns as interest rates rose sharply during the quarter. The interest rate on the benchmark 10-year Treasury bond rose from 2.52% to 3.30% during the quarter. The BarCap Aggregate Bond Index, which measures the performance of the taxable bond market, lost 1.3% during the quarter. The BarCap Municipal Bond Index declined 4.2% as investors worried about the deteriorating financial condition of a number of municipalities.
In general, I remain optimistic about equities over the next several years. In the aftermath of the worst recession and stock market decline since the Great Depression, there has been a relatively steady trend of improvement in economic conditions and corporate performance. In addition, government and corporate leaders are more focused on addressing many of the problems that lead to the recent crisis. While the past several years have been stressful for most investors concerned about their financial future, it appears that those who did not panic and stayed the course are now experiencing a substantial recovery in their portfolios.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.