The following is the Equity Markets Activity article from the 2010-Q1 issue of Portfolio Insights.

The S&P 500 had its the best first quarter in over a decade, but it wasn’t a straight-up rally like that in 2009; January presented a meaningful pause in the rally. 

The first scare came when China tightened lending standards, signaling a reversal to its stimulative policies.  Meanwhile, Greece’s debt problems appeared to be spreading to other European economies.  On top of overseas concerns, political developments in Washington like the healthcare debate and bank regulation weighed on the stock market throughout much of the quarter.

Once it became clear the debt crisis would likely be contained for the time being, stocks began climbing higher.  Providing support for stocks was the growing conviction that the U.S. economy is on the mend despite weak spots in the economy such as housing.

The labor market is making small improvements, but the unemployment rate will remain at higher levels than past recoveries.  Still, the 90 percent of the population that are employed and their propensity to spend is much more important to the continuation of economic growth than the incremental changes in the unemployment rate.

A bigger threat to equity markets is the end of quantitative easing programs and increasing interest rates, also known as the Fed’s “Exit Strategy.”  The equity performance in markets where central banks have raised rates this year (India and Australia) or are expected to start soon (Brazil and China) are examples of how interest rates are weighing on the risk appetite of equity investors.

Australian stocks edged up just 0.2 percent in the quarter, while India gained 0.4 percent.  Brazil rose 2.2 percent, while China declined 5.1 percent as investors worried over tighter monetary policy. Meanwhile, U.S. equity markets drifted higher against the backdrop of steady, low rates.

For market gains to continue we will need a Goldilocks economy – not so hot that the Fed must raise rates, but not so cold that sustainability of the recovery comes into question.

Stocks may very well spend the next quarter or two anticipating the end of the easiest monetary policy in decades.  As the Fed moves from emergency levels to more normal monetary policy, rising bond yields could prompt a sell-off in equities. 

A pullback for equities would be a healthy occurrence for the market and could be a present a nice buying opportunity.  By the time the Fed actually raises rate, the market adjustment will be largely complete, meaning equities could then enjoy some upside.

Also working in favor of equities is investors’ love affair with fixed income in 2010 despite rising rates on the horizon.  A notable feature of the year-long rally has been the strong flows into bond funds.  Money market holdings dropped below $3 trillion last month for the first time since the financial crisis began, compared with $3.9 trillion at their peak.  Rather than invest in equities many investors preferred to buy higher-yielding corporate bonds – a strategy spurred by the low-rate environment and low Treasury yields.

With expectations for rising interest rates, more funds seeking equity-like returns may find their way back into equities.

Even more, firms are favoring shareholder friendly policies such as stock buybacks and dividend hikes, rather than appeasing debt holders.  Buy-out activity is also on the rise, as companies have record cash stockpiles and equity values have increased such that buyers are willing to use their stock as well to finance takeovers.

Peter Lazaroff, Investment Analyst

www.acrinv.com