Historically, stocks have done worse in September than in any other month, but this September the S&P 500 posted an 8.92% return, pushing the index into positive territory for the year.  In the past 20 years, the S&P 500 has had better monthly returns on three occasions: 11.16% in December 1991, 9.67% in March 2000, and 9.39% in April 2009.

The rally came as economic data stabilized and the Federal Reserve reassured investors that the central bank would provide additional stimulus measures if the economy slowed.  This helped eased concerns about a double-dip recession and a prolonged period of deflation.

Growing investor appetite for risk is evident in the declining VIX Index.  A measure of fear in the market, the VIX Index declined 9.02% in September and has descended 48.24% from its May 20 high.  The substantial drop in the VIX suggests that the fear surrounding stocks has dissipated somewhat and demand for risk-taking has increased.  As of the month-end, the VIX still sits roughly 15% above its historical average (index data goes back to 1990).

Another indication of increased demand for risk-taking is evident in the S&P 500’s lagging performance compared to riskier asset classes.  Smaller capitalization domestic stocks continued to outperform the large cap index, with the S&P 400 Mid Cap Index and S&P 600 Small Cap Index climbing 11.31% and 11.40%, respectively.  International stocks also outperformed the S&P 500, as the MSCI EAFE Index advanced 9.83% and the MSCI Emerging Market Index jumped 11.13%.

Every S&P 500 sector posted gains during the month.  After trailing other sectors for most of 2010, the leading sector was Information Technology (+12.14%).  Industrials (+11.40%), and Consumer Discretionary (+11.10%) were the other monthly leaders.  These economically sensitive industries lead all S&P 500 sectors year-to-date.  Laggards this month were Consumer Staples (+5.86%) and Utilities (+2.93%), which are viewed more favorably by investors when the market is declining due to their safe-haven status. 

In the fixed income market, investors continued to pile into corporate bonds to capture yields averaging 2.81 percentage points more than Treasurys.  According to Bloomberg, that compares with the average spread of 2 percentage points in the five years before credit markets began to seize in mid-2007.

Prices of Treasury Inflation Protected Securities (TIPS), which have returns that rise with the rate of inflation, also rose in September as investors expect higher inflation rates in the future in response to the Fed’s extraordinary loose monetary policy.

The stock market’s direction in the final quarter of 2010 remains a bit opaque.   One concern I have is the high expectations for third-quarter earnings reports.  Disappointing results or outlooks could lead to some short-term weakness.  In fact, analysts are already cutting 2011 profit estimates as expectations for future growth become more muted. 

The Fed’s decision regarding quantitative easing is another important catalyst.  Additional quantitative easing may not have a material impact on interest rates, but it will signal that rates will remain low for a long period of time.  This, in turn, encourages investors to place more money in riskier assets like stocks and high-yield bonds.

Finally, many market participants will be focused on the November elections.  The uncertainty surrounding future tax rates and regulatory policy is crippling to economic activity.  The mid-term elections may very well provide greater visibility to businesses and investors.

Peter Lazaroff, Investment Analyst

www.acrinv.com