The S&P 500 rallied 3.81% in October, capping a second-straight monthly advance fueled by an improving outlook for corporate earnings and growing belief the Fed will pump more cash into the economy.  Market participants also are optimistic that the November midterm elections will bring in a wave of business-friendly politicians.

The S&P 500’s 3.81% return slightly bested the MSCI EAFE Index and MSCI Emerging Market Index gains of 3.61% and 2.91%, respectively.  Domestic equities of all market capitalizations made similar gains during the month.  The biggest gaining domestic asset classes were Micro Cap and REITs.  The CRB Commodity Index – an equal weighted basket of 17 commodities – outperformed equities with a 4.81% gain.

For the second straight month, every S&P 500 sector advanced in October.  Materials, Technology, and Consumer Discretionary shares led the pack.  Materials stocks have risen as almost all commodities have rallied in anticipation for the Fed’s plan to buy more Treasuries.  Consumer Discretionary and Technology stocks rose amid expectations that the U.S. economy will continue to grow – albeit at a slow pace.

October’s worst performing sectors were Financials, Telecom, and Utilities.  Financials faced pressure amid uncertainty about defective mortgages – an investigation into banks’ foreclosure practices fueled speculation of additional losses for banks in the future.  Telecoms and Utilities – both typically viewed as a safe haven for risk-adverse investors – underperformed as a result of investors’ new found appetite for risk.

The VIX Index, which is considered the fear gauge of the S&P 500 investors, declined another 10.55% in October to 21.20.  The index’s historical average is 20 (index data goes back to 1990).  Fear surrounding stocks has dissipated somewhat and demand for risk-taking has increased.  This is also evident in the S&P 500 posting weekly gains in eight of the last nine weeks.

Speeches from Fed officials, including Fed Chairman Ben Bernanke, throughout the month indicated that there are risks to QE2, but that is not going to stop the Fed from purchasing more Treasuries.  Ben Bernanke said October 15 that unemployment is too high and inflation too low, and further Fed assistance is necessary for that to change. 

Prices of Treasury Inflation Protected Securities (TIPS), which have returns that rise with the rate of inflation, continued to rise in October as investors expect higher inflation rates in the future as a result of the Fed’s monetary policy.

High-yield (or junk) bonds also made substantial gains in October in light of the low interest rate environment.  More junk bonds have been issued in 2010 than ever before (junk issuance totaled $190 billion as of September 30) as investors clamor for yield.

Mortgage-backed securities (MBS) also had outsized gains relative to other fixed income categories.  Prices of MBS rose as investors speculated that banks would have to buy back mortgages as a result of sloppy foreclosure processes.

The first week of November will bring midterm election results and the official announcement of QE2, then investors must turn their attention elsewhere. Tax policy seems like a good bet to grab front page headlines since it will have a meaningful impact on dividend paying stocks, some corporate taxes, and the disposable income of the consumer in 2011. 

As always, holiday sales will begin to come into focus in late November.  The National Retail Federation forecasts holiday sales rising 2.3% over last year.  This would be a nice improvement, but profit margins may not improve as much since retailers are expected to keep prices low to entice strapped consumers. 

Economic data, particularly labor market and inflation gauges, may receive extra attention given that the Fed could shape its QE policy around those data points.  Given the market participant’s amorous sentiment toward asset price inflation, they will likely be interested to know if more or less QE is on the horizon.

And back by popular demand…Quick Hits!

Quick Hits

 * Stocks in Fast-Growing Emerging Economies Often Disappoint (WSJ.com)

 * Growth in Profit, But Concerns Over Sales (WSJ.com)

 * Banner Year Expected for TIPS (WSJ.com)

Peter Lazaroff, Investment Analyst

www.acrinv.com