Equities closed out the year with an impressive December performance, with all major equity asset classes posting gains.  Stocks with smaller market capitalizations outperformed their larger counterparts.  Developed nations outperformed emerging markets by a small margin. 

All S&P 500 sectors posted monthly gains, led by Financials and Materials.  Financials benefited from the belief that the economy will meaningfully improve and that loan quality will improve with it.  Materials continued their year-long upward trend on rising commodity prices, merger activity, and increasing global economic growth.  Laggards for the month were Utilities and Consumer Staples.  These sectors fell out of favor in December due to their noncyclical, less-economically sensitive nature.

Nearly all global markets (developed and emerging) finished in positive territory.  The one notable exception was China, whose government ordered lenders to park more money with the central bank for the third time in five weeks to counter the threat from inflation.

Treasury yields rose as economic data began to show evidence of growth and President Obama signed an $858 billion tax-cut extension bill.  The entire yield curve sits at or near its 6-month high.   As volume picks up at the start of the New Year, we will see whether these higher rates are here to stay or if they were the result of some late year, low volume volatility.

On the economic front, a larger-than-expected rise in November retail sales and a strong holiday shopping season led investors to believe that consumers will play a bigger role in the recovery. 

Also supporting this belief was improvement in the labor market.  Initial jobless claims fell to 388,000 – the lowest level since July 2008 – as companies are holding on to more workers as sales improve and expectations for growth brighten.  Still, there isn’t enough job creation to meaningfully reduce the unemployment rate or convince the Fed to tighten monetary policy.

Meanwhile, inflation measures remained soft, especially those net of food and energy items that are closely watched by the Federal Reserve.  This data along with the Fed’s announcement that it will continue its $600 billion asset-purchase program reassured traders that rates will remain at historically low levels.

Following an impressive “Santa Claus rally,” the market looks vulnerable to some downside weakness.  There has been an abundance of market-friendly news in recent months – improving economic data, GOP victory in the House, QE2, and the tax extension bill – that has pushed the market higher.  After a 24% rally from the July 2010 low, is all of the good news priced in? 

One thing that is certain is that the downside risks have not gone away.  Escalating fiscal strains at the state and local government levels, particularly those with uncomfortably high pension liabilities, pose a significant threat to the U.S. economy and U.S. markets.  U.S. housing prices could see another down-leg as unsold existing inventory is still 80% above the historical norm, and that does not include the ‘shadow’ foreclosed inventory.  The emerging market world still needs further anti-inflationary policy tightening and Europe still faces relentless fiscal challenges.

Considering the risks at hand and the breakneck pace of the market’s gains, a pause or pullback in the market during first half of 2011 would be a healthy occurrence.

Peter Lazaroff, Investment Analyst

www.acrinv.com

St. Louis, MO