After five consecutive months of losses, U.S. stocks rallied hard in October to push the S&P 500 return into positive territory for 2011.

Mid (+13.75%) and Small Cap (+15.00%) stocks outperformed Large Cap stocks (+10.93%).  Value beat out growth for the first time since February, although value stocks still trail growth by a large margin in 2011.  The more economically sensitive S&P 500 sectors recorded the biggest losses throughout the summer, but Materials (+17.73%), Energy (+17.05%), Financials (+14.33%), and Industrials (+14.00%) produced the best returns in October.

U.S. markets delivered higher returns than developed international markets, but trailed Emerging Markets.  Pacific markets excluding Japan showed particularly strong performance in October (16.07%) as Australia (+17.01%) benefited from surging coal prices.   We continue to overweight out exposure to Australia within our International allocation using iShares MSCI Pacific ex-Japan (EPP).

Economic data in the U.S. has shown some signs of better growth.  Third quarter GDP “came in at 2.5% growth, up from 0.4% in the first quarter and 1.3% in the second quarter, further helping dispel fears of a renewed recession.  Meanwhile, several reports show that manufacturing, which accounts for about 12% of the economy, continues to support the expansion.  The ISM factory index climbed to 51.6 in September from 50.6 in August – a level greater than 50 signals expansion – and we found out yesterday that this gauge showed an increase in new orders in October.  Industrial production advanced on growing demand for automobiles and computers while orders for durable goods excluding transportation rose in September by the most in six months.

Further brightening the U.S. picture is third quarter earnings season with 74% of companies beating expectations thus far and outlooks from management are mildly positive.  Despite the dreadfully low sentiment among consumers and businesses, demand seems to be holding up relatively well and companies are keeping costs low, which has translated into continued earnings growth.  In light of positive earnings reports, it appears that U.S. valuations were too low at the start of the quarter and still are attractive relative to bonds.

The Fed’s most recent program to bring down longer-term mortgage and Treasury rates, dubbed Operation Twist, has left much to desire.  Longer-term interest rates are higher than when the plan was announced and mortgage applications have plunged to a 15-year low.  The majority of Fed policymakers are willing to attempt even further stimulus measure if necessary, even with the headline Consumer Price Index (CPI) rising 3.9% from a year ago.  The Fed will disregard inflationary threats as long as there is high unemployment, minimal wage gains, and below-average capacity utilization.

Most of the media attention remains focused on Europe’s debt crisis.  There were some glimmers of near-term progress during the month, which the market cheered, but long-term solutions are still far off.  Private holders of Greek debt have agreed to a “voluntary” 50% writedown in the value of their bonds, but nothing was done to address the debt held by official bodies that are not willing to take a write-down at all.  Meanwhile European leaders announced a plan to bolster the European Financial Stability Facility (EFSF) and supply more capital to Europe’s banks.  The details for financing these actions are unclear at this point, which leaves the situation susceptible to disappoint markets yet again.

Peter Lazaroff

St. Louis, MO

www.acrinv.com