The price movement for stocks in December, like much of 2011, was characterized by abrupt up and down movements in response to the struggles in Europe and political gridlock in the U.S.  In the end, the S&P 500 managed to return 1.02% in December and finish 2011 with a total return of 2.11%.

Perhaps the biggest reason for positive performance among domestic equities is the receding fear of a U.S. recession in light of improving economic data.  Manufacturing, which accounts for roughly 12% of the economy, continues to support the expansion as growth in Asia and emerging markets help sustain orders for U.S. goods.  Lower initial jobless claims indicate fewer workers are being fired and lay the foundation for an improvement in employment.   Brighter employment prospects as well as lower gasoline prices led to a higher than expected consumer confidence reading during the month.  Even the housing market is showing some glimmers of improvement – it’s still far too early to declare the housing market is on the rebound, but I’d be remiss to not mention improvements in homebuilder sentiment, housing starts, and building permits.

Among U.S. stocks, value dramatically outperformed growth and smaller companies delivered higher returns than large companies.  While value and small cap outperformance may suggest increased risk appetite among investors, sector performance paints a different picture.  Defensive sectors with less economically sensitive businesses such as Telecommunications (+4.01%), Utilities (+3.37%), Healthcare (+2.92%), and Consumer Staples (+2.76%) outperformed.   Materials (-2.11%) and Energy (-1.02%) lagged on lower commodity prices.

Fixed income market performance also suggests an increased risk appetite, as bonds with longer maturities and lower credit quality had higher returns in December.   Even as U.S. government debt exceeds $15 trillion for the first time, U.S. bond yields remain at record lows, with the benchmark 10-year Treasury yielding 1.876% at the month’s end.   According to the Fed’s term premium, a measure of the extra yield investors demand to compensate for the risk of holding long-term securities, Treasuries are as expensive as ever.  Recent gains are driven in part by Fed purchases and the European debt crisis as well as a flight to quality from non-traditional Treasury buyers.  Treasuries could come under pressure going forward if the situation in Europe stabilizes or the U.S. economy continues to strengthen.

Europe’s woes continue to plague major international indexes such as the MSCI EAFE, which fell for the seventh time in the last eight months despite increased action from the European Central Bank (ECB).  In addition to cutting interest rates for a second straight month in early December, the ECB agreed to lend banks as much money as they need for three years and relaxed collateral requirements in an effort to ease strains in eurozone credit markets.  Meanwhile, European Union (EU) leaders are working to devise a master plan for the fifth time in 19 months.  There is little reason to expect any grand plan to surface by the self-imposed March deadline, and the longer the crisis drags out, the greater probability Germany and France lose their AAA rating from Standard & Poor’s.

Emerging markets (-4.17%) also struggled, led by declines in China (-5.74%) where growth has slowed due to sluggish exports and a reduction in construction spending.  Europe’s effect on China’s has been important– exports make up roughly 25% of China’s economy, with 18% of exports going to Europe – but construction spending makes up roughly 50% of the country’s GDP.  People seem to forget that the Chinese government has a decent amount of influence over this part of their economy – after all they did initiate the housing slowdown, so one would think they could reverse policy to stimulate demand if necessary.  India (-4.15%) continued to weigh down the Emerging Market index as their macroeconomic environment has been unstable all year and inflation remains above 9%.

See you next week,

Peter Lazaroff

St. Louis, MO

www.acrinv.com