Positive momentum carried on into the New Year on the prospects of stronger global economic growth and the reduced risk of a Lehman-like event in Europe.

The S&P 500 turned in its best January in 15 years and is now up 19.39% from its October 2011 low.  During that same period, market volatility (as measured by the VIX Index) declined a record 60% – historically, drops of at least 50% in the VIX have led to rallies in the S&P 500 in the following year.

The recent upswing comes as investors shift their focus away from the European crisis and focus on strengthening U.S. economic data. Initial jobless claims continue to trend downward, indicating companies are firing fewer people and may slowly begin hiring.  Brighter job prospects have helped lift consumer confidence, which is important because consumer spending makes up about 70% of the economy.  Manufacturing continues to be a bright spot as sustained demand emerging economies shield U.S. factories from a slowdown in Europe.  Recent data also raised the possibility that housing may not be a negative drag on economic growth, but more evidence is needed before we can buy into that notion.

Expectations for earnings season had been significantly lowered in the final months of 2011 and it’s possible that much of the bad news was reflected in prices before the New Year began.  Earnings reports have been mixed thus far, with signs of increasing demand and activity, but still a great deal of uncertainty from managers.

Some might say the biggest reason for higher market prices in January was the Federal Reserve’s pledge to keep interest rates low through 2014 and the potential for another round quantitative easing.  Interest rates have remained near zero since December 2008 and haven’t increased since June 2006.  The Fed also lowered their estimates for growth and inflation in 2012, and Chairman Ben Bernanke said that additional large scale bond purchases (QE3) is still “on the table.”

Central bank action is all the rage in Europe too.  Despite S&P downgrading several European countries and the lack of agreement on the restructuring of Greek debt, sentiment across the pond seems to be improving as the funding costs of the more systemically important Italy and Spain have fallen from the panicky levels of late 2011.  The European Central Bank’s (ECB) willingness to lend money to European banks for three years is being credited with preventing a Lehman-style banking collapse in the near term as well as lowering short-term sovereign debt yields and encouraging foreign investment in European commercial paper.  In addition to a decline in interbank and credit market stress, European economic data was better than expected, although this can only last so long as austerity programs seem likely to stomp on growth in the short term.  Thus, optimism may be tempered as 2012 unfolds.

This holds true on a global basis as well.  Everything is bright and rosy now, but we may see another bout of volatility by the spring.  Growth is likely to remain slow as economies emerge from a debt crisis.  As I’ve said in the past, policy makers intervened to prevent a repeat of the Depression, but the likely cost is a slow and uneven recovery.  Additional efforts to stimulate the economy are becoming less effective and, at the same time, increasing the dependence on central banks to prop up asset prices.

Moving on to performance….Diversification failed in 2011, with large cap stocks outperforming all other traditional asset classes, but that trend reversed in the first month of 2012.  Mid (+6.61%), small (+6.57%), and micro cap stocks (+8.39%) easily outperformed the large cap stocks (+4.48%) for the month, as did developed International (+5.62%) and Emerging Market (+10.78%) indices.

Sector performance reflects investors’ preference for riskier assets. Utilities (-3.63%), Telecom (-2.76%), and Consumer Staples (-1.51%) were the only three sectors to post losses for the month – these sectors are typically viewed as business of relative safety due to their less-cyclical businesses.  Industries that are more closely tied with the state of the economy outperformed, with Materials (+11.18%), Financials (+8.13%), Technology (+7.63%), and Industrials (6.97%) leading the way.

In the fixed income markets, corporate bonds delivered strong returns in January as improving U.S. economic data has bolstered investor confidence that America’s companies will be able to meet their debt obligations.  Also boosting returns has been an influx of demand from investors that would normally invest in European corporate debt.

With the Fed setting the table for about additional monetary easing and pledging to keep interest rates near zero through 2014, Treasuries of all kinds rallied.  Investor demand for Treasury Inflation-Protected Securities (TIPS) was particularly strong despite 10-year TIPS trading with yields less than zero percent for the first time.

Peter Lazaroff

St. Louis, MO

www.acrinv.com