The stock market continued its upward movement in the 4th quarter of 2010.After moving higher in October and selling off in November, stocks finished strongly in December. The result was that despite a difficult year indices remained positive. The S&P 500 Index finished at 1258, up 13% for the year. The NASDAQ ended up 17% at 2653.
4th Quarter Results and Our Strategy:
Almost all markets pushed higher in 2010, making this the second year in a row of financial recovery.As was the case in 2009, investors can thank continued, unprecedented intervention from governments and central banks around the world for those good returns.
At some point, these strategies will have to be reversed so economies can stand on their own, but for the immediate future it appears that the stimulus will continue.The most direct support came from policy makers who supported government bond markets in the U.S. and Europe.Bonds suffered in December, however, as investors moved dollars out of them into riskier assets such as stocks and commodities.Overall, however, it was a decent year for bonds.
U.S. stocks also got a boost in December with the extension of the Bush tax cuts which were to expire at the end of the year as well as a reduction in the Social Security payroll tax for employees from 6.2% to 4.2%.Prices of economically sensitive commodities continued to rise as central banks in many emerging markets held off raising interest rates despite strong growth and building inflation pressures.This was done out of fear of damaging the fragile global economy.Copper prices rose 33% for the year and oil topped $90 bbl. Gaining 15% for the year.As a reaction to longer term inflation and budget deficit fears, investors pushed up the price of gold to over $1400 an ounce an all time high.Gold gained 29% for the year.
As a whole financial markets rallied strongly in the second half.The Dow is 77% above its 12-year low of 6547 which was hit on March 9, 2009 although it is still 18% below its all-time high of 14,165 hit on October 9, 2007.
As we progressed through the quarter, I moved some dollars into the small-cap area to take advantage of this strong segment of the market.Small-caps were up substantially in 2010 as investors took more risk in anticipation of an imminent recovery.
What to Expect for 2011:
As we move into 2011, overheating of the economy is the major investor concern.All of the stimulus efforts will eventually have an effect on the economy.Though not the most likely outcome, the main fear is that the economy will grow too quickly and that interest rates will rise too sharply thus cutting off any recovery. In this “Too Hot” scenario, the assumption is that the Federal Reserve went too far with the second round of quantitative easing committing to buy $600 billion worth of government securities on top of an estimated $300 billion in bond-buying already planned.The added stimulus from this purchasing drove prices up that were already rising from a recovering U.S. economy.The extension of the tax cuts at the end of the year adds to the concerns that the economy is overheating.
Evidence of too-hot growth showed up in bond yields and commodity prices as we neared the end of the year.Rather than falling as the Federal Reserve hoped, bond yields surged (with a corresponding drop in bond prices) as did commodity prices.So far these increases have showed up much in consumer prices but this could change if companies get confidence that they can pass higher prices onto the public.
Too hot growth could set off a huge drop in bond prices, a dive in the housing market if interest rates rise dramatically and even higher commodity prices.Stocks could thrive temporarily under these conditions but higher interest rates and thus higher borrowing costs would derail any longer stock rally.
The fed would have to step in and restore order by raising interest rates which would further hurt bonds and end the rally in stocks and commodities.The dollar might strengthen with higher rates and thus hurt exports as well.
The “Too Cold” case occurs under the scenario that the economy will freeze up because debt, owed by the government and consumers, is too high to sustain growth.In this scenario, lenders remain leary to lend, thus drying up the credit needed for expansion.If unemployment remains high and housing prices continue to drop another 10%, consumer confidence will wane resulting in less consumer spending.Consumer spending makes up about 2/3 of the economy.With high debt levels and income not growing, this spending will go down and the recovery would stall.
Interest rates might remain low, but stocks would suffer as investors move to the safety of bonds.This could result in a 10% loss, wiping out gains made in 2010.
The “Goldilocks” case (“Just Right) occurs when the U.S. economy keeps growing at a steady pace, about a 3% gain in GDP, but not enough to bring unemployment down quickly.With high unemployment, inflation remains in check despite high commodity prices.The Fed feels justified in keeping the cash spigot open.Interest rates move higher but still remain historically low.
This is a good scenario for stocks as company revenues continue to grow but extensive hiring is not required.The dollar would weaken slightly which would allow increased support for domestic exports, further helping the economy.Investors would pour money into equities under this scenario and the market could gain close to 10% in 2011 getting it closer to the all-time highs reached in 2007.
A majority of prognosticators feel the “Just Right” scenario is the most likely.In this case we will probably have another year like 2010 where markets were rough and required vigil.
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