The fourth quarter of 2010 was a repeat performance of the third quarter as economic indicators continued to hint at a recovering economy while the jobless rate refused to budge from its near double digit figure.

Focusing on the positives, we expect to see continued rising corporate earnings, further surprises from the Federal Reserve’s bond purchase program (QE2) and beneficial effects from the compromise tax plan that will maintain and/or cut many taxes.

First, Standard and Poor’s estimated that S&P 500 companies posted 4th quarter earnings per share were up 27% from the same period a year ago. Earnings have risen as consumer spending has restarted, and companies have continued investments in infrastructure and technology.

Second, the Federal Reserve’s second phase of their quantitative easing program (QE2) during the second quarter is providing unintended consequences. Originally, the goal of QE2 is to lower medium term interest rates by offering to purchase $600 billion of government bonds over the coming months. QE2 has helped to provide an impetus for the equity markets, but has failed to bring down medium term rates as measured by the ten year Treasury. As a matter of fact, the strength in the equity markets has led to a shift away from fixed income and into equities, thereby causing a rise in interest rates.

Third, the last minute compromise reached by the Democrats and Republicans to extend the previous administration’s tax cuts provided the final stimulus needed to propel the stock market by nearly 7% in the month of December. The compromise plan will extend the Bush tax cuts by two years, keep the tax rate for dividends at 15% and extend unemployment benefits, and cut payroll and social security taxes.

Markets by the Numbers

The US Equity markets continued their upward stride posting another double digit return for the fourth quarter of 2010. The U.S. stock market as measured by the S&P 500 posted a return of 10.8% in the fourth quarter, which follows the third quarter return of 11.3%. The index posted double digit returns in six of the ten sectors that are followed, with Energy leading the way posting a 21.5% return for the quarter. While 2010 started with some uncertainty, the latter half helped to propel the S&P 500 Index to a return of 15.1% for the 2010 calendar year.

The S&P MidCap Index posted a return of 13.5% for the quarter and a remarkable 26.6% rate of return for the year. The MidCap index posted the best annual performance of the three primary indexes reported by S&P. The MidCap index has continued to show strength throughout the past decade posting a 7.2% annual return for the last ten years.

The S&P SmallCap Index also posted robust returns with a quarterly return of 16.3%, and an annual return of 26.3%. The S&P SmallCap Index posted double digit returns in nine of the ten sectors that are measured and was led by the Energy sector which posted a return of 38.4% for the fourth quarter. The S&P SmallCap Index has posted an annualized return of 7.7% for the ten years ending December 2010.

The S&P 500 Growth and Value indices posted fairly similar returns for the quarter as they reported returns of 11.0%, and 10.5% respectively. This was the case for the one year returns as both indices posted annual returns of 15.1% for the year ending December 2010. This was the first year in the last four years in which the S&P 500 Value index met or exceeded the return of the S&P 500 Growth Index. The S&P 500 Growth Index had been beating the Value index since 2007 when the financial crisis began. The S&P Value Index was helped by its weighting in the Consumer Discretionary and Industrials sectors which posted returns of 25.8% and 23.4% respectively.

In the international equity markets, the rally from the market bottom in March of 2009 continued through the 4th quarter as massive European central bank stimulus in Europe continued to dramatically improve European banks balance sheets.

Rising earnings and improving consumer confidence led to much firmer stock markets globally. There was a mid-quarter selloff due to overvaluation concerns but was then followed by a rally as participants put their large cash reserves to work before yearend. In addition, commodity prices rallied strongly in anticipation of coming summer shortages.

In the 4th quarter, the US dollar was flat versus a basket of foreign currencies as investors tried to decide if firming US fixed income rates would cause a rally in the dollar. The big question going forward is whether the dollar will continue its upside move and causes the Euro to give back some of its strength.

In the fourth quarter, elevated interest in materials and energy sectors was evident. As many foreign countries are highly reliant on commodity revenues to bolster their economies, the recent quarters’ move in commodities propelled the Russian, Mexican and Qatari economies.

As a result, developed international equity market indices lifted their gains in the 4th quarter. The widely observed MSCI EAFE Index for developed markets was up 6.6% for the quarter, the broadly diversified MSCI All Countries ex US index incorporating developed and emerging markets was up 7.2%. The MSCI Emerging Market index was up 7.3% and the MSCI Frontier Market index was up the most at 8.0%.

The final weeks of 2010 reflected broad based profit taking in the fixed income market, but overall returns for the year across sectors were positive as indicated below. Despite the dramatic rise in Treasury yields during the fourth quarter of 2010, the ten year Treasury ended the year with a yield to maturity 3.29% while the thirty year Treasury was at 4.33%. These yields were down 0.54% and 0.31% for the quarter respectively. Performance for the 12 months ending December 31, 2010, for various sectors as compared to the previous year end, is as follows:

The corporate bond market outperformed government paper in 2010 and spreads trended tighter to Treasuries. While less than 2009, the Barclays Credit Index beat Treasuries, on an absolute basis, by 260 basis points posting a return of 8.47%. Consensus expectations call for additional spread tightening going into 2011.

December was a good month for the mortgage backed market with the commercial mortgage backed sector outperforming Treasuries by 193 basis points and was the only sector reporting a positive return for the month. For the entire year of 2010, commercial mortgage backed bonds had a whopping return of 20.40% as measured by the Barclays Capital Fixed Income Index.

After three consecutive years of stellar historic returns in most sectors, the economy appears to be making strides in the direction of recovery and many fixed income investors are preparing for a challenging environment in 2011.

The information herein is believed to be reliable but World Asset Management does not warrant its completeness or accuracy.

This material has been distributed for general educational/informational purposes only, and should not be considered as investment advice or a recommendation for any particular security, strategy or investment product. The material is based upon information we consider reliable, but its accuracy and completeness cannot be guaranteed. We don not assume any liability for losses that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice, and are not intended as an offer or solicitation with respect to the purchase or sales of any security, strategy or investment product or as personalized investment advice.

Past performance is not indicative of future results. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The investments and strategies discussed herein may not be suitable for all clients. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Clients should consult their tax or legal adviser about the issues discussed herein.