The stock market, as measured by the broadly diversified S&P 500 Index, extended its year-long rally into the first quarter of 2010. The S&P 500 Index posted a return of 5.39% for the quarter and now boasts a one-year trailing return of 49.8%. However, as impressive as this rally may have been, one must keep in mind that the stock market is still 20% below its high set in October of 2007.

The S&P 500 began the first quarter of 2010 with an impressive six-day rally, but then swan dived into February posting a negative 6.7% return for the period starting January 11 and ending February 10. The stock market then rallied through the end of the quarter with 23 of the next 34 trading days recording positive returns.

Some of the volatility we experienced was caused by sovereign states around the globe trying to work out of the financial crisis that enveloped the globe in 2007 and 2008. The first quarter of 2010 saw China taking steps to reverse their economic stimulus program, Greece revealing a greater debt load than they can service, and the United States continuing to work through new social programs that some fear would cost us more. Still, it was strong corporate earnings that led us to end the quarter on a positive note.

The S&P 500 Index posted positive returns in eight of the ten sectors that are tracked. The index further posted double digit returns in the Consumer Discretionary, Industrials, and Financials sectors; negative returns were posted in the Utilities and Telecommunications sectors.

At World Asset Management, we have products broken up in the US markets by size and so we use the S&P 500 for large capitalization stocks, the S&P MidCap index for companies generally valued between $850 million and $3.8 billion, and the S&P SmallCap index for smaller capitalization stocks ranging from $250 million to $1.2 billion. The S&P MidCap Index posted a quarterly return of 9.1%, and the SmallCap index posted a return of 8.6%. For the one-year period ending in March of 2010, the large capitalization stocks as measured by the S&P 500 posted a return of 49.8%, while the smaller companies measured by the MidCap and SmallCap indices each posted a 64% total return.

Another way we break down markets is by companies’ growth/value biases. During the first quarter of 2010, the S&P 500 Growth index posted a return of 3.7%, while the S&P 500 Value index posted a relatively strong 7.1%. The relative underperformance of the growth index is consistent with the past year’s performance in which the S&P 500 Growth index posted a return of 45.4%, while the S&P 500 Value index posted a 54.7% return.

In the international investing environment, the rally off of the market bottom in March of 2009 took a breather in the first quarter as the massive global governmental stimulus continued to dramatically improve foreign companies’ future earnings potential, but at a lesser pace.

The rising earnings environment 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 late participants to last year’s rally put their large cash reserves to work. In addition, commodity prices marked time as concern about large inventories kept a lid on prices.

The US dollar in the first quarter rallied as the currency market realized that several European countries were becoming increasingly poor credit risks. The big question going forward is whether the dollar will continue its upside move and the Euro gives back some of its strength.

In the first quarter, interest in industrials and consumer discretionary sectors was evident. As many foreign countries are highly reliant on commodity revenues to bolster their economies, the recent quarter’s halt in commodity movements stalled the Latin American, Asian, Australian and Russian economies.

As a result, developed-market foreign indices tempered their gains in the first quarter. The widely observed MSCI EAFE Index for developed markets was up 0.9% for the quarter and the broadly diversified MSCI All Countries ex US index incorporating developed and emerging markets was up 1.3%. The MSCI Emerging Market index was up 2.1% and the MSCI Frontier Market index was up the most at 11.4%.

In the fixed income arena, long term US Treasury yields increased 0.09% during the first quarter to 2.37%, remaining relatively unchanged from year ended 2009. For the twelve months ending 03/31/10, long term yields, which started the period at 1.79%, were up 0.58%. Higher Treasury yields in March helped produce negative monthly returns for Treasuries and Agencies. A recap of first-quarter fixed income returns for the Barclays Capital fixed income indices are as follows:

Spread product outperformed Treasuries in March across the board. The CMBS sector provided the highest monthly return of 2.45%. The Treasury market’s total quarterly return of 1.12% is largely the result of a bullish move in rates seen in January, which has mostly reversed in the last two months.

Many investors believe the economic recovery is picking up steam which may lead to gradual rising interest rates. Some of the key factors to watch are the Federal Reserve’s language regarding the “extended period” of low interest rates and the continuance of the government stepping away from intervention in the financial markets.

Kevin Yousif,CFA
Theodore Miller
Gary Bender