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After a tumultuous year for equity investors, stocks rallied in December, boosting their climb in the fourth quarter, to finish the year with impressive gains. In 2010, the S&P 500 Index increased by 12.8% (15.1% including dividends), the Russell 2000^® Index gained 26.9%, and the 30-year Treasury bond returned 8.7%. Gold increased by 29.5%, but cotton increased by 91.5%. Natural gas declined by 20.1%. For most markets, the year was a great follow-up to 2009 results. Yet despite the two years of double-digit returns, the S&P 500 Index is just back to where it was in September 2008, right before Lehman Brothers went bust.

THE ECONOMY
The news that came out in December was mostly positive for the global economy—mostly, but not completely, because Europe is still trying to figure out how to resolve the sovereign debt crisis that is plaguing the eurozone, and housing in America looks like it might be on another decline. The labor market is making slow progress, as initial unemployment claims are trending downward. Retail sales have recovered to the prerecession peak, despite the murky jobs outlook. Going into the new year, markets were reflecting some renewed optimism.

Along with equity prices, most commodity prices continued to increase in December. This is partially attributable to improved attitudes about economic growth. A growing economy typically results in more demand for the basic building blocks of products. However, we think a lot of this increase is purely speculative, with investors doubling-down on the possibility that someone, somewhere, might be willing to buy at a higher price. That type of dynamic does not typically end well for those who keep piling into the trade.

With the continued increase of commodity prices, there is the possible erosion of the purchasing power of workers’ incomes. That is not as pronounced of a problem in the U.S. or other developed countries where commodities are a relatively small part of the basket of goods and services purchased by consumers, but it is a big concern in emerging economies. For example, in China, the central government is trying to tamp down commodity and real estate price increases by increasing interest rates. Higher rates make it harder to finance the purchases, which is a way to lower demand. China is taking a gradual approach in an attempt to orchestrate a “soft landing,” where the prices get tamed without choking off too much economic growth. Higher interest rates will likely put further pressure on the Chinese central bank to increase the value of the Chinese currency relative to the U.S. dollar. China may ring in the Chinese New Year on February 3 with a slightly stronger currency. Not only would that help with the incipient and actual inflation China has, but it would also help mend some relationships with U.S. politicians who have been clamoring for less currency manipulation on the part of the Chinese government. A stronger Chinese yuan would do little for U.S. exports to China, but it would be a nice symbolic move. 

The new Congress
The 111th Congress officially adjourned in December. In January, the 112th Congress takes over. Some of the new members of Congress have high hopes of accomplishing a lot in a little amount of time. That’s a recipe for disappointment, as the political process is anything but fast. We think that could create buying and selling opportunities in the market as the political rhetoric heats up.

The Fed
The Federal Reserve is sticking to its plan of purchasing Treasury securities. With the changing of the year there is also a changing of the guard for the voting members of the Federal Open Market Committee (FOMC). The perennial dissenter, Tom Hoenig of the Kansas City Federal Reserve, is no longer going to be a voting member of the committee. However, Dallas Federal Reserve President Richard Fisher will probably take up Dr. Hoenig’s megaphone and continue to register a dissent. He’ll probably be joined by Philadelphia Fed President Charles Plosser, who will also become a voting member of the FOMC. Dissenters probably won’t do much to alter the Fed’s policy, but two dissenting voices could be louder than just one. This could make FOMC policy statements interesting once again, as they had gotten pretty boring over the past few months with few changes.   

EQUITIES
Stocks rallied in December, boosting their climb in the fourth quarter, to finish the year with impressive gains. To be sure, it wasn’t an easy ride in 2010, as the market had to contend with a variety of issues, including the extent of the economic recovery; the May 6 “flash crash,” where stock prices plunged but recovered rapidly; and the sovereign credit risks in Europe. Yet the domestic economy managed to avoid the dreaded double-dip scenario, and corporate profits consistently beat projections. Another round of accommodation from both monetary and fiscal policymakers managed to boost investor sentiment further, driving stocks higher for the second consecutive year. Indeed, the world’s most recognizable stock market index, the Dow Jones Industrial Average, rode this wave of improving sentiment for gains in excess of 5.0% in December alone, which propelled its year-to-date (YTD) returns slightly ahead of 14.0%. See Chart 1.

The other major domestic equity market indexes all managed to outperform the Dow 30 on a month-, quarter-, and year-to-date basis. Small- and mid-cap stocks led the way, with gains in excess of 25.0%, while the NASDAQ Composite Index and the S&P 500 Index had total returns (including dividends) of 18.2% and 15.1%, respectively. On an international basis, the developed markets struggled with Europe’s debt woes, as well as attempts by China to dampen inflationary pressures by increasing interest rates and bank reserve requirements. Despite these moves by China, emerging markets returned 19.0% for 2010, as solid economic growth boosted corporate profits and equity market returns.

Considering sector performance in the S&P 500 Index, consumer discretionary led the way, with a 27.8% return for the year, despite our macro concerns related to high unemployment and still weak home prices. Three of our favorite sector picks (energy, materials, and industrials) performed well last year, while technology (10.2%) underperformed the market, as businesses largely sat on cash and governments restrained their technology spending in 2010. Financials and health care were weighed down by regulatory uncertainties throughout the year.

CHART 1: EQUITY MARKET PERFORMANCE AS OF DECEMBER 31, 2010

					Total Return (%)
	Equity Index		Level		December		QTD		YTD
	Dow Jones Industrial Average		11,577		5.3		8.0		14.1
	S&P 500 Index		1,257		6.7		10.8		15.1
	NASDAQ Composite		2,652		6.3		12.3		18.2
	Russell 2000		783		7.9		16.3		26.9
	S&P 400 Midcap		907		6.6		13.5		26.6
	S&P 600 Small Cap		415		7.7		16.2		26.3
	S&P 500 Growth		659		5.2		11.1		15.1
	S&P 500 Value		590		8.3		10.5		15.1
	MSCI EAFE		1,658		8.1		6.7		8.4
	MSCI EMG		1,151		7.1		7.4		19.0
	Sector		Level		December		QTD		YTD
	Consumer Discretionary		295		4.2		12.8		27.8
	Consumer Staples		303		4.2		6.1		14.1
	Energy		506		9.0		21.5		20.5
	Financial Services		214		10.8		11.6		12.2
	Health Care		364		4.5		3.6		2.9
	Industrials		301		7.8		11.8		26.7
	Technology		404		5.3		10.3		10.2
	Materials		239		10.5		19.2		22.3
	Telecommunications		128		7.8		7.3		19.0
	Utilities		159		3.1		1.1		5.5

Source: Bloomberg
Past performance is no guarantee of future results.

Consistent with our thoughts written in the 2011 Outlook and our most recent Market Update, “Roundtrip ticket” (December 16, 2010), we believe that stocks are setting up for another volatile year in 2011.

The good news is that the equity market, as defined by the S&P 500 Index, is well positioned both technically and fundamentally to exceed the upper end of the “sustainable trading range” that we highlighted for stocks (1,050 to 1,250) for 2010. Indeed, we believe the combination of firming market technicals and the improvement in market fundamentals may enable stocks to approach, if not exceed, the 1,300 level in the coming weeks.

Yet the bad news is that we suspect that a variety of risks could resurface during the first half of the year that could potentially threaten these hard-fought gains. To be sure, these domestic and global risks are numerous (housing, unemployment, deficit spending, sovereign credit, energy prices, China, Korea, etc.) and could cause stocks to retest the 1,120–1,130 range for the S&P 500 Index. We see good support at these levels, though, and absent a major geopolitical event, they should pose an attractive entry point as investors consider equity prices relative to earnings, book value, sales, and cash flows.

We believe that the combination of low interest rates and low inflation, along with slow but steady growth in gross domestic product (GDP), employment, and corporate profits during the course of 2011, will enable stocks to begin climbing from these levels. As attractive valuations bring new investment, we look for stocks to once again rally above the 1,300 level in the second half of the year. Simply applying a price/earnings (P/E) multiple of 15 times our below-consensus earnings per share (EPS) forecast of $90.00 for the index in 2011 suggests that the S&P 500 Index would be fairly valued in the 1,350 range by year-end.

Given this anticipated volatility, we encourage long-term investors to maintain a fully diversified, actively managed equity portfolio strategy. We recommend a combination of allocation decisions relative to market capitalizations, investment styles, sectors, and regions. Generally speaking, we would slightly overweight large caps over small caps, equally weight growth and value, and use any pullbacks to add to emerging markets exposure over developed markets. On a sector basis, we continue to favor technology, energy, materials and industrials.

A more detailed breakdown of these ideas can be found in our 2011 Outlook and our most recent Market Update, “Roundtrip Ticket” (December 16, 2010).

BONDS
The trends that shaped bond market performance in 2010 are still in place going into 2011. Private-sector borrowing remains flat because households and businesses are still deleveraging and because housing—a big user of borrowed money—is still depressed. While much is being made about banks starting to lend again, loans on the books of the nations’ banks are not increasing. They have merely stopped declining. The consequent weak growth in the monetary aggregates allows the Fed to conduct QE2 (the second round of quantitative easing) and keep the federal funds rate near zero without fear of a spike in inflation. In addition, the absence of private-sector borrowing leaves room for huge Treasury deficits to be financed at relatively low market yields. Foreign investors continue to accumulate U.S. dollars, and the European debt markets are likely to remain troubled. Foreign demand for U.S. securities can ebb at times but probably cannot weaken significantly as long as the U.S. runs huge trade deficits.

The 2010 total return for the investment-grade market was close to that of 2009, but the distribution of the returns in 2010 was not the same as the distribution in 2009. Treasuries staged a recovery in 2010 after a terrible 2009, while the municipal market struggled after an exceptional performance in 2009. The high-yield corporate market again outperformed the investment-grade sectors but not by the once-in-a-lifetime margins seen in 2009.

The municipal market was performing quite well until November and December, when it was overwhelmed by supply pressures. Almost daily media stories on the fiscal problems of state and local governments also hurt the market—prompting some individual investors to liquidate positions in municipal investments. Selling by hedge funds also contributed to the poor performance last quarter. These aggressive total return managers have probably contributed significantly to market volatility in recent years. The fourth-quarter return was the poorest since the first quarter of 1994, when the Fed surprised the markets with a 0.75 percentage point increase in the federal funds rate. The 2010 return, however, was much better than the -6.2% and -6.3% returns of 1994 and 1999, respectively. Nevertheless, the muni market starts 2011 cheaper versus Treasuries than any other domestic fixed-income market.

CHART 2: BOND MARKET TOTAL RETURNS

Market	2008	2009	2010	Q4 2010	December
Master Index	6.20%	5.24%	6.43%	-1.42%	-1.15%
Corporates	-6.81%	19.76%	9.52%	-1.59%	-0.95%
Treasuries	13.98%	-3.72%	5.88%	-2.67%	-1.83%
Agencies	9.69%	0.90%	4.61%	-1.08%	-0.92%
Mortgages	8.30%	5.76%	5.67%	0.31%	-0.49%
Asset-Backed	-21.11%	10.62%	5.02%	0.32%	-0.01%
High-Yield	-26.21%	56.28%	15.24%	2.98%	1.72%
Municipal	-3.95%	14.45%	2.25%	-4.52%	-2.04%
2-year Treasury	7.43%	1.05%	2.28%	-0.13%	-0.18%
5-year Treasury	13.28%	-1.47%	6.76%	-2.66%	-2.30%
10-year Treasury	20.06%	-9.71%	7.90%	-5.59%	-4.05%
30-year Treasury	41.20%	-25.98%	8.65%	-9.85%	-3.68%

Source: Bloomberg
Past performance is no guarantee of future results.

The Fed wanted its second round of quantitative easing to pull down yields on Treasury notes and bonds. Instead, those yields rose sharply in the fourth quarter. That turned a good year into a mediocre year for the Treasury market. By year-end, the market appeared to have priced in expectations of a stronger economy in 2011. This market remains vulnerable, however, to swings in foreign demand. Through the first three quarters of 2010, that demand was strong. In the fourth quarter, demand from overseas appeared to have weakened significantly. With yields now 50 basis points to 100 basis points higher than in early October, foreign investors might be expected to return as major buyers of U.S. Treasuries.

Investors still have enormous sums invested in short-term cash equivalents that are earning next to nothing. That caution potentially cost them four to eight percentage points of interest income over the past 12 months, which they may have earned if they had invested in longer-term securities. The opportunity costs could be just as great in 2011. If GDP growth remains subpar, bond yields could essentially trade within a narrow range, and cash equivalents could again be the poorest-performing assets over the next 12 months.

THE BOTTOM LINE
It’s not just a new year that brings new opportunities; every moment can bring a new opportunity. However, we do like to wax nostalgic at these calendar milestones. At the beginning of 2010, we were concerned that most investors were too pessimistic about the global economy. Now, at the beginning of 2011, we’re concerned that investors may be too optimistic. That does not mean there are not good opportunities out there; it’s just that we think you have to be prepared for momentum to reverse. Investors should make a new year’s resolution to pay attention to their portfolios and to make sure their portfolios are appropriate for their goals.

The Dow Jones Industrial Average is an unweighted index of 30 "blue-chip" industrial U.S. stocks. You cannot invest directly in an index.

The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market-value-weighted index with each stock's weight in the index proportionate to its market value. You cannot invest directly in an index.

The NASDAQ Composite Index measures the market value of all domestic and foreign common stocks, representing a wide array of more than 5,000 companies, listed on the NASDAQ Stock Market. You cannot invest directly in an index.

The Russell 2000^® Index measures the performance of the 2,000 smallest companies in the Russell 3000^® Index, which represents approximately 8% of the total market capitalization of the Russell 3000 Index. You cannot invest directly in an index.

The S&P MidCap 400 Index measures the performance of the mid-size company segment of the U.S. market; this index is used by over 95% of U.S. managers and pension plan sponsors. More than $25 billion is indexed to the S&P MidCap 400. You cannot invest directly in an index.

The S&P 600 SmallCap Index consists of 600 small cap stocks chosen for market size, liquidity, and industry group representation. It is a market-capitalization-weighted index. You cannot invest directly in an index.

The S&P 500 Pure Value Index measures the performance of the pure value stocks from the S&P 500 Index, which represent approximately 33% of the total market capitalization of the S&P 500 Index. You cannot invest directly in an index.

The S&P 500 Pure Growth Index measures the performance of the pure growth stocks from the S&P 500 Index, which represent approximately 33% of the total market capitalization of the S&P 500 Index. You cannot invest directly in an index.

The Morgan Stanley Capital International Europe, Australasia, and Far East ("MSCI EAFE") Stock Index is an unmanaged group of securities widely regarded by investors to be representations of the stock markets of Europe, Australasia, and the Far East. You cannot invest directly in an index.

The Morgan Stanley Capital International Emerging Markets (MSCI Emerging Markets) Index is a free float-adjusted market capitalization index designed to measure the equity market performance in the global emerging markets. The index is currently comprised of 25 emerging market country indices. You cannot invest directly in an index.

Source: MSCI. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed, or produced by MSCI.

The views expressed are as of January 3, 2011, and are those of Brian Jacobsen, James Kochan, John Lynch, and Wells Fargo Funds Management, LLC. The information and statistics in this report have been obtained from sources we believe to be reliable but are not guaranteed by us to be accurate or complete. Any and all earnings, projections, and estimates assume certain conditions and industry developments, which are subject to change. The opinions stated are those of the authors and are not intended to be used as investment advice. The views are subject to change at any time in response to changing circumstances in the market and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally, or any mutual fund.