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Market Insights - October 2010

September has historically been the worst month for stock markets; this September, however, confounded expectations. Financial markets posted a strong rebound for the month and the quarter, and pulled the averages into the black for the year.

After a strong July, stocks slumped in August, weighed down by fears of another slowdown.  In last month's market commentary, "Fear, Greed...and Patience,"  we noted that investor pessimism had fallen to levels not seen since stocks hit their lows of March 2009; so often these extremes are the prelude to strong and sustainable gains.

What changed?

The drumbeat of weak data during May and June faded, replaced by modestly improving economic numbers.  European economies worked through the sovereign debt crisis, which at one point seemed poised to derail the economic recovery. Now, the EU Central banks appear more capable of resolving the issues with the tools at hand.  Fears of a double-dip recession receded, helped in part by strong signals from the Fed that additional stimulus measures are available if needed to support the recovery.

Markets in the third quarter, in fact, were a reimage of the entire year to date; a strong beginning, a sagging, lackluster middle, then finally building momentum. Not exactly the right prescription to bolster confidence, in spite of the strong finish. Throughout, investors continued to draw funds from equity markets; outflows from US stock funds reached an estimated $42.8 billion from July through the end of September, nearly twice the level of the previous quarter.

The numbers

The Dow gained 7.7% in September, the strongest September since 1939 and the largest monthly gain since October 2002.  The Dow is now up 10.4% for the quarter ending 9/30/2010, and 3.6% year-to-date.  The S&P 500 gained 8.8% in September, and 10.7% for the third quarter. Global markets, measured by the Vanguard International Developed Market index fund, gained 2.52% in 2010, while the Developing Market index fund, measuring the performance of emerging markets, was up 11.85%. Real estate was again a strong performer, measured by the Cohen & Steers Realty Fund, which gained 18.2% in 2010.  In the fixed income and bond category, the Vanguard Intermediate Term bond index fund ended ahead 12.8% for the year, the Vanguard Inflation Protected Bond Fund gained 7.2%, the Vanguard Intermediate Term tax exempt fund gained 5.81%, while the Vanguard High Yield tax exempt fund added 7.54%.

What will make a difference now?

Concerns about the pace of expansion continue. Evidence of slowing global growth has led economists to reduce forecasts for U.S. gross domestic product to 2.5 percent in 2010. (The US GDP expanded at a revised 1.7 percent in the second quarter.)

Investors remain wary, and watchful for loss of conviction in the markets. Third quarter corporate earnings will be reported shortly, and although the numbers have been revised downward slightly, consensus third quarter earnings growth estimates for the S&P 500 suggest gains of 23 percent on average. A miss on these numbers would likely have considerable impact on stock prices. Tax rates and tax brackets going forward will loom large in investors’ consciousness, as will midterm elections, as a host of economic policy items may be impacted. If the markets show continuing strength into the last three months of the year, as we think they will, many investors on the sidelines will reenter, and reenergize the markets. 

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