Our Take on the Fourth Quarter

Fueled by aggressive moves by the Federal Reserve and hopes of an improving U.S. consumer, the market ended 2010 on a solid note. The broad-based Morningstar U.S. Market Index rose 11.6% during the last 13 weeks ended Dec. 28. The index tacked on 15.5% for the year, though investors are still down 2% during the last three years.

One of the most talked about events of the fourth quarter was the Fed formally announcing its second round of quantitative easing that it had been hinting at for months. Simply put, the central bank committed to buying $600 billion of long-dated Treasury bonds in an attempt to keep rates low, stave off deflation, move investors into riskier assets, and boost exports. Although the jury is still out if the plan will work or if unintended consequences will crop up, the markets have generally cheered the policy.

Many hope that this round of quantitative easing will be able to firmly push the broader economy into a robust recovery. Morningstar director of economic analysis Bob Johnson thinks improved consumer spending will push the economy over the tipping point. Johnson sees "higher employment levels and higher asset prices, combined with a substantial (though largely unrecognized) improvement in consumer financial positions and lower payroll taxes" as the primary factors driving the consumer forward in 2011.

Looking Abroad
But despite the potentially rosy outlook for U.S. consumers, land mines still lurk in the world economy. The European sovereign debt crisis reared its ugly head again in the quarter as bond investors fretted over Ireland's (and to a lesser extend Spain's and Portugal's) ability to pay its obligations. Although the European Union acted to shore up any short-term problems, the region is still growing at a slower pace than the rest of the world, and the debts these countries have racked up haven't magically disappeared. It will be a long, hard slog to remedy the situation in Europe.

China is having the opposite problem. It emerged from the global recession quite strongly, and Beijing is now having some trouble keeping price levels under control. The Chinese government raised interest rates and bank reserve requirements several times in the quarter, yet inflation remains elevated. This growth has been a boon the world economy, but if asset bubbles developed and then popped in China, the resulting pain could be widespread. The government still has plenty of levers to pull to keep the economy running smoothly, so even though there is likely no immediate danger, it is certainly an issue on which many are keeping a close eye.

Stock Movement
News in the IPO market was dominated by  General Motors (GM) in the quarter. The formerly troubled automaker's return to the market was greeted with a surprising level of optimism leading the firm to raise the size and price of its offering. Shares have risen modestly since then.

All of this news led to a continuation of the equity-returns trends we've seen for some time now; small-cap stocks outperforming large- and mid-cap offerings. During the last 13 weeks, small caps gained 18%, mid-caps were up 14%, and large caps were up 10% according to Morningstar indexes. The differences were much less stark across the core, growth, and value categories.

All stock sectors posted a positive return for the quarter. Industrial materials led the way with a nearly 17% return during the three months with energy, consumer services, and hardware close behind gaining 16%, 14%, 13% respectively. Utilities, health care, and financial services brought up the rear gaining 2.5%, 5%, and 6% respectively during the last three months.

Funds and Fixed Income
In the mutual fund world, the best-performing domestic equity category was equity energy which gained 19% in the quarter. Small growth, small blend, and small value also had an impressive run gaining around 18% each. Utilities (up 5%), real estate (up 6%), and communications (up 6%) were the weakest performers in the quarter.

On the valuation front, Morningstar director of equity research Pat Dorsey believes that "the broad market is modestly undervalued [but he's] finding fewer truly cheap stocks." Health care and financials are the most undervalued sectors.

The fixed-income world ended its upward march in the quarter. Investors started to ditch long-dated Treasuries in the quarter for a number of reasons including being fed up with anemic bond yields, worries over sovereign debt, and a desire for riskier assets. Whatever the reason for the sell-off, investors who stayed put couldn't have been thrilled with the returns this quarter. The Morningstar Government Bond Index fell 2.7% during the last quarter with the Long-Term Index falling 6.8%. Long-term corporate bonds fared slightly better, losing 3.3% during the last 13 weeks. The full-year returns would bring some consolation as the Government Bond Index clocked in a positive 4.7% return.

High-yield bond funds had the best quarter gaining 3.6% during the last 13 weeks with bank loans coming in second with a 3.1% return. Long government funds fell 9% during the period while the long-term bond category suffered a 2.7% loss.

All in all, the fourth-quarter underscores just how far we've come since the depths of the financial crisis and also how much farther we have to go until the U.S. returns to full employment and robust growth.