Financial markets in the western world rallied broadly during the fourth quarter. The impetus was belief that the major players in euroland namely Germany, France and Italy were moving closer to wrapping their arms around the problems of refinancing national debt, ensuring the liquidity of the euro banking sector and tightening fiscal policy in weak sister countries like Greece and Italy.

Economists are now running Spain and Italy. Politicians, like Berlusconi, had to depart if Italy were to qualify for European Central Bank assistance.  Last month, all the central banks, inclusive of China, initiated a change in emphasis in credit markets.  Liquidity was injected into their banking systems at lower rates of interest.

Draconian interest rates in Italy and Spain came down almost 100 basis points on 10-year debt financings but still remain near 7 percent for Italy. This is the equivalent of a B credit in our high yield bond market. The snap back in the financials reached 8 percent overnight for major banks as well as brokerage houses and insurance underwriters. We remain comfortable with our full market weighting in the financial sector, finally starting off the new year buoyantly.

Federal Reserve Board Policy emphasis is explicit.  Money market rates hold near zero the next couple of years.  A QE-3 bond buying program is under consideration, and could drive 10-year and 30-year Treasury bonds to even lower historic rates near term.  Inflation remains dormant, particularly in labor markets while corrections in the industrial and agricultural commodities sector reflect slower GDP momentum, even in China. Euroland is at a near zero rate of growth while we remain in a fragile setting near term but more go than stop.

Most economists, including the Federal Reserve Board, started off the year projecting a near normalized setting of 3 to 3.5 percent.  By midyear forecasters had drawn in their GDP numbers closer to 2 percent and projected even slower momentum in the back half of the year.

Actually, the economy surprised in the third quarter with a 1.7 percent showing.  Despite somber employment statistics and low readings on consumer sentiment, personal consumption expenditures waxed unexpectedly strong.  Individuals drew down their savings rate from approximately 6 percent to under 4 percent.  New car sales stayed buoyant and most retailers reported good numbers.  The quality of the third quarter GDP showing was notable for the decline in inventories and a pickup in capital spending which had been a drag on GDP for many successive quarters.

Our point of view has evolved based on these more favorable readings. Fourth quarter GDP could come in above 3 percent.  Unemployment statistics and home prices no longer remain a drag on consumer sentiment and GDP.  Interest rates are so low that it looks like a driver for consumer spending as well as a capital goods recovery.  December statistics on industrial production, new orders and employment all looked surprisingly strong.

Considering our near dysfunctional Congress, there is no resolution in sight for major tax restructuring and deficit reduction that makes sense.  Ten-year Treasury bonds yielding under 2 percent and 30-year paper below 3 percent is the crowning irony for our financial markets this year, with no change in sight.  We now are the repository of last resort for all the hot and worried capital, worldwide.

The market has largely discounted all the world’s bad macros, but it must focus now on the earnings micros of American corporations.  Businesses face a weakening euro, soon penalized by currency translation of offshore earnings.  We worry more about the spread between actual earnings currently and normalized earnings.  It’s not so high as in 2006, but still far above trend.  The difference between S&P 500 earnings of $90 a share vs. the consensus expectation of $100 could be 100 points on the index in the new year or close to 10 percent.

Our portfolio construct continues to evolve.  We are no longer fearful of industrials and financials and are adding to the consumer discretionary sector with promising results.  Technology remains a major overweighted sector and is working for us. 

We are comfortable in our almost fully invested portfolio construct. The market at approximately 1,270 on the S&P 500 Index is a reasonable working valuation, taking the major variables of corporate earnings, inflation, interest rates and euroland’s deep-seated issues needing near term attention.

A word about portfolio performance. Our long term record is far above average, but we did sustain a dismal year in 2011. Entering the year, our expectations for economic expansion proved too optimistic. This led to underperformance in our cyclical growth overweights. Additionally, we were underweight two of the best performing sectors. Consumer staples and utilities outperformed due to their defensive characteristics rather than earnings acceleration.  Hopefully, we have corrected sector concentration misteps and our stock selection prowess reasserts itself.

The new year finds us moving in the right direction - up.