By Neil Irwin
Washington Post Staff Writer
Friday, December 31, 2010; 8:22 PM
In a year of political upheaval, fiscal crisis in Europe and the threat of a double-dip recession in the United States, the stock market weathered all challenges, plodding upward.
The final tally after Friday's light trading day: The Standard & Poor's 500-stock index closed up 12.8 percent for the year, at 1257.64, and the Dow Jones industrial average closed up 11 percent, at 11,577.51.
It was a solid, middle-of-the-road performance from the stock market, neither the utter collapse of 2008 (when the S&P 500 fell 38 percent) nor the sharp bounce-back of 2009 (up 23 percent). Over the past two decades, nine years have featured better returns and 10 have featured worse.
But given the turmoil of the past three years, middling news can be seen as good news. For now at least, wild swings in financial markets have calmed down and a slow, gradual recovery from the economic and financial turbulence is well entrenched. The VIX index, which measures investors' expectations for future volatility in stock prices, reached its lowest level in three years in December.
"The fears of a double-dip recession are behind us, at least until the next giant shoe to drop," said Alan Levenson, chief economist at mutual fund giant T. Rowe Price. "There's a growing willingness to take on risk and an acceptance that the economy and corporate earnings are on track."
The biggest threat to financial markets - and the year's biggest swoon - came in April and May, when Europe experienced a fiscal crisis. That was followed by a choppy summer in which the U.S. economy seemed to be losing ground fast, stoking fears of a dip back into recession.
By fall, however, a series of actions by governments and central banks around the world had helped address both problems. A program to backstop the debt of Greece and other nations in financial peril, combined with purchases of bonds by the European Central Bank, calmed down the financial sector. When the crisis flared up again in November, with Ireland's finances imperiled, there was little impact on U.S. financial markets.
As for the U.S. economy, the risk of a renewed economic downturn over the summer led the Federal Reserve to enact an expansive new program to ease monetary policy. In early November, the Fed's policy committee announced it would buy $600 billion in Treasury bonds in an effort to push down interest rates. It was earlier that fall, as Chairman Ben S. Bernanke and Fed colleagues hinted that the program was forthcoming, that the stock market got back on track.
The stock market is still well short of its pre-crisis high: The S&P 500 would need to rise another 24 percent to get back to its October 2007 peak. But the higher prices and renewed sense of stability should be a source of strength for the U.S. economy as a whole in 2011. In total, American households' net worth increased $1.7 trillion in the third quarter from a year earlier, helping bolster consumers' ability and willingness to spend money and businesses' comfort level with hiring.
Aside from stocks, other financial markets were buffeted by similar forces. The interest rate on U.S. Treasury bonds plummeted in the late spring and summer as investors spooked by the troubles in Europe plowed money into what was viewed as a safer investment. Then, as the U.S. economic recovery faltered and new Fed easing was discussed, Treasury bonds became even more attractive.
At the start of the year, 10-year Treasury yields were 3.84 percent. That rate fell as low as 2.38 percent in early October.
But by November, as the U.S. economy finally started looking stronger, that flight of money into low-risk bonds ended and investors started to view the Fed interest rate increases as coming sooner than before. Rates spiked further in December when President Obama and Congress reached agreement on a deal to cut taxes for the next two years, a move that may help growth but will increase the budget deficit.
"The tax cut is to be financed by increased borrowing," said Steven Ricchiuto, chief economist at Mizuho Securities. As a result, Ricchiuto forecasts that 10-year Treasury rates will rise above their 2010 closing of 3.29 percent and rise to the range of 3.5 to 4 percent early in 2011.
The biggest gainers in 2010 were commodity prices. With signs that the global economy remains on track - and may even be overheating in China and some other developing nations - the price of oil ended the year at $91.38 per barrel, a 15 percent rise from $79.36 over the course of the year. Other major commodities, as varied as soybeans and copper, showed similarly strong increases.
Indeed, the spike in commodity prices bears some resemblance to what happened in the first half of 2008, before the financial crisis deepened and sent the global economy into a tailspin. Higher prices for food and fuel can act as a tax on consumers and could emerge as a risk to major economies in 2011.
And the actions of the Fed and other world central banks to try to keep the recovery on track may be another factor in the rise in commodity prices. The easy-money policies in place may be leading investors to fear inflation, and hence bid up commodities in order to protect themselves against further price increases.
"It's hard to parse how much of the rise in commodity prices is speculative and how much is fundamental," said T. Rowe Price's Levenson. "With faster growth in emerging economies, there is a genuine underpinning for higher prices, but there's probably some inflation hedging in there, too."