APRIL 1, 2010.

Bull Muscles Through Tumult

Dow Gained 428.58 Points, Overcoming Volatility; What Next, Uncle Sam?

By TOM LAURICELLA

U.S. stock prices extended their rally during the first quarter, battling back from a steep February selloff amid continued global economic and political uncertainty.

The trends that had helped share prices stage a remarkable recovery in 2009 continued to provide a favorable backdrop for U.S. stocks. Corporate earnings again came in stronger than expected and the battered U.S. economy continued its convalescence.

The Dow Jones Industrial Average gained 4.1% or 428.58 points during the first quarter, to 10856.63. That marked the Dow's fourth consecutive quarterly gain and the best first-quarter performance since 1999. The broad Standard & Poor's 500-stock index rose 4.9% to 1169.43, but remains 25% below its all-time high posted in October 2007.

The Dow ended the quarter on a down note, shedding 50.79 points, or 0.5%, as consumer stocks came under pressure from rising oil prices.

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.Along the way, stock investors got a taste of the kind of volatility that could be in store for some time to come as governments and central banks continue to work through the aftermath of the 2008 financial crisis. Markets were rattled as China took the first steps to reverse its economic-stimulus programs, Europe struggled with yawning budget deficits and an unsettled political climate dominated U.S. headlines.

Notably absent from the stock-market rally were individual investors, who continued to pour money into bond mutual funds while largely shunning U.S. stock funds. That flood of cash into fixed income—coupled with the knock-on effect of the Federal Reserve's mortgage-backed securities buying spree—helped lift returns on investment-grade and high-yield bonds.

The turmoil in Europe depressed returns on continental stocks, with Germany's DAX rising 3.3% and France's CAC 40 gaining just 1%. In Asia, the potential for tighter monetary policy in China sent some stock markets lower, with Hong Kong shares losing 3% but Japanese stocks jumped. And commodity prices, which are usually seen as closely linked to China's economic ups and downs, were mixed. Oil prices posted their fifth consecutive quarterly gain with a 5% increase, while copper prices gained 6.6%.

.As the second quarter gets under way, stocks face perhaps their biggest hurdle of the year with the Fed inching forward with its plans to end, and ultimately reverse, its unprecedented easing of credit. Investors seem to take Fed officials at their word that they have everything under control. But should the central bank's removal of credit-market supports fail to go smoothly stocks could be vulnerable to another swoon.

But with U.S. corporate balance sheets in solid shape and valuations reasonable, the underpinning for stocks seem relatively strong at least for the short term. "We think it's going to be a rocky path, but one that will ultimately be enjoyable for equity investors," says Duncan Richardson, chief equity investment officer at Eaton Vance. Events such as central-bank interest-rate increases "may introduce volatility," he says, but shouldn't "be showstoppers."

As has been the case since stocks hit their lows in March 2009, the best-performing stocks have tended to be the most volatile and generally lower-quality names. The Russell 2000 index of small-company stocks posted the largest gain among the big benchmarks with an 8.5% rise. Financial stocks, too, rallied despite the likelihood of stepped-up regulation and lower future profits. The Financial Select SPDR gained nearly 11%.

While stocks chalked up gains for the first quarter, it wasn't the kind of straight-to-the-moon rally seen in 2009. As 2010 got under way, many observers were expecting a repeat of the past three quarters, where better-than-expected earnings sparked a meaningful rally. U.S. earnings largely lived up to the hype, but investors' attention was drawn elsewhere.

First came news in January that China was tightening bank-lending standards as first step in reversing its fiscal-stimulus programs. At about the same time, Greece's debt woes appeared to be spreading toward the core economies of Europe. That combination, along with concerns about political developments in Washington like the health-care debate and bank regulation, sparked a flight out of riskier investments such as stocks. By Feb. 9, the Dow had shed more than 7% from a mid-January high and was down 5% for the year.

But as it became clear the debt crisis would likely be contained, stocks found their sea legs and ground higher through the rest of the quarter.

Providing support for stocks is the growing conviction that the U.S. economy is on the mend despite weak spots such as housing. "People have virtually given up on the double dip" back into recession as a possibility, says Barry Knapp, equity strategist at Barclays Capital. He expects that as economic data roll in during the second quarter, especially on the job-market front, "the sustainability argument will be put to bed."

The downside of the improving economy is the potential for higher interest rates. Cheap money has helped fuel the rally in riskier investments over the past year. The key question is when will rates rise and how will stocks handle the increase.

A growing number of analysts, such as Jeff Kleintop, chief market strategist at LPL Financial, think that in April the Fed will take the first step toward tightening by removing from its policy statement a commitment to keep rates low for "an extended period."Mr. Kleintop argues that stocks should be able to weather that news, which he thinks would signal a rate increase in October or November of this year.

More problematic for the market could be if the Fed's removal of credit-market supports, such as its end on Wednesday to purchases of mortgage-backed securities, doesn't go well. "It's been the healing of the credit markets that has helped power the stock market," he says.

Another wild card for stocks is the potential for higher interest rates in emerging markets and commodity-producing countries. Last month, India raised interest rates and Brazil is seen as likely to tighten soon.

But the focus is on China, where demand for raw materials is seen as driving commodities prices, and therefore, the outlook for energy and materials stocks. Expectations are generally that China will adopt a go-slow approach to raising interest rates. But given the country's role in driving economic growth, "it's definitely a risk ... if China doesn't manage this well," Mr. Kleintop says.

Providing support for stocks is the solid state of corporate balance sheets. By several measures, there never has been more cash in corporate coffers, notes Jason DeSena Trennert, chief investment strategist at Strategas Research Partners.

In the fourth quarter, undistributed corporate profits—which is essentially the flow of cash that companies generate but don't disperse—hit an all-time high of $527 billion at a seasonally adjusted annual rate after a steep decline during the financial crisis. Meanwhile, the nonfinancial companies in the S&P 500 have a record $830 billion of cash on their books, according to Strategas.

Recent weeks brought evidence that companies may start doling out some of that cash to shareholders through higher dividends, a positive trend for stocks.

Mr. Trennert also thinks the cash stockpiles could be put to work in mergers and acquisitions, which is often a catalyst for higher prices. "Companies may not be particularly optimistic about future growth ... and stronger companies could say this is a great time to grow by acquisitions," he says. That could especially true among retail and financial companies, he says.

Write to Tom Lauricella at tom.lauricella@wsj.com

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