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In 4Q2012, large company stocks in the Russell 1000 index gained a fraction, but the big story was the excellent calendar-year performance of U.S. stocks. Stocks have recovered from the global financial crisis.

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The 18.1% annualized return on small-company value stocks in 2012 towers over annualized returns of small-cap growth companies as well as small-cap value companies for 3-, 5-, and 10-years. The outsized performance of stands as a lesson in why rebalancing is important.

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Further underscoring the wisdom of staying broadly diversified, most major asset classes showed positive returns in 2012. As if to show the folly of making investment decisions based on short-term results, only five of the 12 major asset classes showed a positive return in 4Q2012, while 10 of the 12 major asset classes were in positive territory for the 12-month period ended December 31, 2012.

Notable in the final quarter of 2012 was the strength in the euro, which had been pushed lower for most of the year as the Eurozone crisis raised doubts about the future of the Old World.

The flip side was weakness in the U.S. dollar, gold, and commodities.  Gold, which so many market-timers and doomsayers talked up as it soared to new all-time highs again and again in recent years, plunged 5.7% in 4Q2012.  Inflation fears remained dormant despite the Federal Reserve’s easy monetary policy, which has kept interest rates near all-time lows in an effort to stimulate the economy and promote business lending and investment. 

A big winner for the quarter were high-yield “junk” bonds, as investors seeking yield bid up prices of below-investment bonds. While the slowly improving economy reduced the credit risk posed by junk bonds, the credit risk on these bonds and their default rate must be carefully considered in seeking their yield.  

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The reversal in fortunes for some asset classes was evident in U.S. industry sectors in the fourth quarter of 2012. Financial services stocks continued to lead, while technology stocks and telecom lagged.

In a hopeful sign, consumer discretionary, industrials and materials—the sectors considered most sensitive to an improving economic outlook—posted gains in the 4Q2012.

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Regarding the stock market, this one chart best illustrates how stock prices are driven by earnings and how, at the beginning of 2013, analysts expected higher earnings to drive stock prices higher going forward.

The green line representing stock prices, for the most part, follows the purple line representing corporate earnings. You can see how, during the seven years leading up to the tech bubble, the period from 1994  to 2000, the correlation of stock prices with earnings broke down. Along these same lines, you can see that ever since the stock price collapse in 2007 and 2008 corporate earnings have grown at a faster pace than the prices of stocks in the S&P 500 stock index. That’s because, after the drubbing stock investors took in 2008, they are reluctant to bet on stocks again even though earnings have been coming through.  

Moreover, the purple stars illustrate how Wall Street analysts were projecting continued growth in corporate earnings in 2013 and 2014. If Wall Street analysts are correct and the purple line trends higher through the end of 2014, then the green line, based on the historical trend, seems highly likely to be dragged higher by up-trending profits in American companies.

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For 2012, stocks posted strong returns across the globe. The Eurozone’s 16% gain (not including dividends reinvested) was the biggest surprise. At the start of 2012, with Europe teetering, it seemed an unlikely region to stage a stock rally.

The performance of U.S. stock benchmarks versus major global markets shows the importance of diversifying across different styles and market-capitalizations of U.S. stocks as well as global markets.