Stocks Start 2013 With a Bang. What's Next?

Stocks are off to the races this morning, with the S&P 500 (SNPINDEX: ^GSPC  ) and the narrower, price-weighted Dow Jones Industrial Average (DJINDICES: ^DJI  ) up 0.79% and 0.97%, respectively, as of 10:10 a.m. EST.

The short view
The biggest news item of the day is U.S. nonfarm payrolls for January, which rose by 157,000 -- in line with expectations of 160,000. However, that number was insufficient to dent the unemployment rate, which, in fact, ticked up to 7.9% from 7.8% in December.

Why are stocks reacting positively to the news? There are two possible interpretations, depending on your disposition. Optimists will point to the report's substantial upward revisions for November and December as a sign that the economy is gathering steam. Pessimists will suggest that today's increase in the unemployment rate implies that the Fed will be less eager to wean the economy – and financial markets -- off its regimen of monetary steroids.

The longer view
Stocks have gotten off to a terrific start for the year, with the Dow returning about 3.3% in January and the S&P 500 up 5.2% -- its best first-month performance since 1997 and the best return of any month since October 2011. A rising tide lifted all boats, as all sectors advanced in January; the top three sectors were energy, health care, and financials, while materials, telecom services, and information technology brought up the rear.

Pundits have speculated that this strength marks the beginning of a "Great Rotation" out of equities and into bonds, but there is little evidence for that at this stage. The Investment Company Institute reported that more money flowed into bond mutual funds than equity funds in the week ended Jan. 16, for example. That suggests two things: One, there is plenty of room for the stock market to achieve further gains if sentiment continues to improve. Two, given that there has been no fundamental reallocation between stocks and bonds yet, recent gains are vulnerable to a reversal in sentiment. Either way, investors should be prepared for some volatility.

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