In stark contrast to the panic coursing through Wall Street twelve months earlier, the third quarter of 2009 was distinguished by rising confidence. Stocks traded sharply higher, extending the hottest run on Wall Street in thirty-four years. From the ashes of early March, the S&P 500 has soared. Investor fear, as measured by the Chicago Board Options Exchange Volatility Index, receded to a 52-week low.

Government figures revealed brightening conditions in the consumer and manufacturing sectors. Retail sales jumped 2.7% in August (month over month), the largest increase in three-and-a-half years. Industrial production rose for a second month, up 0.8%. Improvements were broad-based, not just a result of the federal ”cash for clunkers” vehicle exchange program. Retail sales ex-autos rose 1.1% in August. Industrial production ex-autos increased 0.6%. Federal Reserve Chairman Ben Bernanke announced “the recession is very likely over.” Skeptics noted ongoing labor market weakness. Employers shed 216,000 workers in August, the twentieth consecutive monthly drop. Unemployment touched a twenty-six-year high.

Opposing reports highlighted hope and fear in the housing market. Bulls were encouraged by month-over-month gains in pending home sales, new home sales, existing home sales, housing starts and building permits. Bears noted a record 13.2% of U.S. mortgages were either delinquent or in foreclosure in the second quarter.

The third quarter earnings season kicked off amid low expectations but favorable guidance. According to Thomson Reuters, S&P 500 profits likely fell 25% during the July-September period. Materials firms were forecast to perform the worst, with profits down 68% compared to third quarter 2008. The financials and consumer discretionary sectors should do the best, with estimated profits up 59% and 17%, respectively. Pre-season announcements suggest actuals could exceed expectations. Entering October, the negative-to-positive ratio of companies guiding lower versus higher was 1.5. The long-term average is 2.1. Firms crushed expectations during the first and second quarter earnings seasons, fueling the summer’s stock rally.

The S&P 500 Index rose between June 30 and September 30. The index is up year-to-date. The Dow Jones Industrial Average and the Nasdaq Composite also increased for the quarter and year to date.

The Mid Cap segment of the market continued its strong rally in the third quarter, with the Russell Midcap Index advancing and posting another blockbuster quarter. The Allianz NACM Mid Cap Growth portfolio trailed the Russell Midcap Growth Index in the third quarter.

Mid Cap Value stocks outpaced Mid Cap Growth stocks during the quarter. Year-to-date, the Russell Midcap Growth Index is still ahead of the Russell Midcap Value Index. Mid Cap Growth continues to be the best-performing Russell Index this year.

The top-performing sectors for the Index were the most economically sensitive segments of the universe such as Energy, Information Technology, and Materials which all posted sector returns for the quarter on an improving economic outlook.

In the third quarter, the portfolio’s overweight in Consumer Discretionary and Information Technology helped relative performance during the period. The portfolio’s relative underweight in Financials, and exposure to insurance names such as Principal Financial Group and Unum proved beneficial.

Strong relative performers in Consumer Discretionary included: consumer GPS manufacturer Garmin, online travel provider Expedia, coffee retailer Starbucks, and apparel retailer Limited Brands. Information technology holdings, Marvell Technology and Western Digital also posted continued strong performance during the quarter on solid earnings results and favorable business trends in the PC-segment.

The portfolio was negatively impacted during the quarter by its relative underweight in Industrials, Energy, and Materials.

On a year-to-date basis, the Allianz NACM Mid Cap Growth Fund trailed the benchmark for the year on a gross return basis. According to Lipper Analytical Services, only 31% of active Mid Cap Growth managers have outperformed year-to-date.

Despite this summer’s rally, equities don’t appear overly expensive. The S&P 500 was priced at 15.1 times expected earnings in September (twelve-month; IBES). That compares with an average of 16.8 over the past ten years and a peak of 24.4 in January 2000. The U.S. economy is likely growing again, a combined result of government stimulus, cheap credit and inventory re-stocking. Leading economic indicators have steadily improved for the past six months (source: Conference Board). Still, the road looks less than smooth. The jobs-related downturn in September consumer confidence underscores the challenges facing retailers entering the holiday shopping season. Early estimates suggest sales and seasonal hiring will be flat relative to last year. Uninspiring, that would still be an improvement over 2008 when retailers cut staff amid falling sales. The Federal Reserve is scheduled to end mortgage-backed securities purchases in March. Calls for extensions should grow louder as expiration dates approach. At Nicholas-Applegate, we believe our products are well positioned to capitalize on the changing market environment.