Mr. Ward’s Armajaro Holdings Ltd. shook up the commodities market in July by buying a $1 billion cache of cocoa, enough to make 15 billion Hershey’s milk-chocolate bars. But since Mr. Ward made his audacious bet, cocoa prices have dropped 26%.

Two hedge funds run by Armajaro, including its CC+ Fund, which focuses on cocoa and coffee, lost about 6% of their value during the first two weeks of August, according to investors who have viewed the returns. And since then, prices have continued to decline, suggesting Mr. Ward could be coming under more pressure.

It isn’t certain the drop in cocoa is to blame for the recent losses. And some analysts say the recent decline in prices may be short-lived. An Armajaro spokesman declined to comment.

The funds remained up about 12% on the year through the middle of August, the investors say.

Mr. Ward, a 50-year-old trader, has gained a level of prominence in the commodities markets, having made big bets on cocoa at least twice before, in 1996 and in 2002.

Farmers work on cocoa pods at a farm in San Pedro, Ivory Coast, earlier this month. Cocoa prices have fallen since a large purchase in July. (Reuters)

Armajaro in July took delivery of 240,100 metric tons of the commodity—accounting for almost all the cocoa stored in approved commodity-exchange facilities across Europe, and totaling about 7% of the world’s cocoa supply.

The purchase was the second-largest delivery of cocoa beans on record, according to figures from ABN Amro, ranking only behind Mr. Ward’s 1996 strike.

Around the time Armajaro took possession of the cocoa in July, cocoa prices had reached 33-year highs amid worries about wet weather in the Ivory Coast, the supplier of 40% of the world’s cocoa.

Armajaro bet supplies out of the Ivory Coast would dwindle, driving prices even higher.

But instead, the weather has improved markedly, and optimism is growing that the next Ivory Coast crop will be plentiful. That has coincided with concerns that a weaker economy could hit demand for chocolate in the U.S. and Europe. There are signs Asia-based processors that provide cocoa butter to some developed markets have reduced production recently, according to a person familiar with the matter.

Cocoa prices have fallen 11% since the end of July on the NYSE Liffe exchange. They settled Thursday at £2,021 ($3,122) a metric ton. Prices are down 10% for the year.

The situation could easily turn in Mr. Ward’s favor, either because of supply shortages or increases in demand. For instance, political tension has been roiling Ivory Coast for years, and elections are to be held at the end of October, introducing the potential for short-term disruptions.

It isn’t known whether Armajaro has sold some or all of the cocoa it bought in July. Armajaro also hasn’t disclosed the price at which it started buying the beans.

Mr. Ward’s funds are volatile, so they could stage a rebound after the recent setback. One Armajaro fund scored gains of 18% in June of this year after losing more than 12% in February.

Mr. Ward has made money on cocoa in the past. His 2002 cocoa play netted him $17 million on a £300 million purchase, according to news reports at the time.

While Armajaro runs a hedge-fund business, with about $1.7 billion under management, it also is a large player in the physical market for cocoa beans. It buys cocoa in Ghana, Ivory Coast, Nigeria, Indonesia, Malaysia, Vietnam and Ecuador. It then sells that cocoa to processors. The group employs more than 1,000 people, according to its website.

Mr. Ward started Armajaro in 1998 as a cocoa merchant and later moved into asset management, opening his first commodities fund in 2004, he said in an interview posted earlier this year by Opalesque, a website that provides news about alternative investments.

Opalesque TV (insert), Reuters

Anthony Ward, inset, in an interview with alternative-investment website Opalesque, in January touted his weather data. His bet on wet weather hurting Ivory Coast cocoa supplies has become cloudy as the forecast improved. Here, workers carry bags of cocoa in San Pedro, western Ivory Coast, earlier this month.

“Pretty much all of you around the world will have had product that’s been sourced by Armajaro,” Mr. Ward said in the interview, of the firm’s cocoa- and coffee-supply business.

The firm puts a premium on data about the weather because of its potential to affect crops, and therefore the balance between supply and demand, he said. “We invest hugely” in weather data, Mr. Ward said in the interview. “We even have our own weather stations, our very own, that no one else has, in some parts of the world.”

—John James in Abidjan, Ivory Coast, contributed to this article.
Write to Gregory Zuckerman at gregory.zuckerman@wsj.com and Liam Pleven at liam.pleven@wsj.com

By GREGORY ZUCKERMAN

A Canadian insurer is turning to a seldom-used strategy to make a big wager on falling prices over the next decade.

Greg Zuckerman discusses a Canadian insurer that has wagered on derivatives that profit from a decline in consumer prices.
As more investors worry about the possibility of deflation—or a sustained period of falling prices that could cripple stocks—Fairfax Financial Holdings Ltd. has spent nearly $200 million to buy derivative contracts wagering on a decline in the consumer-price index, an inflation indicator. The trade could lead to huge profits if deflation occurs.

Fairfax purchased some of the derivative investments in the first three months of the year, when few fretted about deflation and the cost of the contracts was cheap. It added more in the second quarter.

The derivatives now are catching the attention of some on Wall Street. They have gained more than 50% in value since Fairfax made its original purchases from a number of banks, generating paper profits of more than $100 million.

Prem Watsa’s Fairfax Financial has already made a $100 million paper profit by wagering on deflation.

The Fairfax bet, which aims to protect $22 billion of Fairfax’s investment portfolio, comes as investors grapple with a particularly challenging environment, with the economy fragile and stock indexes struggling. Few investors are willing to make big wagers on deflation, despite its potential, with many skeptical any deflationary period would last long. The U.S. hasn’t experienced an extended bout of deflation since the Great Depression.

Still, Fairfax isn’t selling its deflation protection, despite its recent run-up in value. It thinks bigger gains could be ahead if the U.S. experiences a painful bout of deflation.

“We are extremely concerned about a double dip in the economy and about a deflationary environment,” says Paul Rivett, chief operating officer for Fairfax’s investing department.

Derivative bets on inflation aren’t new. Some companies and investors pay small premiums to buy inflation “caps” or “floors” that pay off if inflation rises above or falls below a certain level. Others buy derivatives betting on moves in economic indicators like the CPI, the inflation indicator that is now running at an annual rate of about 1%.

But interest is growing among some larger investors for deflation derivatives like those Fairfax bought. Today it would cost about $330 million to protect the same $22 billion, dealers say.

Traders can sell these contracts to others in the “interdealer market,” where banks trade with each other, something that was rare for such contracts six months ago. About $4.5 billion worth of these contracts have been trading each month in the interdealer market, up from $2.5 billion a month last year, according to traders.

Fairfax was founded in 1985 by Prem Watsa, who has made a series of acquisitions; its name derives from the phrase “fair, friendly acquisitions.” Mr. Watsa’s investments for Fairfax have led some to dub him Canada’s Warren Buffett.

But in the U.S., Fairfax also has drawn attention for heated battles with short sellers; it has claimed these bearish investors helped drive down the insurer’s shares several years ago before they turned higher in 2006. Fairfax shares have soared to more than 400 Canadian dollars (US$377) a share from about C$100 four years ago.

The insurer has a solid track record anticipating bad economic times. In 2003, Fairfax bought credit derivatives wagering on weakness among lenders including Countrywide Financial, scoring several billion dollars of profits when the housing market cracked in 2007.

Lately, the company has been studying bouts of deflation suffered in the U.S. and, more recently, in Japan, and it is getting worried.

“People say they understand deflation, but they don’t understand how corrosive it is,” Mr. Rivett says.

The Fairfax team believes U.S. households have only begun reducing borrowing and increasing savings, a trend it expects will lead to less spending, higher unemployment and deflation.

Fairfax paid $174 million in upfront fees to protect $22 billion of its investment portfolio against the possibility of deflation over the next decade. In exchange, Fairfax will receive a payment amounting to the drop in CPI below 2%—the level of inflation when Fairfax bought its contracts—multiplied by the $22 billion.

If deflation averages 2% annually over the next 10 years, Fairfax’s contracts would rise in value the equivalent of 4% of $22 billion, or $880 million, each year over the next decade, according to traders familiar with Fairfax’s trades.

In that scenario, if Fairfax holds on to its investments during the 10-year period, it would reap nearly $9 billion from its $174 million investment.

The company wouldn’t get anything for its bet if inflation turns out to be higher than 2% over the next 10 years.
Fairfax wouldn’t comment on potential returns or how the trades were structured.

Some banks selling these derivatives say they are skeptical of deflation. Prices for the derivative insurance suggest a 20% chance of deflation over the next 10 years, traders say. The banks say they have hedged their exposure, or reduced their risk, by finding other investors skeptical of deflation to take the other side of the trades or by purchasing their own insurance.

But traders say there are no perfect hedges when selling these derivatives. Some could be on the hook in the event of steep deflation.

Write to Gregory Zuckerman at gregory.zuckerman@wsj.com

Mr. Pellegrini’s PSQR Capital has lost about 11% so far in 2010, according to a person close to the matter. The decline included a drop of about 8% in July, after bets against U.S. Treasurys and other moves went awry. The loss has made it more difficult for him to raise cash from investors.

Mr. Pellegrini’s fund gained more than 61% last year, and he had hopes of growing the firm, which he launched after leaving Paulson & Co. But investors have proved reluctant to place money with midsize hedge funds over the past year. The decision was reported by AR Magazine.

In a letter to his investors this morning, Mr. Pellegrini, who has been bearish on financial assets, the dollar and government bonds, said he could reopen his firm to outsiders in the future. For the time being, the firm will invest only his own money.

“While my views on global economies haven’t changed, I’ve concluded that substantial additional work is required to position the Fund to profit consistently from those views,” Mr. Pellegrini wrote.

Mr. Pellegrini, 53, has been buying industrial commodities over the past year. In his letter, he told his investors he would return their money by September 30.

The move by Mr. Pellegrini comes two days after billionaire investor Stanley Druckenmiller, who once ran George Soros’s hedge-fund firm, told clients he is ending his 30-year run managing money for clients, citing the “high emotional toll” of not performing up to his expectations.

A spokeswoman for Mr. Pellegrini declined to comment.

After joining Paulson & Co. in 2004, Mr. Pellegrini, a former banker and native of Italy, made little mark at the firm as a merger analyst. But soon he began to analyze the soaring housing market and quickly turned bearish. In 2006, Mr. Pellegrini provided Mr. Paulson with data that served as evidence that the housing market would likely collapse. He also helped Paulson & Co. find the riskiest subprime-mortgage securities to bet against, steps that led to the largest trading gain in history.

After leaving Paulson & Co. at the end of 2008 to start his own firm, Mr. Pellegrini led a relatively quiet life, splitting time between his firm’s offices in New York and Bermuda.

His relative anonymity ended in April when the Securities and Exchange Commission charged Goldman Sachs Group Inc. with civil fraud when the company failed to disclose that it worked in part with Paulson & Co. to design a $1 billion collateralized debt obligation. Paulson & Co. eventually made $1 billion of profits from the CDO. It was one of the series of deals that Mr. Pellegrini helped create so Paulson could expand its bearish housing wager.

During the SEC’s investigation of Goldman, Mr. Pellegrini answered questions posed by government officials, according to people close to the matter, telling them that he and Mr. Paulson did nothing wrong. Mr. Paulson and his team, including Mr. Pellegrini, never were charged.

Goldman recently settled the charges, paying the SEC $550 million.

Write to Gregory Zuckerman at gregory.zuckerman@wsj.com

Zuckerman’s book depicts the evolution of hedge fund megastar John Paulson’s massive payday resulting from his timely bet against sub-prime mortgages when housing prices appeared to have a one-way ticket to the moon . Zuckerman’s portrait of the colorful gallery of individuals who won and lost as a result of the housing meltdown makes the book a compelling read even for financial novices.

“The Greatest Trade Ever” has recently received renewed attention amidst the SEC’s allegations regarding Goldman Sachs role in Paulson’s trades. Who thought a book about the hedge fund industry could be a page- turner?

Space is limited, so reservations requested. Call 781-431-1160; events@wellesleybooksmith.com. The event will be downstairs at Wellesley Booksmith, 82 Central St.

John Paulson hasn’t been accused of any wrongdoing. But the hedge-fund billionaire has gone on the offensive to reassure investors that his huge firm will emerge unscathed from a case that has drawn him into a political and legal vortex.

The steps, including a conference call with about 100 investors late Monday, come amid indications from some clients that they might withdraw money from his firm after a lawsuit brought by the government against Goldman Sachs Group Inc. related to an investment created at his firm’s request.

Investors have indicated they are concerned that scrutiny over the firm’s deals may spread, including to overseas regulators. They said they wanted to protect themselves in case new information emerges that could damage the hedge fund, they say. Another issue, they say: The legal case could simply prove a distraction for Mr. Paulson.

“Some of the callers asked pointed questions, almost like a court inquisition, but most people were supportive,” said Brad Alford, who runs Alpha Capital Management. “I felt reassured that he did nothing wrong.”

“It’s not a rush for the doors,” said another investor in Paulson & Co. who has communicated with larger Paulson investors since Friday, when the government unveiled its Goldman case.

Mr. Paulson sent a letter to investors Tuesday night saying that in 2007 his firm wasn’t seen as an experienced mortgage investor, and that “many of the most sophisticated investors in the world” were “more than willing to bet against us.”

Mr. Paulson’s firm focuses on largely liquid investments, those relatively easy to sell without pushing prices much lower. Even if a number of investors ask out, the firm likely will be able to sell investments without crippling their holdings, investors say.

Some traders have been examining Mr. Paulson’s top holdings and positions in which filings indicate he has been a substantial holder since the news, they say. When the news of the lawsuit broke on Friday, some of these stocks, including Conseco Inc., Cheniere Energy Inc. and AngloGold Ashanti Ltd., fell sharply.

The case has delayed the initial public offering of a Canadian investment fund, Propel Multi-Strategy Fund, formed to give investors exposure to two funds advised by Paulson, according to people familiar with the offering. Propel didn’t respond to requests for comment.

On the Monday night conference call, some investors asked if Mr. Paulson or anyone at the firm had received a government notice of potential civil charges, called a Wells notice, according to people familiar with the call.

Mr. Paulson said no. Mr. Paulson said the case wasn’t a distraction that was affecting the firm’s investments, and that he was confident the public glare would abate.

On the conference call, Mr. Paulson calmly explained the trade with Goldman, which involved a “short” bet on mortgage bonds. He said that the very nature of the transaction required both a “long” and “short” investor, suggesting that investors knew that a bearish investor had bet against the deal.

Mr. Paulson suggested to clients that the large investors who purchased the Goldman deal and others relied on rating firms, and didn’t do enough of their homework, investors say.

The hedge-fund firm has a deadline next Friday for investors who want to withdraw money on June 30. Paulson allows most investors to pull out four times a year, but they need to give at least 60 days notice. Investors can cancel redemptions before the end of June.

Magnetar Capital LLC, another hedge-fund firm that, like Paulson, was heavily invested in collateralized debt obligations in 2007 also has been working to reassure investors that it believes its mortgage-linked investment strategy was sound and can withstand regulatory scrutiny.

Investors in Magnetar, which oversees some $7 billion in assets, also have a deadline next week to request June withdrawals of money. The Evanston, Ill.-based firm sent an 11-page letter to investors Monday saying that it didn’t control which individual assets went into CDO deals in which it invested.

It isn’t clear whether scrutiny of Magnetar will rattle its investors, who have known some details of the firm’s strategy for several years. An article this month in news outlet ProPublica was the latest to assert that Magnetar designed deals built to fail that caused cascading losses for investors on the other side of the trades. The hedge fund’s strategy was the subject of a Jan. 2008 Wall Street Journal article. Magnetar told investors this week that it based its mortgage-CDO strategy on statistical models, not a fundamental belief that the housing market would slide.

A Magnetar spokesman said, “Our communications with investors have been very positive and supportive.”

—

Stephen Grocer and Ben Dummett contributed to this article.

Paolo Pellegrini, a former top executive at hedge-fund Paulson & Co., told investigators at the Securities and Exchange Commission that he had informed ACA Management LLC that his firm was betting against the transaction at the center of a lawsuit the SEC brought against Goldman Sachs Group Inc. (GS), according to a person familiar with the matter.

The testimony, in late 2008, could undermine the government’s case against Goldman, which is accused of misleading ACA, the deal manager, about Paulson’s bearish position on the deal.

Pellegrini and the Paulson team worked with both Goldman Sachs and ACA to structure the deal.

(This story and related background material will be available on The Wall Street Journal Web site, WSJ.com.)

SEC spokesman John Nester said, “Our case is built on a thorough evidentiary record that includes testimony, documents, handwritten notes and emails that will be presented in court at the appropriate time.”

Details of Pellegrini’s testimony were reported earlier by CNBC.

The SEC in its complaint alleges that Goldman “misled ACA into believing” the Paulson firm “shared a long interest with CDO investors.” Goldman has denied wrongdoing and is fighting the charges.

ACA Management, an asset-management company set up under the umbrella of bond insurer ACA Financial Guaranty Corp., earned fees for overseeing investment portfolios of mortgage securities, corporate loans and other credit assets. Goldman engaged the firm when Paulson approached it looking for a way to extend its bearish bet on the housing market, the SEC complaint alleges. The CDO management business at ACA was headed by Laura Schwartz, a former Merrill Lynch investment banker who previously worked in divisions of the bank that originated securities backed by U.S. subprime loans and commercial mortgage debt.

Ms. Schwartz was a main point person in the discussions between ACA and Goldman and was at an early 2007 meeting with representatives of Paulson and Goldman, according to Goldman’s responses to the SEC’s “Wells” notice of possible civil charges, regarding the issue. After that meeting, Ms. Schwartz emailed a Goldman employee to ask for feedback on the meeting and said she wasn’t clear about how Paulson wanted “to participate in the space,” the Goldman papers said.

Ms. Schwartz, when reached on her cellphone, did not stay on the line. She no longer works for ACA. A representative for ACA Financial didn’t comment.

Last fall, when Goldman responded to the SEC’s Wells notice, the securities firm argued that whether ACA perceived Paulson to be the so-called “equity” investor in the CDO–and therefore having a “long” position–was “of no moment.” ACA, Goldman has argued, was supposed to be an independent expert on selecting mortgage assets.

Goldman argued in documents it submitted to the SEC that Ms. Schwartz, who was deeply involved in selecting the assets for the Abacus deal, should have known from previous ACA-managed deals that hedge funds could have both long and short positions in a CDO. Goldman cited an ACA-managed CDO that closed in late 2006 whose equity investor was a hedge fund called Magnetar Capital that also took short positions in the same deal. “Certainly, ACA could have questioned Paulson about its interests if the information was significant to it,” Goldman’s Wells response to the SEC said.

At ACA, Ms. Schwartz’s roles included reviewing and approving securities that would be part of investment pools the firm oversaw. In presentations to investors, she often talked about her extensive experience analyzing residential mortgage-backed securities and ACA’s expertise and ability to select mortgage securities, according to people familiar with the matter.

ACA Management managed CDOs put together by several Wall Street firms including Bear Stearns Co. and UBS AG (UBS), according to records reviewed by The Wall Street Journal. At the end of 2007, ACA Management was overseeing around $19 billion in CDOs, the bulk of them bundles of mortgage-backed or asset-backed securities. Of about 30 CDOs managed by ACA, more than half were issued during 2006 and 2007, according to the company’s financial statements.

NEW YORK — Gregory Zuckerman is a senior writer at The Wall Street Journal and author of The Greatest Trade Ever: The Behind-the-scenes Story of How John Paulson Defied Wall Street and Made Financial History.

Thanks to a huge and successful bet that the U.S. housing market would crumble, John Paulson’s firm, Paulson & Co., made $15-billion (U.S.) in 2007. He personally took home $4-billion (U.S.).

Here, Mr. Zuckerman speaks about the controversial 2007 deal that made Paulson & Co. $1-billion and prompted the Securities and Exchange Commission to file civil fraud charges against Goldman Sachs Group Inc. on Friday.

In your book, you describe some of the exact transactions that have now landed Goldman in hot water. How did you hear about them?

Covering the story at the Journal I heard rumblings and complaints for over a year. All kinds of competitors levelled accusations. There were investment bankers, at some of the top firms on the street, who criticized [Paulson] behind the scenes. So there was a lot of smoke – so I figured there must be some fire as well.

Many of the accusations were blatantly wrong. I got to the point where I was comfortable reporting what had happened. Then there’s the question: Was there something improper or not? I’m of the belief that it’s a really fascinating grey area. Especially for Paulson, one can level criticism and there may be some ethical issues, but it’s much harder to say it’s illegal.

You wrote that not every bank was willing to do these kind of deals. So why some and not others?

The ironic thing is that at Bear Stearns, of all places, a senior banker there turned Paulson & Co. down. They may have had some notion of how it might look on the front pages, which is what Goldman Sachs is seeing right now. Clearly, selling these deals to investors is a whole other level than what Paulson did, which was going to the banks and asking them to create this … paper.

You also have to remember what the period was like back then. This was late 2006, early 2007, when people still thought that John Paulson was tilting at windmills, that he was a merger-arb [specialist] who didn’t know that much about real estate. Now we look back and say, “How do you not warn investors that Paulson had a role in creating these things?” At the time, even if he told investors, I’m not sure how many of them would have run the other way.

Some reviewers have said you’re too nice to Mr. Paulson in the book.

I don’t see him as either as a hero or a villain. He’s a great character to me and I love great characters. I’ve been accused of lionizing John Paulson, but he has condemned the book and won’t speak with me … If some people think he was unethical I can understand that view. Other people think he did nothing wrong whatsoever. I’m open to that argument as well. I don’t think it’s my job to shove an opinion down the throat of my reader.

You can argue that he should have been satisfied in betting against billions of dollars of potentially dangerous mortgages and he shouldn’t have taken the step of going to various investment banks and asking that they create more products so he could short them. By the same token, he didn’t sell any of the stuff to investors.

Yes, more toxic mortgage assets were created because of John Paulson and his team, but someone had to be on the other side. These were big boys and sophisticated investors, and [Paulson] had no obligation whatsoever to tell them not to take the other side of this trade. Paulson was very, very focused on making a lot of money from what he saw as a coming collapse of the mortgage market. I don’t believe they saw [these deals] as improper.

Do you think more investigations connected to similar deals will be forthcoming?

You would think so, because this was one of many that John Paulson and his team entered into and that other hedge funds also worked on. I know there are lists of CDOs that [regulators] have been examining since late 2008, if not earlier, so they clearly have been digging into all this stuff. It could be this one was the worst.

In the book, you profile others who also bet against the housing market, including some little-known investors who made huge profits. What did these people, John Paulson included, have in common?

It’s just startling to me, and remarkable, that the experts who should have known better got it wrong and it’s these outsiders who made the most money: John Paulson, who was a merger-arb [specialist]; Paolo Pellegrini, who just a couple of years before doing this trade was living in a one-bedroom apartment with no money in the bank and no job; Michael Burry, a doctor-turned-investor, who knew stocks, but didn’t know anything about mortgages.

It took some outsiders to figure out that a historic collapse was coming. In some ways it gives all of us encouragement that maybe we know a little bit more, and have a little bit more of a perspective than perhaps those on Wall Street, the so-called experts.

A year ago, investors were dealing with heavy losses from the most brutal stock-market selloffs in years. The last thing they expected was a ferocious bull market. And yet, shares soon began to soar — climbing more than 50%.

Last year’s unexpected stock rebound — and the sudden selloff last week — should remind investors to be on the lookout for the next surprise. That’s because big profits come in being early to the next trend, and in preparing for the next downturn.

“If you don’t leave yourself open to surprises, when they occur you probably won’t respond correctly,” says Mike O’Rourke, chief market strategist at institutional trader BTIG LLC.

It’s a simple rule of thumb: Buy before the good news; sell before the bad. The tricky part comes, of course, from guessing where the news might break to begin with.

Here are some places to watch:

Energy Boost: Many analysts expect energy prices to keep climbing, as demand from China pushes oil prices higher.

But Mr. O’Rourke says crude prices could actually drop below $50 a barrel this year, helping to fuel an economic recovery. He argues that as China applies the brakes on its growth, and is no longer focused on filling its strategic petroleum reserve, prices could fall.

“Despite this record Chinese demand in 2009, crude has been unable to sustainably move above the levels achieved in the spring” of 2009, Mr. O’Rourke says. “If this demand wanes, it could have a real problem” for energy prices.

Meanwhile, more energy supply is on the way, which also could pressure prices. There have been major oil discoveries in recent years, including in the Gulf of Mexico and off the coast of Brazil. And the U.S. Geological Service said last month that Venezuela’s Orinoco Belt held far greater oil reserves than had been believed.

Heady Growth: Most economists predict subpar growth in the U.S. and around the globe in 2010. Consumers are dealing with too much debt, help from government spending will peter out, and businesses aren’t spending much.

But if the recovery conforms to historic patterns after major downturns, it could be surprisingly strong.

Some recent data have been encouraging, with manufacturing activity at its highest point since the summer of 2004. An index compiled by the Institute for Supply Management rose to 58.4 in January from less than 55 in December. A reading above 50 indicates expansion. A recent survey showed banks have stopped making it tougher for consumers and businesses to borrow, another hopeful sign.

“The more I look at the data, the more this looks like a typical recovery,” says Norbert J. Ore, chairman of the ISM survey committee.

Robust growth may have to await a rebound in employment. But the improving data are a reminder that the economy just might surprise with its strength.

Japanese Jitters: Investors are concerned about the debt piled up by countries including Spain and Portugal. Some worry that the European Union or others might have to step in to help Greece deal with its debt.

Not as many investors are focused on Japan, though perhaps they should be. Japanese government debt as a percentage of gross domestic product is around 220%, up from 120% in 1998, according to the International Monetary Fund. (In contrast, federal debt is around 85% of the U.S.’s GDP.) Demand has long been strong for Japanese debt, and 10-year bonds yield well below 2%, partly because most of it is held by loyal Japanese citizens. Some observers have been warning about Japan for a decade. The country’s debt markets have been steady, but there are indications that domestic buying is slowing.

Any troubles for that market would be more worrisome than woes in some other countries, given the size of Japan’s bond market — about $7.5 trillion — and the role Japan plays globally.

Another potential worry: the U.K., which has its own debt issues, as well as an economy dominated by the still-troubled financial sector.

Municipal Mess: Municipal bonds have long attracted conservative investors. That might change as the poor health of various states and municipalities comes under scrutiny.

Short-term bonds issued by the state of California yield less than 2%, for example, due to strong demand. But the state is facing a budget deficit of almost $21 billion. As interest expenses rise, they represent a larger chunk of the state’s revenue, a worrisome shift. If investors begin to worry about the health of various municipalities, they could push prices lower for various bonds.

Growing Greenback: There are reasons to expect a dollar rebound. Worries about the debt of European nations took hold last week, pulling down the euro and sending skittish investors back to the U.S. dollar. Gold and commodities fell, too.

If U.S. growth proves stronger than expected, the Federal Reserve could signal an interest-rate increase, which also would help the dollar and weigh on shares of gold miners and other commodity producers.

Health-Care Recovers: Health-care stocks were haunted by the specter of President Obama’s overhaul plans, though the shares have generally held up. In recent days, they’ve been hit by downbeat earnings — such as last week’s quarterly results from Pfizer, which helped send the drug maker’s share price down 5% over two days.

But some of these shares could see healthy gains. Merck, for example, trades at price/earnings multiples that are below the overall market, yet sports a hefty dividend yield of nearly 4%. If the stock market turns rocky (and it certainly did last week), those dividends will look more attractive.

Health-care companies may have an easier time raising prices if the government can’t settle on an overhaul plan, some analysts say.

Write to Gregory Zuckerman at gregory.zuckerman@wsj.com