Money Matters with Rose Greene » economy

LPL Financial Weekly Market Commentary for January 31, 2012

Rose Greene, CFP — Tue, 31 Jan 2012 19:41:22 +0000

January May Seem “Super,” but Don’t Be Bowled Over

Jeffrey Kleintop, CFA
Chief Market Strategist
LPL Financial

Highlights
The upcoming Super Bowl will test the stock market’s historical correlations with the calendar and events that proved rewarding to investors in 2011.
Investors’ New Year’s resolution may have been to buy stocks after five years of selling nearly every month. However, we are afraid this may turn out to be like most resolutions and fade come February.
We expect volatility to return and the stock market to shed some recent gains. But we adhere to our outlook for 8 – 12%* gains for the year for stocks.
* LPL Financial Research provided this range based on our earnings per share growth estimate for 2012, and a modest expansion in the price-to-earnings ratio.

Last week, the Dow Jones Industrial Average (DJIA) hit a new three-and-a-half-year intraday high [Chart 1]. Earnings, gross domestic product (GDP), and consumer spending are already back to new highs, so seeing the stock market return to pre-financial crisis levels seems reasonable.

January’s gain sets a positive tone for the year. When January was positive for the S&P 500, the year as a whole ended with a gain 90% of the time since WWII. This historical relationship is called the “January effect.” Last year, each of these time-worn axioms based on the calendar actually worked for investors. For example:

“Sell in May and go away,” which suggests investors sell and avoid the summer months, worked with stocks peaking for the year on April 29.
October, the “bear killer” month when stock market downturns famously end and reverse in the month of October, ended the 19% peak-to-trough stock market decline with stocks bottoming for the year on October 3.
A “Santa Claus rally” in December produced gains in the week between Christmas and New Year’s.

Although not based on the calendar, and more than a little bit tongue-in-cheek, another classic stock market indicator worth mentioning this week is the “Super Bowl indicator.” Last year, both teams were original NFL teams and the DJIA posted a modest gain for the year. The Super Bowl indicator shows that the DJIA goes up for the year as a whole when the winner comes from the original NFL (NFC team or an AFC team from the pre- 1970-merger NFL — like the Steelers or Colts). But when an original AFL or expansion team wins, the DJIA falls. Going into the 1998 Super Bowl when the underdog Denver Broncos defeated the Green Bay Packers, the Super Bowl indicator had been correct in 28 of 31 years.

However, since 1998, the Super Bowl indicator has had a poor record; it has only been correct about 50% of the time over the past 13 years. The most notable failure was the New York Giants’ upset win in 2008 over the New England Patriots, which was supposed to bring about a bull run for stocks — instead the Dow plunged that year as the financial crisis took hold. This year’s rematch of the 2008 contest will be on Sunday, February 5. While a win for the Giants would suggest gains for stocks in 2012, using longer-term history as a guide, it is unlikely that this event holds any significance for the stock market. In fact, make that highly unlikely.

Individual investor buying is more likely to empower a rally than historical correlations with the calendar or a sporting event. Investors’ New Year’s resolution may have been to buy stocks. Individual investors appear to be beginning to “put a toe back in” to the stock market after five years of selling stocks nearly every month. Data on mutual fund cash flows for the month of January suggests that investors are finally once again buying U.S. stock mutual funds — or have at least temporarily stopped selling them [Chart 2]. However, we are afraid this may turn out to be like most resolutions and fade come February.

We expect volatility to return and the stock market to shed some recent gains. But we adhere to our outlook for 8 – 12% gains for the year for stocks driven by 7% earnings growth and a slight improvement in valuations. In the near term, the recent four weeks of back-to-back gains may give way to a modest pullback, but we expect several factors to mitigate the extent of the slide including upcoming rate cuts in China, solid manufacturing and employment data in the United States, and further steps toward stability in Europe.

IMPORTANT DISCLOSURES

LPL Financial Weekly Market Commentary for January 25, 2012

Rose Greene, CFP — Wed, 25 Jan 2012 21:28:29 +0000

State of the Union Preview

Jeffrey Kleintop, CFA
Chief Market Strategist
LPL Financial

Highlights
President Obama’s State of the Union (SOTU), scheduled for Tuesday, January 24, is unlikely to be a big market mover.
In fact, most SOTU speeches see less than a 1% move in the stock market on the following day.
However, the themes and philosophy presented may shape the market’s movements in the months to come with implications for Financial and Industrial companies and oil prices.

President Obama’s State of the Union (SOTU), scheduled for Tuesday, January 24, is unlikely to be a big market mover. In fact, most SOTU speeches see less than a 1% move in the stock market on the following day and the average move is only 0.14% [Chart 1]. However, the themes and philosophy presented may shape the market’s movements in the months to come.

Rather than break new ground, the SOTU address is likely to echo the President’s December 6 speech in Osawatomie, Kansas. That speech was modeled after President Theodore Roosevelt’s 1910 historic address in that city on economic and social equality that led into 20th century progressivism, the central philosophy of Obama’s presidency.

The many topics of the speech — and their market impacts — can be broken down in terms of what will happen, what will not happen, and what could happen in 2012.

What Will Happen

In the SOTU address, Obama is very likely to highlight the immediate need for Congress to come together to extend the payroll tax cut and unemployment insurance benefits through 2012. In December 2011, a bitterly divided Congress could not come together on how to pay for a year-long extension and so only extended them for two months. We expect Congress to further extend these stimulus measures before they expire at the end of February, but the hostile negotiations — something the markets have had a break from in recent weeks — are likely to garner attention and help to renew market volatility after a remarkably stable advance in the first few weeks of the year.

Regulatory policy, an area where the executive branch is less dependent upon Congress’ leadership, will be a key part of the speech. The President is likely to highlight revamped housing programs, such as the Home Affordable Refinance Program (HARP), and announce a settlement that would end long running negotiations among Obama administration officials, state attorneys general and at least five of the nation’s largest financial services companies over “robo-signing” and questionable foreclosure practices. The settlement could be good news for Financials, one of the top performing sectors this year.

What Will Not Happen

The President is likely to call for increased infrastructure investment in the U.S. economy, including school construction, roads and bridges, and high-speed rails. Congress is unlikely to appropriate the funding to meet the President’s call on these items. Companies in the Industrial sector have performed well so far this year, but do not appear to be pricing in increased domestic infrastructure spending.

Job growth is key to the President’s re-election chances. As you can see in Chart 2, inflation-adjusted, after-tax income growth of about 3% appears to be the threshold for incumbents to get 50% of the popular vote. Currently, this measure of per capita income is only growing at 0.1%.

While factors other than jobs have a bearing on the election, job creation may be the key measure by which Obama’s presidency will be judged. However, much like infrastructure initiatives, measures to stimulate job growth presented in the SOTU are unlikely to be funded.

The President will likely address eliminating the so-called Bush tax cuts for higher earners, especially those making $1 million or more a year. In addition, given the recent attention to Mitt Romney’s tax filings, the President may call for applying income taxes to carried interest. With the President due to release his budget on February 6, he may also address overseas corporate tax breaks. However, with the House in Republican hands, none of these tax proposals will pass this year.

What Could Happen

This SOTU may foreshadow the President tilting his focus away from domestic politics to foreign affairs over the course of 2012. In doing so, he is shifting from the area where the President is institutionally weak (domestic policies) to the place where the President is institutionally strong (foreign policy). A Congress divided into two houses, a Supreme Court, and the states limit the President dramatically in domestic politics. However, the Constitution and American tradition give the President tremendous power in foreign policy. The President will surely highlight the U.S. withdrawal from Iraq and the winding down of the war in Afghanistan. Another foreign policy matter that may move the oil markets will be his discussion about Iran and the potential impact of U.S., Japanese, and European sanctions on Iranian oil.

Obama’s re-election strategy may be one of opposition to Congress. Essentially, this was Bill Clinton’s strategy in 1996 with a Republican Congress and it worked. Going into opposition against Congress could energize the President’s base, but that base is in the low to mid-40s. By itself, this may not be enough. Instead, over the next 10 months, Obama’s strategy may be to shift from the domestic aspects of the presidency where he is weaker to the stronger part, foreign policy, where a president can generally act decisively without congressional backing.

The critical issue for post-Iraq war foreign policy may be the U.S. relationship with Iran. An often rumored “October” surprise is the idea of attacking Iran’s nuclear facilities. But a precise strike can be messy since it carries the risk of Iranian retaliation in the Strait of Hormuz through which a meaningful percentage of the world’s oil travels. An approach with less chance for global economic disruption is a generalized air campaign against both Iran’s nuclear and military sites. But, in our view, starting a war is a huge risk. Setting aside all other considerations, from a political point of view, it would alienate Obama’s political base, many of whom supported him because he would not undertake the unilateral military moves of his predecessor. This is not intended to imply President Obama would consider starting a war for political ends, but merely to show that even if it were a consideration it is unlikely to be a successful strategy.

However, there is another foreign policy option, one that would appeal both to Obama’s political philosophy and to his political situation: pulling a Nixon. In February 1972, the last year of his first term as he ran for re-election, President Richard Nixon visited China in a grand diplomatic gesture even while Chinese weapons were being used to kill American soldiers in Vietnam. In another interesting parallel that rings with echoes of the themes of Obama’s SOTU address, President Theodore Roosevelt did the same thing with the Soviets in 1941. A diplomatic engagement with Iran would seem to appeal to the President and his political base and rejuvenate some of the energy around a theme that helped him win the election in 2008.

We will be listening to the SOTU for clues as to the President’s foreign policy initiatives. If the President were to pursue this foreign policy choice, it may have the effect of sharply lowering oil prices — and help to stimulate the U.S. economy — as geopolitical risk fades and added supply returns with the potential for a lift of the long-running embargo that has blocked critical parts and equipment needed to ramp up Iranian oil output. While a gesture by no means guarantees a resolution, the markets may welcome news of a potential arrangement with Iran.

LPL Financial Weekly Market Commentary for January 18, 2012

Rose Greene, CFP — Wed, 18 Jan 2012 22:05:20 +0000

European Upgrade

Jeffrey Kleintop, CFA
Chief Market Strategist
LPL Financial

Highlights
S&P’s downgrade overshadowed meaningful developments over the past two weeks in Europe which we would call an upgrade in dealing with the debt problems.
The events of the past week show that the rating change at S&P, while warranted, is a lagging indicator of a situation that has been something less than AA-rated for a long time, but has been improving in recent months with more progress made in the past two weeks.
While we have become more positive about the path Europe is taking, these efforts virtually assure a mild recession for Europe in 2012, and reinforce our belief that better investment opportunities lie in the United States and Emerging Markets.

On Friday, Standard & Poor’s Ratings Services, one of the three major U.S. ratings agencies, downgraded France and Austria from AAA to AA+ and downgraded seven others (Malta, Slovakia and Slovenia by one notch and Italy, Spain, Portugal and Cyprus by two notches). The downgrades contributed to the second down day for the S&P 500 Index in 2012. However, the S&P downgrades are likely to have a limited impact for a number of reasons:

The warning on December 5 by S&P that a downgrade of European countries was coming helped to keep it from being a surprise.
The downgrade is a lagging indicator of credit risk in Europe the markets had already priced in. For example, AAA-rated France and Austria had 10- year yields that were over 100 basis points higher than AAA-rated Germany.
Not all downgrades are created equal when it comes to their market impact. The downgrade of the United States was a major blow to confidence in a political environment of inaction. Not true in Europe where confidence has been affected by its fiscal situation for some time, and now new governments are taking substantive actions to address it.
France continues to hold AAA ratings from Fitch Ratings and Moody’s Investors Service.
The headline impact of the downgrade of France may weigh on French Republic President Nicholas Sarkozy’s bid for reelection in April. He is already trailing the Socialist party candidate, Francois Hollande. The uncertain impact of a major shift in France’s leadership during this critical transition for the eurozone may weigh on the markets, but this is not new news for the markets since Sarkozy has been trailing in the polls for some time now.
While largely priced in, there was some risk to the stock market that the European Financial Stability Facility (EFSF) would be downgraded due to the downgrade of some of the six EFSF guarantor members currently rated AAA (Germany, France, the Netherlands, Finland, Austria and Luxembourg) before steps toward greater fiscal integration occur.

The last point may warrant further explanation. The leaders of the eurozone decided this past fall to leverage the available resources of the EFSF in part by using it to provide insurance for bond investors. The idea is that the EFSF will take on the first losses, up to a maximum, that investors would face in the event of a sovereign default. The insurance would apply to newly issued debt sufficient to cover debt newly issued by many troubled European nations over the next few years. A downgrade does not change the overall amount of guarantees provided or the amount of debt issuance covered; but it does suggest a change in the risk profile of these guarantees and a smaller recovery value. Consequently, the yield markets demand may be higher to reflect the higher credit risk of the guarantees. However, the markets are way ahead of the rating agencies on this, and these impacts have already been felt for some time.

S&P’s downgrade overshadowed meaningful developments over the past two weeks in Europe, which we would call an upgrade to the efforts to deal with the debt problems.

Last week’s meeting between Italian Prime Minister Mario Monti and German Chancellor Angela Merkel was significant. In exchange for Monti’s passing recent austerity measures, Merkel agreed to an early implementation of the bailout fund known as the ESM (European Stabilization Mechanism), successor to the existing and temporary EFSF, which had been planned to go into effect in July of this year. The key to getting it up and running is German funding, which seems to have been secured this week.
A second draft of the Merkel-Sarkozy designed “fiscal compact” was presented on Friday, January 6. This agreement on tighter fiscal integration, to be signed no later than March 25, 2012, will establish a credible and enforceable budget discipline across the eurozone in an effort
to avoid future debt problems. The second draft of the original German/ French-crafted agreement defines key provisions such as what constitutes a “balanced budget” (a deficit of less than 0.5% of GDP), a target of 60% debt-to-GDP ratio (and a pathway to get there of as slow as one-twentieth per year), and allows for an appeals process for those member countries found in violation of the treaty.
Recent bond auctions in Europe have gone well. Italy auctioned bills and bonds this week at much lower yields than just a month ago. Spain and Germany also had solid auctions last week and received more bids than the amounts they targeted in their debt sales. This is encouraging since Italy alone needs to issue 220 billion euros of bonds this year.

The events of the past week show that the rating change at S&P, while warranted, is a lagging indicator of a situation that has been something less than AAA-rated for a long time, but has been improving in recent months with more progress made in the past two weeks. With little move in the stock or bond market on the news of the downgrades, it is clear that markets had already made the credit adjustment and are now recognizing improvement. The irony is that the downgrade comes just as the debt situation in Europe is now getting better — not worse.

S&P has assigned more than a dozen European countries a negative outlook, indicating at least a one-in-three chance of a further downgrade in the next two years. The key will be for the eurozone to continue to respond with actions. European leaders are set to meet at a summit on January 30 to discuss how to boost growth and jobs, and Merkel’s words on Saturday suggest she will also be looking for faster progress on tighter common fiscal rules.

While we have become more positive about the path Europe is taking, these efforts virtually assure a mild recession for Europe in 2012, and reinforce our belief that better investment opportunities lie in the United States and Emerging Markets.

To download a complete copy of the commentary click here

IMPORTANT DISCLOSURES
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
International and emerging markets investing involves special risks, such as currency fluctuation and political instability, and may not be suitable for all investors.
An obligation rated ‘AAA’ has the highest rating assigned by Standard & Poor’s. The obligor’s capacity to meet its financial commitment on the obligation is extremely strong.
An obligation rated ‘AA’ differs from the highest-rated obligations only to a small degree. The obligor’s capacity to meet its financial commitment on the obligation is very strong.

LPL Financial Weekly Market Commentary for January 12, 2012

Rose Greene, CFP — Wed, 11 Jan 2012 22:27:39 +0000

What Investors Should be Watching This Earnings Season

Jeffrey Kleintop, CFA
Chief Market Strategist
LPL Financial

Highlights
This week is the start of the fourth quarter 2011 earnings reporting season with big, well-known companies like Alcoa and JPMorgan Chase due to report fourth quarter results.
This is the first quarter in over two years that S&P 500 profit growth is not expected to be in the double-digits.
During this earnings season we are paying special attention to revenues and how companies are putting cash to work either by spending or by returning it to shareholders

U.S. stocks rose last week by 1.7%, as measured by the S&P 500 Index, getting 2012 off to a solid start. A combination of solid and better-than-expected economic data, a quiet week in Europe, and few negative earnings pre-announcements drove the rebound.

While macroeconomic factors are likely to remain key drivers of the market this week, microeconomics will also garner investors’ attention as companies begin to release their fourth quarter earnings reports. Four times a year investors focus on the most fundamental driver of investment performance: earnings. While only five S&P 500 companies report fourth quarter results this week, bringing the total to 31, this week is the start of earnings season with big, well-known companies like Alcoa and JPMorgan Chase due to report fourth quarter results.

The consensus of analysts tracked by Thomson Financial expects operating earnings growth of 8% in the fourth quarter of 2011(compared to the fourth quarter of 2010), as profits end the year at new all-time highs. This is the first quarter in over two years profit growth is not expected to be in the double-digits. If the profits of S&P 500 companies match expectations in the fourth quarter, they will have grown about 10% for 2011, in line with our forecast established a year ago.

In 2012, we expect a slower pace of profit growth of about 7%, modestly below the analyst consensus of 10%. In contrast, market participants have priced no growth in profits into stock market valuations with price-to-earnings ratios at levels not seen since the recession of 1990-91, when earnings fell 20%. We believe earnings expectations will continue to be revised modestly lower and market participants are starting to price in a less dire outlook for profits as results are reported and corporate leaders provide guidance on coming quarters.

In recent weeks, stocks have been rising even as fourth quarter earnings estimates have been falling. Of the 129 companies that pre-announced fourth quarter earnings guidance in recent weeks, the ratio of negative-to-positive news was 3.3, worse than the average ratio of 2.3 since 1995, and the worst ratio since the 3.4 in the fourth quarter of 2008, during the peak of the financial crisis.

The fourth quarter earnings season runs about four to six weeks starting around two weeks after the close of the quarter. During this earnings season we are paying special attention to revenues and how companies are putting cash to work either by spending or by returning it to shareholders.

Revenues and Emerging Markets Drivers – Revenue growth is driven by global economic activity and is expected by analysts to be around 6%. With profit margins near peaks, profits will more closely track revenues in coming quarters. Economic growth is likely to be below average in the United States over the next year, and Europe is on the edge of recession. About 46% of S&P 500 profits come from foreign markets with just under a third of foreign profits derived from Europe. Fortunately, a meaningful and growing portion of profits come from rapidly growing emerging markets. We will be closely watching the impact of the rapidly changing regional composition of revenue and profits in the S&P 500. It is worth noting that in 2012, emerging market countries will for the first time make up more of global GDP (gross domestic product) than developed markets, according to data from the IMF (International Monetary Fund).
How Businesses Are Returning Cash to Shareholders – The first quarter is when companies most often increase or initiate a dividend. While first quarter bank stress tests need to be completed before the traditionally high-yielding Financials sector can be expected to boost payouts, pressure is building for other companies to increase their dividends as U.S. companies sit on record cash stockpiles and payouts remain at all-time lows. S&P 500 companies paid out about 25% of earnings in the form of dividends over the past year, down from 30% for much of the 2000s and below the 30-year average of 40%. Company cash and equivalents have soared to record highs even as companies have paid down debt in a dramatic deleveraging over the past few years. A return to higher dividend payouts would help attract investors seeking income in an environment of very low bond yields. The S&P 500’s dividend yield stands at 2.1%, above the yield on the 10-year Treasury for one of the few times in history. Announcing share repurchases
is another way corporate leaders may put cash to work.
How Businesses Are Spending – While investor attention is often directed on consumer spending as a driver of profits, we will be watching business-spending-driven industries more closely. Business spending and commodity prices are major drivers of S&P 500 profit growth while discretionary consumer spending has a much smaller contribution to the S&P 500. During the fourth quarter, commodity prices generally rose and manufacturing rebounded from the summer weakness, according to the ISM Index (Institute for Supply Management Purchasing Managers Index), supporting modest profit growth for S&P 500 companies [Chart 1] We will be watching to see how effectively this translated into profits for the Information Technology, Industrial, Energy, and Materials companies for clues as to how rapidly their profit growth may slow in 2012.

For S&P 500 companies that have reported fourth quarter earnings so far, 14 of 26 (54%) have exceeded estimates, while 12 have missed estimates. Importantly, the companies that report early in the season are most often not the bellwethers they are commonly thought to be. We may not really know how overall corporate results for the fourth quarter of 2011 are shaping up until early February 2012, when about half of the S&P 500 companies will have reported.

To download a complete copy of the commentary click here

IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
The P/E ratio (price-to-earnings ratio) is a measure of the price paid for a share relative to the annual net income or profit earned by the firm per share. It is a financial ratio used for valuation: a higher P/E ratio means that investors are paying more for each unit of net income, so the stock is more expensive compared to one with lower P/E ratio.
International and emerging markets investing involves special risks, such as currency fluctuation and political instability, and may not be suitable for all investors.
Information Technology: Companies include those that primarily develop software in various fields such as the Internet, applications, systems and/or database management and companies that provide information technology consulting and services; technology hardware & Equipment, including manufacturers and distributors of communications equipment, computers and peripherals, electronic equipment and related instruments, and semiconductor equipment and products.
Materials Sector: Companies that are engaged in a wide range of commodity-related manufacturing. Included in this sector are companies that manufacture chemicals, construction materials, glass, paper, forest products and related packaging products, metals, minerals and mining companies, including producers of steel.
Energy Sector: Companies whose businesses are dominated by either of the following activities: The construction or provision of oil rigs, drilling equipment and other energy-related service and equipment, including seismic data collection. The exploration, production, marketing, refining and/or transportation of oil and gas products, coal and consumable fuels.
Industrials Sector: Companies whose businesses manufacture and distribute capital goods, including aerospace and defense, construction, engineering and building products, electrical equipment and industrial machinery. Provide commercial services and supplies, including printing, employment, environmental and office services. Provide transportation services, including airlines, couriers, marine, road and rail, and transportation infrastructure.

LPL Financial Weekly Market Commentary for November 22, 2011

Rose Greene, CFP — Tue, 22 Nov 2011 22:56:19 +0000

Super Committee: Go Big or Go Home?

Jeffrey Kleintop, CFA
Chief Market Strategist
LPL Financial

Highlights
Even with no agreement from the super committee, an end-of-year deal may still take place that may pair a smaller deficit reduction package of a few hundred billion dollars with the extension of the expiring payroll tax cut and federal unemployment benefits.
With no debt ceiling, default or downgrade threat, the market impact of this week’s public unveiling of the super committee’s recommendations is likely to be muted relative to the debt ceiling debacle of late July and early August.
Congress’ record-low 9% approval rating reflects the low bar of expectations for the super committee. The market expects the default cuts of $1.2 trillion will do the bulk of generating the required savings.

With the congressional super committee’s deadline on finding $1.5 trillion in deficit reduction this week, the markets want to know if they will go big or just go home for the Thanksgiving recess.

The debt ceiling debacle that came to a head in early August 2011 left a lasting impression on the stock market. The S&P 500 index plunged 17% from July 22 to August 9, in part driven by Washington’s inept handling of the increase of the country’s debt limit and the subsequent downgrade of the U.S. credit rating by Standard and Poor’s on August 5.

Fortunately, this week’s public unveiling of the proposals from the super committee tasked with finding the required $1.5 trillion in deficit reduction over 10 years is unlikely to spark the same violently negative market reaction. There are two key reasons the market reaction is likely to be much more muted:

First, there is no debt ceiling or potential default looming this time. This is because the budget act put in place in August 2011 triggers automatic cuts — also called sequester — totaling $1.2 trillion over nine years beginning in 2013, in the event the super committee fails to come up with $1.5 trillion in proscribed savings. This pushes the time frame when the United States will again bump up against the debt ceiling to early 2013 — after the next election.
Second, we are unlikely to see a debt downgrade of the United States this time. In recent months it has become clear through public comments that the major rating agencies are unlikely to downgrade the U.S. credit rating on a failure of the super committee to agree on the deficit reduction as long as they do not remove the sequester that invokes the automatic $1.2 trillion in cuts and do not circumvent the size of the cuts through budget accounting gimmicks. The next credit event is likely not until 2013, under a new Congress. Fitch may move the U.S. credit outlook to negative implying a bias to downgrade and both S&P and Moody’s have said a downgrade is likely absent a major fiscal consolidation package in 2013.

With no agreement, $1.2 trillion in deficit savings will result from the automatic discretionary spending cuts through program spending caps known as sequestration. However, it is unlikely that the cuts triggered by the automatic sequester will actually take place come 2013. This is because there is likely to be a major deficit reduction package in 2013 under a new GOP-dominated Congress following the 2012 elections. This plan will significantly alter the pro-rata allocation of cuts across discretionary spending programs that would take place under the automatic sequester. This base case results in an outcome for the markets that is muted — especially relative to this summer’s reaction.

Congress’ 9% approval rating [Chart 1] highlights the low expectations for the super committee to bridge the partisan divide and craft a ground-breaking deal that addresses the nation’s debt that crossed the $15 trillion threshold last week. However, the failure to come to an agreement does not mean that Congress goes home with no plan to take any fiscal action this year. An end-of-year deal may still take place that may pair a smaller deficit reduction package of a few hundred billion dollars with the extension of the expiring payroll tax cut and federal unemployment benefits.

To download a complete copy of the report click here

LPL Financial Weekly Market Commentary for October 25, 2011

Rose Greene, CFP — Tue, 25 Oct 2011 21:54:19 +0000

The Greek Haircut

Jeffrey Kleintop, CFA
Chief Market Strategist
LPL Financial

Highlights
Despite all the headlines, yields for Italy, Spain, Portugal and Ireland’s sovereign debt are at or below where they were in mid- July when the second rescue package for Greece was drafted.
While the second Greek rescue stemmed the decline in the sovereign bond market, as intended, stocks have plunged since then as investors increasingly priced in a greater “haircut” the banks may have to take on their Greek bond holdings.
The stock market’s rise, despite no resolution on the terms of the comprehensive rescue package, appears tied in part to the increased clarity around limiting the amount of the haircut, lowering the odds of further bank failures and a 2008-style financial crisis.

The euro was born in January 1999, which means the European common currency will turn 13 in January. When I was 13, I never wanted my hair cut as short as my mother did. So we would negotiate — sometimes right down to the final snip in the barber chair. Neither of us was happy, but we could both live with the outcome. This appears to be the key issue for the stock market as it reacts to the amount of the “haircut” in the ongoing Greek debt negotiations.

The S&P 500 Index gained for a third consecutive week, marking the first time that has happened since February. Last week once again featured solid and better-than-expected economic data and earnings reports and no breakthroughs on European debt problems — although discussions seemed to progress on the amount of the Greek bond “haircut”. The S&P 500 Index closed the week at 1238, basically flat for the year, and up 13% from the low of October 3.

Another European summit is set for this week, as European policymakers move toward finalizing the details of the grand plan to deal with the debt problems that were promised by the leaders of Germany and France for early November. The fact that the various factions could not reach an agreement on the exact elements of the plan this weekend is obviously a negative. Yet, the policymakers would not have scheduled a second summit if they did not have the urgency and the political will to come to an agreement very soon, which could be viewed as an offsetting positive. In addition, there is the possibility that there could be support from international sources, such as the International Monetary Fund (IMF) or China. The IMF has about $650 billion in uncommitted resources that could be directed towards bolstering the rescue plan.

The sticking point in the deliberations seems to be Germany’s insistence that the rescue fund (The European Financial Stability Facility, or EFSF) be denied the ability to borrow potentially limitless sums from the European Central Bank, as France has favored. The final plan to contain the problem is likely to have two key components:

First, the EFSF will be used to guarantee investors against principal losses on government bond sales or to set up an EFSF-insured fund that would allow for private investors to participate. The resources of the EFSF will offer insurance on new government debt issues by Italy and Spain likely covering the first 20 – 30% of any principal losses in a default or restructuring. This guarantee could cover all the sovereign debt issuance of Italy and Spain for the next several years as they regain the market’s confidence in their fiscal health, while still providing assistance to Greece, Portugal and Ireland.
Second, a program for bank recapitalization to fill a shortfall resulting from the “haircut” taken by the banks on holdings of Greek debt. The bank capital needs are dependent upon additional debt relief for Greece in the form of a deeper, voluntary haircut on government debt. To meet the requirement that a debt exchange be voluntary and avoid a technical default that would trigger other problems, the haircut will likely be limited to the 40-50% range, rather than the 60%-plus demanded by Germany earlier this month. The bank recapitalization would be met first by banks themselves then by national governments and then possibly some ECB or IMF contributions.

This haircut issue is a major one for the stock market. The draft agreement on a second rescue package for Greece (to cover 2012 and 2013 funding) took place on July 21, 2011. It was a big event in terms of halting the contagion. So big, in fact, that it stabilized yields for other European countries: Spain, Italy, Ireland and Portugal [Chart 1]. Despite all the headlines, yields for these countries’ sovereign debt are at or below where they were in mid-July. However, while that massive policy action stemmed the decline in the sovereign bond market as intended, as you can see in Chart 1, stocks plunged following that day [Chart 2].

The stock market slide that began after the second bailout deal for Greece on July 21 may have been driven by the unrelated debt ceiling debacle in late July and the first few days of August and the ensuing downgrade of U.S. sovereign debt by S&P in early August. But, following these events, a key contributor to the stock market decline may have been the actual terms of the bailout deal. There were over a dozen points to the bailout agreement. One of these was that banks and other private bondholders would voluntarily agree to contribute to the rescue package for Greece in the form of debt exchanges targeting losses of 21% in a one-off, voluntary haircut.

Investors have been pricing in the risk that banks will ultimately be faced with a greater haircut. These rising bank losses have kept the European banks pulling the stock market lower and raising fears of more bank failures and a 2008-style financial crisis erupting in Europe.

On October 3, German officials suggested the haircut may have to be increased — from 21% possibly to as much as 60% — in light of a new funding shortfall and changed market conditions. As these statements were made stocks broke through the early August 2011 low and marked the low point of the year as the market feared bigger and bigger haircuts and the application of those haircuts to the debt of every entity receiving aid from the EFSF.

The stock market’s rise last week, despite no resolution on the terms of the comprehensive rescue package in Europe, appears to be tied in part to the increased clarity around the amount of the haircut banks will be forced to “voluntarily” take being more limited than what Germany was pushing for. This is viewed by markets as reducing the odds of additional bank failures and a 2008-style financial crisis. Ultimately, it may be that finding the haircut that all parties, including the European Central Bank, Germany, France and others, could agree to — if not be happy about — may be the key to restoring confidence.

To download a complete copy of the commentary click here

IMPORTANT DISCLOSURES
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise and bonds are subject to availability and change in price.
Government bonds and Treasury Bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of a fund shares is not guaranteed and will fluctuate.
The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
The International Monetary Fund (IMF) is an organization of 187 countries, working to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty around the world.
International and emerging markets investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.

LPL Financial Weekely Market Commentary for October 18, 2011

Rose Greene, CFP — Tue, 18 Oct 2011 23:27:55 +0000

A More Durable Rally

Jeffrey Kleintop, CFA
Chief Market Strategist
LPL Financial

Highlights
There are several reasons why this stock market rally may be more durable than those that preceded it in recent months.
It is possible that the substantial developments in Europe are taking the fear of a repeat of the financial crisis of 2008 off the table and solid economic data in the United States is taking the fear of a double-dip recession off the table.
Other signs that this rally may be more durable include: global cyclical sector leadership, declining European “TED spread”, and the rising yield on the 10-year Treasury note.

The stock market, as measured by the S&P 500 Index, has returned to the high-end of the trading range of the past two months, as you can see in Chart 1. This is the fourth time the Index has rebounded to around the 1220 level. Each of the prior three rebounds were reversed as the market was pulled lower again by fears of financial crisis and recession. Rather than retreat back to the low end of the trading range over the next week or two, there are several reasons why this rally may be more durable than those that preceded it in recent months and may sustain much of the of the gains, as the S&P 500 Index takes a volatile path back toward a modest, single-digit gain for the year.

The substantial positive policy developments in Europe are taking the fear of a repeat of the financial crisis of 2008 off the table. In addition, solid economic data in the United States are taking the fear of a double-dip recession off the table. These positive developments may allow the stock market to breakout of the range to the upside, given support from still very low valuations.

Other signs that this rally may be more durable that those that preceded it over the past couple of months include:

Global cyclical sector leadership-The global economically sensitive

Energy and Materials sectors have led the rally while these sectors were in the middle of the pack during prior rallies.

Declining European “TED Spread”-The key gauge of stress in the financial sector during the financial crisis in 2008 was the widely-watched TED Spread, which measured banks’ willingness to lend to one another. The European equivalent of the TED Spread (EURIBOR less the EONIA rate) had been rising during the stock market rallies that failed to break out of the trading range over the past couple of months. However, over the past three weeks, the European “TED Spread” has been on the decline as financial risks recede in Europe, as illustrated in Chart 2.

Rising yield on 10-yearTreasury note-The 10-yearTreasury note yield had been steadily declining during the summer stock market rallies that failed to break out of the trading range. Stocks are unlikely to make a sustainable rebound when yields are low and falling. The fear of impending economic doom in the United States weighed on the yield, pulling it to levels last seen just prior to the United States entering VWVII. However, economic data providing evidence that the United States was not in a recession nor likely to experience a return to recession anytime soon helped to change the direction ofTreasury yields. [Chart 3]

While the current stock market level has marked an attractive point to sell over the past couple of months as stocks returned to the lows of the year, we believe signs increasingly point to a market that is likely to retain much of the powerful 10% gain achieved over the past two weeks as it begins a volatile, upward-sloping path back to a gain for the year. Key drivers to watch this week regarding the prospects for a breakout are: the start of the flood of third-quarter corporate earnings reports and announcements surrounding the October 23 European summit.

To download a complete copy of the commentary click here

IMPORTANT DISCLOSURES
The op1n1ons vo1ced 1n th1s mateml are for general 1nformat1on only and are not Intended to prov1de spec1f1c adv1ce or recommendations for any 1nd1V1dual To determine wh1ch 1nvestmentlslmay be appropmte for you, consult your financial adv1sor pnor to 1nvest1ng All performance reference IS h1stoncal and IS no guarantee of future results All indices are unmanaged and cannot be invested into directly
The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that st rateg1es promoted will be successfuI
Bonds are subject to market and Interest rate nsk 1f sold pnorto matur1ty Bond values and y1elds will decline as
Interest rates nse and bonds are subject to availability and change 1n price

Government bonds and Treasury Bills are guaranteed by the US government as to the t1mely payment of pnnc1pal and Interest and, 1f held to matunty,offer a f1xed rate of return and f1xed pnnc1pal value However,the value of a fund shares IS not guaranteed and willfluctuate
The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes 1n the aggregate market value of 500 stocks representing allmajor 1ndustr1es
Stock Investing may Involve r1sk 1nclud1ng loss of pnncipal

Because of the1r narrow focus,sector 1nvest1ng will be subject to greater volat1l1ty than 1nvest1ng more broadly across many sectors and companies

Consumer D1scret1onary Sector Com pan1es that tend to be the most sens1t1ve to econom1c cycles Its manufactunng segment Includes automotive,household durable goods,textiles and apparel,and le1sure equipment The serv1ce segment Includes hotels, restaurants and other le1sure fac111t1es. media production and services, consumer retailing and serv1ces and education serv1ces
Consumer Staples Sector Companies whose busmesses are less sens1t1veto economic cycles It Includes manufacturers and drstnbutors of food, beverages and tobacco,and producers of non-durable household goods
and personal products It also rncludes food and drug retailing companies

Energy Sector Com panres whose busrnesses are dom rnated by erther of the followrng actrvrtres The constructron or provrsron of oil rrgs,drr lling equrpment and other energy-related servrce and equrpment rncludrng sersm rc data collection The exploratron, productron,marketrng, refrnrng and/or transportailon of oil and gas products,coal and consumable fuels
Financrals Sector Companres rnvolved rn actrvrtres such as bankrng,consumerfrnance, rnvestment bankrng and brokerage, asset management insurance and rnvestment and real estate,rncluding REITs
Health Care Sector Com panres are rn two main rndustry groups-Health Care equrpment and supplies or companres that provrde health care-related servrces, rncludrng distrrbutors of health care products, providers of basic health care services,and owners and operators of health care facilities and organizatrons Companres prrmarily rnvolved rn the research,development productron,and marketrng of pharmaceutrcals and brotechnology products
lndustnals Sector Companies whose busrnesses manufacture and distnbute caprtalgoods,includrng aerospaceand defense,constructron,engrneenng and bulidrng products,electneal equrpment and rndustnal machrnery Provrde commercral servrces and supplies,rncludrng pnntrng,employment envrronmentaIand offrce servrces Provrde transportatron servrces,rncludrng arrilnes,couners,manne,road and rail,and transportatron Infrastructure
Matenals Sector Com panres that are engaged rna wrde range of commodrty-related manufacturrng Included rn thrs sector are com panres that manufacture chem rcals,constructron matenals,glass,paper,forest products and related packagrng products,metals,mrnerals and mrnrng companres,rncludrng producers of steel
Technology Software & Servrces Sector Com panres rnclude those that pnmanly develop software rn varrous frelds such as the Internet applicatrons, systems and/or database management and companres that provrde rnformatron technology consultrng and servrces,technology hardware & Equrpment rncludrng manufacturers and drstributors of comm unrcatrons equr pment computers and penpheraIs, electronrc equrpment and related rnstruments,and semrconductor equipment and products
Telecommunrcatrons Servrces Sector Companres that provrde communrcatrons servrces pnmanly through a frxed line,cellular, wrreless, hrgh bandwrdth and/or frber-optrc cable network

Utriltres Sector Com panres consrdered electrrc. gas or water utrlitres,or com panres that operate as
rndependent producers and/or distrrbutors of power

LPL Financial Weekly Market Commentary for August 22, 2011

Rose Greene, CFP — Tue, 23 Aug 2011 22:03:36 +0000

A Recession of Confidence

Jeffrey Kleintop, CFA
Chief Market Strategist
LPL Financial

Highlights
Rather than an economic recession, we seem to be experiencing a confidence recession.
In contrast to the pronounced lack of any recession readings in the U.S. economic data last week, the readings on sentiment were uniformly weak as they priced in a recession.
There are several events here and abroad in the next week or two that may provide the stimulus needed to turn around this confidence recession.

In contrast to last week’s market performance, the U.S. economic data released was generally solid. Shipping traffic, business lending, mortgage applications, industrial production, retail sales, initial jobless claims, corporate earnings reports, and the consumer price index all came in with solid growth readings. Notably, even the Index of Leading Economic Indicators (LEI) posted a solid and better-than-expected 0.5 gain and marking the third straight month of re-acceleration in the year-over-year growth of the LEI.

In contrast to this pronounced lack of any recession readings in the U.S. economic data, the readings on sentiment were uniformly weak as they priced in a recession. The stock and commodities markets fell, as did bond yields, and credit spreads widened. Consumer confidence readings slid to recession-like levels.

The biggest disappointment last week came on Thursday, the day the stock market fell over 4%, when the Philadelphia Fed manufacturing survey was released. While treated like economic data, this is actually a sentiment index based on a survey of manufacturers in the Philadelphia region. The plunge in the Philly Fed survey further heightened fears of a recession and contributed to the sharp decline in stocks last week. However, we believe this is a case of weaker sentiment and not weaker manufacturing. Importantly, the economic data that actually measures the output of the manufacturing sector is the Industrial Production report which posted a strong and better-than-expected gain last week. The increase was led by a rebound in vehicle production which appears to have increased further in August.

Rather than an economic recession, we seem to be experiencing a confidence recession. The market clearly believes that the return of business and consumer confidence to historical lows will inevitably lead to an economic recession — no matter what the data says. Market participants are placing a high probability that businesses will not merely slow their rate of hiring and investment, but actually make cuts despite rising profits and strong sales. They also expect that consumers are in the process of shutting down their spending despite the fact that the past five weeks have seen the strongest year-over-year retail sales increase in a year and the credit card delinquency rate decline further in July to near a record low.

We disagree. Though risk of a recession has risen, we place the odds substantially lower than what the markets are placing on such an event which seems to be well over 50% given stock market valuations and bond yields at recession levels.

Might this place too much emphasis on the prospects for the United States? Concerns about recession have also been driven by events in Europe as second quarter economic growth was weak and fear of default moved on from Europe’s periphery to its core nations, with fear rising that Italy might default. However, Italian bond yields and credit default swap spreads (a measure of the value of an insurance policy against default) declined last week suggesting the already limited risk of default eased further.

What is the confidence stimulus that could turn around this confidence recession? There are several events here and abroad in the next week or two that may affect investor sentiment.

The Federal Reserve’s Jackson Hole conference, the event that helped to turn around last summer’s fear of recession, may lead to bullish comments by chairman Bernanke.
The August employment report is due out September 2. Job growth could again exceed expectations. The consensus of economists expects the U.S. economy created 130,000 private jobs in August.
The White House is expected to deliver an economic plan which could exceed very low expectations.
The European Central Bank (ECB) could make a surprise rate cut. After hiking rates in April and July, the ECB may reverse those hikes, rather than hike again in October, as growth is coming in weaker than expected and inflation pressures are easing.
European policy makers may do more quantitative easing (QE) with the newly flexible mandate of the European Financial Stability Facility (the European version of the TARP).
A possible end to the conflict in Libya as rebel forces lay siege to Tripoli and loyalist forces abandon their positions.
Consistently positive economic readings highlighted by strong back-to-school sales.

The market is often said to climb a wall of worry. It does this when confidence is high and that impedes growth, both real and imagined. However, the markets always overcome no matter how bad they may seem at the time. History shows that it does not take much for the market to turn from agonizing over a wall of worry to climbing it. Importantly, the risks do not need to be resolved; merely confidence returns that the risks will be overcome.

To download a complete copy of the commentary click below

IMPORTANT DISCLOSURES

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and are subject to availability and change in price.

The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

The index of leading economic indicators (LEI) is an economic variable, such as private-sector wages, that tends to show the direction of future economic activity.

LPL Financial Weekly Market Commentary For August 15, 2011

Rose Greene, CFP — Tue, 16 Aug 2011 19:40:53 +0000

Summer Roller Coaster

Jeffrey Kleintop, CFA
Chief Market Strategist
LPL Financial

Highlights
Knowing the extent of the highs and lows and when it is going to be over play a crucial role in the summertime fun of riding a metal roller coaster. Riding a market roller coaster offers no such assurances and is no fun at all.
While last week’s volatility is unprecedented, we can take some comfort that the overall moves and sentiment in the market this summer are familiar; they echo those of last summer.
Last year, the roller coaster did not leave the track and the summer plunge turned into a steep climb as stock and bond yields rose to new post-recession highs. We continue to believe this summer’s drop will end with similar results and ultimately produce a modest single-digit gain for the S&P 500 in 2011.

Summer is a time when many Americans seek out amusement parks for the thrills of riding a roller coaster. The climbs and drops at high speed deliver an exciting mix of fear and exhilaration. But knowing the extent of the highs and lows and when it is going to be over play a crucial role in the fun of riding a metal roller coaster. Riding a market roller coaster offers no such assurances and is no fun at all.

To say last week was volatile for the markets would be a major understatement. The stock market posted one of its most volatile weeks ever with swings of greater than 4% during each of the first four days of the week, changing direction with each day. This pattern of performance has never before been seen in the 83-year history of the S&P 500 index. By Friday, stock market turbulence slowed. For the week, the S&P 500 was down 1.6% adding to the losses that now total 13% since the recent peak on July 7.

While the U.S. debt downgrade in the week before last grabbed a lot of attention and added to the lingering pessimism heading into last week, one of the primary drivers of last week’s volatility was that eurozone leaders, while making some successful efforts, have not gone far enough to resolve the debt problems in the eurozone. Investors feared a downgrade to France, and another banking crisis stemming from some French banks noted by Moody’s, as at risk of a downgrade due to their exposure to troubled debt. Another key driver was the better-than-expected economic data on retail sales and the labor market along with the Fed confirming they intend to keep short-term interest rates low until mid-2013. This optimism that the U.S. economic soft spot was firming vied with the concern that the pace of economic growth in the United States may soften further as stimulus begins to fade.

While last week’s volatility is unprecedented, we can take some comfort at the overall moves and sentiment in the market this summer are familiar; they echo those of last summer.

At the low point of last week, the S&P 500 was down 17%, similar to last summer’s volatile 16% peak-to-trough decline.
The 10-year Treasury note yield has fallen 1.6 percentage points from the high of the year, similar to last summer’s 1.6 percentage point decline from the high of the year.
The drivers of the decline are similar to last summer, as well. Last year, Europe’s debt problems were a main cause of the market’s decline, as was an economic soft spot in the United States as stimulus began to fade when the Federal Reserve ended the QE1 bond buying program and state and local governments were cutting back on spending.

So, maybe we have been on this market roller coaster before, and, if so, we might be near the end. Last year, the roller coaster did not leave the track and the summer plunge turned into a steep climb as stock and bond yields rose to new post-recession highs. We continue to believe this summer’s drop will end with similar results and ultimately produce a modest single-digit gain for the S&P 500 in 2011. We believe the fundamental underpinnings of solid corporate earnings growth (up 19% year-over-year in the second quarter), low valuations (the price-to-earnings ratio fell to levels not seen since 1989 during the lows of last week), and firming economic data (as Japan’s economy rebounds from recession) will combine to support stocks, high-yield bonds, and other business cycle-sensitive investments.

However, there are factors we are watching to determine if this volatility is instead a precursor to a deeper and longer lasting bear market. In the next few weeks there are a number of potentially market-moving events that may continue some of the volatility that was so pronounced last week.

With all the attention on Europe’s sovereign debt problems, this week’s meeting between German Chancellor Angela Merkel and French President Nicolas Sarkozy will garner much attention. The market wants to know how much larger the European bailout fund is going to be and under what conditions it may be used, although this is unlikely to be determined for a number of weeks.
A lot of retailers report second quarter earnings this week. But the solid results will be tempered by an outlook clouded by the sharp decline in confidence seen in the widely-watched University of Michigan consumer sentiment index falling all the way back to the levels during the financial crisis. The question for markets is whether the stock market’s violent sell off has become such a negative for consumer and business confidence that it will impact the economy and profits.
In 2010, the Fed’s annual Jackson Hole meeting at the end of August hinted that QE2 may be coming and got the markets to acknowledge improving economic and profit data and rebound. The Jackson Hole meeting at the end of the month will be closely watched for indications of how the Fed may respond to further economic weakness. In the meantime, this week Dallas Fed President Richard Fisher will speak. Fisher is one of three Fed officials who dissented to the Fed’s statement that interest rates would remain low through mid-2013 and his comments may add to volatility.
U.S. economic growth has started to show signs of improving. This can be seen in a number of economic readings including the fall in initial jobless claims to a four-month low of 395,000 in the past week, retail sales running 4 – 5% above a year-ago levels, and signs that industrial production has increased. In the coming week, gloomy housing-related data is on tap, but stronger readings on manufacturing in the Philadelphia Fed survey along with leading economic indicators may provide positive data points.

Although we expect volatility to continue, we foresee a more muted level than last week’s market roller coaster ride and a climb over the months ahead. In general, we advise investors to do what they normally do on a roller coaster: hang on tightly, grit your teeth, scream if you need to, but do not jump off.

To download a complete copy of the commentary click here

IMPORTANT DISCLOSURES

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and are subject to availability and change in price.

The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Quantitative Easing is a government monetary policy occasionally used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity.

The University of Michigan Consumer Sentiment Index (MCSI) is a survey of consumer confidence conducted by the University of Michigan. The Michigan Consumer Sentiment Index (MCSI) uses telephone surveys to gather information on consumer expectations regarding the overall economy.

High yield/junk bonds (grade BB or below) are not investment grade securities, and are subject to higher interest rate, credit, and liquidity risks than those graded BBB and above. They generally should be part of a diversified portfolio for sophisticated investors.

Government bonds and Treasury Bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of a fund shares is not guaranteed and will fluctuate.

LPL Financial Weekly Market Commentary For August 8, 2011

Rose Greene, CFP — Mon, 08 Aug 2011 21:17:11 +0000

The Downgrade: What You Need To Know

Jeffrey Kleintop, CFA
Chief Market Strategist
LPL Financial

Highlights
We view the U.S. rating downgrade from AAA to AA+ as a disappointing, but lagging indicator of the pressures already reflected in the markets. We find plenty of historical evidence that markets have priced in the events that led to the downgrade much earlier than when the downgrades took place.
While there are some negative consequences, there are not triggers stemming from the downgrade that would spark a chain of events leading to a financial crisis.
Could this mark a “Sputnik moment” for policy makers tasked with finding the additional savings stipulated in the debt ceiling legislation?
The initial beneficiaries of the downgrade include precious metals and Treasuries given the hit to investor sentiment and the desire to seek safety and liquidity. Stocks, led by Financials, may initially suffer. However, low valuations and efforts to address the debt problems in Europe combined with improving economic data may put a halt to the stock market’s decline.

Despite passing the debt ceiling and spending cut deal anticipated by the markets, last week’s data and events pulled bond yields lower and left the S&P 500 now down about 10% from this year’s high. This slide may seem all too familiar. Market participants are worried about a repeat of the 2008 financial crisis. While the message from the markets is important, in last summer’s soft spot the 10-year Treasury note yield fell below 2.4% and the stock market fell 15%, but no recession took place. Instead, as the market became too pessimistic on the prospects for growth in the second half of the year, stock returns and bond yields moved to new post-crisis highs. The summer of 2010 is the more relevant comparison to the current market slide than the summer of 2008, in our opinion.

Friday’s news that one of the three U.S. rating agencies was downgrading the U.S. credit rating from AAA to AA+ hit the markets and sapped the gains fueled by the report of better-than-expected job growth in the month of July (and positive revisions to prior months). As the rumors of a downgrade hit, stocks slumped. Is this a killing blow for a market and economy already suffering from a series of disappointments or a disappointing but lagging indicator of the pressures already reflected in the market’s path and level of recent years? We favor the latter assessment.

Here we will present our views on the downgrade from; why it happened and what it means for investors and policymakers, and what is next for the markets. For more insight, please see the Bond Market Perspectives publications from July 19 and August 2 where we discussed the details surrounding the pending downgrade.

Why did it happen?

While the imbalance in the U.S. long-term fiscal situation is no mystery, the reasoning for the downgrade at this time is best left in the words of Standard and Poor’s. The first news of a near-term potential downgrade came on April 14 of this year. Standard and Poor’s rating agency stated, “We believe there is a material risk that U.S. policymakers may not reach an agreement on how to address medium- and long-term budgetary challenges by 2013; if an agreement is not reached and meaningful implementation is not begun by then, this would in our view render the U.S. fiscal profile meaningfully weaker than that of peer ‘AAA’ sovereigns.”

On July 14, the outlook for a downgrade became even clearer as Standard and Poor’s clarified their position with the statement: “The CreditWatch placement of the U.S. sovereign ratings signals our view that, owing to the dynamics of the political debate on the debt ceiling, there is at least a one-in two likelihood that we may lower the long-term rating on the U.S. within the next 90 days.” Standard and Poor’s cited $4 trillion in savings as part of the debt ceiling bill as the number that would be a trigger to avoid a downgrade. As it became apparent that a “grand bargain” of around $4 trillion was off the table, a downgrade by Standard and Poor’s became likely.

On Friday, August 5, the rumor of a downgrade announcement negatively impacted the markets. The announcement of the downgrade was delayed by the Treasury pointing out an error to Standard and Poor’s in their calculations of $2 trillion as it related to the size of the total debt-to-GDP ratio which was a prominent component of their economic justifiction for the downgrade. S&P
acknowledged the error and removed that component and focused on the political environment for the justification for their downgrade and announced it on Friday evening, after the markets had closed.

What does it mean for government bonds?

Historically, downgrade announcements do not mean much to the markets. They have priced in the events that led to the downgrade much earlier. We can find plenty of evidence of this in the downgrades from AAA of large countries and companies over the past 20 or so years.

Bond prices did not plunge as yields were flat to down when countrieslost their AAA ratings in the past. There are a number of smaller countries that lost their AAA ratings, but they are not really comparable to the United States. The big three of Canada, Japan, and Australia are far more important parisons. In both Australia and Canada, yields fell when the downgrade from AAA came after having run up in the months before. Both of these countries eventually regained AAA status. Yields also declined following Japan’s downgrade from AAA.

In the early 1980s, 60 companies in the S&P 500 were rated AAA, today there are only four: Microsoft, Exxon Mobil, Johnson & Johnson, and Automatic Data Processing. In general, the downgrade from AAA came after the market had already reacted to the drivers that made the rating downgrade an obvious next step. Companies like Berkshire Hathaway, General Electric, and Pfizer all lost their AAA status during the recent financial crisis. But the markets had already priced in the prospects for these companies well before they were downgraded leaving no reaction to the news when it finally came.

We see the prospects for Treasuries more influenced by the outlook for economic growth than by this downgrade. We do not expect sharply rising yields in response to the downgrade, but instead a steady move higher over the remainder of the year as economic growth proves to be better than is currently being priced in the market.

Are there triggers that would cause a financial crisis?

There are not triggers stemming from the downgrade that would cause forced selling of Treasuries or a chain of events leading to a financial crisis. In fact, Treasury yields may decline as investors seek safety and liquidity.

Nearly half of U.S. government bonds are held by foreigners. The biggest holder of U.S. government debt, China, holds U.S. debt as part of their currency management and trade policy and growth strategy rather than as a traditional investment. They are not constrained by ratings as a condition of their holding. In fact, China’s rating agency, Dagong, downgraded the U.S. last year. Importantly, with no other high-quality, liquid bonds of sufficient size to absorb the demand and with other AAA-rated countries on review for downgrade these investors have nowhere else to go.

The next largest holder is the U.S. Federal Reserve who is unlikely to sell the Treasury bonds acquired under the quantitative easing programs until it believes the economy is strong enough to absorb the potentially higher interest rates that would result from the sales.

Insurance companies are required by law to hold a large portion of their portfolios in very safe and very liquid securities. However, they are generally allowed to hold U.S. government bonds no matter what they are rated. For example, the New York life insurance law stipulates obligations issued by “the United States of America or any agency or instrumentality thereof.”

Money market funds will not have to sell. The U.S. short-term debt rating has not been changed. Regardless, money market mutual funds must hold “top-tier” securities with no stipulation for rating.

Banks do not need to raise capital, as they were forced to do after the failure of Lehman Brothers triggered losses that forced additional selling. This was made clear by the Federal Reserve, FDIC, and other bank regulators on Friday, “For risk based capital purposes, the risk weights for Treasury securities and other securities issued or guaranteed by the U.S. government, government agencies, and government-sponsored entities will not change.”

Even those entities that are required to hold AAA-rated debt can still hold Treasuries since two of the three U.S. rating agencies still rate the United States as AAA. Unless S&P cuts the credit rating further or Moody’s and/ or Fitch also cut the U.S.’s long-term rating (both have reaffirmed the U.S.AAA rating) the debt is still considered AAA.

What are the consequences?

The lagging nature of downgrades, coming after the drivers have already been discounted by investors and reflected in the economy, do not usually carry much in the way of major negative consequences. However, there are some negative consequences that while not dire do pose some challenges and should not be completely overlooked.

First, a lower rating may mean that interest rates will be higher over the longer term as investors demand more yield for taking on the perceived greater risk of Treasuries. However, this is not a near-term threat to economic growth or the markets.

It is possible that the municipal bond market may be impacted. The 15 AAA rated states could be subject to a modest downgrade given some funding sources that are dependent upon the Federal government. It is hard to see what the market impact of this rating change may be; however, it is unlikely to be sizable.

A higher cost for collateral in repo, derivative, and swap transactions may result from the downgrade. These agreements are typically collateralized by Treasuries. As a result of the downgrade, counterparties would likely have to post slightly more of these securities as collateral slightly increasing costs.

The United Kingdom and France are likely the next countries to see downgrades from AAA. However, markets have discounted this outcome. French credit default swaps, essentially an insurance policy against the risk of default, are over three times that of the United States.

Finally, the United States is still on negative outlook despite having been downgraded to AA+. Without additional actions to put the United States on a path to fiscal sustainability the United States will likely be downgraded further. This could have ramifications for those entities required to hold AAA-rated bonds even if the other two rating agencies do not change their ratings.

What does it mean for policymakers?

The downgrade adds another point to fuel the increasing divisiveness between the political parties. In addition, Timothy Geithner, who was already considering leaving his post as Treasury Secretary (as is common after more than two years), may have to stay on so as to not appear as the scapegoat for the downgrade.

Washington has repeatedly shown the ability to miss opportunities to address the long-term U.S. fiscal imbalance. However, perhaps the moment has arrived. Could the downgrade of the U.S. credit rating be a Sputnik moment for policymakers? Probably not. But Washington has the ability to address this in the November 23 and December 23 deadlines for agreement on finding the $1.5 trillion in additional savings stipulated in the debt ceiling legislation and for Congress to pass them. They are tasked with finding a minimum of $1.5 trillion, but there is no limit on them finding more than $1.5 trillion in savings. Two weeks ago a bipartisan proposal delivered by the Republican Speaker of the House, John Boehner, and the Democrat Majority Leader in the Senate, Harry Reid, to save nearly $4 trillion over the next 10 years was rejected by the President. Could that plan get dusted off and find new support in light of the downgrade? The markets would welcome a larger bipartisan plan.

What is next for the markets?

The announcement of a downgrade of the U.S. credit rating from AAA to AA+ added to the list of disappointments investors have suffered in recent months, including: softer economic growth (although data has been more mixed than consistently weak as it was last week), European debt problems spreading, and Washington’s debt ceiling demagoguery.

The initial beneficiaries include precious metals and Treasuries given the hit to investor sentiment and the desire to seek safety and liquidity. AAA-rated German bunds may also be winners as investors seek quality while the debt of France and the United Kingdom may suffer as investors’ price in the likelihood that they are next in line for a downgrade.

Stocks may suffer from investors seeking a safe haven. Stocks may go down due to some selling as investors who own Treasuries to diversify riskier positions in their portfolios may want to sell some stocks to recognize that their Treasury holdings are riskier. Among stocks, the banks may suffer the worst — not that they would have to raise capital — but since not only is the “Washington put”, or the willingness of policymakers to intervene with a bailout to avert a crisis, already called into question but now its ability to back stop a failure is also questioned.

However, stock prices reflect a wall of worry. Stocks are inexpensive on both a trailing and forward basis compared to history. The S&P 500 trailing price-to-earnings ratio (measuring earnings over the past four quarters) is 13, the lowest since 1990. The S&P 500 forward price-to-earnings ratio (using earnings forecast over the next four quarters) is 11, the same as it was at the bottom of the financial crisis in March of 2009. While valuations could compress further, the spring is already tightly coiled. The solid second quarter earnings season suggests the market is too bearish with the price it is putting on earnings. Notably, S&P indicated it is not planning on downgrading companies’ AAA ratings despite the agency’s policy not to have a company’s rating be higher than its home country’s sovereign rating.

Finally, while much of the world has been focused on the downgrade of the United States by Standard and Poor’s, the more important credit situation for the world economy is in Europe right now. Both Italy and Spain have been under intense pressure recently after the debt crisis for the peripheral nations of Greece, Ireland, and Portugal was addressed with a second rescue package for Greece. This past weekend the European Central Bank (ECB) announced plans to buy Italian and Spanish debt in the markets, pending fiscal reform commitments. Rather than tap the European Financial Stability Facility (EFSF), which has a flexible mandate but limited funding, the ECB has stepped in. Unlike the EFSF, the ECB has the scale to address bond markets of countries the size of Spain and Italy.

The stock market is likely close to making the low point of the year as events in Europe stabilize and earnings and economic growth prove better than the now overly gloomy expectations priced in for the third quarter.

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Important Disclosures

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and are subject to availability and change in price.
Government bonds and Treasury Bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of a fund shares is not guaranteed and will fluctuate. Precious metal investing is subject to substantial fluctuation and potential for loss.
Because of their narrow focus, sector investing will be subject to greater volatility than investing more broadly across many sectors and companies. The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
Stock investing may involve risk including loss of principal.
Financials Sector: Companies involved in activities such as banking, consumer finance, investment banking and brokerage, asset management, insurance and investment, and real estate, including REITs. An obligation rated ‘AAA’ has the highest rating assigned by Standard & Poor’s. The obligor’s capacity to meet its financial commitment on the obligation is extremely strong.
International investing involves special risks, such as currency fluctuation and political instability, and may not be suitable for all investors. Debt-to-GDP is a measure of a country’s federal debt in relation to its gross domestic product (GDP). By comparing what a country owes and what it produces, the debt-to-GDP ratio indicates the country’s ability to pay back its debt. The ratio is a coverage ratio on a national level.
The P/E ratio (price-to-earnings ratio) is a measure of the price paid for a share relative to the annual net income or profit earned by the firm per share. It is a financial ratio used for valuation: a higher P/E ratio means that investors are paying more for each unit of net income, so the stock is more expensive compared to one with lower P/E ratio.
Quantitative Easing is a government monetary policy occasionally used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity.
The securities mentioned herein are not a recommendation to buy or sell. All decisions should be based on your risk tolerance, time horizon and overall goals.
A Credit Default Swap (CDS) is designed to transfer the credit exposure of fixed income products between parties. The buyer of a credit swap receives credit protection, whereas the seller of the swap guarantees the credit worthiness of the product. By doing this, the risk of default is transferred from the holder of the fixed income security to the seller of the swap.