The “Wall Street” Election Poll

Jeffrey Kleintop, CFA
Chief Market Strategist
LPL Financial

Highlights

• The biggest event for investors over the next six months is likely to be the November elections in the United States. The outcome of the elections will define the political context and leadership for the policies that address the looming fiscal imbalances coming to a head in early 2013.

• Based on the relative performance of legislation-sensitive industries that may react more favorably to one party, we have created two indexes to help us track the markets’ implied forecast of the election outcome reflected in the performance of these industries.

• While there are other factors that may influence the relative performance of these indexes, as time goes on the election consequences may become paramount as investors increasingly vote with their money.

The biggest event for investors over the next six months is likely to be the November elections in the United States. The outcome of the elections will define the political context and leadership for policies that address the looming fiscal imbalances coming to a head in early 2013. We have explored this budget bombshell in prior commentaries and what it could mean for the markets and economy. This week we will take a look at what the market is pricing in regarding the election outcome.

As we explore the issue of what the market is pricing in when it comes to the outcomes of the November elections, it is important to be aware of the shortcomings of overly simplistic election analysis. An illustration of this can be seen in Figure 1, where we plot the odds of President Obama’s re-election (measured by contracts traded on Intrade.com) and the movements in the stock market, measured by the S&P 500 Index. Is the stock market going up because of the rise in Obama’s re-election odds, or are Obama’s re-election odds going up because the stock market is rising — or, more likely, are both tied to something else?

Attempting to draw simple conclusions about what the market is saying about the election is fraught with the potential for misinterpretation. Instead, there is a better, more analytical way for investors to attempt this kind of potentially rewarding analysis. Analyzing the market by the industries most impacted one way or another by the election outcome can provide more precise insight into what the market is pricing in regarding the election.

For example, the components of the 10 stock market sectors are impacted in different ways by election outcomes:

• Health Care is the biggest driver of the long-term budget problems at the Federal level. States are already cutting Medicaid to balance their budgets. A sweeping win for the GOP holds the most promise for Managed Care providers as risks decline and investors increase the odds for a repeal of all or part of the Affordable Care Act. Diagnostic labs, generic drug makers, hospitals, and nursing homes may benefit if the Act is upheld and from Democrats’ leadership, given expanded health care coverage and an emphasis on preventative care and legislation to speed up the introduction of generic drugs to market.
• We may see a relief rally among the banks in the legislation-sensitive Financial sector. If the GOP takes the Senate it will result in the change of chairmanships of key committees. While major changes to the financial reform law, Dodd-Frank, are unlikely, an all GOP Congress might influence regulations implementing the law. On the other hand, Republicans would likely look to address Fannie Mae and Freddie Mac conspicuously left out of the Democrat-led financial reform law, which could have negative ramifications on home loan originators. Democrats may also provide more housing support programs benefitting home builders and construction materials providers.
• As previously mentioned, the potential extension of Bush tax cuts would mean the dividend tax rate may remain closer to 15% instead of going to 43.4%, a plus for companies with lots of cash to distribute. High dividend-paying sectors such as Telecommunications Services, Consumer Staples, and Utilities may benefit. Cash-rich companies in other sectors may also benefit as they introduce or substantially increase their dividend payout as they look to attract a new class of investor seeking yield. Alternatively, some food and staples retailers may benefit from potential for a further extension of unemployment benefits.
• Companies in the Energy sector may be impacted by a strong election for the GOP in a number of ways. Regulations on drilling would be more favorable as would EPA regulations. We could see lower regulatory costs for producers in the Materials sector and users of coal such as Utilities. Gas may benefit from stricter coal regulations under the Democrats. On the other hand, alternative energy companies would face a less supportive outlook for subsidies under a GOP outcome.
• Sectors highly sensitive to trade, including Technology, may benefit from a strong showing by the GOP. The Consumer Discretionary sector could also benefit from the diminished risk of China trade protectionism — a plus for retailers dependent on low-cost imports and U.S. exporters of capital equipment fearing Chinese retaliation.
• The election could hold positives and negatives for companies in the Industrial sector. At 20% of the budget, defense spending will likely see cuts next year, but would likely see a more shallow trimming under the GOP than Democrats. On the other hand, transportation funding will likely be smaller under GOP leadership, resulting in fewer government dollars for engineering and construction companies.

While there are many “man on the street” polls, what matters most to investors is what is priced in on Wall Street rather than what people are saying on Main Street. A stock market based “election poll” is useful in that it highlights what the market is pricing in about the outcome of the election that is more refined than merely looking at the overall market.

Based upon these legislation-sensitive industries, we have created two indexes to help us track the markets’ implied forecast of the election outcome reflected in the performance of these industries. Each index is composed of an equal weighting among seven industries that combined total about 100 S&P 500 stocks.

To track what the market has priced in for the Democrats’ odds of retaining the White House and Senate we have taken the Democrats index and divided it by the Republicans index. An upward sloping line suggests the market may be pricing in a rising likelihood of the Democrats retaining the White House and their majority in the Senate, while a downward sloping line suggests improving prospects for the Republicans. While other factors may influence the relative performance of these indexes, as time goes on the election consequences may become paramount as investors increasingly vote with their money. As you can see in Figure 3, already this year Obama’s re-election odds on Intrade.com are generally tracking the relative strength of our Democrat vs. Republican indexes.

If you elect to follow our “Wall Street” election poll index, we pledge to continue to keep you informed as to how these issues are likely to affect the markets. We will update this index frequently as the election becomes an increasingly important driver of the markets over the coming six months.

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.
Stock investing may involve risk including loss of principal.
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.
Consumer Discretionary Sector: Companies that tend to be the most sensitive to economic cycles. Its manufacturing segment includes automotive, household durable goods, textiles and apparel, and leisure equipment. The service segment includes hotels, restaurants and other leisure facilities, media production and services, consumer retailing and services and education services.
Consumer Staples Sector: Companies whose businesses are less sensitive to economic cycles. It includes manufacturers and distributors of food, beverages and tobacco, and producers of non-durable household goods and personal products. It also includes food and drug retailing companies.
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.
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.
Health Care Sector: Companies are in two main industry groups — Health Care equipment and supplies or companies that provide health care-related services, including distributors of health care products, providers of basic health care services, and owners and operators of health care facilities and organizations. Companies primarily involved in the research, development, production, and marketing of pharmaceuticals and biotechnology products.
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.
Manufacturing Sector: Companies engaged in chemical, mechanical, or physical transformation of materials, substances, or components into consumer or industrial goods.
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.
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.
Telecommunications Services Sector: Companies that provide communications services primarily through a fixed line, cellular, wireless, high bandwidth and/or fiber-optic cable network.
Utilities Sector: Companies considered electric, gas or water utilities, or companies that operate as independent producers and/or distributors of power.
Because of their narrow focus, sector investing will be subject to greater volatility than investing more broadly across many sectors and companies.

Stocks’ Sweet Sixteen

Jeffrey Kleintop, CFA
Chief Market Strategist
LPL Financial

Highlights

• It has been a sweet sixteen weeks for the S&P 500. The broad stock market index has had only three down weeks out of the past sixteen, tying a record unbroken for over 20 years.

• As the NCAA basketball tournament gets down to its own sweet sixteen this week, it is a good time to reflect on the sixteen competing drivers of the markets that may make for an exciting showdown in the weeks and months to come.

• There will likely be some upsets that result in volatility as these factors face off against each other. In the end, we expect the positive factors are likely to win and help to support the strong gains we have already seen this year.

It has been a sweet sixteen weeks for the S&P 500. The broad stock market index has had only three down weeks out of the past sixteen. There has not been a sixteen-week period with fewer weeks of losses in over 20 years — since the period ending September 1, 1989!

As the NCAA tournament gets down to its own sweet sixteen this week, it is a good time to reflect on the competing drivers of the markets that may make for an exciting showdown in the weeks and months to come.

The four “regions” of market moving factors vying for investor attention are: economy, geopolitics, fundamentals, and market dynamics.

Economy

• Employment – Job growth has been picking up with more than 200,000 jobs created in each of the past three months.*
• Housing – The soft housing market could grab attention, given the coming wave of foreclosures.
• Confidence – Consumer confidence has been improving, but it remains well below average.**
• Federal Reserve – As the latest stimulus program, Operation Twist, winds down will the stock market suffer the same sell-off that surrounded the ending of the prior two programs QE1 and QE2?

Geopolitics

• Elections – Upcoming elections in France and the United States potentially could have a material impact on the regulatory and legislative environment affecting the markets.
• Iran Conflict – A military conflict with Iran is a low probability “dark horse” factor that could have a major impact on the markets if it were to develop.
• China’s Growth – A hard or soft landing in China’s economy makes a big difference to global growth and the prospects for stocks.
• European Debt – Further progress on sovereign debt problems and budget challenges must take place in Europe, with Portugal as the next country eyeing a debt restructuring.

Fundamentals

• Earnings – The most consistent factor in recent years, earnings for S&P 500 companies, have grown about 55% since the end of 2008, in line with the gain of about 55% in the S&P 500 over the same time period, but growth has slowed sharply as we look toward the first quarter’s results.
• Oil Prices – Oil prices have been over $100 per barrel for the past four weeks and may begin to negatively impact the markets the longer they linger here.
• Credit – Demand for credit has improved and credit spreads have narrowed; both trends are critical supports to growth.
• Fiscal Policy – A budget bombshell hits the economy in 2013, with tax hikes and spending cuts totaling 3.5% of GDP.

Market Dynamics

• Momentum – Stocks have been on a strong winning streak that could continue.
• Volume – Trading volume in the markets has been light, traditionally seen as a sign that a trend has become vulnerable.
• Volatility – Investors have been net sellers of U.S. stock mutual funds for much of the past month despite strong and steady gains (according to ICI data) – a return to more volatile markets may further undermine individual investor support.
• Interest Rates – Interest rates are on the rise, potentially acting as a drag on everything from housing to the U.S. budget, but from very low levels.

There are quite a few listed here, but these certainly are not all the factors that are influencing the markets.

The key message for investors in considering these factors is: don’t be too confident in any particular outcome. Respect the complexity of the situation. This is a time for caution and taking some profits, not for indiscriminate selling. It is a time to nibble at opportunities as they emerge; it is not a time to jump in with both feet.

Investing is not a game, but it is important also to remember that forecasting is not an exact science, and many factors can affect outcomes that are hard to predict. Last year, the Japanese earthquake had a big impact on markets and natural disasters — despite tremendous advances in technology — are very hard to predict with any degree of accuracy in once we get location or timing. Geopolitical outcomes can also be hard to foresee as we look to the stresses in the Middle East. The markets also rarely offer perfect clarity on their direction because they are driven by these factors as well as many others. Even this week’s NCAA March Madness can be seen as a reminder of how it can be notoriously hard to predict winners. Historically, a team’s ranking has meant nothing after we get down to the elite eight.

These factors will play out in the markets over the course of the year, not just in the coming weeks. This means there will be some upsets that result in volatility and pullbacks as these factors face off against each other. In the end, we expect the positive factors are likely to win and help to support the strong gains we have already seen this year.

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 guaran¬tee that strategies promoted will be successful.
* According to U.S. Bureau of Labor Statistics data.
** According to University of Michigan Survey data.
International and emerging markets investing involves special risks, such as currency fluctuation and political instability, and may not be suitable for all investors.
The fast price swings in commodities and currencies will result in significant volatility in an investor’s holdings.
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 Standard & Poor’s 500 Index is an unmanaged index, which cannot be invested into directly. Past perfor¬mance is no guarantee of future results.
The Federal Open Market Committee action known as Operation Twist began in 1961. The intent was to flatten the yield curve in order to promote capital inflows and strengthen the dollar. The Fed utilized open market operations to shorten the maturity of public debt in the open market. The action has subsequently been reexam¬ined in isolation and found to have been more effective than originally thought. As a result of this reappraisal, similar action has been suggested as an alternative to quantitative easing by central banks.
Gross Domestic Product (GDP) is the monetary value of all the finished goods and services produced within a country’s borders in a specific time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments and exports less imports that occur within a defined territory.
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.
This research material has been prepared by LPL Financial.
The LPL Financial family of affiliated companies includes LPL Financial and UVEST Financial Services Group, Inc., each of which is a member of FINRA/SIPC.
To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial is not an affiliate of and makes no representation with respect to such entity.

The Great American Race

Jeffrey Kleintop, CFA
Chief Market Strategist
LPL Financial

Highlights

• Today at “The Great American Race,” NASCAR’s Daytona 500, a contestant in another great American race, Rick Santorum, will have his logo on the hood of the number 26 car.

• Following the “crash” of 2008, the Federal Reserve (Fed) has the yellow flag out and is playing it safe with the Federal funds rate at a very low level in an attempt to keep the economy on track.

• Each of the GOP candidates has indicated that if elected he would pursue making changes either to the mandate or the chairman of the Fed. Leadership of the Fed will be important for investors to assess when not to “fight the Fed.”

Today, forty-three of the top drivers in the world will compete in “The Great American Race,” NASCAR’s biggest, richest and most prestigious motorsports event. Another great American race will be evident at Monday’s showdown: Republican presidential candidate Rick Santorum’s logo will cover the hood of the number 26 car. While the winner of the Daytona 500 will soon be in the books, it will likely take at least until the so-called “Super Tuesday” in the second week of March — or longer — for the likely winner of the GOP presidential nomination to become clear.

Over the coming weeks, the shift in focus from the differences among the candidates to differences between the likely nominee and President Obama may become a renewed focus for investors. Of course, there are many differences that are well known to investors, such as those surrounding taxes and spending priorities, health care and energy policy, and foreign affairs. However, some differences may be less generally known but are also impactful for the financial markets. One such area is the Fed, or more specifically, the Federal Open Market Committee (FOMC). Led by Chairman Ben Bernanke, this independent group of 17 members of the Federal Reserve system determines U.S. monetary policy including setting interest rates, quantitative easing, and other influential factors. Each of the candidates, including frontrunner Mitt Romney, has indicated that if elected he would pursue making changes either to the mandate or the chairman of the FOMC.

Ben Bernanke was appointed to head the FOMC in 2006 by Republican President George W. Bush, and he was confirmed for a second term after being re-nominated by Democratic President Barack Obama. While his second term ends in 2014, it is possible that pressure from the President could cause Bernanke to step down as chairman prior to the end of his term. While the Fed is structured to remove the influence of politics from monetary policy by granting the governors such as Bernanke 14-year terms, it is challenging for a Fed chairman to operate without the support of the President.

As you can see in Chart 1, Fed policy is — in NASCAR terms — running under a yellow flag. While cars at the Daytona 500 typically vary around 175-200 mph as they go around the oval track, after a crash, officials send out a safety car to slow the cars down until the race is safe to resume. The Federal funds rate is normally much higher than it is today when the economy is operating around full speed. But following the “crash” of 2008, the Fed is playing it safe with the Federal funds rate at a very low level in an attempt to keep the economy on track.

Over the last 15 – 20 years, the FOMC has pushed the Federal funds rate back up to around 5.5 – 6.5% during periods of economic growth. With the rate currently a mere 0.1%, there may be a rapid acceleration in the rate when the time comes to begin to raise the rate. When will the race restart and the Fed put away the caution flag? That may depend on who the Fed chairman is going to be.

The members of the FOMC are not of one mind on when rates should be hiked. In fact, the members have opinions ranging across the board in their view of when rates should next be raised. Three members of the FOMC believe that rates should be hiked for the first time this year, while another three believe next year should be the start. Of the other 11 members of the FOMC, five believe rates should be hiked in 2014, four in 2015 and two in 2016. Chart 2 shows where the 17 individual FOMC members believe the Federal funds rates should be by the end of the specified year and over the longer run. Leadership of the Fed will be important to assessing the Fed’s likely course of action and when to not “fight the Fed.”

In general, based on their statements, the Republican presidential candidates indicate that they would favor a less cautious Fed and an earlier start to getting interest rates back up to more normal levels. This is favored in order to avoid an inflation problem that could be caused by keeping monetary policy too easy for too long.

For investors, the potential for a change in Fed leadership or mandate that would prompt an earlier series of rate hikes than the market currently anticipates could be a negative for stocks. The old adage “don’t fight the Fed” refers to the relatively poor performance of the S&P 500 when the Fed is hiking interest rates, as you can see in Chart 3. While that action by the Fed may still be more than a year away no matter what happens, markets could begin to price in the possibility of more rapid and larger rate hikes as the leaders emerge in the great American race.

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 Federal Reserve is the central bank of the United States. Its unique structure includes a federal government agency, the Board of Governors, in Washington, D.C., and 12 regional Reserve Banks (Atlanta, Boston, Chicago, Cleveland, Dallas, Kansas city, Minneapolis, New York, Philadelphia, Richmond, San Francisco, and St. Louis).
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 Standard & Poor’s 500 Index is an unmanaged index, which cannot be invested into directly. Past performance is no guarantee of future results.
Gross Domestic Product (GDP) is the monetary value of all the finished goods and services produced within a country’s borders in a specific time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments and exports less imports that occur within a defined territory.

The Budget Bombshell

Jeffrey Kleintop, CFA
Chief Market Strategist
LPL Financial

Highlights

• In one week, President Obama is due to submit his budget. The 2013 budget is already going to have the biggest impact since the end of WWII, even if no action is taken in Washington.

• The fiscal headwind under current policy totals over $500 billion, or 3.5% of GDP. The United States has never experienced a deficit cut by more than 2% of GDP that did not end in a sharp decline in GDP.

• The risk that a budget deal to mitigate this potential impact does not happen should keep markets from moving steadily higher in 2012, as they have done year-to-date, without a reality check.

In one week, President Obama is due to submit his 2013 budget, which covers the fiscal year beginning on October 1, 2012. The Congressional Budget Act of 1974 requires the President to submit a budget request to Congress on the first Monday in February, but the Administration has scheduled the release instead for one week later on February 13. In addition, Congress must pass a budget resolution by April 15 of every year. However, the President missed the deadline last year and while the House passed a budget resolution last year, the Senate did not. This year is likely to be no different, with no budget being passed. But this does not mean the 2013 budget does not have potentially market moving consequences.

The 2013 budget is already going to have the biggest impact of any budget in decades even if no action is taken in Washington. The fiscal headwind comprised of both tax increases and spending cuts under current policy totals over $500 billion, or 3.5% of GDP.

The 2013 budget changes, primarily consisting of tax increases, are already in the law and would need to be changed to mitigate or restructure them to be less of an economic drag; if not a return to recession may be looming in 2013.

While the United States economy is not likely to see the big declines in government spending that came after WWI and WWII, the United States has never experienced a deficit cut by more than 2% of GDP that did not end in a sharp decline in GDP. The last time the budget deficit was cut by a similar amount to the 3.5% on tap for 2013, it was 1969. In 1969, the deficit narrowed by 3.1% during the year, and GDP ended up shrinking -1.9% in the fourth quarter (and by -0.6% in the following quarter) as the U.S. entered a recession. Despite the recession, the efforts to narrow the deficit in 1969 had one pleasant outcome: they balanced the budget. Unfortunately, the budget changes on tap for 2013 will still leave the federal budget far from balanced.

The further apart the parties in Washington appear to be, even on extending the unemployment and payroll tax cuts that expire this month, may make investors increasingly nervous. This may result in the return of market volatility in February after stocks got off to a strong start to the year.

While the President’s budget is unlikely to get much attention in Congress, the markets may begin to price in a major budget deal taking place in early 2013 for several reasons:

• the economic impact of the many scheduled tax increases and spending cuts,
• the debt ceiling will be hit again in early 2013 and require legislative action to approve an increase,
• the rating agencies have warned that they will be watching in 2013 for the United States to take actions to return to a path of fiscal sustainability, and
• the President and a newly elected Congress will have maximum political capital to make it happen in early 2013.

But the risk that a budget deal does not eventually happen should keep markets from moving steadily higher in 2012, as they have done year-to-date, without a reality check. With Congress now back in session and the President’s budget due on February 13, just a week away, the markets may begin to refocus on the risks to the economy posed by inaction in Washington leading to a return of volatility.

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.

Gross Domestic Product (GDP) is the monetary value of all the finished goods and services produced within a country’s borders in a specific time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments and exports less imports that occur within a defined territory.

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.

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.
Correlation is a statistical measure of how two securities move in relation to each other. Correlations are used in advanced portfolio management.
Gross Domestic Product (GDP) is the monetary value of all the finished goods and services produced within a country’s borders in a specific time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments and exports less imports that occur within a defined territory.

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.

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.

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.

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.

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

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 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.