Apocalypse Soon

Jeffrey Kleintop, CFA
Chief Market Strategist
LPL Financial

Highlights

• The purported end of the world falls exactly one year from this Wednesday, December 21, 2011. Like a primeval Y2K event, 2012-ers believe that one year from now the earth will experience a catastrophe or an enlightenment.

• Surprisingly, we agree. The year 2012 will be one of transformation: politically, fiscally, and economically, with profound impacts for investors.

A search of the bestsellers with “2012” in their title does not offer the books you might expect such as travel guides, how to crack the SAT exam, or the best new cars to buy. Instead, the top books on the list are among the thousands of books, films, videos, seminars, and websites tied to doomsday predictions about 2012 [see accompanying Table]. In fact, the first non-end of the world entry to make the list does not show up until number 27 when the Dilbert calendar makes the list — then again, the Dilbert universe sure seems like purgatory. Specifically, according to these sources, the apocalypse comes on December 21, 2012 — the purported end of the world falls exactly one year from this Wednesday.

Where does this 2012/end of the world stuff all come from? The Mayans, who spread across Central America from about 2000 B.C. to 900 A.D., used a unique Mesoamerican “long count” calendar that marked time in long cycles lasting 394.3 years called b’ak’tun. A “sun”, or era, may be defined as 13 b’ak’tun cycles. The Mayan creation date was in 3114 B.C. and the 13th b’ak’tun cycle will end next year — on December 12, 2012.

The 2012-ers have pulled together Mesoamerican archaeology, stories about extraterrestrials, New Age spirituality, and pseudo-scientific analysis to produce a prophecy that on December 21, 2012 a profound transformation will occur. Like a primeval Y2K event, they believe that one year from now the earth will experience a catastrophe or enlightenment.

• Surprisingly, we agree. The year 2012 will be one of transformation: economically, fiscally, and politically with profound impacts for investors.
• The global economy is emerging. While we expect the U.S. economy to grow about 2% in 2012, the emerging markets will grow much faster. By the end of 2012, emerging market economies will reach 50% of the world’s gross domestic product (GDP) [Chart 1]. The non-advanced economies made up only 38% of global GDP 10 years ago, but reached 49% in 2011 (with currency adjusted for purchasing power parity), according to data from the International Monetary Fund.
• We believe a mild recession emerges in Europe and the debt dilemma continues to grab headlines and move markets as will the outlook for growth and financial stress in China.
• In addition, the party that emerges in control following the November 2012 elections in the United States will forge the decisions that will represent one of the biggest shifts in federal budget policy since World War II.

Consumer sentiment, business leaders, policymakers and geopolitics are going to have a significant impact on the investment environment in 2012. While volatility is likely to remain elevated, we do not see an end-of-the-world scenario for investors. In fact, the markets may fare better in 2012 than they did in 2011 with stocks posting solid gains (for deeper insight into our 2012 prophesies see our 2012 Outlook).

Works from the Mayans, prophesies of UFO cults, and even films from Hollywood (I Am Legend, Blade Runner, The Running Man) all suggest 2012 is likely to be fraught with danger. However, they also appear to feature flying cars — so it may not be all bad. Here is hoping that a transformational new era emerges in 2012 where politicians, business leaders, and individuals’ interests align to produce an environment of respect and much needed action.

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.

Kicking the Cannes

Jeffrey Kleintop, CFA
Chief Market Strategist
LPL Financial

Highlights

• Stock market volatility was driven by last week’s political brinkmanship derailing plans to secure funding support from China and other countries for the European debt rescue plan, kicking the implementation of the plan down the road well past the G20 meeting in Cannes.
• With every move in the stock market seeming to coincide with a headline coming out of Europe, it would be easy to conclude that this is the only issue that matters to investors.
• By stepping back from the day-to-day and week-to-week trading, it appears the issues in Europe over the past couple of years have merely created volatility around the true focus of investors on the fundamental economic backdrop that continues to slowly improve.

The S&P 500 Index had a bumpy ride last week as it tumbled 5% in the first two days on the eve of the Group of 20 summit in Cannes, France, as the Greek Prime Minister proposed a referendum on the European debt deal. This political move risked scuttling the hard-fought deal that had been unveiled the prior week that contributed to the powerful stock market rally. Stocks recovered most of the lost ground later in the week as the Prime Minister withdrew his call for a referendum and moved toward establishing a new government for Greece that is very likely to approve the controversial debt rescue package.

However, the political brinkmanship derailed plans by the leaders of Germany and France to showcase the new plan in order to secure funding support from China and other countries.The French President said it may take until February 2012 for a funding deal to be reached, kicking the implementation of the plan down the road well past the meeting in Cannes.

While hurdles to implementation of the debt plan are materializing, Italy’s 10-year borrowing costs are slowly nearing the 7% threshold that forced Greece, Ireland and Portugal to seek bailouts last year. The yield on Italy’s 10- year bond rose to 6.35%, the highest since the creation of the euro currency in January 1999. We expect the delay will force changes in the Italian government and result in the passage of the difficult, but necessary reforms to return to a sustainable fiscal path.

With every move in the stock market seeming to coincide with a headline coming out of Europe, it would be easy to conclude that this is the only issue that matters to investors. By stepping back from the day-to-day and week-to-week trading, we can see a different, longer-term pattern of performance emerging — one that reflects a different focus entirely.

If we look back at the past five years, we can see that stocks have very closely tracked real-time economic data, as measured by the weekly tally of initial claims for unemployment benefits as seen in Chart 1. It appears the issues in Europe over the past couple of years have merely created volatility around the true focus of investors on the fundamental economic backdrop that continues to slowly improve.

What else does this chart tell us? That the October rally was justified based on the underlying economic fundamenta

ls and that stocks may have additional modest gains in the months ahead — barring distractions thatcause stocks to again deviate from the underlying driver. In fact, based on this relationship, if initial jobless claims fall to a more normal level of 350,000 by year-end 2012, the S&P 500 would be around 1400, well above Friday’s closing level of 1253.

This would seem to suggest that what the market really cares about are jobs. But we believe that would put too fine a point on it. Initial jobless claims do measure the conditions in the job market, but they are also a real-time, weekly reflection of economic conditions. While the President and GOP presidential candidates focus on promoting their job plans, we think it is important to keep in mind that job growth does not make for a healthy economy; a healthy economy makes jobs grow. The health of the economy reflected in initial jobless claims is critical to gauging the outlook for the magnitude and sustainability of profit growth critical to long-term stock market performance.

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 Group of Twenty (G-20) Finance Ministers and Central Bank Governors is the premier forum for our international economic development that promotes open and constructive discussion between industrial and emerging-market countries on key issues related to global economic stability. By contributing to the strengthening of the international financial architecture and providing opportunities for dialogue on national policies, international co-operation, and international financial institutions, the G-20 helps to support growth and development across the globe.
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.

Trick or Treat

Jeffrey Kleintop, CFA
Chief Market Strategist
LPL Financial

Highlights

• Investors were treated to powerful gains last week as European policymakers crafted a deal to avoid a 2008-like financial crisis and economic and profit reports in the United States reflected solid growth.
• We believe last week’s European rescue deal is more treat than trick, but the devil is in the details. Over the long-term, concerns remain about the tricky outlook for economic growth in Europe and the ability of some peripheral countries to meet budget targets.
• While the stock market is likely to hang on to the powerful gains made in October, there are still a few of scares coming in November that may spook the markets and reintroduce some familiar volatility.

Was last week’s market rally a Halloween trick or a treat for investors? European leaders announced a deal last week that produced a sigh of relief felt around the world as markets welcomed the news of a breakthrough in what had been the biggest threat to the global economy and markets since the 2008 financial crisis.

In general, markets last week provided a treat to investors:

• The S&P 500 climbed 4% putting the gain for the month of October on track to be the best month since October 1974 [Table 1].
• Stocks rose sharply in Europe and Asia, led by the banks.
• High Yield corporate bonds rose 2%.
• Commodities surged with oil rising 7% and copper surging 15%.
• Reflecting a mostly positive outlook for growth, the yield on the 10-year Treasury note rose 12 basis points and traded as high as 2.40% for the first time since early August.

We believe the deal is more treat than trick, but the devil is in the details — many of which remain undisclosed in the statement released by European policymakers last week. There are three broad components of the rescue package:

• Greece’s debt burden is reduced by a 50% “haircut” on Greek bonds.
• European banks will be required to raise 106 billion euros to temporarily maintain a higher buffer against additional losses on their bond holdings.
• The rescue fund will provide guarantees against the first 20 – 25% of losses on about one trillion euros of European government debt.

Over the long-term, concerns remain about the tricky outlook for economic growth in Europe and the ability of some peripheral countries to meet budget targets. Reflecting these lingering concerns and fearing a trick, many investors in European government bonds sold their positions pushing Italian and Spanish bond yields higher for the week. Europe appears headed for a recession as seen in last week’s data included weak readings on employment, economic growth (as measured by GDP), and heavy truck sales in Europe.

The long-term success of the European rescue is dependent upon the members of the Eurozone taking additional steps to adhere to their plans for achieving financial stability and deficit reduction. Skepticism lingers that some nations will successfully hit the targets they have set especially in light of the recession that many European countries are likely to experience next year.

Despite the long-term concerns, the stock market may hang on to the gains it has achieved in the month of October which were supported by other positive news that continued last week:

• The string of solid and better-than-expected economic data in recent weeks was capped by last week’s third quarter GDP coming in at 2.5% and a new all-time high in real GDP. (See this week’s Weekly Economic Commentary for details).
• Strong and better-than-expected corporate earnings reports are on track for a 16.3% year-over-year increase with revenues up 10%. Of the 315 companies in the S&P 500 that have reported earnings to date for the third quarter, 71% have reported earnings above analyst expectations.
• Additional policy actions outside of Europe also helped lift markets. Japan boosted economic stimulus, Turkey cut reserve requirements, and China pushed lending support for small firms as they prepare to reverse efforts undertaken in the past couple of years to tighten credit.

We expect these trends to continue into November. As November gets underway, this week there are several potentially positive drivers for the markets:

• Important economic data is due to be released including the October readings on jobs (employment report from the Department of Labor), business sentiment (ISM), and consumer spending (vehicle sales and retail chain-store sales). This data should be solid — certainly relative to investor and consumer confidence readings, but it is getting harder to surprise to the upside after so many weeks. (See this week’s Weekly Economic Commentary for details).
• On November 3, the European Central Bank (ECB) is set to meet. The next step in a successful plan to stabilize Europe is for the European Central Bank to cut rates soon to promote growth and lending and reverse the two rate hikes they made earlier this year. A rate cut by new ECB head Mario Draghi would be welcomed by markets. In addition, the Reserve Bank of Australia, Australia’s central bank, may cut rates this week.
• Small components of President Obama’s jobs bill with a higher likelihood of passing Congress may be proposed this week.

However, there are some potential negatives on the calendar for November.

• The government is funded through a continuing resolution that runs out November 18 and will result in a government shutdown if not extended.
• The November 23 deadline is looming for the super-committee to vote on a plan with $1.5 trillion in deficit reduction.

So there are still a few scares coming in November that may spook the markets and reintroduce some familiar 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.
International and emerging markets investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.
The ISM index is based on surveys of more than 300 manufacturing firms by the Institute of Supply Management. The ISM Manufacturing Index monitors employment, production inventories, new orders, and supplier deliveries. A composite diffusion index is created that monitors conditions in national manufacturing based on the data from these surveys.

Rose’s interview on asset-based long-term  care was published in the October issue of The Advocate. Read below or click on the link to read Rose’s commentary.

By Rose Greene
CA Insurance Lic# 0690429

Long-term care policies save taxes and pay off before you die.

“A penny saved is a penny earned,” Benjamin Franklin said. But what happens if your savings run out before you do? That’s where long-term care planning comes in. One of the best ways to plan for what happens as you age, without putting your hard-earned net worth at risk, is to invest in an asset-based long-term care policy. Since half of all gay or bisexual men and 25% of all lesbian or bisexual women live alone after 50, such a policy is a wise investment that’ll take care of you when you’re unable to care for yourself.

An asset-based long-term care policy is basically is a modified universal life insurance policy, which is a tax-advantaged investment in which the cash value of your monthly premiums is credited with interest and you can take out loans based on your input without tax penalties (it’s often considered an alternative to Roth IRAs for folks who have income restraints that prohibit them).

But instead of a traditional death benefit you’d get with most life insurance (that big lump sum you got when grandma died), this type of policy provides you with money for extended in-home or assisted living care. It’s purchased the same way as a universal life policy, and it includes a long-term care rider provision and a death benefit if you end up not needing that long-term care. It’s not a “use it or lose it” plan, like your auto insurance.

In addition, with an asset-based long-term care policy, you won’t be saddled with monthly or annual premiums that increase as you get older. Instead, in most cases, you’ll make a single substantial initial payment called a single premium. The account grows tax-deferred and is taxed when you withdraw money; it still transfers free to your beneficiary. The size of that payment is variable depending on what daily amount you want to receive ($50 to $500 is average), the maximum lifetime benefit you want, type of coverage, and optional riders.

This kind of policy pays for a wide range of long-term care needs, anything from transportation to the doctor’s office to in-home meal preparation to end-of-life hospice care. You can also borrow from it, earn interest on it, cash it out, or leave it to your next of kin when you die without paying additional taxes on it.

You can buy such a policy for yourself or for an aging parent in order to protect his or her estate from overtaxation. For LGBT people, the nontaxable death benefit can be paid out to your same-sex partner or anyone you designate—regardless of whether your union is recognized in your state.”

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.

Earnings Season: What to Watch

Jeffrey Kleintop, CFA
Chief Market Strategist
LPL Financial

Highlights

• 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 third quarter earnings reports.
• Market participants have priced declines in earnings into stock market valuations. Yet, analysts have high, double-digit growth expectations for earnings as profits reach a new record high for the first time since the Great Recession.
• During this earnings season we are paying special attention to sales growth, exposure to Europe, and how companies are putting cash to work (or not) and the impact on the outlook for coming quarters.

U.S. stocks rose last week by 2.1%, as measured by the S&P 500 Index, once again rebounding off the low end of the range from about 1100 to 1200 that has constrained the Index for the past couple of months. The rebound was driven by a combination of solid and better-than-expected economic data, few negative earnings pre-announcements, supportive actions by foreign central banks, and talk among European policymakers of injecting capital into Europe’s banks to insulate them from a potential Greek default and recession.

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 third-quarter earnings reports. Four times a year investors focus on the most fundamental driver of investment performance: earnings. As you can see in Chart 1, the performance of the S&P 500 and analysts’ revisions to their earnings per share (EPS) estimates are closely linked.

Market participants have priced declines in earnings into stock market valuations, as we detailed in the Weekly Market Commentary from September 9 entitled Recession Obsession. Yet, analysts have high expectations for earnings. The consensus of analysts expects double-digit, 13% profit growth (compared to the third quarter of 2010) in the third quarter of 2011, as profits reach a new record high for the first time since the Great Recession, and 15% year-over-year growth for the fourth quarter for S&P 500 companies.

Who is right? The truth is likely to be in the middle as earnings expectations are revised modestly lower and markets price in a less dire outlook for profits as results are reported and guidance on coming quarters is provided by corporate leaders. In recent weeks, third-quarter earnings estimates have been falling. Of the 127 companies that pre-announced third quarter earnings guidance in recent weeks, the ratio of negative-to-positive news was 2.6, worse than the average ratio of 2.3 since 1995. For S&P 500 companies that have reported third-quarter earnings so far, 21 of 29 (72%) have exceeded estimates, while six have missed estimates.

The third-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 sales growth, exposure to Europe, and how companies are putting cash to work (or not) and the impact on the outlook for coming quarters.

• Sales Growth – We will be putting more emphasis this season on top-line rather than bottom-line growth. Sales growth is expected by analysts to come in around a strong 10%. One headwind companies face is sluggish economic growth around the world, although they were able to post strong growth in the first half of 2011 despite sluggish economic growth. Another headwind is the movement in the value of the dollar. During the third quarter, the dollar was down about 10%, on average, from a year earlier boosting the translation value of foreign-sourced profits. However, entering the fourth quarter the dollar is flat compared to a year ago, eliminating a positive for profits.
• European Exposure – Economic growth may likely continue, albeit below average, in the United States over the next year and emerging markets are expected to continue to grow. However, developed foreign economies, particularly in Europe, may enter a recession in the next 12 months. S&P 500 companies’ revenues are composed regionally; about 46% of profits come from foreign markets with about 29% of foreign profits derived from Europe. However, that varies widely by sector and industry.
• Putting Cash to Use – Pressure is building for higher dividends as U.S. companies sit on record cash stockpiles and payouts remain at all-time lows. S&P 500 companies paid out 26% 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 2.2%, above the yield on the 10-year Treasury for one of the few times in history. Also, share repurchases are a way of putting cash to work.

This week, just ten S&P 500 companies are due to report earnings. It is important to keep in mind that 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 third quarter of 2011 are shaping up until just after the end of the month of October, 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.

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.

Earnings per share (EPS) is the portion of a company’s profit allocated to each outstanding share of common stock. EPS serves as an indicator of a company’s profitability. Earnings per share is generally considered to be the single most important variable in determining a share’s price. It is also a major component used to calculate the price-to-earnings valuation ratio.

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.

Beyond the Near-Term Clouds the Outlook May be Brightening for Long-Term Investors

Jeffrey Kleintop, CFA
Chief Market Strategist
LPL Financial

Highlights

• We believe that the most consistently accurate predictor of long-term stock market returns is the S&P 500 Index price-to-earnings ratio (P/E). The P/E has demonstrated consistent success predicting long-term returns going all the way back to the 1930s.

• Focusing on the short-term can be paralyzing for many investors. Long-term investors can take heart since the P/E predicts that this is the best time in 20 years to consider buying, not selling, stocks.

• History shows us that what really matters is the price we pay, not so much what happens along the way.

Friday’s (September 9, 2011) stock market loss erased last week’s gain. The S&P 500 ended the week at 1154, down 1.7%, near the middle of the range of about 1120 to 1200 that has prevailed since early August 2011. The near-term outlook remains clouded and uncertain. The main issue keeping the market in this volatile range is coming from overseas.

The sovereign debt problems in the eurozone require policy actions to get peripheral countries on the right fiscal path and ensure their funding until the European banks are sufficiently insulated and a partial default for Greece can take place. We assessed this situation in detail earlier this year in a Weekly Market Commentary, entitled “Greece Fire”, published on June 20, 2011. In that publication, we noted that European banks have taken actions to reduce their exposure; in total, German banks exposure to Greek debt is about 1.2% of consolidated cross-border debt holdings and for France it is 1.8%. But the question of whether or not Greece’s default can be orderly is complex. The fear among some market participants is that the default or restructuring of Greece’s debt will trigger a series of financial institution defaults and a financial crisis throughout Europe and beyond similar to what happened in the fall of 2008 after Lehman Brothers unexpectedly declared bankruptcy. While our analysis suggests this is not likely to be the case, no one knows for sure unless it happens.

The near-term uncertainty over the outcome of the European debt problem, and the fragile state of the U.S. economy, has kept individual investors scared and prompted them to sell their holdings of stocks at the fastest pace since the peak of the financial crisis in 2008. We can see this in the monthly money outflows from U.S. stock mutual funds totaling $35 billion in August [Chart 1].

Fortunately, the long-term outlook offers a clearer picture for investors. Though past performance is not an indicator of future results, we believe that history has made it clear that the most consistently accurate predictor of long-term stock market returns is the S&P 500 Index price-to-earnings ratio (P/E). The P/E is obtained by taking the price level of the Index and dividing it by the earnings per share over the past four quarters. Essentially, the P/E is how many dollars investors are currently willing to pay per dollar of earnings. It makes sense that the price you pay when you buy a stock can have a big impact on your return. The level of the P/E and the annualized return on stocks over the next 10 years has a very close relationship, as you can see in Chart 2. In essence, the lower the P/E, the higher the return over the next 10 years. Currently, this relationship predicts that high single-digit gains are likely, on average per year, for the stock market over the next 10 years.

Despite the fact that the P/E has a nearly perfect track record of forecasting long-term performance, many investors have been selling and believe that it is different this time given the troubled banks, European credit problems, geopolitical tensions, concerns over both inflation and deflation, the U.S. budget deficit, threat of rising tax rates, and uneven economic data, among other concerns. We do not dismiss these issues. However, the P/E has demonstrated consistent success predicting long-term returns over the entire history of the S&P 500 Index — going all the way back to the 1930s.

Investors have always faced challenges. Since 1928, the S&P 500 has weathered massive bank failures, a dozen European countries defaulting, a world war, double-digit inflation, top marginal income and dividend tax rates of about 90 percent, the percentage of U.S. government debt-to-GDP at double the current level, not to mention the Great Depression. And yet, through all of these unprecedented events the P/E remained a consistently accurate forecaster of future long-term returns.

The annualized loss for stock market investors during decade of the 2000s was the result of the record high 30 P/E 10 years ago in early 2000. However, we believe the current P/E of about 12 forecasts a better decade for performance ahead. The current P/E of around 12 suggests a 7 – 8% price return for the S&P 500. The addition of a 2% dividend yield may result in a total return of 9 – 10% [Chart 2].

Based on this relationship between future returns and P/E, the stock market’s lowest valuations in 20 years suggests this the best time in 20 years for long-term investors to consider buying, not selling, stocks.

Often, investing can be emotional, and the near-term clouds of uncertainty too often obscure what we may feel more certain of over the long term. This simple predictive relationship between P/E and future returns gives us hope that it is not different this time. It is easy to focus on all that could go wrong and assume it is insurmountable, but history shows us that what really matters is the price we pay and not so much what happens along the way.

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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.

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.

International investing involves special risks, such as currency fluctuation and political instability, and may not be suitable for all investors.

The Investment Company Institute (ICI) is the national association of U.S. investment companies, including mutual funds, closed-end funds, exchange-traded funds (ETFs), and unit investment trusts (UITs). Members of ICI manage total assets of $11.18 trillion and serve nearly 90 million shareholders.

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.

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 Markets’ Recession Obsession

Jeffrey Kleintop, CFA
Chief Market Strategist
LPL Financial

Highlights

• Investors may not need to worry about the impact of a recession since it already appears to be fully priced in to both stocks and bonds.

• This is not unusual. Historically, the stock market has often bottomed before the recession was even declared. And, importantly, there have been times when the stock market fell and priced in a recession that did not take place, such as the bear markets of 1987 and 1998.

• Based on our analysis of past earnings cycles, a recession level for the S&P 500 Index is about 1120, which is exactly where the Index bottomed out three times during the month of August.

On Friday, the Labor Department said U.S. payrolls were unchanged last month. This was the weakest reading since September 2010 and worse than economists’ forecasts. The weak reading on jobs weighed on stocks as market participants reacted to fears of a recession. The stock market’s sharp 2.5% decline on Friday left the S&P 500 down -0.2% for the week, making last week the fifth of the past six weeks that the stock market suffered a loss.

We continue to believe that, rather than recession, weak economic growth will continue this year. However, in recent weeks, markets have moved to fully price in an impending recession.

• Treasury yields have returned to recession levels. In fact, they are below the levels reached in the depths of the last recession (2007 – 2009) as investors believe the economy will shrink.
• Corporate high-yield bond spreads have widened out to levels seen, on average, in past recessions. Investors expect a recession to reduce corporate earnings and the ability of corporations to make interest and principal payments.
• While stocks remain well above the depths reached during the last recession, a return to recession has been fully priced into the stock market this year during the recent lows based on earnings and valuations.

An analysis of the S&P 500 earnings cycles presented in Table 1 reveals that, typically, earnings grow for 5 – 10 years averaging about 7% a year from the prior peak before they pullback. During a recession they typically fall about 12 – 24%. The only exception to this 12 – 24% range was in 2008 when the companies in the Financials sector, the largest sector by earnings at the time, were forced to write off a decade of profits in just one quarter.

We believe it is possible that if the economy deteriorates further and we entered a recession, earnings may fall 12% from current levels. This 12% pullback is at the smaller end of the historical range for several reasons.

• First, we have not had the buildup of corporate debt levels that typically acts as leverage and boosts earnings in the later years of a business cycle. That leverage later comes out in just a few quarters and acts as a multiplier on the earnings pullback. Instead, the opposite has taken place this time, as corporations have continued to reduce debt after the downturn ended, leaving much less than usual downside to earnings in a recession.
• Second, unlike past cycles, the S&P 500 now gets 25% of sales from fast growing emerging markets relatively unaffected by a recession in the developed markets. That growth will continue for the most part regardless of the U.S. economic backdrop. This is one of the key reasons profits have boomed at a double-digit pace despite the very sluggish economic growth in the United States in the first and second quarter of this year.
• Third, businesses have not done a lot of hiring yet this business cycle. The vast majority of corporate costs are labor. Businesses have not reached the point where a pullback in demand from a recession would result in them being suddenly overstaffed and have to suffer big costs associated with early retirement, mass layoffs, or retaining excess workers as demand falls.
• Fourth, we have barely started to grow earnings above the prior peak. In general, earnings pullbacks are proportional to the gain they achieved during the cycle. The below-average earnings gain is likely to result in a below-average pullback. For example, back in 1959, the earnings cycle was short and earnings pulled back without growing above the prior peak. During that correction earnings fell just 12%.

If a recession develops and earnings fall 12%, the total earnings per share (EPS) of the past four quarters, which now stands at a little over $95 for S&P 500 companies, would fall to about $83.85. This would return EPS to a level first achieved over five years ago.

Historically, the trailing price-to-earnings (PE) ratio for the S&P 500 averaged 13.35 at the recession-driven earnings trough. Some periods were much lower and occurred during periods of double-digit inflation in the late 1970s and early 1980s. Others periods were much higher for various reasons, including the lingering tech bubble mania in the early 2000s.

If we assume recession EPS of $83.85 and multiply that by the average recession PE of 13.35, we get a recession level of about 1120 for the S&P 500, which is exactly where it bottomed out three times during the past month.

It is no wonder that during August the stock market fully priced in a recession as events took place that included:

• The debt-ceiling debacle
• U.S. credit rating downgrade
• Worsening European debt problems
• Riots in London
• The worst month for U.S. casualties in Afghanistan
• Plunging consumer confidence readings

All of these combined to drive the stock market down 18% from the peak that took place back in April of this year.

Investors may not need to worry about the impact of a recession since it already appears to be fully priced in to both stocks and bonds. It is not unusual for the stock market to fully price in a recession well before it has ended or even before it has been declared. Over the past 50 years, the stock market has typically bottomed three to six months before the low point of the recession. In addition, there have been times when the stock market fell and priced in a recession that did not take place, such as the bear markets of 1987 and 1998. It seems that the debate over whether a recession will take place has now been settled for many investors and they have moved on to whether the recession will be much worse than average.

Based on this analysis, a much worse-than-average recession could drive EPS down 22% to $74.32. In that event, the S&P 500 Index may suffer a greater decline to about 1000, which would mark a peak-to-trough market decline of a hefty 36% from the recent high of 1363. We see this as a very low probability. Despite the worries over the weak August job report, it is important to remember that just one month ago (the July 2011 report released in early August) the jobs report was much stronger than expected. As we have been saying all year, volatility in the economic data is to be expected. While sentiment readings were weak, economic data during the month of August was positive, solid, and pointed to continued slow growth. These key reports included: industrial production, retail sales, durable goods orders, shipping traffic, business lending, initial jobless claims, corporate earnings reports, and both the manufacturing and non-manufacturing ISM indices.

We see more upside than downside to the stock market. Our base case remains, as it has all year, for stocks to post modest, single-digit gains in 2011 which suggests about a 15% gain from current levels. A recession, the odds of which we peg at about a 1-in-3 chance of taking place, may mean that stocks revert back to the August lows of 1120 and suffer a 5% decline from the closing level on Friday, September 2. And we see a very low, but not zero, probability of a deep recession that may pull stocks down another 15% from current levels.
The markets’ obsession with recession does not make it a foregone conclusion. Investors’ lack of confidence in economic growth, corporate profit forecasts, and the actions of policymakers is likely already fully reflected in the markets and creates the potential for a bounce if any of them exceed low expectations. Like we said as the market made the lows of August: the stock market climbs a wall of worry not when risks go away, but when the confidence that they will be overcome returns.

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.
International investing involves special risks, such as currency fluctuation and political instability, and may not be suitable for all investors.
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.
Earnings per share (EPS) is the portion of a company’s profit allocated to each outstanding share of common stock. EPS serves as an indicator of a company’s profitability. Earnings per share is generally considered to be the single most important variable in determining a share’s price. It is also a major component used to calculate the price-to-earnings valuation ratio.
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.

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

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.

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.

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.

Debt Ceiling Debate Outcomes and Market Impact

Jeffrey Kleintop, CFA
Chief Market Strategist
LPL Financial

Highlights

• We update the probabilities of the four potential outcomes emerging from the debt ceiling debate over the next two weeks.

• We continue to believe the most likely outcome by Aug 2 contains spending cuts totaling $1 – 2 trillion over 10 years, but no substantive entitlement reform or tax increases.

• The markets have largely priced in this outcome and are unlikely to make a major move in either direction if this is the result. However, dramatic moves are likely in the event of alternative outcomes.

• The longer the uncertainty lingers the worse the market may fare, as last week’s performance attests.

The S&P 500 dropped 2.1% last week. The index retreated after posting the biggest two-week increase since 2009. The lingering impasse in Washington on the debt ceiling weighted on the market and prompted bond rating agencies Moody’s Investors Service and Standard and Poors to say they may cut the United States credit rating. Concern that the debt problems in Europe were spreading also fueled the selling. Positive earnings reports were no help even as the first week of reports resulted in 11 of the 13 S&P 500 companies that released results beat projections.

Over the next two weeks, increasingly the major issue for the markets will be the debt ceiling negotiations. A deal may need to be reached this week to have time to pass congress by August 2. If a deal is not reached the markets may “hit the ceiling” as the United States is forced to default on its obligations or must undertake emergency measures to avoid a default.

Pruning the Tree

There are four key updates to the decision tree we published on July 5.

• No deal was struck by mid-July, as we thought was most likely. As of August 2, the United States will have exhausted its ability to borrow under the existing federal debt ceiling of $14.3 trillion.
• The large debt ceiling increase of $3 – 4 trillion is still possible, but we are lowering the odds to 10% from 20%. To achieve $3 – 4 trillion in savings over 10 years this outcome would likely involve major entitlement reform, substantial tax cuts and some revenue increases, and would put the United States on a path to fiscal sustainability. The likelihood of this outcome went down as both sides have made it clear what that tax hikes and major entitlement cuts were largely off the table. However, rating agency Standard and Poor’s indicated last week that a deal of this size is important to sustaining the U.S.’s AAA credit rating. Also, the President has been pushing for a large deal and the House Republicans have proposed such a large deal. This maintains some possibility that a deal of this size could still be reached. In the event of this outcome, the stock market would likely post a sizable double-digit gain over the following weeks with companies in cyclical sectors such as Consumer Discretionary winning out over defensive sectors that may bear the brunt of the cuts, such as Health Care. High quality bonds would also rally although the already low yields would limit overall gains to a few percentage points. The dollar would likely strengthen sharply, leading to declines in commodity prices ranging from gold to oil.
• The probability of a smaller $1 – 2 trillion deal containing only spending cuts went up to 65% from 60%. On Friday, President Obama said he would sign a deal that may include only spending cuts. This outcome appears to make a large dent in Federal spending, it defers tough decisions on entitlements and taxes to the next Congress (after the 2012 election when the Republicans may control both houses of Congress), and provides a victory for members of both parties going in to the 2012 elections. The markets have largely priced in this outcome and are unlikely to make a major move in either direction if this is the result.
• The risk of no deal by August 2 went up to 25% from 20%. Emergency measures have been increasingly proposed such as a vote by Congress to give power to the President to unilaterally raise the deal ceiling. Whatever the method, if no deal can be reached, congress or the Treasury may take emergency steps to prioritize debt payments to avoid default on the U.S.’s debt. This would be a negative outcome for the markets, but not devastating. With the two sides unable to reach a deal with so much on the line, confidence among investors (and consumers and businesses) would likely plunge. Stocks could experience double-digit pullback as the impasse lingers. Treasury yields would rise as bond prices fell on rising fears of default. Precious metals may rise as investors seek a safe haven alternative to Treasuries.

For more details on these outcomes please see our July 5 Weekly Market Commentary entitled “Will Markets Hit the Ceiling?”

What if?

But what if the deadline passes and the United States defaults? The global financial system seizes up as Treasuries become illiquid. The economy lurches back toward recession. Stocks may enter a bear market as defined as a 20% or more decline and Treasury interest rates would soar as bond prices plummeted. Gold and other precious metals would likely be beneficiaries of the flight from other assets to a safe haven other than Treasuries.

We still believe that default, the worst outcome by far, has very little probability of coming to pass. To answer the “what if” question more completely requires some context that highlights why we believe a deal is likely and becomes self-reinforcing as the deadline gets closer.

Because Federal government revenue is not collected evenly throughout the year, spending in most months vastly exceeds revenue. If there was no debt ceiling increase deal reached and implemented by August 2 funds would fall short of the $307 billion in planned spending for the remainder of the month by $134 billion, or 44%. This would not be business as usual for anyone.

The prospect of a 44% reduction in spending starting August 3rd on everything including: social security, military pay, food assistance, interest on the national debt, Medicare and Medicaid, educational aid, housing programs, unemployment benefits, federal salaries, etc, would have career-ending backlash for legislators.

Under a scenario where the stock market falls 20% or more, draconian spending curbs of 44% kick in, and the economy spasms, voter outrage with all parties would cause members of congress to quickly reconsider voting for a compromise deal on the debt ceiling.

Both sides can declare victory with the smaller $1 – 2 trillion dollar package of spending cuts and debt ceiling increases that do not raise tax rates or involve material entitlement program cuts and that kicks the tough decisions on these issues down the road until after the 2012 elections.

Republicans can deliver on campaign promises to reduce spending and hold firm on tax increases. And a minor tweak to entitlements, such as re-indexing Social Security benefits to inflation rather than wage growth, shows they are serious about eventually dealing with the issues on longer-term fiscal sustainability.

A deal that involved raising revenue through closing some tax loopholes used by corporations or wealthy Americans would offer democrats a chance to declare victory, as well. A deal of at least a trillion would also demonstrate some fiscal restraint popular with voters ahead of a tough Senate race next year.

To download a complete copy of the commentary click below

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.

International and emerging markets investing involves special risks such as currency fluctuation and political instability and may not be suitable for all 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.

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.

Stock investing may involve risk including loss of principal.

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.
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