Following the Path

Jeffrey Kleintop, CFA
Chief Market Strategist
LPL Financial

Highlights

• The stock market, measured by the S&P 500, has posted a high single-digit gain for the year, and the S&P 500 index is around 1,350. Sound familiar? It should. It is exactly what happened last year.

• Last year, stocks shed their gains for the year over the weeks following the run-up into the President’s Day holiday.

• While we do not believe the S&P 500 has reached its high for the year, the index may be due for a modest pullback, driven by a combination of: stalling earnings growth, mounting fiscal headwinds, and European debt and economic concerns resurfacing.

Just seven weeks into 2012 and the markets are off to a strong start. The stock market, measured by the S&P 500, has posted a high single-digit gain for the year, and the S&P 500 index is around 1,350. Sound familiar? It should. It is exactly what happened last year, as you can see in Chart 1.

If stocks continue to follow this pattern they are set for a pullback. Last year, stocks shed their gains for the year over the weeks following the run-up into the President’s Day holiday. Over the four weeks that followed, the S&P 500 slid back to exactly where it had started the year, only to begin a rebound and a pattern of volatility that lasted into the summer months.

Indeed, stocks may be due for a modest pullback, in line with last year’s pattern, driven by a combination of:

• Stalling earnings growth – Stocks have relied heavily on earnings gains for performance over the past three years with earnings and stocks rising by the same amount. Earnings growth for S&P 500 companies is likely to be flat in the first quarter, posing a risk for stocks.
• Mounting fiscal headwinds – As last week’s passage of the payroll tax cut highlights, it will be very difficult to address the U.S. fiscal imbalances. 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 United States has never experienced a deficit cut by more than 2% of GDP that did not end in a sharp decline in GDP.
• European debt and economic concerns resurfacing – Recent policy actions in Europe including actions by the European Central Bank, the fiscal compact agreed to by European leaders, and the path to reforms undertaken by some key countries have resulted in a significant reduction in perceived risks to the financial system and global economy. However, deteriorating economic growth in Europe, the stall in the trend toward declining rates for core European nations, and upcoming elections in France and Greece raise questions about the commitment to achieving the reforms and support necessary to stabilize the markets.

Much like the S&P 500, there are other markets retracing familiar patterns, as well. The euro is following last quarter’s pattern. Why would it do that? Greece needs money in about a month to meet maturing debt payments totaling 14.5 billion euros. The so-called troika (consisting of the ECB, IMF and European Commission) has demanded further austerity. Greek leaders resist these demands and make some bold moves, fearing the domestic backlash to austerity. The EU leaders cancel meetings to make the point that they are serious about their demands, and Greece grudgingly agrees.

Does this scenario sound familiar? It should, since it is a repeat of what played out late last year after former Greek PM Papandreou submitted his referendum proposal in November and stepped down. The euro is repeating the same pattern it traced during the last time this Greek drama played out. If it continues to play out the same way — that Greece dodges another bullet, but is still in front of the firing squad — then maybe the euro continues follows the same path as it did late last year and slides further, as you can see in Chart 2.

While these patterns could be coincidences, they are more likely to be indicative of the most likely reaction by the markets to the events evolving around the world. While we do not believe the S&P 500 has reached its high for the year, the index may be due for a pullback in the coming weeks after a strong four-and-a-half-month run-up of about 25% as it climbed back to the post-crisis highs.

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

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.

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.

New Ideas Are Not Just for Europe

Jeffrey Kleintop, CFA
Chief Market Strategist
LPL Financial

Highlights

• The weaker pace of productivity in recent years could mean slower profit growth ahead for S&P 500 companies.

• Fortunately, business spending on research and development (R&D) has improved, and patent grants are now on the rise. It typically takes about three years for patent grants to result in improved productivity for businesses.

• We believe that productivity and innovation are due for a comeback, helping to support profit growth.

Developing new solutions to battle the debt problems in Europe has been important to making substantive progress toward a long-term solution. Last week’s European summit produced progress in the form of a landmark agreement to strengthen budget rules. While the accord addresses the long-term problems facing Europe, the spending cuts are likely to slow growth and produce a mild European recession in 2012. The breakthrough finally opens the door for the European Central Bank (ECB) to intensify its efforts to stimulate growth and stabilize the debt markets beyond last week’s rate cut.

While the headlines on Europe continue to garner nearly all of the market’s attention, it is worth noting the changes in the trend of innovation since developing new solutions to drive productivity will be important to generating profits in the years ahead for the benefit of investors.

Developing new products and finding new, more productive ways to employ resources to create them is critical to sustaining the growth of a business. The ingredients for innovation are often in the form of patents, copyrights, and licenses to support economic interest in developing new technologies and processes. Competition intensifies companies’ push for cost-saving productivity enhancements through implementation of new technologies and processes.

Post-World War II economic growth has averaged 3.2% on a real (net of inflation) basis annually. Most of this growth has come from increasing productivity rather than using more resources. Productivity growth, measured by industrial production per worker, has averaged 2.2% over the past 100 years. The only notable pauses in this trend were the result of the Great Depression and the inflation spiral of the 1970s, in the latter case, rapidly rising prices masked the benefits of improving efficiency.

New successful consumer products, such as smart phones and internet search engines, are often what come to mind when we think about innovation. It is the broad implementation of new technologies by businesses that accounts for many of the recent advances in productivity. A key component of rising productivity in the 1980s and 1990s was the implementation of just-in-time inventory management systems. The advent of radio frequency identification (RFID) tags allowed the trend to extend further. Putting RFID tags on products enables many types of companies to manage their inventory more efficiently through real-time integration with suppliers. Advanced asset tracking enhances operational efficiency.

Supply chains can be optimized, thereby reducing the risk of input shortages without holding excess (and potentially perishable or obsolescent) critical supplies. This is especially valuable for health-care and manufacturing companies. For retailers there are additional benefits, such as the potential to eliminate the traditional checkout areas, reduced customer wait times, and improved theft detection. This is just one of the new technologies that help to drive productivity.

Productivity is critical to sustaining growth in profits. Over the long-term, S&P 500 company profits have risen by about 7% per year, on average. This rate also happens to be our forecast for profit growth in 2012 (for more details on earnings growth and other aspects of what we envision for 2012 see the 2012 Outlook publication). However, during the past decade, there has been a slowdown in productivity to less than half the historical trend rate. Weaker productivity could mean slower profit growth for S&P 500 companies in the years ahead. The reasons for declining productivity include: the slower pace of business spending, lower tolerance for risk-taking in corporate America, and the stall in patent grants.

One way to measure the potential pace of productivity and innovation in the coming years is to look at spending on research and development (R&D) and the growth in patent grants. Growth in spending in these areas tends to support ongoing productivity growth. After surging in the late 1990s amid the technology boom, business R&D spending as a percentage of gross domestic product (GDP) peaked in 2000. Patent grants soon began to fade and business productivity slumped starting in late 2004.

Fortunately, spending has since improved and patent grants are now on the rise. It typically takes about three years for patent grants to result in improved productivity for businesses [Chart 2].

During the next 10 years, innovative business operations are essential for creating investor wealth. We believe productivity both in and outside the United States will rise in the coming years. Keeping up with the pace of change will be a challenge facing individual companies. The period of competitive advantage offered by a better mousetrap is shrinking. Faster development of products and services means companies must constantly innovate to stay on top. For instance, automobiles go from the design stage to production and the showroom floor in much less time than they did 10 years ago. Companies — and countries — must adapt or face extinction.

Technology and communications have made it cheaper and easier than ever before for someone with an idea to disseminate and develop it. Access to credit was severely curtailed during and after the financial crisis of 2008 – 09; however, credit and capital to finance new ideas have now become more abundant. And, while funding for the patent office had been in doubt as part of reducing overall spending, a November 2011 compromise secured funding through the end of the 2012 fiscal year. We believe that productivity and innovation are due for a comeback in the years ahead.

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 Pink Swan

Jeffrey Kleintop, CFA
Chief Market Strategist
LPL Financial

Highlights

• A “black swan” event — a rare, unexpected event that has a major impact — is most often referred to as something with negative consequences. Investors have sharply discounted the odds of a positive surprise, or “pink swan” event.

• While investors fret over black swans, there are a number of potential pink swans that could take place and grab investors’ attention in the weeks ahead.

• While they may be hard to see at the moment, there are potential pink swans that could result in stronger-than-expected growth over the longer term: a clear path to U.S. fiscal sustainability could emerge in the next few years; China’s consumers could begin to become a powerful force and drive global demand growth; and new technologies could greatly improve resource productivity.

A “black swan” event — a rare, unexpected event that has a major impact — is most often referred to as something with negative consequences. The near-record low investor confidence readings and double-digit decline in the stock market during the third quarter reflect concern that the odds have sharply increased that a black swan event may take place. It is easy to cite a few of them: a European financial crisis; a U.S. recession; a fiscal debacle in Washington. However, investors have just as sharply discounted the odds of a positive surprise, or “pink swan” event. Given the pessimistic tone of investors, the pink swan may have the bigger potential market impact.

Last week the U.S. economic data came in better than expected and progress was made on the European debt problem with Germany’s ratification of the expansion of the European Financial Stability Facility. However, this provided little relief to investors as stocks were basically unchanged on the week and remained near the low end of the 1100 to 1200 range the S&P 500 Index has been stuck in for the past two months. While investors fret over black swans, there are a number of potential pink swans that could take place and grab investors’ attention in the weeks ahead:

• The employment report is released this week and could surprise to the upside. Recent economic data has been better than expected, with the index of leading indicators rising for the fourth consecutive month and initial claims for unemployment benefits falling below 400,000 last week for the first time since April. These indicators may surprise investors braced for weak data.
• Next week the third quarter earnings reporting season gets underway. Corporations were able to post double-digit earnings per share gains in the first and second quarters despite U.S. gross domestic product (GDP) growth that averaged less than 1%. Third-quarter GDP may have been more than twice the first half average, supporting continued solid earnings growth despite low expectations by investors priced into stock valuations.
• Further signs may emerge in the coming weeks that Germany is supporting the euro zone as evidenced by the wide margin of passage on the German vote for the expansion of the European Financial Stability Facility (EFSF). Based on the success in Germany of the EFSF vote, the European Commission may introduce a proposal for so-called eurobonds to the parliament. The potential for the adoption of a long-term solution to the European debt problems would be a confidence boost where it is needed most.
• China may surprise by cutting rates. After hiking rates and restraining growth and inflation pressures over the past couple of years, China has recently declared victory over its inflation problem and could return to a more pro-growth policy after economic growth slowed from about 12% to 9% in the past year and a half. This would be a surprise positive for the markets — particularly commodities.

• The Federal Reserve’s last effort to help the economy, the so-called Operation Twist, could spur home buying as it creates the lowest mortgage rates in history. Already low rates helped to lift existing home sales 18% over the past year and new home sales are up 6%. A rise in home prices, with median home prices basically unchanged since the free-fall ended in early 2009 [Chart 1], would be a welcome surprise.
• It is possible that the “super committee” tasked with finding the minimum of $1.5 trillion in deficit reduction by the end of this year as part of the debt ceiling legislation passed in August may succeed and recommend real fiscal reform. The bar is low. Many political pundits expect the group to fail by only finding a fraction of the intended deficit reduction, resulting in an automatic sequester to discretionary spending, the outcome largely reflected by markets.
• Over the past 50 years, when stocks post a double-digit decline in a quarter they typically rebound 6% during the following quarter. Out of the 16 times the S&P 500 has registered a double-digit loss during a quarter, 13 of those times — or over 80% of the time — the following quarter posted a gain and those gains averaged 9%. It is worth noting that the month of October is historically the month that typically ends stock market slides as the market begins to reverse declines.

• Looking beyond the next several weeks or months, we continue to expect a below average growth environment in the years ahead. However, while they may be hard to see at the moment, there are potential pink swans that could result in stronger-than-expected growth.
• A clear path to U.S. fiscal sustainability could emerge in the next few years. The current political gridlock may give way to action after the 2012 elections as rising interest costs force broad fiscal reforms.
• China’s consumers could begin to become a powerful force and drive global demand growth rather than just the growth in the global supply of goods. Employment and incomes are rising sharply in China. While domestic consumer spending currently only accounts for about one-third of China’s GDP it is rising quickly. The United States is the world’s largest manufacturer. U.S. companies would benefit from solid growth in Chinese consumer spending.
• New technologies could greatly improve resource productivity. There is a correlation between patent grants and productivity a few years later [Chart 2]. The United States is currently saddled with a backlog on new patent requests; however, this logjam is beginning to break. If recent efforts at patent reform are combined with an increased emphasis on providing protection to new ideas we could see an explosion of efforts driving innovation and creating new products.

With consumer, business, and investor confidence readings near historic lows it is hard for negative black swan events to surprise an unprepared marketplace. Alternatively, with so few expecting positive developments it is more likely that a pink swan event is the true outlier with the most potential market impact.

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.

Debt-to-GDP is a measure of a country’s federal debt in relation to its gross domestic product (GDP). By comparing what a country owes and what it produces, the debt-to-GDP ratio indicates the country’s ability to pay back its debt. The ratio is a coverage ratio on a national level.

Correlation is a statistical measure of how two securities move in relation to each other. Correlations are used in advanced portfolio management.

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 reexamined 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.

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

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.

Quote of the week.

Reputation is what other people know about you. Honor is what you know about yourself.”

– Lois McMaster Bujold

4Q GDP: 5.7%: That is the preliminary reading from the Commerce Department, and that is the best reading since 3Q 2003. Economists

pointed out that much of the increase reflected companies rebuilding their inventories rather than personal spending.1

Consumers think positive. The final University of Michigan/Reuters consumer sentiment index for January improved 1.6 points to 74.4. Economists polled by Briefing.com felt it would come in at 73.0.2

New concerns about home sales. Both new and existing home sales retreated markedly in December with the threat of federal tax credits being pulled. Existing home sales fell by 16.7% in that month while new home sales slipped 7.6%. In annual terms, residential resales for 2009 were about 5% higher than 2008 totals. Just 373,000 new single-family homes were sold in 2009, the fewest since the government began tracking sales stats in 1963.3,4

A $5K hiring rebate? Last week, President Obama pitched the idea of giving companies of all sizes a $5,000 credit to offset payroll taxes for each new worker, up to a $500,000 ceiling. Net new hires (increasing employee hours) and salary increases could also make companies eligible. A proposal to enact the plan is now in the Senate.5

Dollar hits highest level since August. The buck went on an intraday climb to 90.92 yen and the euro traded below $1.39. The new GDP report helped.6

So long to a subpar month. Stocks retreated in the last week of January, with the Dow ending the month at 10,067.33, the NASDAQ at 2,147.35 and the S&P 500 at 1,073.87.7

(Source: CNBC.com, CNNMoney.com, ustreas.gov, bls.gov, 1/29/10)7,8,9,10
Indices are unmanaged, do not incur fees or expenses, and cannot be
invested into directly. These returns do not include dividends.

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