Highlights

• The U.S. stock market's stalling momentum and increasing volatility, combined with other signs evident in the market'srecent behavior, suggest investors may be looking for new inspiration.

• A flu pandemic or an act of war by North Korea could be a shock that results in a setback to the economy and stock market, while the aggressive stimulus in Japan could be a boost that finally gets stocks to break out of their month-long range.

The S&P 500 Index closed at 1553 on Friday, April 5, the level the current rally first reached a month ago. The stock market's stalling momentum and increasing volatility, combined with other signs evident in the market's recent behavior, suggest investors might be looking for new inspiration.

• Daily push-and-pull action: The S&P 500 has now reversed direction on a daily basis 12 times in a row - that has never happened before in the 85- year history of the S&P 500 Index. It may be noteworthy that the only time the index had reversed direction daily for 11 days in a row was July 26, 1981, ahead of a 15% loss, and the last time it reversed direction 10 days in a row was April 17, 2002, ahead of a 30% stock market decline.
• Stronger selling conviction: Over the past month, trading volume for the S&P 500 stocks has been 20% higher on down days than on up days.
• Risk vs. safety battle: Last week, traditional opposites - the S&P 500 Index and gold prices - both traded at the same level (1554). Gold rebounded later in the week while stocks slumped. The last time their paths crossed was May 2010, just before the stock market reversed its trend and began a pullback.
• Defensive leadership: Stocks have recently been led higher by defensive, rather than economically-sensitive, stocks.

These signs suggest that an event in the coming weeks could tip the market trend into a modest pullback or refresh it for another run.

While much of the attention in recent months has been directed toward Europe as a source of potential crisis or breakthrough, global attention has now turned to Asia. The weak U.S. economy and extended stock market run-up may be vulnerable to a shock or due for a recharge. A flu pandemic or an act of war by North Korea could be a shock that results in a setback to the economy and stock market, while the aggressive stimulus in Japan could be a boost that finally gets stocks to break out of their month-long range.

Spreading Bird Flu

An influenza pandemic has the potential to exact a great human and financial toll. The Chinese stock market suffered last week, despite better economic data, from the spreading outbreak of the bird flu, referred to as the H7N9 virus. None of the 21 confirmed cases in China have yet confirmed that the virus has spread from human to human. In the past, it was at that point that it began to impact the markets.

The sudden spread of human-to-human transmission of Severe Acute Respiratory Syndrome (SARS) briefly added to the pressures on global stock markets in March 2003.

In May 2006, the strain of avian flu referred to as H5N1, was spread directly between members of an Indonesian family. This first case of human-to-human transmission of the lethal virus garnered much attention and pressured the markets.

Adding to the stresses of the financial crisis in early 2009 was the fast-spreading swine flu as the World Health Organization (WHO) confirmed human-to-human transmission.

While in each of these cases the U.S. stock market experienced at least a 5 - 10% decline around the time of initial human-to-human transmission, other contributing factors helped to result in a weak environment for stocks.

The market may react negatively to headlines about infections spreading and the potential for limited human-to-human transmission. We will continue to watch these developments closely.

North Korean Aggression

South Korea's stock market was down each day last week as geopolitical risk escalated. North Korea, angered over recent U.N. sanctions prompted by the North Korean nuclear test in February and routine U.S.-South Korean naval exercises, has threatened to launch a nuclear strike against U.S. territories and a missile strike on South Korea.

While likely inflated, such rhetoric has been followed by action in the recent past with attacks that included the sinking of ships and short-lived artillery barrages. The sinking of the South Korean naval vessel Cheonan, and the resulting deaths of 46 crewmen, took place on March 26, 2010. An investigation concluded a month and a half later that the source of the attack was a North Korean submarine and contributed to global stock market weakness. On November 23, 2010, North Korea launched artillery shells and rockets at South Korean military and civilian targets on Yeonpyeong Island - contributing to a pause in the rally among global stock markets.

Last week, stocks fell on Wednesday, April 3, when the news broke that the Pentagon will deploy a missile defense system to Guam in the coming weeks in response to North Korea's threat. This may mark a break from much of the past 20 years, when threats and aggressive actions by North Korea typically resulted in high-level meetings, a short-lived agreement, and economic aid. Stocks may react negatively to any escalation. Action could occur ahead of the anniversary of North Korea's founding President Kim Il-Sung's birthday on April 15.

Japan's Shock-and-Awe QE

In contrast to the weakness seen in other major world stock markets, Japan's Nikkei Index was up 3.5% last week, adding to a year-to-date rally of over 20% on an aggressive policy move to revive growth by the Japanese central bank.

The Bank of Japan (BoJ) announced it will buy 7.5 trillion yen ($76 billion) of bonds a month. Japan was the first nation to use the now common bond purchases known as quantitative easing (QE) 12 years ago and has had little success to show in combating deflation and a stagnant economy. The new, bolder approach is intended to achieve a two-year inflation target of 2%, a level achieved only briefly over the past 20 years (in 1997 and 2008 as oil prices rose sharply). The BOJ shifted its focus to expanding the amount of cash in circulation and on deposit at the BOJ, intending to grow it in excess of the pace of economic output. The surprisingly bold move weakened the yen, which has fallen over 20% in the past six months.

A weaker currency may help promote exports and raise domestic inflation, while higher inflation expectations may encourage consumers to spend now rather than wait. Pushing down bond yields may also encourage banks to stop holding so many government bonds and instead be more eager to make loans. Of course, the ability to pull forward spending among aging consumers and the willingness by businesses to borrow is not assured. Also, there is a risk posed by the longer-term consequences of driving up inflation, resulting in a serious increase in interest costs for a country already using 25% of its budget to service debt. In fact, the interest rate on Japan's 10-year government bonds is now less than 0.5% - the lowest in the world, despite a very high level of government debt and annual budget deficits. Japan's debt is roughly 230% of gross domestic product (GDP) and rising, higher than that of Greece (175% of GDP) and nearly twice that of Italy (125%). Japan believes the only way to turn this trend around is to drive GDP higher and is pulling out all the stops.

Perhaps this bold move may inspire investors to believe more stimulus may be forthcoming from the European Central Bank or the U.S. Federal Reserve, given the weak manufacturing and jobs reports last week, capable of renewing the stock market's rally.

Plenty of events - including those listed here - may serve as inspiration for investors to sell and take profits or put more money to work in the coming weeks. Given the market's recent behavior, we expect a modest pullback is most likely.

Highlights

• In each of the past three years, the stock market began a slide in the spring that lasted well into the summer months.

• This week, we update the status of the 10 indicators we identified that foreshadowed the 10 - 19% declines in recent years.

• On balance, the indicators do not yet point to a significant risk of a repeat of the 10 - 19% spring slide this year. But a more modest, 5 - 10% pullback is far from out of the question.

One year ago, we provided our list of the 10 indicators to watch that seemed to precede the stock market declines in 2010 and 2011 and accurately warned of another spring slide in 2012.

We again look to these indicators for signs of a potential spring slide in the stock market this year.

In early 2010, 2011, and 2012, run-ups in the stock market, similar to this year, pushed stocks up about 10% for the year as April began. Specifically, on April 23, 2010, April 29, 2011, and April 2, 2012, the S&P 500 made peaks that were followed by 10 - 19% losses that were not recouped for more than five months. This recurring phenomenon is often referred to by the old adage "sell in May and go away." Now that it is around the time the prior slides have begun, it is time to revisit the status of our indicators.

Currently, only two of the 10 indicators are waving a red flag, while three are yellow for caution, and the other five are green. On balance the indicators do not point to a significant risk of a repeat of the 10 - 19% spring slides in the stock market this year. However, a smaller decline of about 5% or so is far from out of the question and remains our most likely scenario, as presented in recent Weekly Market Commentaries. We will continue to monitor these indicators closely in the coming weeks.

1. Fed stimulus - In 2010 and 2011, Federal Reserve (Fed) stimulus programs known as QE1 & QE2 came to an end in the spring or summer, and stocks began to slide until the next program was announced. Operation Twist was announced on September 12, 2011 and was scheduled to conclude at the end of June 2012, helping to prompt a market slide before it was extended at the end of June 2012. This year, the current program is unlikely to be slowed or stopped until much later this year. Therefore, this is unlikely to be a driver of a slide in stocks this spring.

2. Economic surprises - The Citigroup Economic Surprise Index [Figure 1] measures how economic data fares compared with economists' expectations and has marked the spring peaks in both economic and market momentum in recent years. While the latest readings have not surged up near the 50-level that marked the peaks of recent years, the weakening trend does suggest expectations may have become too high. Turning points typically have coincided with a falling stock market relative to the safe haven of 10-year Treasuries.

3. Consumer confidence - In the past few years, early in the year the daily tracking of consumer confidence measured by Rasmussen rose to highs just before the stock market collapse as the financial crisis erupted [Figure 2]. The peak in optimism gave way to a sell-off as buying faded. Investor net purchases of domestic equity mutual funds began to plunge and turned sharply negative in the following months. This measure of confidence is once again beginning to fall from the highs.

4. Earnings revisions - The earnings estimates moved higher heading into the first quarter earnings season of each of the past few years, only to begin a decline that lasted the remainder of the year as guidance disappointed analysts and investors. This year, earnings expectations have not risen as much as in prior years, which may limit the disappointment. In addition, last week saw disappointing reports from bellwethers such as Oracle and FedEx, among others. It is too early to say whether this indicator is flashing a warning sign. We will be watching to see if estimates begin to taper off.

5. Yield curve - In general, the greater the difference between the yield on the 2-year and the 10-year U.S. Treasury notes, the more growth the market is pricing into the economy. This yield spread, sometimes called the yield curve because of how steep or flat it looks when the yield for each maturity is plotted on a chart, peaked in February of 2010 and 2011, and March of 2012. Then the curve started to flatten, suggesting a gradually increasing concern about the economy, as the yield on the 10-year moved down. Although not as steep as in prior years, this year we will be watching to see if the yield curve flattens further after peaking in mid-March.

6. Energy prices - In 2010, 2011, and 2012, oil prices rose about $15 - 20 from around the start of February, two months before the stock market began to decline. This year, oil prices rose to $98 at the start of February and have eased slightly since then, suggesting less risk to consumers already struggling with higher taxes. However, the national average retail gasoline price has risen 50 cents this year, similar to the average rise from the beginning of the year through March over the past three years. With prices starting to ease along with crude oil the risk is fading, but a further surge in prices at the pump would make this indicator more worrisome.

7. The LPL Financial Current Conditions Index (CCI) - In 2010 and 2011, our index of 10 real-time economic and market conditions peaked around the 240 - 250 level in April and began to fall by over 50 points. It may still be early, but this year, the CCI recently reached 253 - in line with the post-recession highs with no signs yet of weakening.

8. The VIX - In each of the past three years the VIX, an options-based measure of the forecast for volatility in the stock market, fell to the low of the year in the low-to-mid teens in April before ultimately spiking up over the summer. In recent weeks, the VIX has declined once again to the lows of the year. This suggests investors have again become complacent and risk being surprised by a negative event or data.

9. Initial jobless claims - It was evident that first-time filings for unemployment benefits had halted their improvement by early April 2010, and beginning in early April 2011, they deteriorated sharply. In 2012, April again led to deterioration in initial jobless claims as they jumped by about 30,000. While claims have fallen to post-recession lows this year as the labor market has improved, we will again be watching for a move higher in April that would echo the spike seen in recent years. (See this week's Weekly Economic Commentary for what the Fed is watching in the labor market.)

10. Inflation expectations - The University of Michigan consumer survey reflected a rise in inflation expectations in March or April of the past three years. In fact, in 2011, the one-year inflation outlook rose to 4.6% in both March and April from 3% at the start of the year. This year, there has been almost no rise in inflation expectations, as they remain about 3.3%.

Finally, one issue not addressed specifically in the indicators, but important in the markets, is the surge in European stresses - evident in the spring of each of the past few years. The weakening economic data in Europe's core countries such as Germany and France (seen most recently in last week's German manufacturing and sentiment data), combined with financial stresses in peripheral countries such as Cyprus pose a risk to global markets if too little is done to address the key issues. Europe continues to focus on capping banker bonuses and financial transactions taxes rather than core issues. This could risk a bond market sell-off that could negatively affect stocks here in the United States, similar to the spring slides in recent years.

While this list may seem incomplete, it is notable that many of the most widely watched indicators of economic activity such as manufacturing (the Institute for Supply Management Purchasing Managers' Index known as the PMI or the ISM), job growth, and retail sales, among others, did not deteriorate ahead of the market decline, but along with it. It is not that they are not important; it is just that they did not serve as useful warnings of the slide to come, while the above indicators did.

Shorter Slide?

While it is possible we will experience another spring slide this year, there are factors that may mitigate any decline short of the 10 - 19% seen in the past few years.

Looking back, in 2010 the negative environment that helped fuel the decline included the uncertainty around the impact of the Dodd-Frank legislation, the Eurozone debt problems and bailouts, central bank rate hikes, and the end of the homebuyer tax credit. In 2011, it was the Japan earthquake and nuclear disaster that disrupted global supply chains and pulled Japan into a recession, the Arab Spring erupted pushing up oil prices, the budget debacle and related downgrade of U.S. Treasuries, rising inflation, and central bank rate hikes that contributed to the decline. In 2012, the Eurozone debt problems coming to a head, China's slowdown, the European recession, the election uncertainty, and anticipation of the 2013 budget bombshell of tax hikes and spending cuts weighed on markets.

Some of these challenges presented in prior years are repeated again this year - potential for flare-ups over European problems and the debt ceiling come to mind. However, there are some positives this year that may help offset some of the negatives making for a potential decline that may be less steep than those of recent years. First, job growth finally appears to be reaccelerating with three of the past four months posting more than 200,000 in net job creation. Second, the housing rebound is now well-entrenched, supporting economic activity and household confidence. Finally, business spending growth appears to be reaccelerating and likely to support manufacturing activity, which had fallen in May through July of the past few years and contributed to the market decline.

Given this year's nearly double-digit gain in the S&P 500 and the possibility of another spring slide for the stock market, investors may want to watch these indicators closely for signs of a pullback despite the current upward momentum in the stock market and solid economic growth.

IMPORTANT DISCLOSURES
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
The economic forecasts set forth in the presentation may not develop as predicted and there can be no guaran¬tee that strategies promoted will be successful.
The company names mentioned herein was for educational purposes only and was not a recommendation to buy or sell that company nor an endorsement for their product or service.
Stock and mutual fund investing involve risk, including loss of principal.
International and emerging markets investing involves special risks, such as currency fluctuation and political instability, and may not be suitable for all investors.
The fast price swings in commodities and currencies will result in significant volatility in an investor's holdings.
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 princi¬pal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of fund shares is not guaranteed and will fluctuate.
The Federal Open Market Committee action known as Operation Twist began in 1961. The intent was to flatten the yield curve in order to promote capital inflows and strengthen the dollar. The Fed utilized open market operations to shorten the maturity of public debt in the open market. The action has subsequently been reexam¬ined in isolation and found to have been more effective than originally thought. As a result of this reappraisal, similar action has been suggested as an alternative to quantitative easing by central banks.
Gross domestic product (GDP) is the monetary value of all the finished goods and services produced within a country's borders in a specific time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments and exports less imports that occur within a defined territory.
Quantitative easing is a government monetary policy occasionally used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity.
Operation Twist is the name given to a Federal Reserve monetary policy operation that involves the purchase and sale of bonds. "Operation Twist" describes a monetary process where the Fed buys and sells short-term and long-term bonds depending on their objective.
Yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. The most frequently reported yield curve compares the three-month, two-year, five-year and 30-year U.S. Treasury debt. This yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates. The curve is also used to predict changes in economic output and growth.

 

INDEX DESCRIPTIONS

The Barclays U.S. 7-10 Year Treasury Bond Index includes all publicly issued, U.S. Treasury securities that have a remaining maturity of between 7 and 10 years, are non-convertible, are denominated in U.S. dollars, are rated (at least Baa3 by Moody's Investors Service or BBB- by S&P), are fixed rate, and have more than $250 million par outstanding. The Index is weighted by the relative market value of all securities meeting the Index criteria.
The Standard & Poor's 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
The Standard & Poor's 500 Index is an unmanaged index, which cannot be invested into directly. Past perfor¬mance is no guarantee of future results.
Citigroup Economic Surprise Index (CESI) measures the variation in the gap between the expectations and the real economic data.
The VIX is a measure of the volatility implied in the prices of options contracts for the S&P 500. It is a market-based estimate of future volatility. When sentiment reaches one extreme or the other, the market typically reverses course. While this is not necessarily predictive it does measure the current degree of fear present in the stock market.
Purchasing Managers Index (PMI) is an indicator of the economic health of the manufacturing sector. The PMI index is based on five major indicators: new orders, inventory levels, production, supplier deliveries and the employment environment.
The Rasmussen Consumer Index and Investor Indexes, measures the economic confidence of consumers on a daily basis. The Rasmussen Consumer Index and Investor Indexes are derived from nightly telephone surveys of 500 adults and reported on a three-day rolling average basis. The baseline for the Index was established at 100.0 in October 2001.
The Michigan Consumer Sentiment Index (MCSI) is a survey of consumer confidence conducted by the Univer¬sity of Michigan. The MCSI uses telephone surveys to gather information on consumer expectations regarding the overall economy.

 

 

Highlights

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

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

• There will likely be some upsets that result in volatility as these factors face off against each other.

It has been a sweet sixteen weeks for the S&P 500. The broad stock market index has had only three down weeks out of the past sixteen. While this stretch is tied by the same period a year ago, it is important to note that there has not been a sixteen-week period with fewer weeks of losses in over 20 years - since the period ending September 1, 1989.

March has been maddening for investors in the past few years (2010 - 2012) as the S&P 500 raced higher in March only to reverse all of those gains in a pullback of about 10% that began in late March or April. It later took stocks at least five months to climb back to the peaks of March.

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

As we narrow down stocks' "sweet sixteen" potential drivers this year, the four "regions" of market-moving factors vying for investor attention are: economy, policy, fundamentals, and market dynamics.

 

Economy

• Employment - Job growth has been picking up with more than 200,000 jobs created in three of the past four months and first-time filings for unemployment benefits have started to fall after stabilizing around 350,000 for over a year.
• Housing - The powerfully rebounding housing market, as seen in data such as housing starts and building permits, is a positive for growth.
• Confidence - Last week's University of Michigan data showed that consumer confidence fell sharply in the preliminary reading for March to the lowest level in over a year.
• Gasoline Prices - Retail gasoline prices are back up near the "danger zone" that coincided with stock market pullbacks in each of the past few years.

 

Policy

• Federal Reserve - "Don't Fight the Fed" rally is intact, but as the Federal Reserve publicly contemplates ending the latest stimulus program, the stock market may suffer the same sell-off that surrounded the ending of prior quantitative easing programs, so-called QE1 and QE2.
• Europe - With the Eurozone back in recession, an inconclusive election leaving no government in Italy, a political scandal hampering the ability to implement needed reforms in Spain, Greece unlikely to meet the terms of its own bailout, and Germany pushing hard terms on any aid ahead of its fall elections, the events in Cyprus could provide the catalyst for another Europe-driven spring slide in the world's stock markets.
• Geopolitics - The hot spots are heating up again given the power grab following the death of Chavez in Venezuela, the coming elections in Iran, different factions vying for power in war-torn Syria, and North Korea annulling its cease fire agreement.
• Fiscal Cliff - A fiscal drag on gross domestic product (GDP) of about 2%, and showdowns over the continuing resolution funding the government and the debt ceiling still to come, may weigh on investor sentiment as the recently implemented sequester threatens to halt labor market improvement with an estimated cost of 750,000 jobs, according to the Congressional Budget Office.

 

Fundamentals

• Earnings - Earnings are the most fundamental of all drivers of stocks. Earnings growth has been the most consistent factor driving the markets in recent years, but growth has now slowed to the low-single digits for S&P 500 companies.
• Valuations - The price-to-earnings ratio of the S&P 500, at around 15 on the past four quarters' earnings, is well below the 17 - 18 seen at the end of all prior bull markets since WWII.
• Credit - Demand for credit has improved and credit spreads have narrowed; both trends are key supports to growth.
• Corporate Cash - Strong cash balances provide a cheap source of capital to invest and incentive to buy back shares to boost earnings per share growth.

 

Market Dynamics

• Momentum - Stocks have been on a strong winning streak that could continue.
• Volume - Trading volume in the markets has been light this year, 10 - 15% below last year, traditionally seen as a sign that a trend has become vulnerable.
• Volatility - Investors have once again become net sellers of U.S. stock mutual funds in the past two weeks, according to data from the Investment Company Institute (ICI), despite strong and steady gains. A return to more volatile markets may further undermine individual investor support.
• Interest Rates - Interest rates are on the rise, potentially acting as a drag on everything from housing to the U.S. budget, but from very low levels.

 

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

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

Investing is not a game, but it is important also to remember that forecasting is not an exact science, and many factors can affect outcomes that are hard to predict. Two years ago, the Japanese earthquake had a big impact on markets and natural disasters - despite tremendous advances in technology - are very hard to predict with any degree of accuracy. Geopolitical outcomes can also be hard to foresee as we look to the stresses in the Middle East. For example, the outcome of the Arab Spring uprisings and the changes they have led to in countries including Syria and Egypt were hard to foresee. The markets rarely offer perfect clarity on their direction because they are driven by these factors as well as many others. Even this week's NCAA March Madness can be seen as a reminder of how it can be notoriously hard to predict winners. Historically, a team's ranking has meant nothing after getting down to the elite eight.

These factors will play out in the markets over the course of the year, not just in the coming weeks. This means there will likely be some upsets that result in volatility and pullbacks as these factors face off against each other. In the end, we expect a positive year with many opportunities for investors.

 

Highlights

• The Dow Jones Industrial Average powered its way to a new all-time high last week - four years after the low point on March 6, 2009.

• The good news is that since WWII, only two of the six bull markets that made it to their fourth anniversary failed to make it to a fifth. But the bad news is that we may need a modest pullback to sustain this bull market.

• Rather than signal a sign of weakness, pullbacks are often the pauses that refresh the bull market.

The film, Oz: The Great and Powerful, the prequel to The Wizard of Oz, premiered last week. The story of how the wonderful wizard overcame the risks and prevailed worked its magic on moviegoers and proved popular with a strong box office showing. In the same week, the Dow Jones Industrial Average (Dow) proved popular with investors as it powered its way to a new all-time high, as it overcame many risks to reach the fourth anniversary of the start of the current bull market from the low point on March 6, 2009.

The Dow stands 115% higher than it did four years ago. However, if we do not disregard the stocks behind the curtain of the great and powerful Dow, we see that this time the index no longer holds the stocks of AIG, Citigroup, and General Motors (among others) as it did at the prior peak on October 9, 2007. The many changes to the 30 companies that make up the Dow make it worthwhile to take a look at the stock market defined by broader indexes like the NASDAQ and S&P 500.

• On the 13th anniversary of the peak in the NASDAQ, this tech-heavy index is still more than 35% away from the peak reached on March 10, 2000. Nevertheless, this index has outperformed the Dow with a gain of 149% over the past four years.
• The broadly diversified S&P 500 Index is also outpacing the Dow with a gain of 125% since its March 2009 low and experiencing the second-best four-year bull market in history, second only to the bull that began on August 12, 1982 [Figure 1].

What is next for the bull market? The good news is that since WWII, only two of the six bull markets that made it to their fourth anniversary failed to make it to a fifth. Each of those four bull markets that extended through a fourth year posted a double-digit return in the year leading up to the fifth anniversary [Figure 2].

The current bull market is not likely to be over, but the bad news is that we may need a pullback to sustain it. Of the 18 pullbacks of 5% or more over the past four years, the current rally, at 114 days without a 5% or more pullback, is one of the longest of the bull market.

Rather than a sign of weakness, pullbacks are often the pauses that refresh the bull market. When the market has avoided pullbacks for an extended period, the bull market has tended to be shorter and result in a bear market when the decline eventually came. For example, the long bull markets of the 1980s and 1990s had dozens of 5% or more pullbacks with many of 10% or more, whereas the much shorter four-year 2003 - 2007 bull market did not have a single pullback of 10% or more and ended by erasing the entire bull market gain.

Therefore, pullbacks do not have to be viewed as wicked; instead we should cheer them, since they help to sustain the bull market and provide opportunities for investors to put money to work at a discount.

 

 

Highlights

• Watching the Daytona 500 from the "danger zone" can be a thrill, but gasoline's "danger zone" may be just plain scary. Gasoline prices are nearly back to the highs of the past five years that marked a "danger zone" for market participants.

• In each of the past two years, rising energy prices have been one of the 10 "spring slide" indicators that helped us to predict the stock market pullbacks that took place during the second quarter of each year.

Do you feel like you are paying too much for gasoline? At least you did not have to fill up for the Daytona 500. The special ethanol-blended fuel that NASCAR drivers put into their tanks at the race on Sunday cost more than twice the national average for regular unleaded. And at about 18 gallons per tank, that comes to about $150 a fill up in a car that gets single-digit miles per gallon!

Even so, you are paying more. The U.S. average retail price of regular gasoline has risen to $3.75 per gallon, up 16 cents from last year at this time. The national average price has seen double-digit increases two out of the last three weeks and is up 45 cents since the beginning of the year.

The race higher in gasoline prices is worth watching closely. In each of the past two years, we have tracked 10 "spring slide" indicators that helped us to predict the stock market pullbacks that took place during the second quarter of each year. Energy prices were one of 10 that accurately predicted a market slide each year. In each of the past two years, energy prices began to climb sharply in February, two months ahead of the peak in the stock market.

Danger Zone

Watching the Daytona 500 from the "danger zone," where cars whip by at high speeds of around 175 to 200mph - but can also burst through the walls in a crash - can be a thrill. But gasoline's "danger zone" may be just plain scary. At $3.75, retail gasoline prices are nearly back in the "danger zone" marked by the highs of around $3.85 to $4.10 per gallon seen over the past five years, as you can see in Figure 1. This range has marked a "danger zone" for market participants. When gasoline prices reached this range in the past, it preceded the stock market slides experienced in 2008, 2011, and 2012.

While high gasoline prices were certainly not the driving factor in the 2008 U.S. financial crisis-driven plunge in the stock market, the high prices did add to stress on the economy as they did again in the springs of 2011 and 2012, when concerns over a European financial crisis rattled investors. Again in the fall of 2012, high energy prices weighed on investor sentiment and helped to fuel a pullback driven by the election and fiscal cliff concerns. In short, high energy prices can make the economy and markets more vulnerable to a negative event that drives stocks lower.

Factors Driving Gasoline Prices

Three major factors have combined to drive the surge in gasoline prices this year: oil prices, gasoline margins, and refinery outages.

Crude oil prices are on the rise. The price of waterborne light sweet crude that drives the wholesale price of gasoline sold in most U.S. regions rose about $6 per barrel, or about 15 cents per gallon. This accounts for about one-third of the rise in gasoline. Gasoline's gains are outstripping crude oil's run up this year.

Throughout much of November and December 2012, gasoline refining margins were very low, and in some cases negative with a barrel of gasoline worth less than a barrel of crude. As a result, retail gasoline prices were lower relative to crude oil prices. Since the beginning of 2013, gasoline prices versus crude oil have started to rebound.

Both planned and unplanned maintenance at several refineries have supported higher refining spreads. Many refineries schedule maintenance early in the year when gasoline demand is seasonally low. A string of refinery outages resulted in substantial off-line capacity. The U.S. Energy Information Administration (EIA) estimates that inputs into U.S. refineries fell 9% from 15.9 million barrels per day in mid-December 2012 to 14.4 million for the week ending February 15, 2013.

A factor that is often misunderstood, but likely did not contribute to higher prices was the surge in exports. The United States has become a net exporter of gasoline. The turnaround in U.S. gasoline net exports is remarkable after about five decades of being a net importer, as you can see in Figure 2. But that has not come as a result of undersupplying the U.S. market.

U.S. demand for gasoline has declined, but solid global demand has allowed refineries to export gasoline produced using capacity that would otherwise have been taken offline. Over 80% of U.S. exports of total gasoline are produced and shipped from the Gulf Coast, while U.S. gasoline is generally imported along the East Coast. Given the Jones Act (which effectively limits the ability to ship oil from one U.S. port to another), infrastructure constraints, and costs of transporting gasoline around the U.S., were U.S. gasoline exports to be constrained, global gasoline supply would likely decline and U.S. gasoline consumers, especially in the Northeast, would face higher prices.

Avoiding the Danger Zone

Hopefully, gas prices can avoid the danger zone. There are indications that gasoline prices may soon ease.

• Both gasoline futures and crude oil prices declined last week.
• The EIA notes that 11 million barrels of waterborne gasoline are en route to the United States and Canada.
• U.S. refinery maintenance, which reduces capacity, typically peaks in February, and output should return to normal in the coming weeks.

However, the seasonal increase in demand, which typically begins in the spring, could keep upward pressure on prices. If prices again enter the danger zone, we will be watching this spring slide indicator along with the others closely for signs of an impending stock market slide. We will provide an update of all of our spring slide indicators in an upcoming Weekly Market Commentary.

IMPORTANT DISCLOSURES
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
Stock investing involves risk, including the risk of loss.
Alternative investments may not be suitable for all investors and involve special risks such as leveraging the investment, potential adverse market forces, regulatory changes and potentially illiquidity. The strategies employed in the management of alternative investments may accelerate the velocity of potential losses.
Futures and forward trading is speculative, includes a high degree of risk, and may not be suitable for all investors.
The fast price swings in commodities and currencies will result in significant volatility in an investor's holdings.

 

 

Highlights

• The volatility and classic 5 - 15% pullbacks we have seen in each of the past few years is perfectly normal and very likely to be a recurring pattern in 2013.

• There are several ways to benefit from market volatility and potentially enhance returns, including: more frequent tactical adjustments to portfolios, focusing on yield, using active management rather than passive indexing strategies, and increasing diversification by adding low-correlation investments.

On Friday, the S&P 500 was up about 7% from the start of the year. This is very similar to the gains through mid-February in 2011 and 2012. These steady gains then began to be revealed as the first stage of a volatile year that frequently exhibited 5 - 15% swings in the stock market.

Again in 2013, the stock market may post a gain, but those gains may be hard to discern during the course of a year that exhibits frequent swings of 5 - 15%. Fortunately, this volatility is perfectly normal.

The investing environment may be like that of 1994 and 2004, the last two times the economy experienced a transition in Federal Reserve (Fed) policy. Both 1994 and 2004 had multiple 5 - 15% pullbacks in the S&P 500 as the recovery matured, stimulus faded, and the Fed hiked interest rates marking a return to normal conditions. Both years also provided only single-digit buy-and-hold returns. Yet neither year marked the end of the bull market.

Just as in 1994 and 2004, market participants are likely to remain focused on the Fed over the coming two weeks. First, this week the Fed releases the minutes to their January meeting, providing more detail on the deliberations. Second, next week (February 26 - 27) Fed Chairman Ben Bernanke will deliver his semi-annual report on the economy and interest rates to House and Senate panels.

A key contributor to the volatility in 1994 and 2004 was the normalization of monetary policy - or, in other words, hikes to the federal funds rate by the Fed. The volatility began early in those years as the Fed signaled the coming of the rate hikes that took place later in the year. While a rate hike remains a year or two away at the earliest, the Fed is likely to begin to slow or stop the current bond-buying program, known as quantitative easing, later this year or very early in 2014. The Fed will likely note that this change in policy marks a "normalization" after providing exceptional liquidity since late 2008. Regardless of the Fed's description, these steps toward a return to a more normal monetary environment are likely to lead to higher interest rates and tighter credit conditions for borrowers, even without the hikes to the federal funds rate that can weigh on the stock market.

Changes to Fed programs - or even deliberations months ahead of the potential end of a program or start of a new one - have punctuated the volatile moves in the market over the past five years, as you can see in Figure 2. The coming weeks could begin to reintroduce some Fed-related volatility to the markets if the Fed signals any potential upcoming actions. However, pronounced moves are more likely to come later in the year as the Fed is closer to a change in policy.

It is relatively easy to figure out how to invest when you believe the market is likely to go up or go down, but how do you invest when it is likely to go both up AND down? There are several potential ways to benefit from market volatility, including:

• Rebalance tactically - More frequent rebalancing and tactical adjustments to portfolios are recommended to take advantage of the opportunities created by the pullbacks and rallies. Seeking undervalued opportunities and taking profits are key elements of a successful volatility strategy.
• Seek yield - Focusing on the yield of an investment rather than solely on price appreciation can help enhance total returns. Bank loans and even alternative vehicles like master limited partnerships (MLPs) offer a potential yield advantage over investments that are solely price-driven during periods of high volatility.
• Go active - Using active management rather than passive indexing strategies to enhance returns. In general, active managers tend to outperform their indexes when volatility rises, according to LPL Financial Research analysis. Opportunistic-style investments provide a wide range of opportunities for managers to exploit during volatile markets.
  
• Think alternatively - Increase diversification by adding low-correlation investments and incorporating non-traditional strategies that aim to provide downside protection, risk management, and may benefit from an environment of increased volatility. This would include exposure to covered calls, managed futures, global macro, long/short, market neutral, and absolute return strategies.

Some investors are wary of this volatility and view it as a sign of a fragile market. We see volatility as a normal, and even potentially rewarding, part of the investing environment for those who know how to invest for volatility.

 

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.
Stock investing involves risk, including the risk of loss.
Correlation is a statistical measure of how two securities move in relation to each other. Correlations are used in advanced portfolio management.
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.
Bank loans are loans issued by below investment-grade companies for short-term funding purposes with higher yield than short-term debt and involve risk.
Master limited partnership (MLP) is a type of limited partnership that is publicly traded. There are two types of partners in this type of partnership: The limited partner is the person or group that provides the capital to the MLP and receives periodic income distributions from the MLP's cash flow, whereas the general partner is the party responsible for managing the MLP's affairs and receives compensation that is linked to the performance of the venture.
Federal Funds Rate is the interest rate at which a depository institution lends immediately available funds (balances at the Federal Reserve) to another depository institution overnight.
Operation Twist is the name given to a Federal Reserve monetary policy operation that involves the purchase and sale of bonds. "Operation Twist" describes a monetary process where the Fed buys and sells short-term and long-term bonds depending on their objective.
Yield is the income return on an investment. This refers to the interest or dividends received from a security and is usually expressed annually as a percentage based on the investment's cost, its current market value or its face value.
Alternative investments may not be suitable for all investors and involve special risks such as leveraging the investment, potential adverse market forces, regulatory changes and potentially illiquidity. The strategies employed in the management of alternative investments may accelerate the velocity of potential losses.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
INDEX DEFINITIONS
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.

Highlights

• President Obama's State of the Union, scheduled for Tuesday, February 12, is unlikely to be a big market mover. However, two major themes that we will be listening for with potential market impacts: the fiscal cliff and energy independence.

• Fiscal cliff-related comments hold potential consequences for defense, consumer discretionary, and high dividend-paying stocks.

• Comments on energy independence could lead to a bounce in clean energy stocks that soon fades. Talk of the elimination of tax breaks for the exploration and production companies in the energy sector could act as a negative.

President Obama's State of the Union (SOTU), scheduled for Tuesday, February 12, is unlikely to be a big market mover. In fact, most SOTU speeches see less than a 1% move in the stock market on the following day, and the average move is only 0.15% [Figure 1].

In his SOTU address on Tuesday, President Obama will present key themes that may impact certain industries and asset classes. While gun control and immigration will likely comprise important themes, they have minor market impact. The two major themes that we will be listening for with potential to impact the markets are: the fiscal cliff and energy independence.

Fiscal Cliff Part II

Early in his speech, the President will be forced to talk about the fiscal cliff part II. There are three remaining components to the fiscal cliff that are yet to be resolved: the sequester taking effect March 1, the government shutdown set for March 27, and the debt ceiling to be hit on May 19.

• The President will likely restate his recent comments about replacing the spending cuts that kick in on March 1, known as the sequester, with some combination of tax increases and spending cuts. However, this has little chance of passing the House after Republicans supported tax increases in the first fiscal cliff deal. The Congressional Budget Office estimates that the fiscal drag from the sequester in 2013 would be about $85 billion, or about 0.5% of gross domestic product (GDP.) This adds to the roughly 1.5% drag on the economy from the fiscal cliff tax increases that went into place January 1. That is a materially negative impact for an economy that registered a contraction in the fourth quarter and is on track for only sluggish growth in the current quarter.

Comments that suggest the President is open to mitigating the defense cuts in exchange for cuts elsewhere, rather than tax increases, may be a positive for the markets - especially for stocks in the defense industry, which have been pulling back lately as the cuts have loomed. Unless changed, defense spending (other than for military personnel) will be cut by around 8% across the board, while nondefense funding that is subject to the automatic reductions will be cut by between 5% and 6%.

• The continuing resolution funding the government expires on March 27 and could prompt a government shutdown (though certain essential components like the armed forces will continue to operate). While tax collections will be reaching their seasonal peak as the April 15 deadline approaches, tax refunds processed by the IRS may take much longer than usual and could cause consumer spending to drop and negatively impact stocks in the consumer discretionary sector. In 2012, the average tax refund check was nearly $3,000, all together totaling $175 billion. The drag on incomes could be felt since consumers have lacked the confidence to fund spending with credit cards in recent years [Figure 2]. During the previous two government shutdowns, it was short-lived. It lasted five days in November 1995 and was followed by 21 days in January 1996. As long as talks are proceeding, we expect another continuing resolution to be passed to fund the government for a few more months or until September 30 to avoid a lengthy shutdown.

• While the debt ceiling has been pushed back to May 19, it will soon be upon us again. If no further action is taken before May 19, the Treasury will once again resort to extraordinary measures to allow the government to continue operating. As precursor to restating these negotiations, President Obama will likely talk about a "balanced package" of spending cuts and tax increases to reduce the deficit and need for additional borrowing. With the potential for additional tax rate increases on the horizon, high dividend-paying stocks and municipal bonds (given the potential elimination of some deductions) could react negatively, which may present a buying opportunity.

These fiscal cliff issues leave little likelihood that other recurring themes in the President's SOTU address see any legislative action that otherwise could impact certain asset classes. For example, the President is likely to again tout the need for greater infrastructure investment - a potential positive for some stocks in the industrial and materials sectors were it to actually take place. Another example is a new program to modify underwater mortgages that could act as a negative for mortgage-backed securities, if implemented.

Energy Independence

The President is likely to highlight the need for U.S. energy independence, noting the increasing domestic oil and gas production and voicing his continued support for sources of clean energy. Given their dependence on federal support programs, the stocks of producers of wind, solar, and other clean energy sources often tend to be volatile around the SOTU addresses in recent years - sometimes seeing a big bounce that soon fades.

Regarding traditional sources of energy, investors are unlikely to hear anything on natural gas or coal that may turn around slumping coal stocks, but probably nothing that would accelerate their decline either. However, the President will likely highlight energy tax incentives for elimination known as the "percentage depletion allowance" and "expensing of intangible drilling costs." These incentives exist to encourage small companies to produce oil from marginal wells that become profitable with the tax breaks. These marginal wells are old or small wells that do not produce much oil individually, but in total constitute most of the U.S.'s domestic oil and gas production. The percentage depletion allowance was eliminated in 1975 for the major oil companies, and their ability to expense intangible drilling costs expensing is very limited. Therefore, the potential elimination of these tax breaks would be unlikely to have a major negative effect on the major companies in the energy sector. However, the exploration and production industry of the energy sector could be negatively impacted, were these incentives to be eliminated, which we doubt will happen in 2013.

IMPORTANT DISCLOSURES
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
Stock investing involves risk including loss of principal.
The commentary expresses the political view of the author and in no way represents the views of LPL Financial. The assumptions made are based upon approvals by Congress and are subject to change. While individual advisors and investors may of course have their own personal views or preferences when it comes to matters of public and political policy, the author is trying to provide insights from the available data, allowing readers to make fully informed decisions.
Municipal bonds are subject to availability and change in price. They are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise. Interest income may be subject to the alternative minimum tax. Municipal bonds are federally tax-free but other state and local taxes may apply.
Mortgage-Backed Security (MBS) is a type of asset-backed security that is secured by a mortgage or collection of mortgages. These securities must also be grouped in one of the top two ratings as determined by a accredited credit rating agency, and usually pay periodic payments that are similar to coupon payments. Furthermore, the mortgage must have originated from a regulated and authorized financial institution.
Mortgage-Backed Securities are subject to credit, default risk, prepayment risk that acts much like call risk when you get your principal back sooner than the stated maturity, extension risk, the opposite of prepayment risk, and interest rate risk.
Investments in specialized industry sectors have additional risk such as credit, regulatory, operational, business, economic and political risk which should carefully be considered before investing.
Consumer Discretionary Sector: Companies that tend to be the most sensitive to economic cycles. Its manufacturing segment includes automotive, household durable goods, textiles and apparel, and leisure equipment. The service segment includes hotels, restaurants and other leisure facilities, media production and services, consumer retailing and services and education services.
Energy Sector: Companies whose businesses are dominated by either of the following activities: The construction or provision of oil rigs, drilling equipment and other energy-related service and equipment, including seismic data collection. The exploration, production, marketing, refining and/or transportation of oil and gas products, coal and consumable fuels.
Industrials Sector: Companies whose businesses manufacture and distribute capital goods, including aerospace and defense, construction, engineering and building products, electrical equipment and industrial machinery. Also, companies that provide commercial services and supplies, including printing, employment, environmental and office services, or provide transportation services, including airlines, couriers, marine, road and rail, and transportation infrastructure.
Materials Sector: Companies that are engaged in a wide range of commodity-related manufacturing. Included in this sector are companies that manufacture chemicals, construction materials, glass, paper, forest products and related packaging products, metals, minerals and mining companies, including producers of steel.
INDEX DEFINITIONS
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.

 

Highlights

• In the past few weeks, market and economic performance have decoupled.
• This may be explained by the weak economic data increasing the odds of a new Federal Reserve (Fed) stimulus program that may be holding Treasury yields down even as it boosts the stock market.
• A gap in market and economic performance similar to the current one appeared in July of 2011, only to close with a sharp drop in the S&P 500.

Economic data continues to disappoint. The economic surprise index, which measures whether data reports come in better or worse than economists' estimates, has continued to fall for the world's largest 10 economies.

The performance of the stock versus the bond market over the prior three months has tended to track the economic surprise index closely in recent years. But in the past few weeks, market and economic performance have decoupled, as you can see in Figure 1.

Consistent with this pessimistic tone of the economic data, the yield on the 10-year Treasury note has fallen to near all-time lows as investors bid up prices for Treasuries by 4% over the past few months as they seek a safe haven from risk. Yet stocks proved resilient to the data in recent weeks as the S&P 500 recouped some of the earlier losses and are now about flat over the past three months. This relative performance is a far cry from the 20% gap suggested by the economic surprise index.

Stocks have either priced in an expectation for a sharp turnaround in economic performance or investor behavior is being driven by factors other than the economy. However, earnings, Europe, and the election are not likely to be the drivers.

While stocks have tended to rise during the earnings season, as we pointed out a few weeks ago, the earnings reports thus far in the second quarter 2012 reporting season are not particularly strong on an absolute or on a relative to expectations basis.

The situation in Europe has not improved as demonstrated by yields on Spanish debt rising over 7% on Friday.

And election polls on the presidential race in the United States remain close with no clear breakout for either candidate for the markets to react to.

Instead, the reason for the markets' behavior may be the Federal Reserve (Fed). Last week's semi-annual testimony by Ben Bernanke in front of Congress was the catalyst for the gains as stocks turned around on the Fed chairman's comments on Tuesday, July 17 and headed higher for the next couple of days. His downbeat comments on the economy suggested the Fed may announce another stimulus program before the year is over.

The stock market would welcome a third round of stimulus as an inoculation shot against the economic drag of tax increases and spending cuts on tap for next year. The potential for Treasury purchases by the Fed that would likely be part of the stimulus program may also be holding Treasury yields down even as it boosts the stock market.

For the gap between market and economic performance depicted in Figure 1 to close, either upcoming economic data must surprise to the upside or stocks need to drop sharply. It is notable that a gap similar to the current one appeared in July of 2011. Ominously, that gap closed with a sharp drop in the S&P 500, as you can see in Figure 2.

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.

Treasuries: A marketable, fixed-interest U.S. government debt security. Treasury bonds make interest payments semi-annually and the income that holders receive is only taxed at the federal level.

Highlights

• Europe's leaders have seen the ghost of Christmas Past (2008), Present (Greece, etc.) and Yet to Come (break up).

• Their pursuit of Scrooge-like austerity measures may allow the leaders of Germany and France to see the light and let the ECB buy the turkey (troubled debt) in the window for the troubled countries (Spain, Italy, etc.).

• If not, it will scare the Dickens out of the market.

Last week, the stock market had the best week since the week ending March 13, 2009, which marked the beginning of the rebound from the long 2007 - 2009 bear market. The S&P 500 Index regained 7.4% last week after a similarly steep slide in the prior week and a half. Volatility remains high as investors focus on every development in Europe.

With the holiday season arriving, Europe appears to be experiencing a transformation worthy of a classic tale. Europe's leaders have seen the ghost of Christmas Past (in the form of the financial crisis of 2008), Present (the spreading troubles plaguing Greece, Portugal, Spain, Italy and others) and Yet To Come (the possibility of a break up of the eurozone has been discussed). While these countries are pursuing Scrooge-like austerity measures as they cut spending to close their budget deficits, the market recognized last week that the leaders of France and Germany may have seen the light. German Chancellor Merkel and French President Sarkozy are pursuing treaty changes to enforce budget limits that they continue to hint will allow them to permit the European Central Bank to buy the turkey (troubled debt) in the window for the troubled countries (Spain, Italy, etc.).

The ongoing European debt dilemma will continue to affect the market in 2012, as it did in 2010 and 2011. In 2012, we expect:

• The U.S. economy to grow about 2%, while emerging markets post stronger growth and Europe experiences a mild recession.
• The U.S. stock market is likely to post an 8 - 12%* gain, supported by a boost from a slight improvement in valuations and mid-to-high single-digit earnings growth.
• Corporate bonds post modest single-digit gains as interest rates rise and credit spreads narrow. The yield on the 10-year Treasury is likely to end the year around 3%.

For further insight into what 2012 holds for investors, please see the 2012 Outlook, published last week. This comprehensive take on 2012 reveals what investors can expect in the coming year and how to position to seek to profit from the opportunities and protect from the risks.

While the S&P 500 ended November basically unchanged, it took a wild ride during the month as a number of major events played out. The event calendar for December is not as prone to disappoint or create as much volatility as November did. For example, November saw government changes in Italy and Spain, a large number of European bond auctions, and the super committee failure in the United States. In December, no elections in Europe, fewer bond auctions will be held, and the likelihood of a relatively quiet passage of year-end business in Washington (a continuing resolution to extend government funding and legislation to extend payroll tax cuts and unemployment benefits along with the annual AMT and physician Medicare fixes) may make for a quieter month for investors.

However, there is a risk that the market rebound and decline in European bond yields takes some pressure off of the efforts to cut spending and risks the loss of critical momentum. The leaders of the troubled countries - especially those with new governments - must continue these efforts in order to secure support from Germany and France. If not, it will scare the Dickens out of the market.

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.

Dear Valued Client and Future Client,

Continued concern over the debt burden of the developed world combined with the deeply divided political landscape in Washington, D.C. has many investors questioning the sustainability of the economic recovery following the Great Recession of 2008. Growth has slowed and we believe the chance of revisiting a recession has increased to approximately 35%. However, the most likely scenario remains that global growth will continue at its modest pace, which could offer an upside surprise for an increasingly bearish-biased market.

While these volatile markets are sending many investors scrambling for a rock to hide under to wait out the uncertainty, I believe turning over those rocks in search of investment opportunities may prove fruitful over the long term. Fear and emotion oftentimes defines short-term market reactions. However, when fear is at its pinnacle, a patient temperament, faith in your investment plan, and a commitment to opportunistic investments can ultimately turn short-term market challenges into long-term investment success.

One does not have to go far into the history books to find two periods where short-term fear transitioned into investment triumphs. Today's investment environment is causing investors to face similar challenges to those that haunted them in 2008 and again during the summer of 2010. In both of those periods, prices had declined further than their fundamental values and proactive policy action by central banks served as the catalyst to lure opportunistic investors back into the market. I believe that the same environment exists today and the same elixir is needed for these uncertain times.

The crowded trade certainly remains bearish, but policy actions to stoke the economic growth fire have begun again in earnest. The Federal Reserve Bank announced today that they will provide additional stimulative monetary policy through Operation Twist. Moreover, many central banks around the world that had been intentionally slowing their country's growth in an attempt to head off inflation are now switching from the brake to the gas pedal to provide more stimulus to jump start growth and the stalling global economic recovery.

The market appears to be suffering much more from a lack of clarity and a wave of uncertainty than it is a degradation in economic fundamentals. While growth has undoubtedly slowed, most corporations are still on pace to post near-record third quarter profits, business spending continues to be strong, and retail sales remain positive. In fact, buoyed by surging auto production and sales following the disruption caused by Japan's springtime natural disaster, economic growth this quarter for the United States may be poised to not only be the fastest of the year, but also to be faster than the first two quarters of the year combined.

Despite this modest and far from disastrous outlook, uncertainty has outweighed optimism and question marks have outpaced clarity. The market is essentially suffering from a recession of confidence. With the mood decidedly bearish, the market does not believe in this recovery and investors do not have faith that policy makers can avert the second recession in three years. But, it is fear and emotional disbelief that often serves as the catalysts to lower expectations - and stock prices - to levels that even market bears see the value of owning. While the market still faces a challenging environment and has a wall of worry to overcome, I believe that patience and a vigorous commitment to your investment plan is the best strategy to weather this bout of uncertainty and serve as yet another example of the resiliency of the markets, the global economy, and American business. As always, if you have questions, I encourage you to contact our office.

Best regards,
Christopher L Boggs

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 me prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.

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

The Federal 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.

This research material has been prepared by LPL Financial.