2011 Second Quarter Market Review Executive Summary

Written by:

Rick Vollaro, CPAChief Investment Strategist

Partner

Carl Noble, CFASenior Analyst

July 2011

•The second quarter was a rollercoaster ride that punished some risk assets and rewarded the flight-to-quality trade despite paltry yields on Treasury securities.The quarter was largely defined by a widespread loss in economic momentum, causinginvestorstoquestionwhethertheglobaleconomicrecoverywasinjeopardy.

•One of the bigger risks that surfaced during the quarter was a resurgenceof problems on the periphery of the Eurozone. The European debt drama refuses to go away, and towards the end of the first quarter Greece again tookcenter stage as fears of a possible default rippled through financial markets.

•PinnacleAdvisoryGroupmanagedaccountsgainedinthesecondquarter,butatamuchmoresubduedpaceasfinancialmarketsgrewincreasinglyvolatile.Itwasthefourthconsecutivequarterofgainsandreturnsremainveryhealthyonatrailingoneyearbasis.

•As the third quarter begins the U.S. business cycle seems to be at an inflectionpoint. Duringthesecondquarteraslowdownunfoldedthroughouttheglobalecon-omy.Theall-importantissuethatmarketparticipantsarecurrentlywrestlingwithiswhether themost recent soft patch in economic data has been driven by transitoryfactors,orifmorepermanentforcesareatwork.Unfortunatelytheevidenceisstill ambiguous,which lowers conviction levels andmakes for averyvolatile investing c l ima t e . f f f f f f f f f f f f f f f f f f f f f f f f f f f f f f f f f f f f f f f f f f f f f f f f f f f f f f f f f f f f f f f f f f

•OurbaselineexpectationforthepastfewquartershasbeenthatthecyclicalbullmarkethasthepotentialtocarrytheS&P500tonewcyclicalhighs.Giventhecurrentinflectionpointinthecycle,thereisanincreasinglywideconfidenceintervalaroundthatforecast.Wearenotyetconvincedthatacyclechangeisimminent,butrisksareclearlyrising.

•Given the current lack of clarity regarding the investment landscape, we continueto believe that positioning close to benchmark levels of risk in client portfolios is appropriate at this time. As difficult as it may be at times, sticking with the disciplineofourprocessshouldeventuallyleadtohigherconvictionlevelsandamore definitivestanceonewayortheother.Intheinterimwecontinuetofocusonshoringupourdefensiveholdingsgiventhepresentrisks,andexecutingrelativevaluetradesasopportunitiesarise.

2

SecondQuarter2011MarketReview

www.pinnacleadvisory.com

Second Quarter ReviewThe second quarter was a rollercoaster ride that punished some risk assets and reward-ed theflight-to-quality trade despite paltryyields onTreasury securities. The quarterwas largely defined by a widespread lossineconomicmomentum,causing investorsto question whether the global economicrecoverywasinjeopardy.Corporateearn-ingscontinuedtoberesilientbuteconomicdatawidelydisappointed across theglobe.Investors were left to digest and navigateamyriadofdifferent risks to the investinglandscape. It was a particularly poor en-vironment for commodity investors whilebeingsurprisinglyprofitableforbondinves-tors. The S&P 500 Index finishedwith aminimalnetchange,buttheflatreturnwasdeceptiveasthequarterwasavolatileaffairthatcontainednumeroustwistsandturns.Bytheendofthequarter,the“wallofworry”thatthebullmarketmustclimbcontinuedtogrowduetodeceleratingeconomicdata,theendoftheFederalReserve’ssecondquantitativeeasingprogram,tighteningmonetarypolicyintheemergingworldandEurope,anduncer-taintyregardingtheoutcomeofthefastapproachingdebtceilingdeadline.

Index Second Quarter ReturnS&P500Index(w/dividends) +0.10%Russell2000Index(smallcapstocks) -1.61%MSCIEAFEIndex(internationalstocks) +1.83%DowJones/UBSCommodityIndex -6.73%BarclaysCapitalAggregateBondIndex +2.29%3-monthT-bills +0.01%

OneofthebiggerrisksthatsurfacedduringthequarterwasaresurgenceofproblemsontheperipheryoftheEurozone.TheEuropeandebtdramarefusestogoaway,andtowardstheendofthefirstquarterGreeceagaintookcenterstageasfearsofapossibledefaultrippledthroughfinancialmarkets.Onthesurface,Greeceseemsinsignificantenough,ac-countingforlessthan3%oftheEurozoneeconomy.ButasimmaterialasGreecemightseemfromaGDPperspective,investorsdread thepossibilityofanothercripplingcontagioneffect similar towhatoccurred in theU.S. in2007-08.

OneformofcontagionrisklieswithsovereigndebtexposureonthebooksofEuropeanandU.S.financialinstitutions.Approximatelytwo-thirdsofGreekgovernmentdebtisheldoverseas,withlargeholdingsinmajorEuropeanbanks.U.S.banksholdverylittleactualGreekdebt,buttheyarenotimmuneeitherduetoderivativeexposurethatcouldforcelargepayoutsonprotectiontheysoldagainstsovereigndefaults.Whilethetotalmagnitudeofdebtandderivativesdoesnotap-peartobeasinsidiousasthetoxicmortgagesthattoppledtheglobaleconomyin2008,thereisenormousuncertaintyre-gardingthefullramificationsandrippleeffectsthataGreekdefaultwouldhaveonthebankingsystemandglobaleconomy.

July 2011

3

SecondQuarter2011MarketReview

www.pinnacleadvisory.com

AnotherriskthatcouldcarryalargeshockvalueformarketsisthepossibilityofoneormorecountriestoexittheEuro-zoneandEurocurrency.SeventeendifferentcountriessharetheEurocurrencyandanswertothesameEuropeanCentralBank(ECB)formonetarypolicy.TheproblemwiththecurrentsystemisthatthecountriesboundbytheEuroandECBpolicydifferintermsofpolitical,economic,andculturalissues.WhileGermanyandFranceappearhealthyenoughtostomachastrongcurrencyandtightermonetarypolicy,thePIIGS(Portugal,Ireland,Italy,Greece,andSpain)desperatelyneedaweakercurrencyandeasiermonetarypolicytoassistinjumpstartingtheirailingeconomies.ThebasicneedforadifferentapproachinmonetaryandcurrencypolicyiscreatingstressthroughoutEuropeonanumberoflevels.Sofarmembercountrieshavebandedtogetherandboughttimetoavoiddefaultandkeepthesystemintact.ButifEuropedoesn’tgetitsacttogetherandfindamorepermanentsolutiontocurrentproblemsfacingtheperipheralcountries,thentherisksofoneormoremembersleavingwouldescalate.Giventheinterconnectednessoffinancialmarketsandtheun-knownquantityofderivativesrelatedtosovereigndebtandcurrencies,thishasthepotentialtocreatemajorindigestioninfinancialmarketsifitweretohappen.

ThesecondquarterstartedwithU.S.equitymarketsdriftinghigher,abruptlyhittingthewallofworry,andendingwithastrongrally.Somebelieveproblemsplaguingthemarketaretemporaryandthatriskassetswillonceagainfindawaytolookthroughthevalleyandclimbtonewbullmarkethighs.Otherstakeadarkerviewthattheunintendedconsequencesofeasymoneyandtoomuchliquidityarefinallycominghometoroost.It’sbeenanicerunsince2009,andlargegainshavebeenachievedinarelativelyshortperiodoftime.Bytheendofthequarterinvestorswerelefttomullwhetherthebusinesscyclewasundergoingamajorchangeoriftherecentsetbackwasjustanothercorrectionthatshouldbeviewedasabuyingopportunity.

For a detailed analysis of Pinnacle’s current views, please read the section titled “Market Outlook.”

Pinnacle Performance AnalysisPinnacleAdvisoryGroupmanagedaccountsgainedinthesecondquarter,butatamuchmoresubduedpaceasfinancialmarketsgrewincreasinglyvolatile.Itwasthefourthconsecutivequarterofgainsandreturnsremainveryhealthyonatrailingoneyearbasis.

Composite

Second QuarterComposite Return3/31/11 to 6/30/11

Trailing 12-MonthComposite Return6/30/10 to 6/30/11

DynamicConservative +0.98% +5.81%DynamicConservativeGrowth +0.91% +12.85%DynamicModerateGrowth +0.61% +17.59%DynamicAppreciation +0.51% +19.82%DynamicUltraAppreciation +0.36% +20.51%

Please see the last page of this report for important performance-related disclosures.

ThetopthreesecuritiesduringthequarterweredefensiveU.S.equitysectorpositions.Defensivesectorleadershipisathemethatbegantoemergeinthelatestagesofthefirstquarter,andPinnacleportfolioscarrysubstantialweightingsinthesesectors.EnergyandTechnologyrelatedholdingswereamongtheworstperformersascommoditypricescorrectedandsignsofaslowdownemerged.

July 2011

4

SecondQuarter2011MarketReview

www.pinnacleadvisory.com

Internationalequitypositionsoutperformedduringthequarter,while theloneremainingequityalternative,gold,alsoperformedwell.

Withinfixedincome,inareversalofpriorquarters,high-qualityU.S.Treasuriesoutperformedinresponsetofreshcon-cernsabouttheeconomywhilecredit-sensitiveholdingswerepositivebuttrailed.Fixedincomealternativeswerealsobehind,buthadmodestlypositivereturns.

Top Five Performers of the Second Quarter 2011Position Weight ReturniSharesPharmaceuticalsETF 3% 10.9%UtilitiesSectorSPDR 2% 6.1%ConsumerStaplesSPDR 8% 5.2%PowersharesAerospace&DefenseETF 2% 4.6%GoldSPDR 3% 4.4%

Bottom Five Performers of the Second Quarter 2011Position Weight ReturnEnergySectorSPDR 6% -4.9%S&POil&GasExploration&ProductionETF 0% -5.5%iSharesSemiconductorETF 2% -5.9%iSharesNetworkingETF 5% -9.6%CapitalMarketsSPDR 2% -9.7%

Quarterly Portfolio ActivityTherewereseveralportfoliotransactionsduringthequarter,mostofwhichweredesignedtoshoreupportfoliodefensesasmarketvolatilityincreased.Wenolongerownadiversifiedcommoditiespositionforthefirsttimeinseveralyears,duetoconcernsthatthecommoditycomplexmaybepoisedforaperiodofunderperformanceif theglobaleconomycontinuestoslow.Inaddition,weaddedtohighqualityTreasuryholdingswithinfixedincomeallocationsandinitiatedanewpositioninaU.S.dollarindexfund.

Wecontinuetoviewportfoliosasbeingveryclosetoneutralonavolatilitybasisrelativetotheirriskbenchmarks.Wehavetakensomeinitialstepstoacknowledgetheweakeningthatoccurredduringthequarter,whileatthesametimetry-ingtogivethecurrentbullmarketthebenefitofthedoubtaslongasitremainsintact.However,iftheindicatorswefol-lowcontinuetodeteriorateintheweeksahead,thenwemaybecompelledtotakeadditionalstepstoreduceriskexposure.Asalways,wecontinuetomonitorportfolioperformanceandvolatilityonadailybasisacrossavarietyoftimeframestohelpguideusasweconsiderfurtherpotentialportfolioadjustments.Thefollowingtabledetailsthecurrentassetmixacrossstrategies(thenetchangefromthepriorquarterisindicatedbythenumberinparentheses):

July 2011

Please note that the returns and weightings used for this illustration are based on the Dynamic Moder-ate Growth portfolio at the end of the period. The individual security returns for other strategies may vary due to trade execution or security selection differences. Securities may have been bought and sold during the quarter; therefore, client returns (which are shown here) may not reflect a security’s actual quarterly return. Holdings identified do not represent all of the securities purchased, sold, or recommended for advisory clients. Past performance does not guarantee future results.

5

SecondQuarter2011MarketReview

www.pinnacleadvisory.com

Composite EquitiesEquity

AlternativesFixed

IncomeFixed Income Alternatives

DynamicConservative 13(+5) 4(-3) 71(0) 12(-2)DynamicConservativeGrowth 39(+5) 7(-3) 47(-2) 7(0)DynamicModerateGrowth 56(+2) 4(-2) 33(0) 7(0)DynamicAppreciation 71.25(+3.25) 4(-3) 20(-0.25) 4.75(0)DynamicUltraAppreciation 94(+3) 4(-3) 2(0) 0(0)

Market Outlook AsthethirdquarterbeginstheU.S.businesscycleseemstobeataninflectionpoint.Duringthesecondquarteraslow-downunfoldedthroughouttheglobaleconomy.IntheU.S.theevidencewaswidespread,reflectedinmeasuressuchasleadingindicators,wages,housing,andjobs.AtthemomentthereisstilladeeppoolofU.S.liquidity,butmoneymul-tipliershavedecelerated,quantitativeeasinghasended,andseveralmajorinternationalcentralbanksareraisinginterestrates.Thisleavesinvestorsworryinghowtheeconomywillrespondtolessstimulusgoingforward.Theall-importantissuethatmarketparticipantsarecurrentlywrestlingwithiswhetherthemostrecentsoftpatchineconomicdatahasbeendrivenbytransitoryfactors,orifmorepermanentforcesareatwork.Unfortunatelytheevidenceisstillambiguous,whichlowersconvictionlevelsandmakesforaveryvolatileinvestingclimate.

Long-termtechnicalconditionsremainconstructiveasthebulltrendfromthe2009lowremainsintact,thenumberofadvancing stocks continues tooutpacedeclining stocks, andmajor indexes are tradingnear their recent cyclehighs.However,someintermediatetechnicalconcernsarestartingtoappear,suchasdivergentmomentumindicatorsandun-derperformancebythefinancialsector.Additionally,ameasureofimpliedmarketvolatilityhadrecentlyfallentolevelsindicatingthatinvestorshadbecomecomplacentagain,whichcouldbeapotentialcatalystforfurtherdownsidevolatilityifitreverses.Lookingpastnormalconsolidationphasesthatareahealthypartofbullmarkets,webelievethecyclicaltechnicalconditionscontinuetobesupportiveforfinancialmarkets,butarestartingtoshowsomecracks.Iftheinterme-diate-termpicturedeterioratesfurthertherecouldbepotentialforlonger-termconditionstofollowsuit. Earningscontinuetobestrongandselectmarketvaluationmetricscaneasilycreatetheimpressionofanextremelycheaporexpensivemarket,dependingonwhichmeasureofearningsoneprefers.Fromourperspective,marketvaluationre-mainssomewhereclosetofairvaluewhenapplyingaweightoftheevidenceapproachandthusdoesnothaveamajorinfluenceoncurrentportfolioconstruction.OurbaselineexpectationforthepastfewquartershasbeenthatthecyclicalbullmarkethasthepotentialtocarrytheS&P500tonewcyclicalhighs,withaloosetargetrangeofsomewherebetween1400toashighasthepreviouspeaksinthemid-1500s.Giventhecurrentinflectionpointinthecycle,thereisanincreas-inglywideconfidenceintervalaroundthatforecast.Wearenotyetconvincedthatacyclechangeisimminent,butrisksareclearlyrising.

Giventhecurrent lackofclarityregardingthe investment landscape,wecontinuetobelievethatpositioningclose tobenchmarklevelsofriskinclientportfoliosisappropriateatthistime.Insteadofgivingintothetemptationtojumptoaconclusion,wecontinuetobepatientandlettheweightoftheevidencebuild.Asdifficultasitmaybeattimes,stickingwiththedisciplineofourprocessshouldeventuallyleadtohigherconvictionlevelsandamoredefinitivestanceonewayortheother.Intheinterimwecontinuetofocusonshoringupourdefensiveholdingsgiventhepresentrisks,andexecut-ingrelativevaluetradesasopportunitiesarise.Asalways,we’llcontinuetofollowourprocess,andmakethenecessaryadjustmentsinaccordancewiththeweightoftheevidenceasitchanges.

July 2011

6

SecondQuarter2011MarketReview

www.pinnacleadvisory.com

Soft Patch or Something More?Duringthequartertherewasanotabledownshiftinavarietyofeconomicdata.Leadingindicators,liketheEconomicCycleResearchInstitute’sWeeklyLeadingIndex,aswellasmarketbasedindicatorslikecopper,bothyieldedthesamemessageofslowinggrowth.Themajorityofregionalmanufacturingsurveyshavealsobeenindicatingsteadyerosioningrowthoverthelastfewmonths,andafewhaverecentlyregisteredreadingsconsistentwithcontraction.Atthesametimehousinghascontinuedtosink,realwagesarefallingfast,andstagnantmoneymultiplierscontinuetosignalthatlendingvolumesarenotexpandingastheynormallyshouldbeatthispointinthecycle.

Thebiggestpieceoftheeconomicpuzzlethathasbeenmissinginthisrecoveryhasbeenemployment,andthenewsonthatfrontduringthequarterwaslargelydisappointing.Sincethemarketbottomin2009,wehaveheldtheviewthatthestructuraljobspictureismessyandthatthelabormarketwilllikelygothroughaperiodofprolongedsluggishness.Thisthesisisviewedasalonger-termheadwindbuthastakenabackseatrecentlyassometentativesignsofimprovementap-peared.Duringthefirstquarterthereweresomeencouragingreportsonthelabormarketanditlookedlikeprogresswasbeingmade,butinthesecondquarterthejobspicturetookabigstepback,asbothleadingandcoincidentindicatorsofemploymentshoweddeterioration.Goingforwarditwillbecrucialforthejobmarketfindafootingandbegintoreac-celerate.Withoutsteadyjobgrowththerewillbenoincomegainstoboostspending,ortohelpthehousingmarketfindbottom,orforcreditdemandtopickupandletmoneymultiplythroughouttheeconomy.Indeed,astagnantlabormarketmeansthatthevirtuouscyclethattypicallytakesholdatthisstagefollowingarecoveryisatriskofsimplyfizzlingout.Inshort,theeconomyneedsabetterjobspicturetomaterializeincomingmonthsifthiscycleistotakehold.

Thattheeconomyhasslowedisnotinquestionanymore,butthemorepertinentforwardlookingissueiswhethertheeconomycanreaccelerateinthesecondhalfofthisyear.Thebullscontendthatwehavesimplyencounteredasoftpatchthatwascreatedbyacombinationofsupplychain issuesdrivenby theJapaneseearthquakeandtsunamidisasters,atemporarywhiffofinflationwhengaspricesspikedto$4/gallon,andsevereweatheracrosspartsofthecountry.Iftrue,thenthesoftpatchshouldfadeintothedistancebythefourthquarter.Whileweareskepticalthatrecentsoftnesscanbeentirelyattributabletotemporaryfactors,thereareafewreasonstobecautiouslyoptimisticaboutsecondhalfgrowth.First,supplychainissuesandhighergashavebeenpartofproblem.

ThereforesomeresurgencebyJapan,andtherecentreductionincommodityprices,gasoline,andinflationexpectations,couldhelpgrowthrates,profitmargins,andconsumerspendingtorebound.BondyieldshavefallensharplysinceApril,whichshouldalsohelptostabilizetheeconomy.U.S.creditconditionscontinuetoimproveaslendingstandardsease,providingU.Sconsumersandbusinessesincreasingaccesstocredit.AnddespiteQE2ending,theFederalReserveiscommittedtomaintainingthecurrentrecordsizeofitsbalancesheetbyreinvestinginterestandprincipalpaymentsfrommaturingholdingsbackintoTreasuries.Lastly,businessesmayrampupcapitalspendingtotakeadvantageofa100%depreciationtaxcreditthatexpiresattheendoftheyear.

Continuing RisksItwouldbenicetohavefaiththattheeconomywillreassertitselfovertheremainderoftheyear,butatthemomentwehavesomelingeringdoubts.Justastherearegoodreasonsnottocompletelybattendownthehatchesandreduceriskjustyet,thereareequallycompellingreasonsnottotakeonexcessiveriskatthisjuncture,either.Manycountriesaroundtheworldaredealingwithinterestratetighteningcampaignsthatarearesponsetoinflationpressures.ChiefamongthemisChina,whichcontinuestodrainliquidityfromthesystemtocombatinflationandtocoolpropertymarketspeculation.Theireffortsarebeginningtohaveanimpactasthelatestdatashowsthateconomicgrowthisclearlyslowingthere.

July 2011

7

SecondQuarter2011MarketReview

www.pinnacleadvisory.com

Investorsareanxiouslytryingtodetermineiftheycansuccessfullyachieveasoftlanding,whichiscriticalbecauseofChina’sroleasanengineforglobalgrowth.

Meanwhile,hereintheU.S.,investorshavebeenbracingfortheendoftheFed’sQE2bondbuyingprogram,whichendedonJune30th,duetotheuncertaintyofhowmarketswillreacttolessstimulusmovingthroughthesystem.Thebullsbe-lievethatthereisstillplentyofpolicyaccommodationthroughzeropercentinterestratesandtheFed’sdecisiontomain-tainitsbalancesheetatitscurrentsize.Butinvestorscan’tbecertainexactlyhowthemarketwillreacttothesechangesinthefinancialsystemgiventheunprecedentednatureoftheprogram.ThebearshavepointedoutthatthelastfewtimestheFedstoppedbuyingbonds,markets struggled. Noone can rule out additional quantitative easing mea-sures ifmarketssag in theabsenceoffreshbondbuy-ing. However, given thatthe latest quantitative eas-ing program is now beingblamed for higher inputcosts,andthatthereappearsto be a growing austeritymovementgoingonwithinpolitical circles, it wouldlikely take a sustained downturn in the economy andmarketstogettheFedtoridetotherescueagain.Lastly,thedeadlinetoraisetheU.S.debtceilinglooms,andthoughmarketsareratherwellbehavedatthemomentdespitedirepredictionsofanotherfinancialcalamityifanagreementisn’treached,itcreatesthepotentialforfurthervolatilityifapolicymistakeismadeandtheU.S.goesintoatechnicaldefault.

ConclusionTheglobaleconomysputteredinthesecondquarter,causingthestockmarkettospinsideways.Theeconomyisslowingandmarketscurrentlyappeartobeataninflectionpoint,forcinginvestorstodiligentlyparsedataforcluesastowhethertheslowdownistransitoryorpotentiallymoreentrenched.Weacknowledgethatrisksarebuilding,butwecontinuetofindtheevidencetooambiguoustopulltheplugandgiveuponthisbullmarketjustyet.Atpresentweareaimingtokeepportfoliosclosetoneutralvolatility,whilerecenttradingactivityhaslargelybeenfocusedonbolsteringourhedgesandexecutingrelativevaluetradeswherepossible.Ultimatelytheevidencewillpointtowardseitherareaccelerationintheeconomyoralargerchangeinthetides,andwhenitdoeswewillpositionaccordingly.Fornowwearecontenttobepatientandfollowourprocess.

Pinnacle’s views are current as of the date of this communication and are subject to change as economic and market conditions dictate.

July 2011

8

SecondQuarter2011MarketReview

www.pinnacleadvisory.com

July 2011

9

SecondQuarter2011MarketReview

www.pinnacleadvisory.com

July 2011