3rd qtr 2011 market insight

MARKET INSIGHT

Market Insight

Table of ContentsIntroduction

Stock Markets

Economy

2

3 – 4

4

Commodities Asset Classes

Fixed Income – Taxable

Fixed Income – Tax-Free

4 – 5

5 – 6

6

Third Quarter 2011

LPL FINANCIAL RESEARCH

of 8 LPL Financial Member FINRA/SIPC

News & Views from LPL Financial ResearchMarket Insight is a quarterly publication intended to inform and empower your investment decision making.

The S&P 500 Index endured its worst quarter in nearly three years during the third quarter of 2011. Investors had to deal with a number of issues — ongoing European debt concerns, the drawn-out debate on the debt ceiling, a downgrade of the U.S. credit rating — and embraced safe-haven assets as a result.

Despite those concerns, the U.S. economy continued to expand, albeit at a slow pace. Investors are more pessimistic now, however, than at any point in the recent past, as reflected in consumer sentiment surveys, yet they continue to spend at a healthy pace. Such is the environment facing the market as the fourth quarter arrives — a tug-of-war between how investors say they are feeling and what they are actually doing. In the third quarter, sentiment dictated performance. With high-quality bonds recording a second consecutive strong quarter and the 10-year Treasury yield hitting record lows, significant gains likely will be hard to come by. But, with the S&P 500 Index near the lows for the year, we see more potential upside return than downside risk in equities between now and year-end given the likelihood that a credible European rescue plan emerges. Any plan is likely to be accompanied by the solid fundamental backdrop in the United States with corporate earnings remaining strong and supported by attractive valuations with the forward price-to-earnings ratio near 30-year lows.

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.

Please note all return figures are as of September 30, 2011, Unless otherwise noted.

LPL Financial Member FINRA/SIPC page 3 of 8

MARKET INSIGHT

The U.S. stock market, as measured by the S&P 500 Index, posted its first quarterly loss since the second quarter of 2010 and its largest quarterly decline since the depths of the Great Recession in the fourth quarter of 2008 with a loss of 13.9% in the third quarter of 2011. The Index had increasingly larger declines in each month of the third quarter, with the 7.0% decline in September marking the fifth consecutive monthly decline for the Index and the largest one-month decline since the 8.0% decline in May 2010; the Index declined 2.0% in July and 5.4% in August [Chart 1]. Some of the same issues that impacted the market during the second quarter of 2010, notably the European debt problems, had a similar impact in the third quarter of 2011. For the year thus far, the S&P 500 Index has posted a -8.7% return.

The third quarter was a battle between the strongest quarter of economic growth this year and the increasingly negative investor and consumer sentiment. Economic data, while not pointing to robust economic growth, suggested the economy continues to expand, albeit at a painfully slow pace that is well below historical averages at this point in an economic recovery. In that sense, the slow pace of growth probably feels like a recession to many investors. Those feelings were reflected in consumer and investor sentiment surveys that were decidedly pessimistic in the third quarter. However, the gap between what investors say they are doing (i.e., consumer sentiment) and what they are actually doing (i.e., consumer spending) is wide. On balance, negative sentiment overwhelmed the market in the third quarter and remains an overhang for investors as the fourth quarter begins.

In dissecting sector performance of the U.S. equity markets, defensive sectors generally outperformed cyclical sectors in the third quarter. Utilities was the only sector to post a gain in the third quarter with a return of 1.6% [Table 2]. Utilities is the best performing sector in the S&P 500 Index year-to-date with a return of 10.7%. With the stock market lower and interest rates below 2.0%, investors have looked to the Utilities sector given its defensive nature and healthy dividend yield of approximately 4.4% (as of September 30, 2011). The notable outperformer among cyclicals in the third quarter on a relative basis was the Technology sector, which posted a decline of -7.7%. The performance was notably worse among the other cyclical sectors — Energy, Materials, Industrials, Financials — which all declined more than 20% in the quarter on concerns of a global economic slowdown. Materials was the worst performing sector in the third quarter with a drop of more than 24%.

From a market capitalization perspective, large-cap stocks outperformed their mid-cap and small-cap counterparts as large caps tend to be more defensive in nature. From a style perspective, there was not much of a distinction in returns between growth and value. The Russell 1000 Growth Index, a proxy for Large Growth stocks, was the best performing domestic asset class in the third quarter with a return of -13.1%, as Technology stocks significantly outperformed. The Russell 2000 Growth Index, a proxy for Small Growth stocks, had the biggest decline among the nine style boxes with a drop of 22.3% in the quarter.

For the second consecutive quarter, U.S. stocks outperformed their Large Foreign and Emerging Market counterparts on a relative basis, though the magnitude of outperformance was far greater in the third quarter. The MSCI

Stock Markets

1 S&P 500 Q3 Performance

Source: LPL Financial, Bloomberg 09/30/11

The S&P 500 Index is an unmanaged index, which cannot be invested into directly. Past performance is no guarantee of future results.

Sector Q3 YTD

Utilities 1.6 10.7

Consumer Staples - 4.2 3.4

Information Technology -7.7 -5.8

Telecommunications -8.0 -1.5

Health Care -10.0 2.5

Consumer Discretionary -13.0 -5.7

Energy -20.5 -11.4

Industrials -21.0 -14.7

Financials -22.8 -25.2

Materials -24.5 -21.8

Source: LPL Financial, FactSet 09/30/11

Because of their narrow focus, sector investing will be subject to greater volatility than investing more broadly across many sectors and companies.

2 Q3 2011 and Year-to-Date Performance of S&P 500 Sectors (% Returns)

1350

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S&P 500 Index

06/30/11 07/31/11 08/31/11 09/30/11

Negative sentiment overwhelmed the market in the third quarter and remains an overhang for investors as the fourth quarter begins.


EAFE Index, a proxy for developed foreign markets, declined 19.0% in the quarter due in large part to the woes in Europe. France and Germany each witnessed declines of more than 25% in their domestic stock markets during the quarter and now reside in “bear market” territory with declines of more than 20% in 2011. Similar to the second quarter, the MSCI Emerging Markets Free Index had the worst returns of the major world indexes in the third quarter, declining 22.5%. Brazil’s stock market declined 17.5% in the quarter and is down 24.5% year-to-date, while China declined 14.5% in the quarter.

EconomyMuch like the second quarter, economic reports in the third quarter were again uneven, introducing fears of a global economic slowdown, which contributed to market volatility and overwhelmingly negative sentiment. While many of the reports came in below expectations, they did not suggest a return to recession.

With regard to economic growth, gross domestic product (GDP) continued to hit new all-time highs in the second quarter [Chart 3]. Second quarter GDP was revised higher late in the third quarter from 1.0% to 1.3% annual growth. The third quarter is on pace to grow at a 2 – 2.5% rate, the strongest growth rate so far this year. The second quarter revision was due in part to better-than-expected consumer spending, which remains robust with 4.6% year-over-year growth in same-store sales as of the end of August [Chart 4]. The Index of Leading Economic Indicators (LEI), which is a grouping of several economic statistics that are usually predictive of future economic conditions, continued to suggest slow growth and not a double-dip recession. In fact, LEI posted a solid and better-than-expected gain in September — the fourth straight month of re-acceleration in the year-over-year growth of the LEI — which suggests that a recession is unlikely. Despite the lack of recessionary indicators, however, consumer sentiment was near 30-year lows in the third quarter, as measured by the University of Michigan Consumer Sentiment report [Chart 5].

Over time, these consumer spending and consumer sentiment measures are highly correlated as the more confident consumers feel, the more likely they are to spend money. However, the recent periods have seen a near historic disconnect, as consumers are filling out surveys suggesting a dismal outlook, but not significantly adjusting spending. Consumers are acting differently than they are feeling. The fundamental data shows that consumers, which make up nearly 70% of the U.S. economy, are going to the malls and spending at levels not seen since 2007. However, that fundamental data flies in the face of the sentiment data, which suggest consumers are as gloomy and pessimistic as they were at the depths of the 2008 recession.

Commodities Asset ClassesBroad commodity prices declined for the second straight quarter, as the Commodity Research Bureau Index fell 7.7%. Much of the decline

Stock Markets (continued)

5 University of Michigan Consumer Sentiment vs. LEI

4 Same-Store Sales, Excluding Wal-Mart

3 Gross Domestic Product


Source: ICSC, Haver Analytics 10/02/11

Source: Bureau of Economic Analysis, Haver Analytics 10/02/11

125

110

95

80

65

50

15

10

5

0

-5

-10

Consumer Confidence (Left Axis)Index of Leading Indicators (Right Axis)

1981 201120062001199619911986

12%

8%

4%

0%

-4%

-8%

ICSC: Comparable Store Sales Excluding Wal-MartNot Seasonally Adjusted, Year-Over-Year % Change

10090807060504030201 11

16000

14000

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Gross Domestic ProductSeasonally Adjusted Annual Rate, Bil.$

10090807060504030201 11


MARKET INSIGHT

6 West Texas Intermediate Crude


occurred late in the quarter, following a downgrade of the economy from Federal Reserve (Fed) Chairman Ben Bernanke at the September Federal Open Market Committee (FOMC) meeting. Bernanke cited “significant downside risks” to the Fed’s more optimistic view of the economy and a more benign inflation view going forward. Given mixed economic data, the assessment was not surprising and partially served to justify the Fed’s launch of “Operation Twist”, a program intended to stimulate growth by keeping interest rates low through the purchase of longer-dated Treasury securities.

However, not all commodities asset classes moved in lockstep during the quarter, leading to divergent performance. Commodities like oil and copper, which are typically more sensitive to economic activity, continued to move lower on concerns of an economic slowdown. West Texas Intermediate crude oil started the quarter near $98, and climbed as high as $101 in late July before falling sharply in early August and settling into a range between $79 and $90 [Chart 6]. With oil prices at their lowest level in nearly a year, consumers are seeing some relief in the percentage of spending dedicated to energy costs.

On the other hand, precious metals, generally viewed as a safe haven in times of uncertainty, were mixed during the quarter. The ride for gold was again volatile, as the yellow metal surged to yet another all-time high in late August near $1,900 [Chart 7]. Gold was moving back to the $1,800 range in early September before a precipitous decline late in the month to near $1,600. Despite the late-quarter decline, gold still increased 7.8% in three months.

Silver also fell sharply following the downgrade of the economy from the Fed. Silver began the month near $35, rallied as high as $43 in late August and finished the quarter near $30 [Chart 8].

Fixed Income – TaxableThe broad bond market, as measured by the Barclays Capital Aggregate Bond Index, followed a strong second quarter with a solid gain of 3.8% in the third quarter, the best quarterly return since the fourth quarter of 2008. July was a particularly strong month for high-quality bonds, as the Index gained 1.6%, the best month for the Index in exactly two years. For the second consecutive quarter, investors generally avoided riskier sectors of the bond market and sought the comfort of high-quality bonds. As was the case in the second quarter, the 10-year Treasury yield again moved lower in the third quarter, hitting an all-time low of 1.7% in late September before ending the quarter near 1.9% [Chart 9].

Long-term high-quality bonds, as measured by the Barclays Capital Government/Credit Long Index, posted a 15.6% return in the third quarter. Among other high-quality bond sectors, Treasury Inflation Protected Securities (TIPS) posted strong returns in the quarter (4.5%), as did Mortgage-Backed Securities (2.4%). Given the flight-to-safety rally in the bond market, more credit-sensitive areas of the market underperformed the broad Aggregate Index. Notably, high-yield bonds had their worst quarter since the fourth quarter of 2008 and fourth worst quarter in the past decade with a return of -6.1%, as measured by the Barclays Capital High Yield Index.

Commodities Asset Classes (continued)

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Crude Price

08/31/1107/31/1106/30/11 09/30/11

7 Gold


$1900$1850$1800$1750$1700$1650$1600$1550$1500$1450

Gold Price

08/31/1107/31/1106/30/11 09/30/11

8 Silver


The fast price swings in commodities and currencies will result in significant volatility in an investor’s holdings.

Precious metal investing is subject to substantial fluctuation and potential for loss.

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Silver Price

08/31/1107/31/1106/30/11 09/30/11


Fixed Income – Taxable (continued)

Preferred Stock investing involves risk which may include loss of principal.

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.

High-Yield/Junk Bonds are not investment-grade securities, involve substantial risks, and generally should be part of the diversified portfolio of sophisticated investors.

Municipal bonds are subject to availability, price, and to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rate rise. Interest income may be subject to the alternative minimum tax. Federally tax-free but other state and local taxes may apply.

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

Other credit-sensitive fixed income sectors, such as Bank Loans (-4.4%) and Preferred Securities (-4.2%), struggled in the third quarter, as did Emerging Market Debt (-1.8%).

Fixed Income – Tax-freeMunicipal bonds are arguably the best story of 2011 as the positive run that began in the first half of the year continued in the third quarter. Municipal bonds, as measured by the Barclays Capital Municipal Bond Index, gained another 3.8% in the third quarter bringing the year-to-date gain to an impressive 8.4%. On the lower end of the quality spectrum, the Barclays Capital High-Yield Muni Bond Index posted a 3.3% return in the quarter, and has also posted an 8.4% return year-to-date. As was the case in prior quarters, state and municipal budgets continued to improve through a combination of revenue increases and cost cuts, and fears of massive defaults among municipal issuers continued to abate. While some forecasters predicted defaults totaling hundreds of billions of dollars, thus far in 2011 the total amount of defaults is just $1.2 billion (as of September 22, 2011), on pace to finish well below the $3.6 billion in defaults in 2010.

9 10-Year U.S. Treasury Yield


3.3%

3.1%

2.9%

2.7%

2.5%

2.3%

2.1%

1.9%

1.7%

10-Year Treasury Yield

08/31/1107/31/1106/30/11 09/30/11

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.

Treasury inflation-protected securities (TIPS) help eliminate inflation risk to your portfolio as the principal is adjusted semiannually for inflation based on the Consumer Price Index - while providing a real rate of return guaranteed by the U.S. Government.


MARKET INSIGHT

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 may involve risk including loss of principal.

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

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.

Because of their narrow focus, sector investing will be subject to greater volatility than investing more broadly across many sectors and companies.

Precious metal investing is subject to substantial fluctuation and potential for loss.

The fast price swings in commodities and currencies will result in significant volatility in an investor’s holdings.

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

The Federal Open Market Committee action known as Operation Twist began in 1961. The intent was to flatten the yield curve in order to promote capital inflows and strengthen the dollar. The Fed utilized open market operations to shorten the maturity of public debt in the open market. The action has subsequently been reexamined in isolation and found to have been more effective than originally thought. As a result of this reappraisal, similar action has been suggested as an alternative to quantitative easing by central banks.

Materials Sector: Companies that are engaged in a wide range of commodity-related manufacturing. Included in this sector are companies that manufacture chemicals, construction materials, glass, paper, forest products and related packaging products, metals, minerals and mining companies, including producers of steel.

Energy Sector: Companies whose businesses are dominated by either of the following activities: The construction or provision of oil rigs, drilling equipment and other energy-related service and equipment, including seismic data collection. The exploration, production, marketing, refining and/or transportation of oil and gas products, coal and consumable fuels.

HealthCare Sector: Companies are in two main industry groups—Health Care equipment and supplies or companies that provide health care-related services, including distributors of health care products, providers of basic health care services, and owners and operators of health care facilities and organizations. Companies primarily involved in the research, development, production, and marketing of pharmaceuticals and biotechnology products.

Utilities Sector: Companies considered electric, gas or water utilities, or companies that operate as independent producers and/or distributors of power.

Consumer Staples Sector: Companies whose businesses are less sensitive to economic cycles. It includes manufacturers and distributors of food, beverages and tobacco, and producers of non-durable household goods and personal products. It also includes food and drug retailing companies.

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.

Telecommunications Services Sector: Companies that provide communications services primarily through a fixed line, cellular, wireless, high bandwidth and/or fiber-optic cable network.

Financials Sector: Companies involved in activities such as banking, consumer finance, investment banking and brokerage, asset management, insurance and investment, and real estate, including REITs.

Industrials Sector: Companies whose businesses manufacture and distribute capital goods, including aerospace and defense, construction, engineering and building products, electrical equipment and industrial machinery. Provide commercial services and supplies, including printing, employment, environmental and office services. Provide transportation services, including airlines, couriers, marine, road and rail, and transportation infrastructure.

Technology Software & Services Sector: Companies include those that primarily develop software in various fields such as the internet, applications, systems and/or database management and companies that provide information technology consulting and services; technology hardware & equipment, including manufacturers and distributors of communications equipment, computers and peripherals, electronic equipment and related instruments, and semiconductor equipment and products.

MSCI EAFE is made up of approximately 1,045 equity securities issued by companies located in 19 countries and listed on the stock exchanges of Europe, Australia, and the Far East. All values are expressed in US dollars. All values are expressed in US dollars. Past performance is no guarantee of future results.

The Barclays Capital Long Government/Credit Index measures the investment return of all medium and larger public issues of U.S. Treasury, agency, investment-grade corporate, and investment-grade international dollar-denominated bonds with maturities longer than 10 years. The average maturity is approximately 20 years.

The University of Michigan Consumer Sentiment Index (MCSI) is a survey of consumer confidence conducted by the University of Michigan. The Michigan Consumer Sentiment Index (MCSI) uses telephone surveys to gather information on consumer expectations regarding the overall economy.

The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. As of May 2005 the MSCI Emerging Markets Index consisted of the following 26 emerging market country indices: Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Jordan, Korea, Malaysia, Mexico, Morocco, Pakistan, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, Turkey and Venezuela.

MARKET INSIGHT

This research material has been prepared by LPL Financial.

To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial is not an affiliate of and makes no representation with respect to such entity.

The LPL Financial family of affiliated companies includes LPL Financial and UVEST Financial Services Group, each of which is a member of FINRA/SIPC.

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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 CRB Commodities Index is a measure of price movements of 22 sensitive basic commodities whose markets are presumed to be among the first to be influenced by changes in economic conditions. As such, it serves as one early indication of impending changes in business activity.

Russell 1000® Growth Index measures the performance of those Russell 1000 companies with higher price-to-book ratios and higher forecasted growth values.

Russell 2000® Growth Index measures the performance of those Russell 2000 companies with higher price-to-book ratios and higher forecasted growth values.

This Barclays Aggregate Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment-grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.

The Barclays Capital High Yield Index covers the universe of publicly issued debt obligations rated below investment grade. Bonds must be rated below investment-grade or high-yield (Ba1/BB+ or lower), by at least two of the following ratings agencies: Moody’s, S&P, Fitch. Bonds must also have at least one year to maturity, have at least $150 million in par value outstanding, and must be US dollar denominated and non-convertible. Bonds issued by countries designated as emerging markets are excluded.

The Barclays Capital High Yield Municipal Bond Index is an unmanaged index made up of bonds that are non-investment grade, unrated, or rated below Ba1 by Moody’s Investors Service with a remaining maturity of at least one year.

3rd qtr 2011 market insight

Economy & Finance

Transcript of 3rd qtr 2011 market insight