February 2010

The Investment Environment: From “Value”- to “Fundamentals”-Driven

A “disconnect” between financial-market performance and “Purchasing Power” Moving Back in the “Black”
underlying economic “fundamentals” has been created by Annualized Percent Change From 3 Months Ago;
fresh worries over the global economic outlook and by policy 3-Month Moving Averages
uncertainties in the U.S. Performance has been under- 8%
mined further by heightened volatility from the unintended 01/10 est.
side effects of ample central-bank “liquidity” to cushion 4% Avg. Wkly.
Earnings
economies from a lingering credit “crunch,” encouraging 0%
periodic “re-leveraging,” and asset-price inflation that
leaves the market unusually vulnerable to a debilitating -4%
“flight to quality” in response to outside disturbances.
-8%
CPI
Through it all, the U.S. economy has mounted an increas- -12%
ingly self-sustaining recovery, positioning the country to Dec-07 Apr-08 Aug-08 Dec-08 Apr-09 Aug-09 Dec-09
take up some of the slack created by any growth slowdown Source: U.S. Labor Department Data
in China. However, the economy’s strength, if sustained,
could create fresh challenges for the financial market The recovery underway since the summer has been
and for the economy itself by lessening optimism over the stronger than those early in the last two growth cycles
inflation outlook and by lifting interest rates still geared but is below the “boom”-like conditions following the two
for a much weaker economic environment and the threat deep recessions in the mid-1970s and early 1980s. Housing
of “deflation.” The hope among investors in equities, and “big-ticket” consumer spending (excluding “clunker”-
commodities, and other “alternative” assets is that the distorted auto sales) have led a classic recovery, with a
distortions created by sovereign risk and by other credit supporting role from an inventory-related boost to manu-
issues will subside enough to accommodate a transi- facturing. And, as in the past, the rebound in business
tion from a value-driven rally to one driven by strength- investment is being led by tech, autos, and trucks. Solid
ening economic “fundamentals.” Bond investors will be fourth-quarter growth of 5.7 percent—a six-year high—
bracing for a more challenging year, now that out-sized extended beyond the usual winding down of inventory
yield premiums have narrowed enough to produce more “liquidation” to double-digit growth of business-equip-
broad-based increases later this year. ment investment, near double-digit gains of “big-ticket”
non-auto consumer goods, and the strongest rise in U.S.
The Economy: Toward Self-Sustaining Growth exports in more than 35 years (see chart below).
Gathering evidence of a self-sustaining recovery is laying
the groundwork for further gains in stocks and certain More than Just a Rebound in Inventories During the Fourth Quarter
“alternative” assets this year and for a more challenging Annualized Quarter-to-Quarter Growth; In Percent
bond-market environment. Economic stimulus, instru- 20%
mental to a recovery of auto and other spending since last 10% Consumer “Durables” ‘09Q4
summer, is giving way to other, non-government sources Ex. Autos
of strength. The saving rate has stabilized at a historically 0%
low, 4.5 percent-5 percent rate. “De-leveraging” has left -10%
the ratio of consumer debt to after-tax (“disposable”) Equipment Real GDP
-20% Investment
income at a nine-year low. Moreover, the combination
of strengthening wage gains and diminishing job losses -30%
has lifted average weekly earnings (an important income
-40%
component) past inflation for the first time in nearly a Dec-07 Sep-08 Jun-09 Mar-10
year, signaling an increase in “purchasing power” critical
Source: U.S. Commerce Department
to consumer-spending growth.
Monthly Market Outlook By: Gary Schlossberg
Looking ahead, growth may shift gears in coming months,
slowed by cost-cutting’s lingering effect on hiring and
wage gains and by fall-out from last year’s credit “freeze”
on foreclosures, household wealth and savings behavior,
and the bank lending recovery. However, odds are tilting
increasingly from the threat of a “double-dip” reces-
sion toward a “mini burst” of economic growth similar
to those after an unusually slow start to the last two
economic recoveries. In fact, The Conference Board’s
Index of Leading Indicators continues to flash “green,”
with a sustained, double-digit pace exceeding peak rates
during the last two recessions, though still well short of
rates after the deep recessions several decades ago. The
labor market’s leading indicators—capped by the stron-
gest “temp” worker growth in more than 19 years—point
toward a return to the kind of sustained jobs growth
supporting income and spending gains. More fundamen-
tally, the gathering recovery of household incomes could
be the catalyst needed to allow an array of latent strengths
to surface in consumer spending, hiring, and housing.
The Financial Market: Buyer Beware
After-shocks from the financial “meltdown” of 2008-09
continue to shape the markets here and abroad. Ironi-
cally, “flight” capital continues to shrug off massive U.S.
Treasury borrowing in responding to global economic
uncertainties created by China’s credit tightening and
by Greece’s fiscal and debt problems. Unsettled market
conditions also have slowed an uneven credit “thaw,”
benefiting corporate bonds most but doing little for
markets for securitized assets. Moreover, consolidation of
bank balance sheets continues, though a decline in bank
credit standards to a three-year low suggests a fairly quick
reversal of accelerated declines in loan balances with
strengthening loan demand.
The Bank Lending Slump Takes a Turn for the Worse
Percent Change From 13 Weeks Ago, Seasonally Adjusted Annual Rate
20
15
All Securities
10 Investments
5 2008, led by longer-term yields. Rising long-term rates in
0 the past year opened up an unusually wide gap between
-5
All Loans 2/3/10 Wk.
-10
and Leases
-15
-20
12/31/08 3/31/09 6/30/09 9/30/09 12/31/09
Source: The Federal Reserve Board
 February 2010
Is a “Greek Tragedy” Headed to a Theater near You?
The drama being played out in a small Euro-zone economy has
stirred debate over the implications for the U.S. Large U.S. money-
center banks, accounting for much of the lending here, are exposed
indirectly through loans and other ties to European banks that have
lent aggressively to Greece. Moreover, sovereign risk worries have
turned the spotlight on other aggressive borrowers throughout the
world, including the U.K. and the U.S.
True, the U.S. is no Greece. It is not locked into a regional currency
arrangement that has eliminated the “exchange-rate” option for
Greece through devaluation. The economy isn’t saddled with a
large underground economy undercutting the ability to mobilize tax
revenues or with a heavy-handed government role undermining the
Greek economy’s efficiency and growth potential. Equally important,
the dollar’s key currency role as the principal medium of exchange and
reserve assets in world trade and finance adds a layer of demand,
cushioning the currency from international upheavals.
However, the dollar’s central role in the global economy increases
the stakes in any international loss of confidence in the U.S. and its
currency. Growing dependence on foreign borrowing to finance the
deficit adds to that vulnerability. A loss of confidence in U.S. economic
policy occurred in the late 1970s, triggering a pullback from dollar-
denominated assets that roiled the dollar and the U.S. financial market.
Inflation isn’t the clear and present danger that it was 30 years ago.
However, the deficit is far larger now, dependence on foreign capital is
considerably greater, and the global financial market is far more fluid.
The silver lining to sovereign-risk worries and to the warning by
Moody’s, Inc. about the longer-term threat to the U.S. AAA rating is
awareness of the cost of aggressive borrowing and of rising public debt
to finance an array of economic, social, and political goals. Borrowing
discipline is only one of two issues affecting the government’s impact
on longer-term growth potential, however. The other is the balance
between growth-debilitating tax increases and spending restraint in
achieving that goal.
The credit “freeze” and subsequent “thaw” have already
shaped this financial-market cycle in several ways. First,
adjustment to last year’s turmoil trigger ed an unusually
early rise in interest rates from historic lows at the end of
them and shorter-term yields, creating fresh opportuni-
ties for bond investors and a net interest margin for banks
wide enough to boost profits available to replenish capital.
Second, ample liquidity provided by the Federal Reserve
to counter the credit freeze has rekindled commodity and
certain other asset price inflation, while blunting the usual
deterioration of credit quality by easing company debt
Monthly Market Outlook By: Gary Schlossberg

restructuring. Nowhere is that impact on credit quality mortgage-backed securities, along with an early discount-
more apparent than in the market for non investment- rate increase. Banks’ excess reserves will be mopped
grade debt, where yield premiums have narrowed ahead up through increases in interest rates on banks’ excess
of an unusual and marked decline in projected default reserves, supplemented, perhaps, by issuance of less
rates this year amid ample funds for debt restructuring liquid term deposits and by short-term sales of securities
(see chart below). (dubbed “reverse repos”). Actual rate increases probably
are months away, delayed by still-moderate growth and
Ample “Liquidity” Loosens the Link Between Yield Spreads and by a recent easing of investors’ inflation expectations.
Default Rates
Percent of Companies with Debt Basis Points Navigating past the financial turmoil of the past 18 months
16% 2500 will pose the greatest challenge for the Federal Reserve
Recession in the past 70 years. Getting the timing and speed of the
14%
Yield Differences, 2000 policy shift right will be difficult, even under the best
12% High-Yield Vs. Comparable of circumstances. Tightening too soon will leave a still-
High-Yield Treasury Securities
10% Default Rate (Right Scale) 1500
fragile economy vulnerable to a “double-dip” recession.
(Left Scale) Waiting too long risks lifting investors’ inflation expecta-
8%
tions—and yields on inflation-sensitive bonds—enough
6% 1000
to pose an equally grave threat to the economic recovery.
4% Complicating the Fed’s efforts to reverse its accommoda-
2/12/10 500 tive credit stance will be a pullback of liquidity preceding
2%
those rate hikes that uses untested strategies and a key
0% 0 policy tool (i.e., interest on banks’ excess reserves) granted
Dec-96 Dec-99 Dec-02 Dec-05 Dec-08 only recently by Congress. Unusually intense political
Source: Moody’s Inc., via Merrill Lynch, Inc. pressure in the run-up to an unusually important mid-term
election will weigh on the Fed, too. At the very least, the
Signs of a self-sustaining recovery have encouraged the Chairman’s bruising confirmation battle increases investor
Fed to lay out a blueprint for a two-part, sea-change in uncertainties: will he move to “tighten” credit early and
monetary policy, first draining massive liquidity from the aggressively, to establish his inflation-fighting credentials,
financial market before formally raising short-term rates. or to try to placate Congress by moving too deliberately?
Phase I includes a pullback in the Fed’s direct lending to What is clear is that the pressure is building on interest
financial institutions, through an end to its special lending rates to return to a level more in line with moderate growth
facilities, and to direct purchases of agency-guaranteed and a diminishing threat of “deflation.”

The Stock Market: From “Value”- to “Fundamentally”-Driven

A Victim of Its Own Success? and reliable increases over the years—climbed to a nine-
Stocks have suffered a long-awaited correction from their month high against the S&P 500 by mid-February.
January 19 peak, triggered by global and U.S. economic
outlook uncertainties, heightened volatility in the global S&P 500 Performance by Economic Sector Through 2/12/10
financial market, and their effect on risk tolerance. The Percent Change in Price Indexes (%)
sell-off, leaving the S&P 500 down just more than 3.25 12/31/09-2/12/10 1/19/10-2/12/10
Consumer Staples -0.6 Consumer Staples -2.3
percent on the year through mid-February, has been broad
Industrials -0.8 Consumer “Cyclicals” -3.8
and deep enough to extend to all 10 of the benchmark’s Healthcare -1.2 Telecom. Services -5.4
sectors and across 95 of the 134 industry groups. As indi- Consumer “Cyclicals” -2.0 Industrials -6.1
cated in the chart at the right, S&P 500 performance Financials -3.5 Healthcare -6.4
Energy -3.5 Energy -7.5
rankings since the start of the year have been interspersed
Materials -6.4 Tech -7.8
with “defensive” and highly charged sectors, a lack of Tech -6.5 Financials -8.2
conviction suggesting either a limited correction or one Utilities -7.9 Utilities -8.6
still in its early stages. Caution among investors has had a Telecom. Services -10.2 Materials -9.7
S&P 500 -3.6 S&P 500 -6.5
more noticeable effect on high-dividend stocks. So-called Memo: R2000 -2.2 Memo: R2000 -5.8
“dividend aristocrats”—companies with high dividends Sources: Standard & Poors, Inc.; Bloomberg Financial News, Inc.

 February 2010
Monthly Market Outlook By: Gary Schlossberg

Equity Scorecard Losses on international stocks in developed and emerging

(Total Returns, in Percent) markets have been worse than those by the S&P 500
Yr-to-Date benchmark, particularly after adjusting for
Feb 1-12, ‘10 Jan ‘10 Feb 12, ‘10 2009
S&P 500 0.3 -3.6 -3.3 26.5
Russell 1000 0.5 -3.6 -3.1 28.4 “translation” losses from a strengthening dollar. Not
Russell 1000 Growth 1.1 -4.4 -3.4 37.2 surprisingly, proximity to problems in Southern Europe
Russell 1000 Value -0.1 -2.8 -2.9 19.7 has produced the steepest declines in developed-European
Russell Midcap 1.4 -3.3 -2.0 40.5
markets, while credit tightening in China has left equities
Russell Midcap Growth 1.6 -4.0 -2.4 16.3
Russell Midcap Value 1.1 -2.7 -1.6 34.2
there and in Taiwan on the leading edge of Asia’s sell-off.
Russell 2000 1.5 -3.7 -2.2 27.2 Interestingly, U.S. multinationals have overcome the drag
Russell 2000 Growth 2.1 -4.5 -2.5 39.0 on earnings from “translation” losses associated with a
Russell 2000 Value 0.9 -2.9 -2.0 20.6 rising dollar in exceeding local-currency returns on inter-
MSCI EAFE ($ Terms) -2.9 -4.4 -7.2 31.8
national stocks, demonstrating, again, their closer link to
(Loc. Curr. Terms) -1.6 -3.5 -5.0 24.7
Emerging EAFE ($ Terms) -1.2 -5.6 -6.7 78.5
large cap U.S. stocks.
Sources: S&P; Frank Russell Co.; MSCI
Weighing the Stock Market’s Four Pillars of Support
Mid caps have been the most resilient of the company-size The focus on financial market turbulence and on credit
sectors in a “down” market (see Equity Scorecard above). tightening in parts of the world has masked improve-
However, the ability of more highly charged Russell ment in the U.S. market’s underlying “fundamentals,”
2000 small caps to overcome fairly “rich” valuations in capable of supporting further gains in the market this year.
outperforming more “liquid” Russell 200 large-caps can Looking ahead, U.S. stocks can rely on at least four pillars
be viewed as one sign of investors’ outlook optimism. of support:

Russell 2000 Small Caps Bounce Back 1) Profits The earnings cycle is in transition from more
Ratio, R2000 Small Caps to R200 Large Caps; Index 12/26/08=100 than just cost-driven growth, signaled by the start of the
112 long-awaited recovery of top-line revenues in the fourth
quarter. The First Call consensus forecasts unusually
109 strong S&P 500 earnings growth over the next two years,
2/12/10 Wk.
peaking at its strongest pace in more than 55 years and
106
lifting earnings per share past its previous high by late
2011 (see chart below).
103

100
A New High for S&P 500 Earnings by Late 2011?
Dollar Earnings Per Share, S&P 500 Stocks
97 100
First Call
Census
94 90 “Bottom-Up
12/26/08 3/27/09 6/26/09 9/25/09 12/25/09 3/26/10 Forecast”
‘11Q4
Source: Russell Mellon Analytics, Inc. 80

Russell 1000 Value stocks have been hit harder than their
70
Growth counterpart by the sell-off of the past month.
However, value-stock declines have been more limited
60
on the year, due both to a slight performance advantage
in five of the nine constituent industry groups making up
the two benchmarks and to a more moderate decline in 50
Value’s dominant financial services sector compared to
that of Growth’s important tech group. 40
Dec-99 Dec-02 Dec-05 Dec-08 Dec-11
Source: First Call, Inc.

 February 2010
Monthly Market Outlook By: Gary Schlossberg
Revenue gains will boost corporate income directly and
indirectly, through a “wild card” lift from the highest oper-
ating leverage (i.e., the ratio of revenues to costs) in more
than 45 years that allows more top-line sales growth to go
right to the bottom line. The gains could be “supercharged”
even more by another “mini-burst” of economic growth
like those during the previous two economic recoveries.
2) Valuation The S&P 500’s price-earnings (P/E) multiple,
based on the IBES consensus forward earnings estimate
for 2011, fell back during the early part of February to its
lowest reading since April 2009 after rising to its long-term
average from a 20-year low in October 2008 (see chart
on next page). Stocks are particularly attractive compared
to bonds at these low yield (and high bond-price) levels,
though prospective interest-rate increases are a potential
“head wind” to future gains by the stock market.
The S&P 500’s Valuation at a 10-Month Low
Price-Earnings (P/E) Multiples, Based on Forward Operating Earnings
26
23
2/12/10 P/E=13.8x
20 IBES Consensus Forward
Earnings ($77.70/Share)
17
14
Avg. 1983-2009=14.9 Times
11 Forward Opening Earnings
8 accelerated economic growth from a weak initial recovery
Dec-94 Dec-97 Dec-00 Dec-03 Dec-06 Dec-09
Source: Standard & Poors, Inc.
The Bond Market: All Fall Down?
A Taste of Things to Come?
Bonds retraced some of January’s gain during the first half
of February, leaving the benchmark U.S. Aggregate Index
of investment-grade, taxable bonds with a still-respect-
able, 1.3 percent return on the year (see Bond Market
Scorecard on next page). Treasury Inflation-Protected
Securities (or “TIPS”) have suffered sizable losses this
month, hit hard by lowered inflation expectations associ-
ated with a more guarded economic outlook. Corporate
securities have also suffered losses from reduced risk
tolerance associated with doubts about the economic
 February 2010
3) “Dry Powder” There’s still a sizable amount of
investor “cash” on the sidelines, despite sizable declines
since the start of the stock market’s rally last March. Bond
funds have attracted most of that money, though stocks
still attract their share if institutional investors can jump-
start and sustain a rally long enough to lure individual
investors still “spooked” by the market’s free-fall in late
2008 and early 2009. By late January, money fund assets
(a common “parking” vehicle for stock and bond invest-
ments) were still equivalent to nearly 27 percent of the
U.S. stock market’s total size, as measured by the Wilshire
5000 Index, or nearly $2.5 trillion more than the expected
amount based on the long-term average ratio of less than
15.5 percent.
4) Corporate Cash Balances Pressure on non-financial
corporations to deploy sizable cash balances accumulated
during the recession could be supportive of stocks in at
least three ways. Beyond spending on wages and invest-
ments already underway, companies can increase stock
buybacks, increase dividend pay-outs, and step up merger
and acquisition activity as they gain better “visibility” on
the economic outlook.
Highly charged tech, small caps, and cyclically sensitive
industrials, materials producers, and consumer “cyclicals”
are best-positioned to benefit from accelerated economic
and earnings growth, particularly with the group’s stock
prices still below their long-term average against the
market’s “defensive” sectors. Delayed leadership by the
market’s more economically sensitive sectors in a future
rally would mirror the pattern of the past two cycles when
reversed a relatively strong performance by the market’s
defensive stocks.
outlook, financial turbulence abroad, an earlier backup in
longer-term yields, and talk of eventual credit tightening
by the Federal Reserve. Non investment-grade corporate
securities (outside the Aggregate universe) were hit even
harder by profit-taking, reduced risk tolerance, and the
setback in stocks, to which the sector is closely tied.
The sell-off in corporate bonds has lifted yield premiums
on investment and non investment-grade issues to their
highest levels this year. Shorter-term, less interest-sensitive
asset-backed securities have been among the more resilient
Monthly Market Outlook By: Gary Schlossberg

of the investment-grade Aggregate sectors, though commer- Lingering Interest-Rate Worries Keep Investors “Short” Their
cial mortgage-backed securities have been the stand-out Benchmarks
performer within that benchmark index. 4-Wk. Averages, In Percent 12-Mo. Percent Change
102 50%
Elsewhere, municipal securities extended their moderate Neutral (100% of
“Benchmark” Duration) Portfolio “Duration” Vs. Target 40%
January gain through mid-month, keeping the yield ratio 101
(Left Scale) (Left Scale)
30%
on long-term tax-exempt to taxable Treasury securities
near its long-term average (see chart below). Munis have 100 20%
benefited from a light supply of traditional tax-exempt 10%
issues, thinned by the popularity of Federally subsidized 99
2/12/10 0%
Build America Bonds (or “BABS”), and talk of increased Wk.
dividend, capital gains, and income tax rates. Overseas, 98 -10%
gains in European centers allowed foreign Treasury 30-Yr. T-Bond -20%
securities to buck this month’s decline in the U.S. sector, 97 (Right Scale)
-30%
though their modest rise still left their year-to-date return
96 -40%
at just a fraction of that here.
12/11/07 9/30/08 6/30/09 3/30/10

Long-Term Muni Yields Back near Their Historic Norm Vs. Source: Stone McCarthy Research, Inc.

Comparable Treasury Rates

Yield Ratio, Bond Buyer 20 GO Index Vs. 30-Year Treasury Bond (%) Bond investors are bracing for a more challenging year
220% compared to 2009, in which so-called “spread” (or non-
Treasury) sectors were propelled by unwinding “flight”
190% capital that produced out-sized declines on Treasury
bonds. The performance disparity between Treasury secu-
160%
rities and other parts of the bond market will likely narrow
now that yield differences are close to their historic norm
in many parts of the market. Narrowing yield premiums
130%
4/91-12/09 and interest-rate increases driven more by less-sanguine
2/12/10 Wk.
Avg.=92.9% inflation expectations could leave the bond market more
100%
vulnerable to broad-based declines this year.

70%
Bond Market Scorecard
12/27/07 6/26/08 12/25/08 6/25/09 12/24/09
(Total Returns, in Percent)
Sources: The Bond Buyer; Bloomberg Financial News, Inc. Yr-to-Date
Feb 1-12, ‘10 Jan ‘10 2/12/10 2009
Barclays Capital Aggregate -0.2 1.4 1.3 5.2
Will a Rising Tide Sink All Ships? Treasuries -0.2 2.2 1.4 13.7
Bond strategies have become more cautious as inves- Agencies 0.0 1.0 1.1 9.1
Mortage-Backeds 0.0 1.4 1.3 8.3
tors have guarded against profit-taking and the threat of
U.S. Credit -0.8 -0.1 0.8 -3.1
higher interest rates over the course of this year. Investors Asset-Backeds 0.1 2.0 1.8 -12.7
have raised cash holdings and reduced “duration” (i.e., Municipals 0.6 0.0 1.1 -2.5
a measure of a portfolio’s interest-rate sensitivity, largely High-Yield -1.9 3.2 -0.7 -26.2
linked to a portfolio’s maturity). Lured, in part, by the U.S. “TIPS” -1.1 0.5 0.5 -2.4
Non-U.S. Governments* 0.2 0.3 0.5 2.4
recent rise in corporate yield premiums, investors have Emerging Markets -0.2 0.8 0.6 34.8
also moved into corporate securities from Treasury and, *Denominated in dollars, fully-hedged.
particularly, agency issues. Sources: Barclays Capital; Citigroup, Inc.; Merrill Lynch, Inc.

 February 2010
Monthly Market Outlook By: Gary Schlossberg

The more limited opportunities in sector and so-called
duration strategies (the latter involving shifts between
shorter- and longer-term securities) will likely keep the
attention on an unusually “steep” and potentially “steep-
ening” yield curve as a means of enhancing returns. (The
yield curve, the path traced by interest rates at various
maturities, “steepens” when differences widen between
long- and short-term interest rates.) An unusually wide gap
between long- and short-term rates has given investors in
longer-dated securities a cushion against rising yields and
added to potential returns through a so-called “roll-down”
effect, in which securities’ prices rise as they move toward
maturity and compete with lower rates on shorter-term
debt issues. Prospects for a further widening of yield differ-
ences will open fresh opportunities to enhance returns by
shifting from a neutral “laddered” portfolio to a yield-curve
strategy of targeting a single maturity for investment.
Gary Schlossberg February 16, 2010

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 February 2010