Compass Financial - Lpl Research 2009

LP L FINANCIAL 2 0 09ROUT E S E AR L OOK CH

Outlook

Lincoln Anderson Managing Director, Chief Economist Chief Investment Officer Burt White Managing Director Director of Research Jeffrey Kleintop, CFA Senior Vice President Chief Market Strategist Anthony Valeri, CFA Senior Vice President Fixed Income Strategist John Canally, CFA Vice President Investment Strategist John Guthery, CFA Vice President Alternative Investment Strategist

Table of contents 2-5

6 - 18

2009 Outlook What’s on the Horizon 2009 Outlook at a Glance Chapter 1 How We Got Here & Where We Are Headed

19 - 22

Chapter 2 Great Depression II? Why It Is Highly Unlikely

23 - 27

Chapter 3 Impact of Change in Washington

2 0 09 OUT L OOK

2009 Outlook

What’s on the Horizon Every year LPL Financial Research compiles its Outlook for the following year to let investors know where we believe the markets are heading and how to best position portfolios. The heightened uncertainty and conditional nature of the current macroeconomic and policy backdrop generated a wider range of possibilities for 2009 than for most years. As a result, we present three scenarios for 2009, our base case, a bear case, and a bull case. Three scenarios for 2009 include our base case, the scenario we believe to be most likely, a bear case or continued downturn, and a bull case or market rebound.

1. Base Case The financial panic that began in September 2008 will subside in early 2009 allowing a normalization of financial markets by mid-year 2009. Why would the base case prevail? „

Intervention policies implemented by the U.S. government begin to take effect.

„

Market sentiment remains cautious through volatile January markets.

„

Consumers remain cautious after a dismal 2008 holiday sales season.

„

Unemployment remains relatively high through much of the first half of the year.

The base case scenario: „

The economy emerges from recession in the second half of 2009.

„

Inflation turns negative early in 2009, but rises by the end of the year.

„

The stock market, as measured by the S&P 500, posts a return in the mid-teens, as a volatile first half of the year gives way to more consistent improvement in earnings and sentiment in the second half. We anticipate the year-end S&P 500 close to be around 1000-1050.

„

The bond market, as measured by the Barclays Aggregate Bond Index, posts a return in the mid- to high-single digits range.

„

In alternatives “volatility thriving” strategies continue to benefit returns in the first part of the year.

2. Bear Case The financial panic lingers well into 2010, and financial markets do not normalize at all over the course of 2009. Why would the bear case prevail? 2

2 0 09 OUT L OOK

„

Foreign bank failures continue without the type of intervention seen in the United States.

„

Housing sales break down from the stable levels of the past year and follow the path of auto sales sharply downward.

„

Increasingly aggressive forced selling by financial institutions or a major negative geopolitical event further disrupts the markets.

The bear case scenario: „

The economy lingers in a recession throughout 2009 and into 2010 with a frozen lending market.

„

Stocks post another year similar to 2008, marked by a possible 35% decline as confidence fails to return and earnings tumble another 20%. The year-end S&P 500 close would be about 560.

„

Bonds return low- to mid-single digits, with additional Treasury gains offset by price weakness in non-Treasury sectors: Corporate Bonds, Mortgage-Backed Securities (MBS), and Agency Bonds.

„

The alternative investment areas of opportunity are: Long/Short, Covered Calls, Managed Futures, Global Macro, Absolute Return, and Market Neutral—all those strategies that help with volatility.

3. Bull Case The financial panic that began in September 2008 dissipates at the very start of 2009, and financial markets begin to normalize early in the year. Why would the bull case prevail? „

Evidence of a sharp rebound in market sentiment comes in late 2008 or early 2009.

„

Policy actions take effect sooner than expected.

„

Falling mortgage rates help to deliver a bottom in home prices.

„

The Federal Reserve (the Fed) injects more capital into financial institutions, and lending accelerates.

The bull case scenario: „

The economy experiences a quick rebound from the recession and a rebound in the credit markets as confidence is restored.

„

Stocks rebound up to 50%; both earnings and valuations snap back as a mountain of cash is returned to the capital markets. The year-end S&P 500 close would be about 1365.

„

The bond market returns high-single digits as income and price appreciation, from Corporate Bonds in particular, more than offsets Treasury weakness.

„

Most alternative strategies provide positive results but trail the strong stock market in this bullish scenario.

Under all of these scenarios, the outcome of the 2008 elections creates heightened uncertainty for business leaders and investors about changes affecting the business climate. We expect changes to the investor tax cuts of 2003, among others, to impact investors in 2009. 3

2 0 09 OUT L OOK

2009 Outlook

Outlook At A Glance BASE CASE

BEAR CASE

BULL CASE

Financial panic subsides in early 2009

Financial panic lingers

Financial panic subsides at start of year

ECONOMY FORECAST

„

Recession ends mid-year

„

„

Unemployment rate rises to 8%-9%

Recession extends throughout 2009

„

Unemployment rate rises past 10%

„

Deflation intensifies leading to stagflation into 2010

„

Double-digit home price declines

„

„

Inflation will turn negative early in 2009, but rise by the end of the year Home prices fall another 5%

„

Economy rebounds in first half of 2009

„

Unemployment rate peaks at 7%-7.5%

„

Inflation rises as oil rebounds

„

Home prices begin to rise by mid-year

PORTFOLIO CONSTRUCTION - Relative to Strategic Weights „

First half: Overweight alternative asset classes, slight underweight to stocks and bonds

„

Second half: Trim alternative asset classes, neutral to slight overweight to stocks and neutral to bonds

„

„

Underweight stocks

„

Overweight stocks

„

Overweight alternative asset classes

„

Underweight bonds

„

Underweight alternative asset classes

„

Overweight conservative bonds and cash

S&P 500 posts mid-teen returns

„

The S&P 500 posts a 35% decline

„

The S&P 500 posts a 50% gain

„

S&P 500 EPS is likely to be about $80, or up only about 7% from 2008

„

S&P 500 EPS to plummet another 20% to about $58

„

S&P 500 EPS increases to above 20%

„

P/Es go to 8 by year-end

„

„

P/Es go to 12 by year-end

P/Es rise to 13 a 50% rise from its current level

EQUITIES FORECAST

MARKET CAP

STYLE

Underweight Large Caps relative to strategic weights in the first half of the year „

Larger Cap stocks are not as dependent on credit

„

Small Cap stocks will benefit from easing credit conditions and less international exposure

Overweight Growth relative to Value „

Growth stocks outperform Value stocks when valuations are rising

„

Growth stocks are more defensive than Value stocks

U.S. VS. Overweight U.S. relative to INTERNATIONAL International „

International markets are lagging the U.S. in terms of policy stimulus

„

Deeper linkages between banks and businesses will cause the international recovery to be slower and weaker than the U.S.

„

4

International stocks are more value oriented

Overweight Large Cap „

Large Caps are more defensive than Small Caps

„

Underweight cyclicals and Small Caps

Overweight Growth relative to Value „

Defensive Growth stocks hold up better

Overweight U.S. relative to International

Overweight Small Caps relative to strategic, slight underweight of Large Caps relative to strategic „

Small Caps outperform during the beginning of the business cycle and offer more market beta

Overweight Value relative to Growth „

Overweight cyclicals

„

Underweight defensive

„

Overweight high beta

Overweight International relative to strategics

„

International stocks are more value oriented and therefore less defensive

„

International stocks are more value oriented and therefore more cyclical

„

Key value sectors like Financials negatively impacted by lingering financial panic

„

As investors move away from the safe haven of the U.S., the dollar return on international investments rises

2 0 09 OUT L OOK

2009 Outlook

Outlook At A Glance (continued) BASE CASE

BEAR CASE

BULL CASE

FIXED INCOME FORECAST

DURATION

„

High Quality Bonds return mid- to high-single digits

„

High Quality Bonds return low- to mid-single digits

„

High Quality Bonds return high-single digits

„

High Quality Corporate Bonds and Mortgage-Backed Securities outperform U.S. Treasuries

„

Treasuries continue outperformance relative to Corporate Bonds and Mortgage-Backed Securities

„

„

Municipal Bonds remain cheap to Treasuries but improve in second half of 2009

„

Municipal Bonds underperform Treasuries and municipal yields rise on credit quality concerns

Corporate Bonds lead performance by wide margin and Treasuries lag among domestic sectors

„

Municipal Bonds outperform Treasuries and get added boost late in 2009 on prospects of higher tax rates

Remain duration neutral „

SECTOR

Better risk-reward lies in sector bets than in interest rate bets

Favor Corporates, Agencies, Preferred Stocks, and MBS over Treasuries „

Yield advantages in spread sectors are notable

„

Higher quality spread product will likely benefit first

U.S. VS. Favor International over U.S. INTERNATIONAL „ Foreign banks have more rate cuts than the Fed left to make

Lengthen out duration „

Lower yields and rising prices are more pronounced for longer maturities

Favor Treasuries „

Explicit government backing is necessary

„

Avoid High Yield Bonds, investment-grade Corporate Bonds, and Preferred Stocks

Favor U.S. over International „

More uncertainty remains with what foreign banks will have to do

Shorten duration „

Focus on more eclectic fixed income sectors, not duration

Favor High Yield Bonds, investment-grade Corporate Bonds and Preferred Stocks „

Quickly improving credit markets favor higher beta spread product

„

Avoid Treasuries

Favor International over U.S. „

Unhedged outperform hedged due to dollar weakening

„

Volatility subsides

„

Equity markets rally

„

Alternative investment strategies underperform relative to equities but provide opportunities relative to fixed income

ALTERNATIVE INVESTMENT MUTUAL FUND STRATEGIES FORECAST

„

„

POSITIONING VOLATILITY THRIVING: Covered Call, Managed Futures, Global Macro

RISK MANAGEMENT:

Distressed Debt, REITs, Commodities

„

Alternative investment strategies outperform during the first half of the year, but underperform as the markets rebound in the second half

„

Volatile markets prevail throughout the year Alternative investment strategies continue to outperform relative to equities, but underperform relative to fixed income

Overweight volatility thriving and risk Overweight volatility thriving and risk management strategies in first half of management strategies throughout the year and migrate to opportunistic the year strategies in the second half „ Volatility thriving and risk „ Use strategies that manage management strategies provide greatest relative outperformance risk and returns when markets throughout the year go up and down for the first half of the year „ Continue to avoid economically „

As the economy recovers, migrate to opportunistic strategies that help with economic distress such as Distressed Debt

„

Continue to avoid economically sensitive opportunistic strategies, such as REITs and Commodities until later in the cycle

Long/Short, Market Neutral, Absolute Return

OPPORTUNISTIC:

Volatile markets prevail in the first half of the year

sensitive opportunistic strategies, such as REITs and Commodities

Overweight opportunistic strategies; underweight volatility thriving and risk management strategies „

Strategies that help with volatility and risk management underperform relative to equities

„

Overweight opportunistic strategies such as Distressed Debt

„

Overweight to opportunistic, economically sensitive strategies such as REITs and Commodities

5

HOW WE GOT HE R E

Chapter 1

How We Got Here & Where We Are Headed In order to know where we are headed, we need to know how we got here. 2008 has been a tumultuous year but the seeds were planted years ago. Appreciating how policies and motivations have changed over time can help us better understand how the market collapse and recession came about.

How We Got Here 1. Industry changes that led to a lack of oversight and regulation over a number of major financial institutions. 2. Drastically lowering lending standards without recalibrating risk assessment tools. 3. Financial institutions increasing leverage to inappropriate levels and their dependence on the capital markets. Over the last 10 years, legislative changes transformed the financial services industry. The Gramm-Leach-Bliley Act of 1999 effectively repealed the GlassSteagall Act of 1933. This Great Depression era act had separated lending (the extension of credit) from investing (the use of credit), after combining both activities in the same financial services entity had led to abuses that threatened the safety of deposits. The 1933 act’s repeal in 1999 allowed for consolidation between commercial banks, investment banks, and insurance companies, and blurred the distinctions between these lines of business and their regulatory oversight.

Oil Prices Amid the growing financial crisis, rising commodity prices were bearing down on the economy. Soaring oil and commodity prices weakened the U.S. economy in the first half of 2008. Oil doubled in price from a year earlier and peaked during the summer at $147 per barrel. This pushed gasoline prices over $4 per gallon and sapped consumer spending power. The subsequent collapse in oil and other commodity prices wreaked havoc among a number of hedge funds causing some to fail and destabilized some emerging market nations resulting in dramatic declines in the stock markets of oil exporters like Russia.

6

The result was an increased incentive for banks to provide loans, bundle loans into complex housing-related investments, and then buy, hold, or trade these newly created securities. At the same time, relatively low interest rates set by the Federal Reserve Bank and other Central Banks following the 2001 recession triggered a boom in housing activity. Consequently, the typical home price rose from about 3.5 times household income to 5.0 times income by mid-2006. Financing from the investment banks was abundant, mortgage rates were low, home prices were rising, and volume was the key driver of profits. So, lending was extended to less credit-worthy borrowers than traditional mortgage lending would have approved, as innovations in structured finance broadened the appetite for mortgage debt in a yield-hungry marketplace. Tight credit spreads forced investment banks to use high amounts of leverage through debt issuance in order to reach profit targets on investments. To illustrate the problem, consider that a homeowner would be leveraged 5-to-1 with a purchase of a home with 20% down payment and an 80% mortgage. If the price of that home declined 10%, the mortgage would stay the same and the value of the homeowners’ equity would be cut by 50%. Some investment banks were leveraged 20-to-1 or even 30to-1 on housing-related investments, but continued to rely on quantitative tools that used historical inputs to measure risk on them. The historical

HOW WE GOT HE R E

data underrepresented the actual potential losses these new types of investments could bring to those inside and outside these institutions. The inappropriate use of leverage will go down in history in 2008, as it did in 1929, as one of the villains of the market crisis. Some hedge funds that use leverage got caught over-levered, and these funds, along with investment banks, individuals, and institutions, all played a role in levering our markets to a point of irresponsible risk. The changes among financial institutions made investment banks more dependent upon borrowing from other banks to fund investments, whereas in the past funding relied more upon commercial bank deposits. This borrowing made many of the banks incredibly interdependent and securities highly intertwined. As prices began to slide, investment banks became unable to raise funds from other banks in the interbank market and were forced to sell their investments. Because the investment banks made up a large portion of the demand for these securities in recent years, there were few buyers to absorb the supply, which accelerated the decline in the value of the securities. The prices of housing-related securities entered freefall. The Fed’s surprising decision to let Lehman Brothers fail caused interbank lending to suddenly seize up in September. With banks unwilling and unable to lend to each other, the markets went into a tailspin and the previously undiagnosed recession intensified and became apparent.

Housing Valuations Returning to Normal When this value is rising, home buyers are paying more for their homes relative to their income. Median Home Price Divided by Median Household Income 5.5 5.0 4.5 4.0 3.5 3.0 2.5

1978 1982 1986 1990 1994 1998 2002 2006 2010 Source: LPL Financial Research, Bureau of the Census, National Association of Realtors.

The Fed and Treasury have responded with enormous and unprecedented policy actions to thaw the financial markets and restore funding to financial institutions. These include making more than $1 trillion available by: „

Directly injecting capital into embattled institutions (the Troubled Asset Relief Program or TARP).

„

Opening credit facilities available to banks and other financial institutions (Fed Primary Dealer Credit Facility or PDCF).

Credit Default Swaps

„

Creating the commercial paper program to lend directly to businesses.

„

Directly purchasing Mortgage-Backed Securities and loans.

„

Providing explicit guarantees of the liabilities of a few financial institutions including AIG and Citigroup.

The failure of Lehman Brothers and rescue of AIG in mid-September of 2008 led to a blow up of the credit default swap market. Credit-default swaps are financial instruments based on bonds and loans that are used to speculate on a company’s ability to repay debt. They pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower default. A rise in the CDX North America Investment Grade Index, which tracks 125 companies, indicates declining confidence in these companies’ ability to repay debt. After ranging between 1% and 1.5% prior to mid-September 2008, the credit-default swap spread on the index broke out of the range to the upside and continued to rise to about 2.75%. The proliferation of these financial innovations introduced additional credit exposure to financial institutions such as insurance companies and exacerbated the financial crisis.

Intervention by policy makers has historically marked the turning point for bear markets and limited the duration of recessions. While this financial crisis is more severe than most, the scope of the policy response is unprecedented. And while key policy actions are taking time to implement, we believe the trillions of dollars being marshaled to stabilize the global financial markets are likely to prove to be successful. Indeed, signs of progress evident in late 2008 include a sharp fall in interbank lending rates, stabilizing credit spreads, and the return of the commercial paper market. However, many potentially negative unintended consequences stemming from these unprecedented policy actions create a lot of uncertainty as we enter 2009. These consequences include the impact of sweeping regulatory changes, political oversight, more conservative consumer financing, the ongoing deleveraging of financial institutions, and the potential for rising inflation as growth resumes.

7

B AS E C AS E

Key Gauge of Crisis Now Showing Signs of Easing 3 month U.S. LIBOR Less 3 Month Treasury Bill Yield

Where We Are Headed? Three Potential Scenarios for 2009

5.00 4.50

The range of possibilities for 2009 is wider than for most years, given the heightened uncertainty and conditional nature of the macro economic and policy backdrop. We believe there will be an overall gradual improvement in conditions in the credit markets and economy in 2009. But rather than present one base case that we believe has the highest probability of occurring, we have opted to also explore two other paths that 2009 may follow.

4.00 3.50

Percent

3.00 2.50 2.00 1.50 1.00

1. Base Case

0.50 0.00

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Source: Bloomberg, LPL Financial Research LIBOR: The London Interbank Offered Rate is a measure of the cost incurred by banks when borrowing from each other. As competition for limited funding increases, the rate rises.

Key premise: The financial panic that began in September 2008 subsides by early 2009, allowing a normalization of financial markets by mid-year 2009. Economy Economic Backdrop Assumptions: „

Recession status: The U.S. economy emerges from the recession—that officially began in December 2007—sometime in the second half of 2009. The U.S. Gross Domestic Product (GDP) contracts by at least 5% in the fourth quarter of 2008, as consumers retrench and U.S. exports dry up amid the dramatic slowdown in overseas economic activity. We expect that real GDP growth in both the first and second quarters of 2009 will be negative—close to the fourth quarter 2008 decline in the first quarter, and less negative in the second quarter. We expect real GDP growth to be roughly flat in the third quarter of 2009 making this the longest and deepest recession in the post-war period. We expect that the economy will begin to emerge from the recession in the fourth quarter. However, GDP growth remains choppy and well below the economy’s long-term potential growth rate, which keeps pushing the unemployment rate higher.

„

Inflation: As measured by the Consumer Price Index (CPI), headline inflation turns negative early in 2009, but rises by the end of the year. Core inflation—inflation excluding the impact of food and energy prices—continues to move lower over the first half of 2009, but then stabilizes and begins to move higher in the latter part of the year as the Fed grows the money supply (reflation).

„

Unemployment: The unemployment rate rises from 6.7% (as of November 2008), maxing out between 8% and 9% in late 2009 or early 2010.

„

Home prices: Housing prices decline nationally roughly another 5% in the first half of 2009, but bottom at mid-year as low rates and the increased availability of credit spur buying.

„

Oil: Oil prices bottom near $30, then stabilize in a $30 to $50 range in 2009.

„

Dollar: The US dollar continues on an upward path, rising another 10% or so in 2009.

Which of our past recessions does the current recession most resemble? We expect that the current recession, which began in December 2007, will linger until mid-2009 and end up being the worst recession in terms of duration and severity. Our view is that while the recession technically began in December 2007, the recession intensified and went “global” in mid-September 2008 in the wake of the collapse of Lehman Brothers, which led to a seizing up of global credit markets. The 1973-75 and the 1981-82 recessions lasted 16 months each, the longest duration for post-World War II recessions. (The average post war recession lasted just 10 months.) The unemployment rate, a proxy for the severity of a recession, peaked at 9.0% (from a low of 4.6%) just after the end of the 1973-75 recession, and peaked at 10.8% late in the 1981-82 recession, up from the pre-recession low of 5.6%.

Federal Reserve Actions: „

8

Target interest rate: The Fed maintains near zero effective fed fund rate.

B AS E C AS E

„

„

Balance sheet: The Fed continues to make capital injections into U.S. corporations, mainly financial institutions, as needed. As rates approach zero, the Fed is likely to continue to take on troubled assets and issue government securities (known as a balance sheet expansion program) as it attempts to reflate the economy.

Unemployment Insurance Despite a small drop in the latest week, jobless claims remain at their highest level since the 1981-82 recession. Unemployment Insurance: Initial Claims, 4-wk Moving Avg Unemployment Insurance: Initial Claims, State Programs

Money supply: The Fed’s reflation policy will sharply increase the money supply by late 2009.

700

„

Stimulus package: A fiscal stimulus package that equates to between 2% and 4% of GDP passes early in 2009. The package will be aimed at infrastructure, but the bill will also contain more traditional forms of stimulus, such as the extension of unemployment benefits and job training programs, among others. A middle class tax cut—possibly coupled with tax increases for taxpayers in the upper brackets—is passed as part of the stimulus program.

„

Budget deficit: The U.S. budget deficit will rise to more than $1 trillion in 2009, or roughly 7% of GDP.

„

Other measures: The remaining $350 billion of the funds authorized by Congress in October 2008 as part of the TARP is likely to be spent aiding more “Main Street” finance like student and auto loans. Some kind of direct housing relief is implemented in early 2009 (likely establishing a set mortgage rate for traditional loans to all new buyers and refinancers alike). Tax rates on dividends and capital gains move higher, but not until the end of 2010.

In Thousands

600

Government Actions:

500 400 300 200

85 90 95 00 05 Source: Department of Labor / Haver Analytics 12/08/08

Unemployment Rate Typically Peaks Close to the End of Recessions The unemployment rate is headed higher in 2009. Civilian Unemployment Rate 12 10

Percent

Equity Markets At year-end 2009, we anticipate the S&P 500 index will be at around 1000 or 1050. The rise to this level would be driven by a price-to-earnings ratio (P/E) of 12 on the next 12-months expected earnings per share (EPS) of about $88 in 2010 and a dividend yield of 3% to 4%. For context, this would be the level at the top of the range of the S&P 500 since mid-October 2008. Details follow about how we reached these values for the three component parts of S&P 500 total return: EPS, P/E, and dividend yield.

In 2008, S&P 500 operating EPS were down about 20% from their peak in mid-2007. The largest factor pulling down overall EPS was Financials sector companies. Therefore, a key component of an earnings growth rebound is what happens with the Financials sector. The likely rebound in earnings from the Financials sector in 2009 comes in part from the impact of the

6 4 2

75 80 85 90 95 00 05 Source: Bureau of Labor Statistics / Haver Analytics 12/02/08

Core and Headline Inflation Both headline and core inflation set to slow in early 2009, but inflation could return towards the end of 2009. Year-Over-Year Change in Core Inflation Year-Over-Year Change in Headline Inflation 15.0 12.5 10.0

Percent

Earnings per share (EPS): As credit markets improve and the economy emerges from recession, earnings growth is likely to rebound. As a result of the contributions of the various sectors, EPS in 2009 is likely to be about $80, or up only about 7% from 2008. By way of comparison, the Thomson Financial-tracked Wall Street analyst consensus for EPS in 2009 is in the mid$80s—that is a consensus forecast for an increase of about 15-20%. Our estimate of the four quarter sum of EPS in 2009 is for about $80, which will leave 2009 well below the mid-2007 peak of $92. A tough next few quarters for earnings, combined with a relatively shallow recovery in the economy beginning in mid-2009, would take EPS to about $88 in 2010 as the U.S. economy more fully emerges from recession. The potential 10% gain in EPS to about $88 in 2010 is only half of the average 20% gain in the year following a recession owing to the lingering impact of deleveraging.

8

7.5 5.0 2.5 0.0

75 80 85 90 95 00 05 Source: Bureau of Labor Statistics / Haver Analytics 12/03/08

9

B AS E C AS E

U.S. Budget Deficit U.S. facing the worst budget deficit as percent of GDP since World War II 4.0 2.0

Percent

0.0 -2.0

different mix of companies from those that comprised the index for much of 2008. Many of the companies that made up a large portion of the index at the end of 2008 had more defensive sources of revenue and are likely to experience much lower write-down amounts than those that comprised the index at the beginning of 2008. Without the impact of the outsized losses from the failed investment banks that took place in 2008, combined with the actions of the Fed and Treasury to stem losses elsewhere, earnings growth will rebound for the sector. However, this rebound will be partially offset by weakness overseas; S&P 500 companies derive about 40% of their revenue from non-U.S. markets.

-4.0 -6.0 -8.0 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 09E

Source: Bureau of Labor Statistics / Haver Analytics 12/03/08

Price-to-earnings ratio (P/E): The level of the S&P 500 at the end of 2009 will be dependent upon the confidence in the outlook for earnings in 2010. We anticipate valuations rising from the current price-to-earnings ratio of 9 on the next 12 months S&P 500 EPS to 12 as of year-end 2009. This valuation is shy of the long-term average of 15, as fears of inflation loom and uncertainty lingers despite the start of a modest mid-year economic and EPS recovery. The rebound in valuation is contingent upon confidence returning as credit markets begin to heal, mortgage-related debt values stabilizing, home prices stabilizing after a further decline of about 5%, and market participants anticipating an economic and earnings rebound taking place in the second half of the year. Prior to 2008, the last time the S&P 500 traded as low as 12 times expected earnings was in 1994, when the uncertainty surrounding the so-called “jobless recovery” from the 1991 recession, combined with the perceived threat of sweeping legislative and regulatory changes to the healthcare industry, pulled down valuations. The uncertainty of the political and economic environment of 2009 may result in a similar valuation. A potential percentage gain in the index in the mid-teens for 2009 is well below its typical rebound from a recession, which typically runs between 25% and 30% in just the first 90 days. Dividend yield: The dividend yield on the S&P 500 will likely be in the range of 3% to 4% in 2009. The dividend yield may remain above the yield on the 10-year Treasury note for much, if not all, of the year, a rare occurrence. The S&P 500 dividend yield has not been above the 10-year Treasury yield for 50 years—in 1958 the 10-year Treasury yield was around 3%, and the dividend yield on the S&P 500 was around 4%, similar to today. International equities: International markets are likely to lag the United States again in 2009 as the deeper and longer recession takes hold overseas and the US dollar strength continues. While we believe the policy actions by the Treasury and the Fed will begin to cure the financial crisis in the U. S., we are not so optimistic on the measures being taken abroad to treat the symptoms of the crisis, much less provide the cure. The economies of Europe may lack some of the tools and resources to address the crisis effectively, and Asian economies are suffering from falling export growth, driving those economies deeper into recession.

Fixed Income Markets We expect a choppy bond market where improvements in non-Treasury Bonds, big laggards in 2008, are met with selling and potential retests of record low valuations established in the fourth quarter of 2008. We expect bond performance, as measured by the Barclays Aggregate Bond Index, to range from mid- to high-single digits for 2009, based on the assumptions of Treasury yields declining by 0.25% then rising by 1.00% later in the year and of modest spread contraction among Corporate Bonds, Agency Bonds, 10

B AS E C AS E

and Mortgage-Backed Securities (particularly Agencies). As these spreads contract, yields on non-Treasuries fall, causing their prices to rise. In 2008, investors became risk averse—flocking to Treasuries which have become very expensive (meaning they have low yields). As we move further into and then out of this recession during 2009, we anticipate that investors will be more willing to take on some risk—as long as they are paid for it—and move away from Treasuries to other spread products (Corporate Bonds, Agency Bonds, Mortgage-Backed Securities (MBS), High Yield Bonds, Foreign Bonds, Bank Loans, and Municipal Bonds).

Fixed Income Excess Returns Barclays Aggregate Bond Index Excess Return Duration Adusted performance vs Treasuries (%) 6 4 2 0 -2 -4

Given the preponderance of cheap assets in the spread product sectors of fixed income markets, we believe that investors will be drawn first to the high grade sectors—Corporate Bonds and MBS—before migrating down the credit quality spectrum to lower grade bonds, such as High Yield or Bank Loans. While we find valuations for both of these lower grade products attractive, we believe higher quality bonds will improve first. More detail follows on each of the market segments.

-8 -10 12/1990

12/1993

12/1996

12/1999

12/2002

12/2005 YTD 2008

Source: Barclays Capital / LPL Financial Research

Barclays Corporate Index Yield Spread to Treasuries As the yield spread rises, yields of non-Treasury bonds are increasing, meaning that their prices are falling. In general, this causes the returns on individual bonds to fall. 700 600 Yield Spread (basis points)

Treasuries: We expect Treasury valuations to remain historically expensive as bond investors monitor the degree and depth of the recession and falling inflation in the beginning of 2009 keeps real yields well below the historical average of 3.0%. Treasury yields will likely remain near historical lows over the first half of 2009, before economic improvement begins to exert upward pressure on yields later in the year. Liquidity is the key to improvement for non-Treasury bond sectors. Liquidity is likely to remain constrained over the first three to six months of 2009, despite unprecedented Treasury and Federal Reserve support packages. Banks and other financial institutions will continue to rebuild balance sheets during these months and limit participation in fixed income markets. Illiquid markets exacerbate the impact of forced liquidations. Although we believe the bulk of deleveraging is behind us, additional forced sales are certainly possible and would support our expectation of a choppy market, with Treasuries retaining a safe haven premium.

-6

500 400 300 200 100 0

Source: Barclays Capital / LPL Financial Research

High Yield Spreads and the Default Rate Investors are paid more (the High Yield spread) when the risk level of default (the default rate) is rising. The key is to find the point where there is more spread than actual—as opposed to anticipated or priced in—rate of default. Default Rate (left hand scale) Yield Spread (right hand scale) 2000

18

1800

16

1600

Default Rate (percent)

20

1400

12

1200

10

1000

8

800

6

600

4

400

2

200

0

0

1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

14

Basis Points

Although we expect limited spread contraction, we still expect non-Treasury sectors to outperform due to their income advantage. Investment-grade Corporate Bond yield spreads relative to Treasuries remain close to record wide levels. Using Barclay’s index data, the average investment- grade rated Corporate Bond yielded over 6% more than comparable Treasuries. The previous record wide level in investment grade Corporate Bond yield spreads was 2.7% back in 2002. Not only are Corporate Bond yield spreads wide, but also overall yields are their highest since the early 1990s. MBS yield spreads remain well above their 10-year average of 1.2% after having contracted from record wide levels, a direct benefit of the Fed’s recently announced $500 billion MBS purchase program. With Treasury yields still at historic lows and the Fed MBS purchasing program yet to begin, we expect the sector to be well supported and continue to benefit. MBS pose an attractive high quality bond option for investors.

Dec-90 Dec-91 Dec-92 Dec-93 Dec-94 Dec-95 Dec-96 Dec-97 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08

Corporate Bonds, Agency Bonds, and MBS: As banks and financial institutions recapitalize, they will gradually increase market participation by taking down more inventory and facilitating trading over the second half of 2009. This process will occur slowly but lead to slightly narrower yield spreads for Corporate Bonds, Agency Bonds, and Mortgage-Backed Securities, which together account for 73% of the Barclays Aggregate Bond Index. Narrower yield spreads relative to the index would fall more in line with historical averages.

Source: Moody’s / Barclays / LPL Financial Research 11

B AS E C AS E

What should investors do if they believe the base case will unfold in 2009? The policy actions discussed, as part of the Base Case, are very likely to limit the duration and depth of the recession and turn the stock and credit markets around after a record-breaking plunge. However, lingering uncertainties remain surrounding the unintended consequences of the policy actions, which are likely to foster a high volatility environment and may warrant a shift in some portfolios. The focus on whether markets will go up OR down is misplaced—they will go up AND down. Rather than a period of rising or falling markets, we will continue to be in a bull market for volatility until financial markets normalize in mid-2009. These conditions place a premium on adaptation and magnify the potential rewards from effective tactical decision making during the beginning of 2009. Alternative investments that help with market volatility, such as Global Macro funds and Covered Call mutual fund strategies, are likely to be increasingly effective at helping manage risk and return. We continue to favor U.S. markets over international and Emerging Markets. Minimizing exposure to foreign markets proved to be valuable in 2008. With less policy stimulus in the pipeline overseas and deeper linkages between banks and businesses, we expect the recovery will be slower and weaker than in the United States. We also favor Growth over Value among Large Cap stocks. Growth stocks tend to outperform Value during periods when valuations are rising. We expect valuations to drive much of stocks’ performance in the coming months as investors reassess market risk premiums while earnings weakness lingers. In fixed income markets, we remain duration neutral with an emphasis on intermediate bonds as a better risk/reward relationship lies in sector allocation rather than taking interest rate risk. Our focus remains on non-Treasury sectors, where underperformance in 2008 has left spread sectors at historically cheap valuations. [Continued on page 13] 12

High-Yield Bonds: The High Yield market has priced in a substantial rise in defaults. We expect default rates to reach Moody’s year-end 2009 forecast of 11.2%, roughly in line with the 2002 peak in default rates. With a current yield spread of 21.8% above comparable Treasuries, the High Yield market has priced in a rise in defaults to approximately 20%. Foreign Bonds: Foreign Bond yields are likely to be stable or decline further. Overseas central banks, most notably the European Central Bank (ECB) and Bank of England, are behind relative to the Fed in terms of cutting interest rates and will likely continue to cut interest rates even after the Fed is done. Although rate cuts are priced in, the possibility of greater than expected rate reductions should make high quality Foreign Bonds look more attractive than their U.S. counterparts and support high quality Foreign Bonds. Municipal bonds: Municipal Bonds will remain volatile over the first half of 2009, but we expect improvement later in the year. The continued absence of non-traditional buyers, potential for additional forced selling, and above average new issuance will likely keep Municipal Bonds cheap relative to Treasuries. Supply needs will likely remain elevated as states and municipalities issue debt to help finance budget shortfalls. The supply/ demand imbalance will likely persist, despite the longer-term possibility of higher tax rates. This implies that high quality municipal yields are likely to remain above Treasury yields well into 2009. Recall that current marginal tax rates are set to expire at the end of 2010, when the top rate will revert back to 39.6% from its current 35%.

Alternative Investments ^ In our 2009 base case, we expect a more challenging environment for alternative asset classes on a relative return basis as the equity and credit markets improve. However, those same factors will likely put alternatives in a better position to provide help with the market’s volatility. The market dislocation of 2008 provided alternative investments with the opportunity to move into the mainstream and prove their worth as long-term participants in the portfolios of retail clients. Conservative use of alternatives resulted in more stable performance, even in the face of challenges within many alternative asset classes. Most alternative strategies—though not all—managed to outperform the equity markets. From a portfolio perspective, strategies that can take advantage of volatility, such as Managed Futures, Global Macro, Covered Calls, Market Neutral and to a lesser extent, Absolute Return and Long/Short, rose to the challenge and once again proved to be useful diversifiers. Some of the prominent themes we expect to see playing out in our base case: „

Equity fundamentals will regain importance in stock selection. This return to fundamentals should be positive for Long/Short, Market Neutral, and other alternative strategies that focus on valuations and enterprise value.

„

Low Treasury yields will create an opportunity for conservative use of Market Neutral and Absolute Return funds.

„

The investment case for Distressed Debt will continue to grow as the economy faces continued challenges.

„

The volatility that will continue into 2009 should moderate as we move through the year. Declining volatility will gradually lessen the advantage of Covered Call strategies.

B E AR C AS E

„

Managed Futures may see more moderate performance as some of the significant trends of 2008 plateau.

„

A delevered market will create opportunities both in alternative and longonly strategies.

2. Bear Case Key premise: The financial panic that began in September 2008 lingers well into 2010, and financial markets do not normalize at all over the course of 2009. Economy Economic Backdrop Assumptions: „

Recession status: The recession in the United States is worse than the 1981-82 experience and lasts much longer than 16 months. Real GDP growth declines sharply (by 5% or more) in both the fourth quarter of 2008 and the first quarter of 2009, ahead of a choppy, but still negative last three quarters of 2009 where real GDP growth is likely to average -1.0%. The persistent lack of liquidity and credit availability causes businesses and consumers to spend even less, and international economies are even worse off than the U.S. economy due to lack of global lending. Our bear case assumes that the economy experiences the worst recession since the 1930s and that the policy response, both fiscal and monetary, will be unlike anything we have seen since the 1930s. The recession that began in 2007 will be long in terms of time and vast in terms of impact.

„

Inflation: Deflation intensifies and persists throughout 2009, and severe stagflation—high and rising inflation combined with near zero or negative economic growth—is likely in 2010.

„

Unemployment: The unemployment rate moves well past 10%. (The unemployment rate hit 10.8% at end of 1981-82 recession.)

„

Home prices: The U.S. housing markets continue to deteriorate, with rising delinquencies and foreclosures, and another sizeable (10% or more) drop in U.S. home prices over the course of the year.

„

Oil: Oil prices sink to their long-term average price per barrel of between $18 and $22.

„

Dollar: International economies approach full-out depression as the United States pulls back swap lines with other foreign central banks. The US dollar rallies more than 10% in a flight-to-safety from crumbling overseas economies.

Federal Reserve Actions: „

Target interest rate: The Fed maintains near zero effective fed funds rate.

„

Balance sheet: The Fed continues to buy Mortgage-Backed Securities and starts to buy U.S. Treasuries and Corporate Bonds to recapitalize most financial institutions. The Fed expands its balance sheet rapidly and intensifies reflation efforts.

„

Money supply: The Fed’s reflation policy sharply increases the money supply in 2009.

[Continued from page 12]

The yield advantages of Corporate Bonds, Agency Bonds, Preferred Stocks, and Mortgage-Backed Securities relative to Treasuries are at or beyond the biggest ever witnessed in the bond market. The added income benefit should provide a buffer to help weather the storm of volatile markets. In a bond world awash with cheap securities, we believe higher quality bonds will benefit first as investors reach for these first in taking baby steps out on the risk spectrum. Although this process may take some time, liquidity will likely improve for high quality assets first. Municipal Bonds were a victim of the credit crunch, but yields remain above Treasuries across the maturity spectrum. Investors in slightly lower tax brackets that may not have traditionally considered Municipal Bonds may wish to do so given the historic dislocation and still high credit quality of the asset class. The challenges that some alternatives faced in 2008 may lead to some remarkable opportunities in 2009 and beyond. Throughout 2009, however, there is likely to be a shift from mutual fund strategies that help with volatility, like Covered Calls and Global Macro, to investments that search for value in credit and stocks. Attractive valuations and an increase in default rates, for instance, appear to be providing opportunities to build positions in Distressed Securities. Long/Short and Absolute Returns strategies should also provide solid returns if we see credit markets normalize and stocks rebound.

^ Keep in mind such strategies are subject to increased risk due to the use of derivatives and futures and may not be suitable for all investors and should be considered as an investment for the risk capital portion of the investor’s portfolio. The strategies employed in the management of alternative investments may accelerate the velocity of potential losses.

13

B E AR C AS E

Spot Oil Price: West Texas Intermediate In our bear case for the economy, oil prices could return to their long-term average of $18 to $22 per barrel.

Government Actions: „

Stimulus package: The first stimulus package enacted in early 2009 (2% to 4% of GDP) does not prove to be enough. A second plan has to be enacted—roughly the same size as the first, but with direct cash payments to taxpayers.

„

Budget deficit: The U.S. budget deficit exceeds $1 trillion, or more than 7.0% of GDP.

„

Other measures: The U.S. government embarks on a more dramatic and direct program of housing relief, and begins to buy homes from homeowners, banks, and other mortgage holders. The U.S. Congress and foreign governments press for more protectionist measures, which further slow world trade.

150 125

Long Term Average is Between $18 and $22 per Barrel

100 75 50 25 0

75 80 85 90 95 00 05 Source: Wall Street Journal / Haver Analytics 12/03/08

Equity Markets In our bear market scenario, at year-end 2009, we anticipate the S&P 500 index will be at around 560. This would be driven by an 8 price-to-earnings ratio (P/E) on the next 12-months expected earnings per share (EPS) of about $58 in 2010 and a dividend yield of 3% to 4%. For context, these levels would result in about another 35% decline after stocks have already posted a 52% peak-to-trough decline (through November 2008). More details follow about how we reached these values for the three component parts of S&P 500 total return: EPS, P/E, and dividend yield. Earnings per share (EPS): The ongoing financial crisis causes S&P 500 EPS to plummet another 20% to about $58 in EPS for 2009. The earnings would be made up of the earnings streams of only the most defensive S&P 500 companies. The Healthcare, Consumer Staples, Utilities, and Telecommunication sectors would likely contribute half of the total, while the defensive positions of the other six, more cyclical, sectors of the S&P 500 would make up the rest. Each of the Energy, Industrials, Information Technology, Consumer Discretionary, Financials, and Materials sectors would likely contribute less than half of the dollar amount Wall Street analysts expect in 2009. This outcome would bring the earnings for these cyclical sectors down more than 50% from peak levels. The result would be the worst earnings decline in the post-WWII period. Some improvement in the macro economic backdrop, earnings growth, and confidence by the second half of 2010 may result in the return of some cyclical sources of earnings, and then EPS may lift to about $70, below the 2008 level and more than 20% below the mid-2007 peak. Price-to-earnings ratio (P/E): If confidence remains weak as the recession deepens and lingers while credit markets remain seized, and aggressive deleveraging is ongoing throughout the year, an 8 forward P/E multiple appears reasonable. Dividend yield: The dividend yield would rise as stock prices fall proportionately more than dividends are cut. The yield would likely average between 4% and 5% during 2009. International equities: Though stocks around the world would suffer major additional declines in the bear case, the flight-to-safety havens like U.S. Treasury debt would push up the value of the dollar, which would boost the relative performance of U.S. over international stocks. In addition, the generally more cyclical earnings streams of non-U.S. companies would likely result in even greater earnings declines in Europe and Asia than in the United

14

B E AR C AS E

States. Valuations outside the United States may fall under more pressure as well as protectionism stemming from the crisis increases. A return to more fiscal spending in the Eurozone could lead to a breakdown of the European Union and Asia, as China’s GDP nearly turns negative after a decade of growth of 10% or more.

Fixed Income Markets In the bear case for bonds, liquidity does not improve in 2009 and financial institutions limit participation in financial markets. We expect bond performance, as measured by the Barclays Aggregate Bond Index, to range from low- to mid-single digits for 2009. Illiquidity plagues the spread sectors, and yield spreads to Treasuries creep wider, establishing new record wide levels. Thus, investors would flock to Treasuries, causing the prices of nonTreasuries (Corporate Bonds, Agency Bonds, Mortgage-Backed Securities (MBS), High-Yield Bonds, Foreign Bonds, Bank Loans, and Municipal Bonds) to decline further. Within credit markets, lower rated issues and longerterm issues underperform as investors seek top quality issuers and keep maturities short. Illiquid markets also exacerbate market impacts resulting from further deleveraging. Treasuries: We expect Treasury yields to drop further into record low territory as the flight-to-safety continues and approach levels of Japanese government bonds; the 5-year Treasury yield drops below 1.0%, and the 10-year note yield drops below 2.0%. Real yields drop further, making Treasuries even more expensive as they outperform spread sectors by a notable margin. Corporate Bonds, Agency Bonds, and MBS: We believe that yield spreads on these non-Treasury sectors will widen, failing to benefit from price appreciation associated with Treasury yields’ declining 0.25 to 0.75 percentage points. Treasury price gains are offset by price weakness in Corporate Bonds, Agency Bonds, and Mortgage-Backed Securities, although we expect to a lesser degree than in 2008. Overall, these sectors generally continue to suffer, as investors are unwilling to take on risk. High-Yield Bonds: High-Yield Bond spreads widen to the mid-to-high 20% range as the market braces for a surge in defaults. The severity and depth of the recession pushes the default rate several percentage points past the 1991 record of 13%. Foreign Bonds: Along with U.S. Treasuries, high grade Foreign Bond yields move lower, spurred not only by the flight to quality but also by more aggressive interest rate cuts. Therefore, the prices on these government securities continue to climb. Foreign central bank lending rates, except Japan’s, approach those of the target Fed Funds rate. Hedged Foreign Bonds outperform unhedged ones as the currency effect of a stronger US dollar, which benefits from flight-to-safety flows, is likely to more than offset potential price gains from lower interest rates. In fact, we would expect a greater performance differential between hedged and unhedged Foreign Bonds under this case than under the base case scenario. Municipal Bonds: Municipal Bonds underperform Treasuries as investors price in decreasing credit quality at the state and local level. Under this scenario it is likely Municipal yields could increase even as Treasury yields decline, repeating a situation that has happened on a few occasions over the past 15 months. The supply/demand imbalance worsens and also contributes to Municipal Bond underperformance.

What should investors do if they believe the bear case will unfold in 2009? In the bear case, investors may want to adopt a defensive posture by underweighting the stock market and favoring the safest investments, such as cash equivalents. The outlook for deflation in this bearish scenario means that gold, a traditional safe haven, may also suffer. With substantial additional downside likely for stocks in this scenario, focusing stock market exposure on Large Cap Growth defensive sectors like Consumer Staples and Healthcare and underweighting cyclical stocks in the Financials, Consumer Discretionary, and Information Technology sectors is likely to result in the best relative performance. Alternative strategies that emphasize short positions may also provide a hedge against further stock market declines. In the fixed income market, investors should overweight long maturity Treasuries. The safe haven of the explicit government backing of these securities may likely result in lower yields and rising prices, which is typically more pronounced for longer maturities. Investors should underweight the credit markets—especially High-Yield Bonds, investment grade Corporate Bonds, and Preferred Stocks. If the bear market case ensues, alternative asset classes may be one of the few areas of the market in which to find refuge. Alternative asset classes can serve as substitutes for equity and fixed income allocations, delivering strong relative returns in the markets. To help with volatility prevailing in both markets, the areas of opportunity are: Long/Short, Covered Calls, Managed Futures, Global Macro, Absolute Return, and Market Neutral funds. Distressed Debt funds will also continue to find attractive values; however, in a continued bear market, positive returns from these strategies will be delayed.

15

B UL L C AS E

Alternative Investments

Counterintuitive: Beware Being in Cash When this Bubble Bursts A 50% gain in the S&P 500 could be the outcome of the bursting of a bubble in cash equivalents. Because investments in money market securities are unlikely to produce large losses on the downside of the bubble, the growth in demand for money market securities is not a typical financial bubble. However, a comparison to the dot-com bubble can help illustrate the opportunity cost when the cash equivalents ‘bubble’ bursts. During the Tech bubble, the market value of the Tech sector grew to about 35% of the S&P 500 index before returning to the mid-teens weighting it had averaged over the long term. Money market mutual fund assets are now nearly as high as the market value of the S&P 500 Tech sector at its peak, about $4 trillion. This amount of cash is equivalent to nearly half the value of the entire S&P 500. Prior to the enormous accumulation of cash in money market mutual funds over the past year, money market mutual fund assets were equivalent to about 20% of the value of the S&P 500. If this demand bubble bursts, the classic pattern suggests a return to the 20% level, and that would result in an opportunity cost for holding cash equivalents as trillions flow back into the capital markets and the stock market experiences powerful gains.

Another Sort of Bubble Has Formed Tech Sector and Money Market Assets as a Percent of S&P 500 Market Cap

Regardless of market scenario—base, bear, or bull—some alternative investments will present opportunities. In the bear case, those that help with volatility and distress in the markets are poised to perform well on an absolute and relative basis. Managed Futures and Global Macro could potentially deliver double-digit returns as economic and market trends continue. Covered Calls and Long/Short equity funds would likely see smaller declines than the broad equity market, potentially in a range of 12% to 22%. Investing in alternative investments may not be suitable for all investors and should be considered as an investment for the risk capital portion of the investor’s portfolio. The strategies employed in the management of alternative investments may accelerate the velocity of potential losses.

Bull Case Key premise: The financial panic that began in September 2008 subsides by year-end 2008 or early 2009, allowing a normalization of financial markets shortly thereafter. Economy Economic Backdrop Assumptions: „

Recession status: The U.S. economy experiences one last big down quarter in the fourth quarter of 2008—with real GDP contracting by more than 5%—but then stabilizes in the first half of 2009 before rising at an annualized rate of between 2.5% and 3.5% in the second half of 2009. The recovery is spurred by the cumulative impact of Fed and Treasury policy actions taken to date. These actions, along with more “toxic asset” lift outs—similar to the Citigroup rescue plan that was put into place in mid-November 2008—for other large financial institutions finally gain traction and allow credit to flow to all sectors of the economy. Healing in markets that have been directly impacted by government intervention spreads to markets where there has not been direct intervention.

„

Inflation: Headline inflation moves higher with oil, and the lagged effect of the expansion of the money supply the Fed did in late 2008 into early 2009 leads to a sharp uptick in core inflation in 2010 and beyond.

„

Unemployment: The unemployment rate peaks out between 7% and 7.5% during 2009.

„

Home prices: Aided by a massive effort by the FDIC and other government entities to rework millions of mortgages, the housing market bottoms in the fourth quarter of 2008. Home prices stop falling and even begin to rise, and foreclosures dry up. The risk of defaults in earlier (vintage 2004 and 2005) tranches of mortgages fades.

„

Oil: Oil prices average $70 and end the year at $80, as the global economy recovers.

„

Dollar: Massive stimulus overseas dampens impact to non-U.S. economies, allowing U.S. export growth to decelerate, but not decline outright as it has in prior severe recessions. The US dollar is flat to down between 5% and 10%, as the “flight to quality” bid ebbs.

Tech Sector Weighting in S&P 500 from Feb 1996 - Feb 2004 Money Market Assets as Percent of S&P 500 Market Cap Since Sep 2004 50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0%

Sep-2004

16

Sep-2006 Sep-2008 Sep-2010 Source: Haver Analytics / LPL Financial Research

B UL L C AS E

Federal Reserve Actions:

Balance sheet: Seeing its prior policy actions take hold, the Fed lessens its rate and amount of capital injections. The Fed balance sheet begins contracting.

20%

Money supply: Though there is some increase in the money supply in late 2009, it is minimal.

10%

„

Budget deficit: The U.S. budget deficit rises to more than $700 billion, or about 5% of GDP.

„

Other measures: The unneeded second stimulus package raises the odds of more aggressive Fed rate hikes (and higher inflation) in 2010 and beyond.

Equity Markets At year-end 2009, our bull case puts the S&P 500 index at about 1365, driven by a 13 price-to-earnings ratio (P/E) on the next 12-months expected earnings per share (EPS) of about $105 in 2010 and a dividend yield of 2% to 3%. If the bull case were to unfold the biggest risk to the economy in 2009 and beyond would be an uptick in inflation. The upward movement would begin to appear late in the year and continue into 2010. If the preventive measures taken by the Fed to quell inflation do not succeed then it is likely that a Fed induced “double dip” recession occurs in 2010 and 2011. Earnings per share: The rapid turnaround in the credit markets and economy lead to a typical post-recession earnings rebound for S&P 500 companies of between 20% and 25% year-over-year growth for the eight quarters beginning in the second quarter of 2009, which would result in 2009 EPS in line with the Wall Street analyst consensus of about $87, rising to a new high of about $105 in 2010. Price-to-earnings ratio (P/E): If confidence returns swiftly in 2009, valuations may rise from the current 9 to 13. Over the 30 years prior to 2008, when the yield on the 10-year Treasury note was below 7.5%, the lowest price-toearnings ratio on the Thomson Financial-tracked analyst consensus earnings expectations over the next 12 months for the companies in the S&P 500 index was 13. Dividend yield: The dividend yield would fall as stock prices rise. The yield would likely average between 2% and 3% during 2009. International equities: If the global economy picks up in tandem with the U.S. economy, the relatively more value-oriented international markets may outperform U.S. stocks. International stocks tend to outperform as global growth reaccelerates. When global leading indicators are rising, the MSCI EAFE Index has almost always outperformed the S&P 500. In addition, the dollar may reverse the gains of 2008 as capital seeks higher returns

5% 0% -5% -10%

2005

1997

1989

1981

1973

1965

-15%

1957

Stimulus package: The first fiscal package (infrastructure based and roughly 2% to 4% of GDP) is enough to boost the economy. There is no need for a second stimulus package, but Congress passes one, as they have in the past. A middle class tax cut—likely coupled with tax increases for taxpayers in the upper brackets—is passed as part of the stimulus program.

15%

1949

Government Actions: „

Year-Over-Year Change in Consumer Price Index 25%

1941

„

The United States has Experienced Five Periods of Deflation Since 1925

1933

„

Target interest rate: The fed funds rate is slowly moved back to “neutral” by year-end 2009 (about 3%–4%) in an effort to prevent inflation from flaring up in 2010 and beyond.

1925

„

Source: Bloomberg / LPL Financial Research

It is important to keep in mind that not all periods of deflation have had negative consequences. Deflation, or a negative rate of inflation, often brings to mind the painful period of the Great Depression in the U.S. However, a mild case of deflation — following a period of above average inflation — has been welcomed by market participants. The United States experienced mild bouts of deflation in the 1920s and 1950s. During these periods, stocks rose at an above average pace. If mild deflation is as bullish for equities as it was on average in the 1920s and 1950s gains of about 50% could be forthcoming in 2009.

MAGNITUDE OF DEFLATION AND MARKET PERFORMANCES Performance in the U.S. measured by Dow Jones Industrial Average and in Japan measured by the Nikkei 225 Stock Average* Mild Deflation Periods

Extreme Deflation Periods Stock Market Stock Market Period Performance Period Performance +86% Jul 1930 -62% July 1926 - May 1929 Oct 1933 Mar 1938-Jan 1940

+24%

May 1949-Jun 1950

+29%

Sep 1954-Aug 1955

+47%

Sep 1999 Sep 2007

-5%*

Source: Bloomberg / LPL Financial Research 17

B UL L C AS E

What should investors do if they believe the bull case will unfold in 2009? In the bull case, investors would want to overweight stocks and underweight highquality bonds. While volatility may remain high, trimming alternatives exposure and focusing on long-only investments is likely to deliver the best leverage to sharply and steadily rising markets. In the stock market, investors would want to overweight the most cyclical stocks in the Financials and Consumer Discretionary sectors along with the high beta Information Technology sector, while underweighting the defensive Utilities and Consumer Staples sectors. The Financials sector will benefit from the improvement in the credit markets, and the Consumer Discretionary and Information Technology sectors will benefit the most from accelerating economic and earnings growth. Additionally, the domestic equity asset class that tends to perform the best as the credit markets and economy rebound from recession is Small Cap Value. The rebound in the credit markets and the pace of economic growth would result in a powerful rebound in EPS for Small Cap Value stocks. Small Cap stocks have always outperformed Large Cap stocks during the first third of the business cycle as the markets rebound from recession. In the fixed income markets, investors should underweight Treasuries and overweight High Yield Bonds, investment grade Corporate Bonds and Preferred Stocks as the credit markets quickly improve and the financial crisis fades while the year gets underway. Investors should reduce the overall portfolio allocation to alternative asset classes. Investors may also consider opportunities presented by Absolute Return and Market Neutral funds as substitutes for fixed income securities in the face of rising yields.

rather than a safe haven. As the dollar falls, the dollar return on international investments rises.

Fixed Income Markets In the bull case, bond market liquidity improves during the first quarter of 2009. We would expect strong Corporate Bond performance in the highsingle digits to low double-digits to push overall bond market performance up to a range of high-single digits. Treasuries: Treasury yields bottom during the first quarter of 2009. Throughout the remainder of the year Treasury yields gradually move higher because of heavy Treasury issuance, stronger economic growth and possible Fed rate hikes late in the year. Under this scenario we would expect Treasury yields to rise by 0.50 to 1.50 percentage points, lowering the price of these securities. (Real yields increase as Treasury valuations decrease.) Corporate Bonds, Agency Bonds, and MBS: Credit spreads begin to slowly and steadily tighten early in 2009, and all spread sectors outperform Treasuries. Within spread sectors, lower rated spread sectors such as High Yield and Bank Loans outperform. Corporate Bond prices would rise, but Agency Bonds and Mortgage-Backed Securities prices would be mixed, depending on the degree of the interest rate change. High-Yield Bonds: The improved liquidity environment and stronger economic growth lead to substantial spread tightening in the High Yield sector. Default rates continue to increase but rise less than expected to 7% to 9% and do not impede spread tightening. In an environment where the economy shows meaningful improvement, spreads could tighten by roughly half, which would still only take the market to just below 2002 peak High Yield spread levels. Foreign Bonds: Overseas Foreign Bond yields are stable to slightly higher. A move higher in bond yields is greater in Treasuries as the United States emerges first out of the global recession and foreign central banks likely continue rate cuts and then remain on hold longer than the Fed. Friendlier foreign central banks help keep the rise in Foreign Bond yields more restrained compared to the rise in U.S. Treasury yields. Unhedged Foreign Bonds outperform hedged Foreign Bonds due to the currency effect as the dollar weakens on a reversal of flight-to-safety flows. Municipal Bonds: Municipal Bond yields stabilize and then improve versus Treasuries. Municipal Bonds would outperform Treasuries for the entire year. Non-traditional buyers would return in limited capacity by mid-year and help resolve the supply/demand imbalance sooner than anticipated. Forced liquidations do not materialize and new issuance is less than expected as state revenues hold up better than expected. Municipal Bonds receive an added push late in 2009 on the prospect of the Bush tax cuts expiring or higher tax rates as the economy improves.

Alternative Investments With both equity and credit markets up significantly, most alternative strategies would trail on a relative basis. Managed Futures, Covered Calls and other “volatility thriving” mutual fund strategies would likely provide returns in the low- to mid-single digits but with significant volatility along the way. Distressed Debt and long-biased Long/Short would provide returns more in-line with equities for the year. Investing in alternative investments may not be suitable for all investors and should be considered as an investment for the risk capital portion of the investor’s portfolio. The strategies employed in the management of alternative investments may accelerate the velocity of potential losses.

18

GRE AT DE P R E S S I ON I I

Chapter 2

Great Depression II? — Why it is Highly Unlikely The Great Depression came about because of serious economic and monetary policy errors that compounded what was already a serious recession. Actually, according to the National Bureau of Economic Research (NBER), the official date setter of U.S. recessions, there were two major backto-back recessions in the 1930s, with a significant recovery in the middle. The economy and regulatory environment of the 1930s are a far cry from today’s, but can a great depression occur again? We believe it cannot. But it is important to understand why the 1930s great depression unfolded as it did and the lessons that the experience offers for today. 1930s Recessions There are several key elements of recessions. As shown in the four charts in the margins (recession areas are shaded), there was a recovery that started in 1933 but was aborted in 1937. During the recovery, U.S. industrial production rose 121% before nose diving a second time in 1937 and 1938. Additionally, the unemployment rate followed a similar up, down, and then back up pattern. The main problem throughout the Great Depression was, in our opinion, highly ineffective monetary policy on the part of the Federal Reserve. As the first recession was underway in mid-1929, the Fed did nothing; actually worse than nothing, it allowed the money supply to contract and did nothing to support the banking system. The Fed is supposed to be the “lender of last resort”, but back then it did not accept that role. Its policy was to lend reserves to banks only if those loans were collateralized by investment grade corporate debt. It would not even accept government securities as collateral. As the recession deepened, more and more corporate debt on banks’ balance sheets dropped below investment grade. When depositors started withdrawing money from the banks, the Fed refused to give banks enough borrowed reserves to meet the deposit runs, and a wave of bank failures

1

Industrial Production Index during the 1930 Recessions In recessions, the industrial production index drops and in recoveries, it rises. 12

10

8

6

4

28 29 30 31 32 33 34 35 36 37 38 39 40 Source: Federal Reserve Board / Haver Analytics 12/01/08

19

GRE AT DE P R E S S I ON I I

2

recoveries, it drops.

ensued. This first wave made the 1929-32 recession very deep. Then, the recovery started underway. However, between 1936 and 1937 the Fed doubled the bank reserve requirements. The demand by the Fed for higher reserves triggered a second wave of bank failures, and another deep recession took hold. Industrial production plunged again, real GDP fell again, and the GDP price index, which had already fallen about 25% in the first recession, fell again in the second.

29 30 31 32 33 34 35 36 37 38 39 40 Source: Federal Reserve Board / Haver Analytics 12/01/08

So, although there were a number of serious blunders in fiscal, regulatory, and trade policies, we view the main cause of the depression to be very counterproductive monetary policy by the Fed. Today, we view monetary policy as strongly headed in the exact opposite direction—the right direction. Over the last three months, the Fed has expanded bank reserves from their normal level of about $45 billion to more than $650 billion, accepting just about any assets the banks have as collateral for loans. The Fed is also in the process of generating a major expansion in the money supply, with the monetary base nearly doubling during the last three months. M1 has increased 9% during the last three months. Given these actions, coupled with much improved fiscal, regulatory, and trade policies, we consider the probability of a return to the “Great Depression of the 1930s” to be highly unlikely.

Real GDP during the 1930 Recessions

Not Repeating the 1930s

Unemployment Rate during the 1930 Recessions In recessions, the unemployment rate rises and in 30 25

Percent

20 15 10 5 0

3

Generally one of the requirements for a recession is negative growth in real GDP. 22.5

Percent Change

15.0

For the United States to enter into a depression like the one in the 1930s, huge policy mistakes would have to be made, and made quickly. We do not think these mistakes will be made, but want to outline what they might be and how they would impact the economy and markets. Policy mistakes would include:

7.5

„

The Fed reversing course and increasing rates over the course of 2009.

„

The Fed raising bank reserve requirements.

„

The Fed abruptly discontinuing the reflation program that it has already begun.

„

A wave of global protectionism.

„

The elimination of the TARP and related housing and bank rescue measures.

0.0 -7.5

15.0

29 30 31 32 33 34 35 36 37 38 39 40 Source: Bureau of Economic Analysis / Haver Analytics 12/02/08

Consequences of those policy mistakes for the economy and markets would include: 4

GDP Price Index During the 1930 Recessions Generally during recessions the price of products fall.

„

Real GDP falls by an annualized 7% per quarter for all of 2009.

„

The unemployment rate soars past 25%.

„

Deflation grips all asset prices.

„

Oil approaches $5 a barrel.

„

Massive corporate and personal defaults—greater than 20%-25%.

„

Social unrest increases in the United States, along with a continued increase in social disorder overseas.

„

The US dollar rises due to a flight to quality.

„

The Eurozone breaks apart.

„

Gold soars.

12.00 11.25 10.50 9.75 9.00 8.25

28 29 30 31 32 33 34 35 36 37 38 39 40 Source: Bureau of Economic Analysis / Haver Analytics 12/01/08

20

GRE AT DE P R E S S I ON I I

Equity markets: Under another great depression, we believe the S&P 500 index would fall to a level of 360, driven by an 8 price-to-earnings ratio (P/E) on the next 12-months expected earnings per share (EPS) of about $45 in 2010 and a dividend yield of 5% to 7%. For context, this would be an additional 60% decline from current levels and would erase 12 years of earnings growth. The index would likely be mired there for the next few years. If this scenario of “completely eroded confidence with no end in sight” unfolds, investors would focus on only the most defensive of earnings streams, and relative performance among equity asset classes would be immaterial to the magnitude of the losses across all asset classes. Fixed income markets: We would expect T-bill yields to turn negative and expect the 10-year Treasury Bill to trade below 1% and move close to 0%. Investors would be seeking any and every safe haven—and governmentissued and guaranteed debt would be the place to go. With yields at 0% or negative, investors would be paying the government to hold their money. However, investors acknowledge that knowing their assets are safe is worth the price.

Definitions of M1, M2, and M3 M1. A money supply category which approximates cash used by consumers and companies; consisting primarily of currency in public circulation, credit union share account balances, NOW account balances, automatic transfer account balances, demand deposits, and travelers checks. M2. A money supply category consisting of all money in the M1 category plus “quasi-cash” balances such as Eurodollar deposits, savings and other small deposits, and private holdings in money market mutual funds. M3. A money supply category consisting of all money in the M1 and M2 categories, plus large deposits, institutional shares in money market mutual funds, and term repurchase agreements.

21

GRE AT DE P R E S S I ON I I

Japan’s Great Depression While we all agree that we are in uncharted territory and that there are plenty of risks and uncertainty, we do not see the U.S. economy following a path similar to Japan’s sustained deflation that began in the late 1990s and continues through today. Cash returns at 1% does not become a “store of value” if the money supply expands sufficiently to generate a medium to high inflation rate. We think this fact will solve the “liquidity trap”, help solve the problem of further home price declines, and thereby help stop further bank mortgage loan deterioration. We believe Federal Reserve Chairman Bernanke understands this situation and that we will, in part, inflate our way out of the current financial crisis. Japan

The United States

Japan made a number of serious mistakes leading to years of sustained deflation.

While this country does share some of the Japanese issues, and there is some risk of creating “zombie” banks, it is not nearly as universal as it was in Japan. There are still a lot of good banks with positive net worth and motivated management teams in the United States that will likely be making loans at rates well above 1%. We do not think many U.S. banks will be content to sit on nearly $1 trillion in excess bank reserves collecting 1% as a viable long-term strategy. We do think the Fed will allow a sizable expansion of the money supply (M1 has already accelerated to a 10% growth rate) and this expansion will create a rise in inflation at the end of 2009 and into 2010. Until then the plunge in oil and commodity prices will drive a sharp decline in the total CPI and other inflation rates. In our opinion, the previous five years of rises in housing, oil, and commodity prices were bubbles, due to a nearly complete disregard for risk and regulatory failures, not due to an inflationary U.S. monetary policy. Therefore, the current decline in these prices does not signal a deflationary U.S. monetary policy.

No forced failures: They did not force bank failures or mergers and left many banks standing as “zombies,” with negative net worth and unmotivated management that did not have the capital to expand lending. Consequently, net private sector lending in Japan has been flat over the last 15 years. No money supply growth: The Bank of Japan (BoJ) did expand their balance sheet, but did not permit a major expansion of the money supply. In Japan, M1, M2 and M3 have experienced very low or no growth for many years. Argentina, Mexico, and many other nations have effectively expanded their money supply and created higher inflation. No yen devaluation: Japan did not foster a devaluation of the yen, which had appreciated enormously (about 200%) since the 1970s. Instead, they chose to get back to purchasing power parity the hard way, through continuous deflation. Unlike the Federal Reserve in the 1930s, Japan’s central bank did stop a general bank collapse. However, the BoJ didn’t avoid making all of the Fed’s 1930s mistakes as it allowed a halt in bank lending and did foster deflation. In Japan, the GDP price index has been falling continuously for more than a decade. Japan is the only major industrial country that can print currency without a AAA government bond rating. We believe the rating agencies worry that the BoJ may not effectively manage or produce yen to pay the bond coupons. Japan also has been plagued by extremely poor fiscal policy, regulatory oversight, corporate governance, actuarial snafus, among other issues that make recovery very difficult. The complete control of policy by the Liberal Democratic Party (LDP) has not been good for the economy. It is a testament to the commitment of Japanese workers and management to have carried on under such a heavy burden, considering the level of industrial production in Japan is about the same as it was 15 years ago—compared to a 50% increase in U.S. industrial production over the same time period. 22

IMPACT OF WA S HI N GT ON

Chapter 3

Impact of Change in Washington The President has a lot of impact on foreign policy and trade, and selects the heads of the regulatory agencies. The Senate sets the pace on taxes, laws affecting business, and other issues of interest to investors. What impacts the new administration and Senate and House majorities will have on the economic and market revitalization are not clear. With that caveat, the following descriptions illustrate what the investment environment for various sectors might look like in 2009, assuming our base case scenario for the economy and markets.

Consumer Discretionary „

Potential copyright legislation under a Democrat-controlled Congress is likely to favor entertainment content providers.

„

A bailout package is likely for the big three automakers that will postpone cuts to the workforce. However, the auto industry is unlikely to have it easy in 2009.

„

A Democrat-appointed head of the EPA, with authority upheld by a recent Supreme Court ruling, will push automakers for higher fuel efficiency standards. New technology comes at a higher cost than consumers have been willing to embrace, which may negatively impact already low profit margins in the industry.

Consumer Staples „

Pro-union measures adopted by Congress may weigh on profitability and limit expansion by companies in this sector.

„

Expanding ethanol use to 85% ethanol/gas blends via tax incentives or mandates benefits ethanol producers.

„

Potential extended FDA restrictions on advertising for tobacco products could benefit producers by saving them billions while only slowing domestic consumption marginally as international growth continues. An increase in the tobacco tax could be a slight negative. 23

IMPACT OF WAS HI N GT ON

Energy „

Headline risk rises for energy companies. However, we doubt oil and gas firms will be subject to any especially negative actions, such as a windfall profits tax.

„

Increased royalty payments for the use of public land and offshore sites may be an incremental negative for major integrated oil companies.

„

A climate change program for greenhouse gas emissions, which raises the cost of using coal, may be an incremental positive for natural gas producers.

„

The delay in adding new capacity for other utilities, combined with the additional time frame to actually build new power generation plants, will likely lead to increasing natural gas demand to meet rising demand for power.

Financials „

New, more sweeping regulation is likely for this sector. We may see increased scrutiny and liability for predatory lending.

„

Democrats may enact legislation allowing bankruptcy courts to lower mortgage loans, change interest rates, and prohibit prepayment penalties—all negatives for lenders.

„

Credit rating agencies may be negatively affected by potential legislation mandating changes in their business models or banning consulting.

„

The potential cap on the tax exemption for annuities above $1 million may be a negative for insurers.

„

The potential expansion of retirement savings plans may benefit asset management companies.

„

Climate change initiatives may expand new trading markets such as carbon emissions and weather futures. Venture capital and private equity investment in clean energy firms has surged, and is likely to continue to be a boost to advisory and underwriting fees.

Healthcare

24

„

Healthcare legislation is more likely a 2010 event, as 2009 legislation focuses on the more pressing fiscal stimulus and tax issues.

„

Potential legislation on universal healthcare would be a negative for the managed care industry, making private health insurance less profitable and shifting market share to government plans. More importantly, managed care could be hurt by changes to Medicare Advantage reimbursements.

„

The threat to government control of pricing for pharmaceuticals has been priced in for years—with U.S. drug stocks trading at valuations comparable to counterparts in Europe, where healthcare is socialized.

„

Under comprehensive healthcare reform, many healthcare industries would likely benefit. For example, drug companies could experience increased demand, as they did after Medicare Part D was introduced. Other industries including providers (hospitals, nursing homes), diagnostic labs, and even generic drug makers may benefit from Democrats’ healthcare proposals expanding healthcare coverage, emphasizing preventative care, and focusing on generics.

IMPACT OF WA S HI N GT ON

Industrials „

Congress may demand through regulation, taxation, and incentives, that environmentally-friendly technologies like carbon capture, solar, and wind become a much larger portion of U.S. power generation—creating opportunities for companies that provide alternative power and delivery of alternative fuels.

„

Companies tied to large defense programs could come under additional pressure, although companies tied to port security, chemical plant security, homeland security spending, and regulation in general should benefit, as Democrats may increase funding in these areas.

Information Technology „

Potential legislation supporting healthcare technology investment and a potential network tied to Medicare reimbursement could be positives for this sector.

„

Climate change initiatives may boost companies producing solar and energy efficiency products or the semiconductor equipment used in those products.

Materials „

A fiscal stimulus package focused on highway infrastructure spending may benefit the suppliers of paving and other materials as well as the construction companies.

„

Extraction industries may face tougher environmental rules and enforcement.

„

The potential for climate change initiatives invokes a wide range of new product opportunities for the chemical industry, including emission treatments, additives and catalysts for cleaner fuels and fuel cells, improvements in energy-efficiency through better insulation and lighter weight materials, and new materials for solar panels and wind turbines. On the other hand, the chemical industry is a large consumer of energy as a raw material and in the refining process. Higher costs could come for the industry from fuel prices as well as from the cost of complying with greenhouse gas emissions requirements.

Telecommunications Services „

A change in the head of the FCC along with Democrats’ preference for network neutrality could be a positive for the smaller competitors at the expense of the largest players.

Utilities „

Coal is the dominant fuel source for power utilities. With the highest proportion of costs attributed to energy of any sector, utilities are the most exposed to any increased regulations on greenhouse gases likely from Democrat-led executive and legislative branches of government. Power utilities with relatively “clean” production from nuclear, wind, hydro, and other renewable sources will have the advantage over those that will need to undertake the costs of becoming “clean”. Even for those companies at the forefront of environmental stewardship, higher costs are likely. 25

IMPACT OF WAS HI N GT ON

HISTORICAL PERSPECTIVE ON CAPITAL GAIN TAX CHANGES Change Cut top rate from about 40% to 28%

Enacted Nov 6, 1978

Cut top rate from 28% to 20%

Aug 13, 1981 Jun 9, 1981

Effective Date Aug 13, 1981

Hiked rate from 20% Oct 22, 1986 Nov 1, 1987 to 28% (cap gains treated as ordinary income) Cut top rate from 28% to 20%

Aug 5, 1997

„

May 7, 1997

Hiked rate from 20% May 28, 2003 May 6, 2003 to 28% Source: “A Chronology of Postwar U.S. Federal Income Tax Policy” by Shu-Chun Suan Yang of CAEPER at Indiana University, and Joint Committee on Taxation

The exact emissions standards will be determined by politicians, and that could be a lengthy process—consider the fact that coal-producing Appalachia has 12 seats in the Senate. Utilities are unlikely to commit to substantial outlays for new plants until the technical details are clear and they can safely adopt the technology best suited to the new rules. This delay may have the effect of slowing profit growth.

Taxes in 2009 Income tax increases for the top wage earners may be coupled with tax cuts for the middle class in 2009. The investor tax cuts of 2003 that lowered dividends and capital gains tax rates to 15% are likely to be at least partially reversed in 2009. It is possible that the tax code changes which include income and dividends will be passed by mid-2009 and made retroactive to the start of the year. However, we believe it is unlikely that a capital gains tax hike passed in 2009 will be made retroactive. „

In 2003, the investor tax cuts were passed in May and made retroactive to the start of the year, but the capital gains portion was not made retroactive.

„

In 1993, the tax increase was made retroactive to the start of the year after narrowly passing the Senate in August. However, this tax hike did not affect the capital gains rate.

„

The one time the capital gains rate was increased in the recent past was in 1986, and the effective date was not until the following year. Because investors move to recognize long-term gains ahead of an impending capital gains tax increase, setting the date for the increase produces a near-term revenue windfall for the government.

While many investors may mourn the passing of the investor tax cuts of 2003, the market impact was difficult to discern given the geopolitical and economic environment at the time. The impact of the reversal of these provisions may be equally difficult to discern separately from their macroeconomic context in 2009. We can get a sense of this difficulty by looking back at the stock market’s reaction to the news of a proposed investor tax cut and then the passage of those cuts:

26

„

Initial details of the 2003 investor tax cuts began to appear in early December 2002 with a statement from President Bush providing further insight into the package of tax cuts on January 7, 2003. Stocks slumped in December and January—even around the days details came to light—as investors were focused on the impending invasion of Iraq. Nondividend-paying and dividend-paying stocks performed very similarly, despite the prospects for a cut in the dividend tax rate.

„

Attention returned to the tax cuts in April 2003, as competing bills with various provisions moved through both houses of Congress. There was much uncertainty as to the final tax cut elements and whether any investor-specific cuts were going to be passed.

„

The tax bill narrowly passed in mid-May 2003 with Vice-President Cheney breaking the tie in the Senate. The package including the investor tax cuts was signed by the President on May 28, 2003. In April and

IMPACT OF WA S HI N GT ON

May (and over the rest of the year), the stocks of low- or non-dividend paying companies outperformed high- dividend payers as stocks rallied powerfully and the invasion of Iraq got underway.

Performance of the top 20% and bottom 20% of stocks in Russell 1000 Index by dividend yield. High Dividend Payers Low Dividend Payers 70 60

First Year Performance During the year following an election, the markets have demonstrated some impact from the election. Over the long-term, there has been no significant stock market performance difference in the year after a presidential election based purely on which political party won the White House. Instead, the stock market has been more likely to respond to whether the incumbent political party won or lost. In the years after an election over the past 80 years, the stock market’s reaction has had three distinct periods. „

During the turbulent period of the 1920s, 1930s, and early 1940s that included the stock market crash of 1929, the Great Depression, and World War II, the stock market favored challengers over incumbents.

„

From the mid-1940s until the early 1970s, stock market reaction to the election outcome was mixed—neither favoring nor fretting over incumbents.

„

Over the past three decades, noted for above-average stock market returns and lengthy economic expansions, investors appear to have displayed a strong preference for incumbents.

2009 may provide some insight into whether or not we are entering a new era, wherein change is once again embraced by investors.

40 30 20

In theory, stocks are valued by investors based on their expected total return net of applicable taxes. For example, if dividend and capital gains taxes were each set at 100%, stocks would have little or no value to a taxable investor. It is reasonable to believe that the lower the tax rate, the more of the total return on stocks the investor keeps on an after-tax basis, and the more the investor would value the stocks. Looking at the post-WWII relationship between investor tax rates and stock market valuations, based on trailing price-to-earnings ratios, it is evident that stocks may have already priced in an imposition of higher investor tax rates. With Congress likely to push forward with legislation favoring higher tax rates than those cited by Obama during his campaign, it is also worth noting that the average price-to-earnings ratio was 12 during the mid-1980s and mid-1990s, when the top capital gains and dividend rates averaged about 35%. While many more issues than tax hikes are weighing on stock valuations, it appears that potentially even higher tax hikes would not necessarily lower valuations.

50

10

Dec-03

Nov-03

Oct-03

Sep-03

Aug-03

Jul-03

Jun-03

Apr-03

0

May-03

After passage, U.S. and non-U.S. stocks also performed very similarly, with the world focused on Iraq. The impact of the investor tax cuts in the United States did not result in U.S. stock market outperformance. Also, low- and non-dividend paying stocks outperformed the high-dividend payers that would be expected to benefit most from the lower dividend tax rate. It appears that the tax cuts played little or no role in stock market performance. Possible reasons may be that investors discounted the effect on future dividends since the cuts were not made permanent, or that the effects on after-tax returns were deemed negligible relative to the macroeconomic and geopolitical drivers.

Return (percent)

„

High Dividend Paying Stocks Underperformed when Dividend Tax Cut Passed

Source: FactSet, LPL Financial Research

STOCK MARKET ELECTION REACTION HAS HAD THREE DIFFERENT PERIODS Bold Lines Represent Years When Incumbent Lost S&P Price Performance Market Performance Election Year After Average Return Year Election Year after Favored 1928 -11.9 1932 46.6 Challengers Challenger = 46.6% 1936 -38.6 Incumbents= -22.8% 1940 -17.9

Incumbent Party R R D D

Winning Party R D D D

1944 1948 1952 1956 1960 1964 1968 1972

30.7 10.3 -6.6 -14.3 23.1 9.1 -11.4 -17.4

D D D R R D D R

D D R R D D R R

1976 1980 Year after Favored 1984 1988 Incumbents Challenger = - 6.8% 1992 Incumbents= 18.9% 1996 2000 2004

-11.5 -9.7 26.3 27.3 7.1 31.0 -13.0 3.0

R D R R R D D R

D R R R D D R R

?

?

R

D

Mixed Challenger = 1.7% Incumbents= 3.7%

2008

Source: Bloomberg, LPL Financial Research Past performance is no guarantee of future results.

27

LP L FINANCIAL R E S E AR C H IMPORTANT DISCLOSURES The opinions voiced in this material are for general information only and are not intended to provide or be construed as providing specific investment advice or recommendations for any individual. To determine which investments may be appropriate for you, consult your financial advisor 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. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and are subject to availability and change in price. Stock investing involves 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. Small cap stocks may be subject to a higher degree of risk than more established companies’ securities. The illiquidity of the small-cap market may adversely affect the value of these investments. 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 and change in price and 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 tax. Federally tax-free but other state and local taxes may apply. Government bonds and Treasury Bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. Investing in alternative investments may not be suitable for all investors and involve special risks such as risk associated with leveraging the investment, potential adverse market forces, regulatory changes, and potentially illiquidity. There is no assurance that the investment objective will be attained. Investing in real estate/REITs involves special risks such as potential illiquidity and may not be suitable for all investors. There is no assurance that the investment objectives of this program will be attained. Investing in mutual funds involves risk, including possible loss of principal. Investments in specialized industry sectors have additional risks, which are outlined in the prospectus. The market value of corporate bonds will fluctuate, and if the bond is sold prior to maturity, the investor’s yield may differ from the advertised yield. An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although the Fed seeks to preserve the value of your investments at $1.00 per share, it is possible to lose money investing in the Fund. The Barclays Aggregate Bond Index is composed of securities from the Barclays Government/Credit Bond Index, Mortgage-Backed Securities Index and Asset-Backed Securities Index. The Standard & Poor’s 500 Stock Index (S&P 500) is an unmanaged index generally representative of the U.S. Stock Market, without regard to company size. Covered Call mutual fund strategies typically hold a long portfolio of stocks and then sell calls. Some covered call strategies then buy puts to further protect against downside risk. The net result is a portfolio that is correlated to the broader markets, but with significantly less volatility and increased risk due to the use of derivatives. Global Macro funds use fundamental inputs (focused on broad global economic themes) in their models as well as technical (or price related) inputs. Global Macro funds may also be less systematic than the typical managed futures fund. Historically, the benefit of global macro has been solid long-term returns with very low correlation to equities and fixed income securities. Long/short funds focus on managers who go long and hedge against the market through options or shorting equity securities with the goal of outperforming the market while limiting volatility. These funds tend to have a higher correlation to equities than other alternative strategies and, therefore, are most appropriate for more aggressive portfolios. Consumer Discretionary: 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. Consumer Staples: 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. Energy: 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. Financials: Companies involved in activities such as banking, consumer finance, investment banking and brokerage, asset management, insurance and investment, and real estate, including REITs. Healthcare: Companies in two main industry groups: Healthcare equipment and supplies or companies that provide healthcare-related services, including distributors of healthcare products, providers of basic healthcare services, and owners and operators of healthcare facilities and organizations. Companies primarily involved in the research, development, production and marketing of pharmaceuticals and biotechnology products. Industrials: Companies whose businesses: (1) Manufacture and distribute capital goods, including aerospace and defense, construction, engineering and building products, electrical equipment and industrial machinery, (2) Provide commercial services and supplies, including printing, employment, environmental and office services, (3) Provide transportation services, including airlines, couriers, marine, road and rail, and transportation infrastructure. Information Technology: Technology Software & Services, including companies 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 and technology Hardware & Equipment, including manufacturers and distributors of communications equipment, computers and peripherals, electronic equipment and related instruments, and semiconductor equipment and products. Materials: 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. Telecommunications Services: Companies that provide communications services primarily through a fixed line, cellular, wireless, high bandwidth and/or fiber-optic cable network. Utilities: Companies considered electric, gas or water utilities, or companies that operate as independent producers and/or distributors of power. This research material has been prepared by LPL Financial. The LPL Financial family of affiliated companies includes LPL Financial, UVEST Financial Services Group, Inc., Mutual Service Corporation, Waterstone Financial Group, Inc., and Associated Securities Corp., each of which is a member of FINRA/SIPC. Not FDIC/NCUA Insured | Not Bank/Credit Union Guaranteed | May Lose Value | Not Guaranteed by any Government Agency | Not a Bank/Credit Union Deposit

Member FINRA/SIPC

www.lpl.com

RES 1131 1208 Tracking #497432 (Exp. 12/10)