LP L FINANCIAL R E S E AR C H

Weekly Economic Commentary

January 9, 2012

Does Economic Momentum Exist?

John Canally, CFA
Economist LPL Financial

In June 2011, Federal Reserve (Fed) Chairman Ben Bernanke noted that the economic recovery had been uneven across sectors and frustratingly slow. In November 2011, Bernanke said that there have been some elements of bad luck impacting the economy. Even before November, however, the recovery had been picking up some steam. Has the economys luck turned, and is some forward momentum happening finally? This weeks rather modest set of data, compared to the deluge of data in the first week of 2012, is unlikely to change the markets view that the U.S. economy gained some momentum as 2011 ended and 2012 began. The slate of economic data this week which includes early January readings on initial claims for unemployment insurance and weekly retail sales, December readings on retail sales and consumer sentiment, and November readings on job openings, business inventories and merchandise trade will likely continue to show that the economy gathered momentum as 2011 drew to a close. The Fed's Beige Book, a qualitative assessment of banking and business conditions in each of the Fed's 12 regional districts, is also likely to garner significant market attention ahead of the late January Federal Open Market Committee (FOMC) meeting. Overseas, Chinese economic reports for December are due this week and are likely to show that China is headed for a soft landing, not a hard landing, and, more importantly, that Chinese inflation continued to moderate in December, which paves the way for more monetary policy easing in China in the coming weeks.

Highlights

Episodes of economic momentum have been rare in the past 20 years. Recent evidence points to modest momentum in the U.S. economy as 2011 turned into 2012. Another round of economic speed bumps could temper hard-won momentum.

Economic Calendar
Construction Spending Economic Calendar Nov Tuesday, January 10 Wholesale Inventories Nov NFIB Small Business Optimism Index Dec JOLTS Data Nov Wednesday, January 11 Beige Book Thursday, January 12 Initial Claims wk 1/7 Monday, January 9 Retail Sales Dec Business Inventories Nov Treasury Statement Dec Friday, January 13 Trade Balance Nov Import Price Index Dec U of M Consumer Sentiment Jan

Economic Momentum Is Rare

The U.S. economy rarely proceeds, either forward or backward, in a straight line, accelerating or decelerating evenly as a car would when its driver is applying steady pressure to the gas pedal or the brakes. Normally, economic growth in the United States from quarter to quarter is a series of uneven fits and starts, acting more like a car with a manual transmission being operated by a teenager just learning how to drive. As noted in the nearby chart, over the last 60 years, the quarter-to-quarter change in gross domestic product (GDP), the most comprehensive measure of the health of the economy, has rarely moved steadily up (or down) for more than a few quarters at most [Chart 1]. The last time the economy steadily accelerated for three consecutive quarters was in mid-2004 into

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The last time the economy steadily accelerated over four consecutive quarters was in the mid-1950s!

early 2005. The last time the economy steadily accelerated over four consecutive quarters was in the mid-1950s! During the first nine quarters of the current economic expansion (which began in mid-2009), the economy has posted an average annualized growth rate of just 2.4%. This pace of growth trails the average growth rate experienced over similar time periods after the mild 1990 91 and 2001 recessions (2.8%), and is well below the average growth rate (5.7%) seen in the nine quarters after the severe 1973 75 and 1981 82 recessions. However, over the first three quarters of 2011, the economy actually accelerated in a straight line, with growth in the first quarter increasing at a 0.4% annualized rate, 1.3% in the second quarter, and 1.8% in the third quarter. Our view is that the straight-line acceleration will continue into the recently completed fourth quarter of 2011, with real GDP rising at a 3.0 to 3.5% pace versus the third quarter. The third quarter GDP data is due out in late January, although financial markets have probably already discounted the acceleration in economic growth in the fourth quarter. Market participants are now more concerned with growth prospects in the current first quarter of 2012, and, to a larger extent, growth prospects for all of 2012. The longer-term growth rate (or speed limit) for the U.S. economy is regulated by the growth in the labor force plus the output per worker (productivity). The Great Recession and its aftermath had noticeable impacts on both the growth in the labor force and productivity. However, the Fed (and other market participants) estimate the U.S. economys longer-term speed limit as being around 2.5 to 3.0%. Often, the economy is subject to temporary factors (natural disasters, unusual weather, supply chain disruptions, worker strikes, geopolitical events, etc.) that depress growth for a quarter or two, and the economy grows at a pace below its long-term potential. Once those factors fade, the economy oftentimes plays catch up, and growth can accelerate for a quarter or two, and grows above its long-term potential growth rate. Recently, most of the fits and starts impacting the economy have depressed, rather than boosted, economic growth. From the fourth quarter of 2009 through the second quarter of 2010, the economy grew at 3.8%, 3.9%, and 3.8% as growth accelerated from the end of the Great Recession in the second quarter of 2009. However, the first flare-up of the European fiscal crisis in the spring and summer of 2010 (Greece, Portugal and Ireland) acted to depress growth, and later in the year and into 2011, rising consumer energy prices (largely the result of political turmoil in the Middle East) also pressured growth. By mid-2011, the European fiscal crisis broadened out, the dysfunction in Washington surrounding the U.S. fiscal situation negatively impacted both business and consumer sentiment, and the earthquake in Japan in March 2011, along with the long lasting disruptions to the global supply chain, slowed growth to nearly stall speed. An unusually snowy early 2011, together with record flooding and tornadoes in the U.S., also hampered growth in early 2011 [Chart 2].

Economic Momentum Is Rare

Real Gross Domestic Product: Quantity Index Seasonally Adjusted Annual Rate, %Change

22.5 15.0 7.5 0 -7.5 -15.0

55 60 65 70 75 80 85 90 95 00 05 10

Source: Bureau of Economic Analysis, Haver Analytics 01/09/12 (Shaded Areas Indicate Recession) Real Gross Domestic Product Quantity Index is a number that measures the change of output (quantity) from a base year. The value of the quantity index is 100 for the base year.

Surging Consumer Sentiment is One Sign That the Economy Has Some Momentum as 2011 Turns into 2012
Rasmussen Consumer Index Oct-01=100

97.5 90.0 82.5 75.0 67.5 60.0 52.5

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan

Source: Rasmussen Reports, Inc., Haver Analytics 01/09/12 The Rasmussen Consumer Index and Investor Indexes, measures the economic confidence of consumers on a daily basis. The Rasmussen Consumer Index and Investor Indexes are derived from nightly telephone surveys of 500 adults and reported on a three-day rolling average basis. The baseline for the Index was established at 100.0 in October 2001.

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Momentum Turned in Late 2011

As 2011 turned into 2012, however, many, but by no means all, of these temporary factors that depressed growth between mid-2010 and mid-2011 were fading and beginning to reverse course, which appeared to provide the economy with some momentum:

The global supply chain disruptions due to the earthquake in Japan had largely run their course, although massive flooding in Thailand in midto-late 2011 has already begun adversely impacting output of some key components in the technology area. Consumer energy prices moved sharply lower over the second half of 2011, and declines in food prices have also helped to cool consumer inflation. The fiscal and legislative concerns surrounding the debt ceiling, our nations credit rating, and the extension of payroll tax cuts and unemployment insurance benefits appear to have waned for now. In general, the market and economy-driving political battles that hampered growth in 2011 are unlikely to be repeated in 2012, although they simmer just below the surface. While the uncertainty surrounding the European fiscal situation remains a concern for consumers and businesses, our view is that recent policy actions by European politicians and the European Central Bank (ECB) have taken the worst case scenario off the table for now.

Looking ahead, warmer-than-usual weather, monetary policy easing in China, strong auto production schedules for the first quarter, the recent drop in initial claims for unemployment insurance, the surge in consumer sentiment, and the solid December jobs report (released on Friday, January 6) all suggest that economic momentum will persist into the first quarter of 2012. However, with several sectors of the economy still struggling (housing, state and local government, construction of office parks, malls and factories), another round of economic speed bumps could very easily slow the economys hard won momentum as 2012 progresses.
IMPORTANT DISCLOSURES The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. Stock investing involves risk including loss of principal. International investing involves special risks, such as currency fluctuation and political instability, and may not be suitable for all investors. Credit rating is an assessment of the credit worthiness of individuals and corporations. It is based upon the history of borrowing and repayment, as well as the availability of assets and extent of liabilities.
This research material has been prepared by LPL Financial. The LPL Financial family of affiliated companies includes LPL Financial and UVEST Financial Services Group, Inc., each of which is a member of FINRA/SIPC. To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial is not an affiliate of and makes no representation with respect to such entity.
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Weekly Market Commentary

January 9, 2012

What Investors Should be Watching This Earnings Season

Jeffrey Kleintop, CFA
Chief Market Strategist LPL Financial

U.S. stocks rose last week by 1.7%, as measured by the S&P 500 Index, getting 2012 off to a solid start. A combination of solid and better-thanexpected economic data, a quiet week in Europe, and few negative earnings pre-announcements drove the rebound. While macroeconomic factors are likely to remain key drivers of the market this week, microeconomics will also garner investors attention as companies begin to release their fourth quarter earnings reports. Four times a year investors focus on the most fundamental driver of investment performance: earnings. While only five S&P 500 companies report fourth quarter results this week, bringing the total to 31, this week is the start of earnings season with big, well-known companies like Alcoa and JPMorgan Chase due to report fourth quarter results. The consensus of analysts tracked by Thomson Financial expects operating earnings growth of 8% in the fourth quarter of 2011(compared to the fourth quarter of 2010), as profits end the year at new all-time highs. This is the first quarter in over two years profit growth is not expected to be in the doubledigits. If the profits of S&P 500 companies match expectations in the fourth quarter, they will have grown about 10% for 2011, in line with our forecast established a year ago. In 2012, we expect a slower pace of profit growth of about 7%, modestly below the analyst consensus of 10%. In contrast, market participants have priced no growth in profits into stock market valuations with priceto-earnings ratios at levels not seen since the recession of 1990-91, when earnings fell 20%. We believe earnings expectations will continue to be revised modestly lower and market participants are starting to price in a less dire outlook for profits as results are reported and corporate leaders provide guidance on coming quarters. In recent weeks, stocks have been rising even as fourth quarter earnings estimates have been falling. Of the 129 companies that pre-announced fourth quarter earnings guidance in recent weeks, the ratio of negative-topositive news was 3.3, worse than the average ratio of 2.3 since 1995, and the worst ratio since the 3.4 in the fourth quarter of 2008, during the peak of the financial crisis. The fourth quarter earnings season runs about four to six weeks starting around two weeks after the close of the quarter. During this earnings season we are paying special attention to revenues and how companies are putting cash to work either by spending or by returning it to shareholders.

Highlights
This week is the start of the fourth quarter 2011 earnings reporting season with big, well-known companies like Alcoa and JPMorgan Chase due to report fourth quarter results. This is the first quarter in over two years that S&P 500 profit growth is not expected to be in the double-digits. During this earnings season we are paying special attention to revenues and how companies are putting cash to work either by spending or by returning it to shareholders.

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Revenues and Emerging Markets Drivers Revenue growth is driven by global economic activity and is expected by analysts to be around 6%. With profit margins near peaks, profits will more closely track revenues in coming quarters. Economic growth is likely to be below average in the United States over the next year, and Europe is on the edge of recession. About 46% of S&P 500 profits come from foreign markets with just under a third of foreign profits derived from Europe. Fortunately, a meaningful and growing portion of profits come from rapidly growing emerging markets. We will be closely watching the impact of the rapidly changing regional composition of revenue and profits in the S&P 500. It is worth noting that in 2012, emerging market countries will for the first time make up more of global GDP (gross domestic product) than developed markets, according to data from the IMF (International Monetary Fund). How Businesses Are Returning Cash to Shareholders The first quarter is when companies most often increase or initiate a dividend. While first quarter bank stress tests need to be completed before the traditionally highyielding Financials sector can be expected to boost payouts, pressure is building for other companies to increase their dividends as U.S. companies sit on record cash stockpiles and payouts remain at all-time lows. S&P 500 companies paid out about 25% of earnings in the form of dividends over the past year, down from 30% for much of the 2000s and below the 30-year average of 40%. Company cash and equivalents have soared to record highs even as companies have paid down debt in a dramatic deleveraging over the past few years. A return to higher dividend payouts would help attract investors seeking income in an environment of very low bond yields. The S&P 500s dividend yield stands at 2.1%, above the yield on the 10-year Treasury for one of the few times in history. Announcing share repurchases is another way corporate leaders may put cash to work. How Businesses Are Spending While investor attention is often directed on consumer spending as a driver of profits, we will be watching business-spending-driven industries more closely. Business spending and commodity prices are major drivers of S&P 500 profit growth while discretionary consumer spending has a much smaller contribution to the S&P 500. During the fourth quarter, commodity prices generally rose and manufacturing rebounded from the summer weakness, according to the ISM Index (Institute for Supply Management Purchasing Managers Index), supporting modest profit growth for S&P 500 companies [Chart 1] We will be watching to see how effectively this translated into profits for the Information Technology, Industrial, Energy, and Materials companies for clues as to how rapidly their profit growth may slow in 2012. For S&P 500 companies that have reported fourth quarter earnings so far, 14 of 26 (54%) have exceeded estimates, while 12 have missed estimates. Importantly, the companies that report early in the season are most often not the bellwethers they are commonly thought to be. We may not really know how overall corporate results for the fourth quarter of 2011 are shaping up until early February 2012, when about half of the S&P 500 companies will have reported.

ISM Suggests Slower S&P 500 Profit Growth

Institute for Supply Managements Purchasing Manager Index and S&P 500 Earnings per Share Growth Rate Year-Over-Year ISM Index (Left axis) S&P 500 EPS Growth Rate Year-Over-Year %Change in EPS (4 qtr ma) (Right axis)

80 55% 75 45% 70 35% 65 25% 60 15% 55 5% 50 -5% 45 -15% 40 -25% 35 -35% 30 1950 1960 1970 1980 1990 2000 2010 Source: LPL Financial, Thomson Financial, Bloomberg data 01/07/12 The S&P 500 Index is an unmanaged index, which cannot be invested into directly. Past performance is no guarantee of future results. Earnings per share (EPS) is the portion of a companys profit allocated to each outstanding share of common stock. EPS serves as an indicator of a companys profitability. Earnings per share is generally considered to be the single most important variable in determining a shares price. It is also a major component used to calculate the price-to-earnings valuation ratio.

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IMPORTANT DISCLOSURES The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful. The Standard & Poors 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. The P/E ratio (price-to-earnings ratio) is a measure of the price paid for a share relative to the annual net income or profit earned by the firm per share. It is a financial ratio used for valuation: a higher P/E ratio means that investors are paying more for each unit of net income, so the stock is more expensive compared to one with lower P/E ratio. International and emerging markets investing involves special risks, such as currency fluctuation and political instability, and may not be suitable for all investors. Information Technology: Companies include those that primarily develop software in various fields such as the Internet, applications, systems and/or database management and companies that provide information technology consulting and services; technology hardware & Equipment, including manufacturers and distributors of communications equipment, computers and peripherals, electronic equipment and related instruments, and semiconductor equipment and products. Materials Sector: Companies that are engaged in a wide range of commodity-related manufacturing. Included in this sector are companies that manufacture chemicals, construction materials, glass, paper, forest products and related packaging products, metals, minerals and mining companies, including producers of steel. Energy Sector: Companies whose businesses are dominated by either of the following activities: The construction or provision of oil rigs, drilling equipment and other energy-related service and equipment, including seismic data collection. The exploration, production, marketing, refining and/or transportation of oil and gas products, coal and consumable fuels. Industrials Sector: Companies whose businesses manufacture and distribute capital goods, including aerospace and defense, construction, engineering and building products, electrical equipment and industrial machinery. Provide commercial services and supplies, including printing, employment, environmental and office services. Provide transportation services, including airlines, couriers, marine, road and rail, and transportation infrastructure. Because of their narrow focus, sector investing will be subject to greater volatility than investing more broadly across many sectors and companies.

This research material has been prepared by LPL Financial. The LPL Financial family of affiliated companies includes LPL Financial and UVEST Financial Services Group, Inc., each of which is a member of FINRA/SIPC. To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial is not an affiliate of and makes no representation with respect to such entity.
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