It has been a sweet sixteen weeks for the S&P 500. The broad stock market index has had only three down weeks out of the past sixteen. There has not been a sixteen-week period with fewer weeks of losses in over 20 years — since the period ending September 1, 1989!

As the NCAA tournament gets down to its own sweet sixteen this week, it is a good time to reflect on the competing drivers of the markets that may make for an exciting showdown in the weeks and months to come. (view full post here)

The three-year anniversary of the bull market took place on Friday, March 9. In the three years since March 9, 2009, the S&P 500 index is up 103% (with a 116% total return including dividends). This has been the strongest bull market since WWII.

So, after doubling in three years what is next for the bull? More gains, when using history as a guide. The average return in year four of bull markets was 12.7% (six of the 10 post-WWII bull markets lasted that long). While a slightly different time period (view full post here)

Hollywood has a thing for sequels. So do the markets. In recent weeks, we have pointed to the rise in the stock market and the euro early this year as mirroring those gains of early 2011. While stock market gains and currency moves can certainly grab headlines, they lack the drama of a move in oil prices. The move higher in oil prices so far this year is similar in pattern to last year’s surge, (view the full post here)

Today, forty-three of the top drivers in the world will compete in “The Great American Race,” NASCAR’s biggest, richest and most prestigious motorsports event. Another great American race will be evident at Monday’s showdown: Republican presidential candidate Rick Santorum’s logo will cover the hood of the number 26 car. While the winner of the Daytona 500 will soon be in the books, (View the full post here)

Just seven weeks into 2012 and the markets are off to a strong start. The stock market, measured by the S&P 500, has posted a high single-digit gain for the year, and the S&P 500 index is around 1,350. Sound familiar? It should. It is exactly what happened last year, as you can see in Chart 1.

If stocks continue to follow this pattern they are set for a pullback. Last year, stocks shed their gains for the year over the weeks following the run-up into the President’s Day holiday. Over the four weeks that followed, the S&P 500 slid back to exactly where it had started the year, only to begin a rebound and a pattern of volatility that lasted into the summer months.

Indeed, stocks may be due for a modest pullback, in line with last year’s pattern, driven by a combination of:

ƒƒ Stalling earnings growth – Stocks have relied heavily on earnings gains for performance over the past three years with earnings and stocks rising by the same amount. Earnings growth for S&P 500 companies is likely to be flat in the first quarter, posing a risk for stocks.

ƒƒ Mounting fiscal headwinds – As last week’s passage of the payroll tax cut highlights, it will be very difficult to address the U.S. fiscal imbalances. The 2013 budget is already going to have the biggest impact of any budget in decades, even if no action is taken in Washington. The fiscal headwind comprised of both tax increases and spending cuts under current policy totals over $500 billion, or 3.5% of GDP. The United States has never experienced a deficit cut by more than 2% of GDP that did not end in a sharp decline in GDP.

ƒƒ European debt and economic concerns resurfacing – Recent policy actions in Europe including actions by the European Central Bank, the fiscal compact agreed to by European leaders, and the path to reforms undertaken by some key countries have resulted in a significant reduction in perceived risks to the financial system and global economy. However, deteriorating economic growth in Europe, the stall in the trend toward declining rates for core European nations, and upcoming elections in France and Greece raise questions about the commitment to achieving the reforms and support necessary to stabilize the markets.

Much like the S&P 500, there are other markets retracing familiar patterns, as well. The euro is following last quarter’s pattern. Why would it do that? Greece needs money in about a month to meet maturing debt payments totaling 14.5 billion euros. The so-called troika (consisting of the ECB, IMF and European Commission) has demanded further austerity. Greek leaders resist these demands and make some bold moves, fearing the domestic backlash to austerity. The EU leaders cancel meetings to make the point that they are serious about their demands, and Greece grudgingly agrees.

Does this scenario sound familiar? It should, since it is a repeat of what played out late last year after former Greek PM Papandreou submitted his referendum proposal in November and stepped down. The euro is repeating the same pattern it traced during the last time this Greek drama played out. If it continues to play out the same way — that Greece dodges another bullet, but is still in front of the firing squad — then maybe the euro continues follows the same path as it did late last year and slides further, as you can see in Chart 2.

While these patterns could be coincidences, they are more likely to be indicative of the most likely reaction by the markets to the events evolving around the world. While we do not believe the S&P 500 has reached its high for the year, the index may be due for a pullback in the coming weeks after a strong four-and-a-half-month run-up of about 25% as it climbed back to the post-crisis highs.

To download the pdf version of this week’s market commentary, click here.

Jeffrey Kleintop, CFA
Chief Market Strategist
LPL Financial

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 & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

The Standard & Poor’s 500 Index is an unmanaged index, which cannot be invested into directly. Past performance is no guarantee of future results.

Gross Domestic Product (GDP) is the monetary value of all the finished goods and services produced within a country’s borders in a specific time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments and exports less imports that occur within a defined territory.

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

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.

Not FDIC or NCUA/NCUSIF Insured | No Bank or Credit Union Guarantee | May Lose Value | Not Guaranteed by any Government Agency | Not a Bank/Credit Union Deposit

Earnings have mattered a lot for the U.S. stock market. Over the past three years, earnings are up about 58% and the S&P 500 is up about 55%.* That one-to-one relationship is no coincidence. Stock market valuations, measured by the price-to-earnings ratio — or what investors are willing to pay per dollar of current earnings — have not changed over the past few years and remain around 13 for the S&P 500, well below the long-term average. The relentless climb in earnings has been what has pulled stocks higher over the past three years, not increasing optimism in the durability of the business cycle.

With such a heavy reliance on earnings growth, are stocks vulnerable to declines with earnings growth now appearing to stall? It would appear so based on the statistics. With 70% of companies having reported, the earnings growth rate for the S&P 500 for the fourth quarter 2011 is about 8%. This is the slowest earnings growth rate since the recovery in earnings began over two years ago.

This 8% growth rate is half of what it was expected to be at the beginning of the fourth quarter. As October of last year got underway, earnings per share were expected to be up 15% from a year earlier. Next quarter (first quarter of 2012) earnings growth is now expected to slide to a gain of just 3% yearover-year, down from expectations for a 10% gain at the start of the fourth quarter of 2011.

Moreover, just 63.9% of companies that have reported results for the fourth quarter of 2011 have beaten the lowered estimates. This is just below the historical average of 66.7% over the past 10 years and the lowest since the eruption of the financial crisis in the fourth quarter of 2008, as you can see in Chart 1.

Looking ahead to the first quarter results, slightly more companies have lowered than raised earnings guidance along with their fourth quarter reports. Of the companies that issued guidance, 52 in the S&P 500 have issued negative guidance compared to only 20 that have issued positive earnings guidance for Q1 2012. The ratio of negative to positive preannouncements of 2.6 is the weakest showing since the worst of the recession in the first quarter of 2009.

Not as Bad as Was Feared

In recent weeks, stocks have been rising even as earnings estimates have been falling and fourth quarter earnings growth was the slowest it has been in years. Fading optimism of analysts and business leaders was offset by fading pessimism among individual investors. The explanation is their expectations were much worse.

Investor, analyst and business leaders’ expectations for earnings are meeting in the middle. This is a key theme for 2012, as many divergent trends of the past year become more in alignment. Earnings estimates have been coming down to be in line with our estimates. Analysts’ expectations for earnings growth for 2012 as a whole were about 13% at the end of last year and now are 8%, very close to our long-held 7% target (as you can see in Chart 2). At the same time, investors had priced into the stock market a decline in earnings in 2012 (valuations started the year in line with where they were last at the end of 1990, during recession when earnings fell 20% over the following six months) and are now realizing that earnings are instead likely to post modest growth in 2012.

Key drivers of earnings can tell us about the durability of earnings growth. During this earnings season we have been paying special attention to revenues and business spending.

With profit margins near peaks, profits will more closely track revenues in coming quarters. With over 70% of S&P 500 companies having reported, revenue growth for the fourth quarter is tracking toward an 8% increase year-over-year, according to Thomson Financial. As expected, demand from
emerging markets was a key driver of revenue growth, enabling companies
to offset some anticipated softness in Europe. Companies continue to report
solid demand from emerging markets; several examples highlighted this trend with their reports last week:

ƒƒMcDonald’s Corporation announced global comparable sales growth for January 2012 driven largely by growth in emerging markets where sales were up over 7%.

ƒƒWhile Coca-Cola’s North American and European volumes grew just 1%, China produced a 10% gain and sales volume in India rose 20%.

ƒƒ Yum! Brands’ same-store sales rose 21% in China, compared with 1% in the U.S.

In addition, strong demand continues to come from business spendingoriented sectors such as Industrials and Information Technology. These sectors have the highest growth rates for the fourth quarter of 2012 averaging about 17%, much better than analysts’ estimates. Investor attention is often directed on consumer spending as a driver of profits. However, business-spending-driven sectors are major drivers of S&P 500 profit growth while discretionary consumer spending has a much smaller contribution to the S&P 500. Continued strength in business spending can help drive profit growth in 2012, helping to lift stocks for the year.

Finally, a positive aspect of the earnings season is that dividend growth is making a comeback. The first quarter is when companies most often increase or initiate a dividend. 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 30% of earnings in the form of dividends in the fourth quarter of 2011 up from 28.7% in the third quarter, down from the average of 30% for much of the
2000s and well below the 30-year average of 40%. We have seen 58 S&P 500 companies increase their dividend so far this year, slightly ahead of last year’s pace. Looking at the broader universe of U.S. stocks, which includes smaller companies, the return of the dividend story is more compelling with a 38% increase in the number of companies issuing dividends over the past year with 188 increases in January 2012 compared to 136 in January 2011, according to data from Standard and Poor’s.

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 continued return to higher dividend payouts would help attract investors seeking income in an environment of very low bond yields. The S&P 500’s dividend yield stands at 2.1%, above the yield on the 10-year Treasury for one of the few times in history.

To download the pdf version of this week’s market commentary, click here.

Jeffrey Kleintop, CFA
Chief Market Strategist
LPL Financial

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.

*Earnings data are from the fourth quarter of 2008 through the fourth quarter of 2011. S&P 500 data are from the fourth quarter of 2008 through February 10, 2012.

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 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.

Earnings per share (EPS) is the portion of a company’s profit allocated to each outstanding share of common stock. EPS serves as an indicator of a company’s profitability. Earnings per share is generally considered to be the single most important variable in determining a share’s price. It is also a major component used to calculate the price-to-earnings valuation ratio.

LPL Financial doesn’t provide any recommendations or analysis on individual companies. The mention of any securities noted herein is not a recommendation to buy or sell their product or services.

The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure
performance of the broad domestic economy through changes in the aggregate market value of 500 stocks
representing all major industries.

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.

Not FDIC or NCUA/NCUSIF Insured | No Bank or Credit Union Guarantee | May Lose Value | Not Guaranteed by any Government Agency | Not a Bank/Credit Union Deposit

In one week, President Obama is due to submit his 2013 budget, which covers the fiscal year beginning on October 1, 2012. The Congressional Budget Act of 1974 requires the President to submit a budget request to Congress on the first Monday in February, but the Administration has scheduled the release instead for one week later on February 13. In addition, Congress must pass a budget resolution by April 15 of every year. However, the President missed the deadline last year and while the House passed a budget resolution last year, the Senate did not. This year is likely to be no different, with no budget being passed. But this does not mean the 2013 budget does not have potentially market moving consequences.

The 2013 budget is already going to have the biggest impact of any budget in decades even if no action is taken in Washington. The fiscal headwind comprised of both tax increases and spending cuts under current policy totals over $500 billion, or 3.5% of GDP.

The 2013 budget changes, primarily consisting of tax increases, are already in the law and would need to be changed to mitigate or restructure them to be less of an economic drag; if not a return to recession may be looming in 2013.

While the United States economy is not likely to see the big declines in government spending that came after WWI and WWII, the United States has never experienced a deficit cut by more than 2% of GDP that did not end in a sharp decline in GDP. The last time the budget deficit was cut by a similar amount to the 3.5% on tap for 2013, it was 1969. In 1969, the deficit narrowed by 3.1% during the year, and GDP ended up shrinking -1.9% in the fourth quarter (and by -0.6% in the following quarter) as the U.S. entered a recession. Despite the recession, the efforts to narrow the deficit in 1969 had one pleasant outcome: they balanced the budget. Unfortunately, the budget changes on tap for 2013 will still leave the federal budget far from balanced.

The further apart the parties in Washington appear to be, even on extending the unemployment and payroll tax cuts that expire this month, may make investors increasingly nervous. This may result in the return of market volatility in February after stocks got off to a strong start to the year.

While the President’s budget is unlikely to get much attention in Congress, the markets may begin to price in a major budget deal taking place in early 2013 for several reasons:

„„ the economic impact of the many scheduled tax increases and spending cuts,

„„ the debt ceiling will be hit again in early 2013 and require legislative action to approve an increase,

„„ the rating agencies have warned that they will be watching in 2013 for the United States to take actions to return to a path of fiscal sustainability, and

„„ the President and a newly elected Congress will have maximum political capital to make it happen in early 2013.

But the risk that a budget deal does not eventually happen should keep markets from moving steadily higher in 2012, as they have done year-todate, without a reality check. With Congress now back in session and the President’s budget due on February 13, just a week away, the markets may begin to refocus on the risks to the economy posed by inaction in Washington leading to a return of volatility.

To download the pdf version of this week’s market commentary, click here.

Jeffrey Kleintop, CFA
Chief Market Strategist
LPL Financial

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 & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks
representing all major industries.

Gross Domestic Product (GDP) is the monetary value of all the finished goods and services produced within a country’s borders in a specific time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments and exports less imports that occur within a defined territory.

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.

Not FDIC or NCUA/NCUSIF Insured | No Bank or Credit Union Guarantee | May Lose Value | Not Guaranteed by any Government Agency | Not a Bank/Credit Union Deposit

Last week, the Dow Jones Industrial Average (DJIA) hit a new three-and-ahalf-year intraday high [Chart 1]. Earnings, gross domestic product (GDP), and consumer spending are already back to new highs, so seeing the stock market return to pre-financial crisis levels seems reasonable.

January’s gain sets a positive tone for the year. When January was positive for the S&P 500, the year as a whole ended with a gain 90% of the time since WWII. This historical relationship is called the “January effect.” Last year, each of these time-worn axioms based on the calendar actually worked for investors. For example:

ƒƒ “Sell in May and go away,” which suggests investors sell and avoid the summer months, worked with stocks peaking for the year on April 29.

ƒƒ October, the “bear killer” month when stock market downturns famously end and reverse in the month of October, ended the 19% peak-to-trough stock market decline with stocks bottoming for the year on October 3.

ƒƒ A “Santa Claus rally” in December produced gains in the week between Christmas and New Year’s.

Although not based on the calendar, and more than a little bit tongue-incheek, another classic stock market indicator worth mentioning this week is the “Super Bowl indicator.” Last year, both teams were original NFL teams and the DJIA posted a modest gain for the year. The Super Bowl indicator shows that the DJIA goes up for the year as a whole when the winner comes from the original NFL (NFC team or an AFC team from the pre-1970-merger NFL — like the Steelers or Colts). But when an original AFL or expansion team wins, the DJIA falls. Going into the 1998 Super Bowl when the underdog Denver Broncos defeated the Green Bay Packers, the Super Bowl indicator had been correct in 28 of 31 years.

However, since 1998, the Super Bowl indicator has had a poor record; it has only been correct about 50% of the time over the past 13 years. The most notable failure was the New York Giants’ upset win in 2008 over the New England Patriots, which was supposed to bring about a bull run for stocks — instead the Dow plunged that year as the financial crisis took hold. This year’s rematch of the 2008 contest will be on Sunday, February 5. While a win for the Giants would suggest gains for stocks in 2012, using longerterm history as a guide, it is unlikely that this event holds any significance for 2008 2009 2010 2011 2012 the stock market. In fact, make that highly unlikely.

Individual investor buying is more likely to empower a rally than historical correlations with the calendar or a sporting event. Investors’ New Year’s resolution may have been to buy stocks. Individual investors appear to be beginning to “put a toe back in” to the stock market after five years of selling
stocks nearly every month. Data on mutual fund cash flows for the month of January suggests that investors are finally once again buying U.S. stock mutual funds — or have at least temporarily stopped selling them [Chart 2]. However, we are afraid this may turn out to be like most resolutions and fade come February.

We expect volatility to return and the stock market to shed some recent gains. But we adhere to our outlook for 8 – 12% gains for the year for stocks driven by 7% earnings growth and a slight improvement in valuations. In the near term, the recent four weeks of back-to-back gains may give way to a modest pullback, but we expect several factors to mitigate the extent of the slide including upcoming rate cuts in China, solid manufacturing and employment data in the United States, and further steps toward stability in Europe.

To download the pdf version of this week’s market commentary, click here.

Jeffrey Kleintop, CFA
Chief Market Strategist
LPL Financial

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.

President Obama’s State of the Union (SOTU), scheduled for Tuesday, January 24, is unlikely to be a big market mover. In fact, most SOTU speeches see less than a 1% move in the stock market on the following day and the average move is only 0.14% [Chart 1]. However, the themes and philosophy presented may shape the market’s movements in the months to come.

Rather than break new ground, the SOTU address is likely to echo the President’s December 6 speech in Osawatomie, Kansas. That speech was modeled after President Theodore Roosevelt’s 1910 historic address in that city on economic and social equality that led into 20th century progressivism, the central philosophy of Obama’s presidency.

The many topics of the speech — and their market impacts — can be broken down in terms of what will happen, what will not happen, and what could happen in 2012.

What Will Happen

In the SOTU address, Obama is very likely to highlight the immediate need for Congress to come together to extend the payroll tax cut and unemployment insurance benefits through 2012. In December 2011, a bitterly divided Congress could not come together on how to pay for a year-long extension and so only extended them for two months. We expect Congress to further extend these stimulus measures before they expire at the end of February, but the hostile negotiations — something the markets have had a break from in recent weeks — are likely to garner attention and help to renew market volatility after a remarkably stable advance in the first few weeks of the year.

Regulatory policy, an area where the executive branch is less dependent upon Congress’ leadership, will be a key part of the speech. The President is likely to highlight revamped housing programs, such as the Home Affordable Refinance Program (HARP), and announce a settlement that would end long running negotiations among Obama administration officials, state attorneys general and at least five of the nation’s largest financial services companies over “robo-signing” and questionable foreclosure practices. The settlement could be good news for Financials, one of the top performing sectors this year.

What Will Not Happen

The President is likely to call for increased infrastructure investment in the U.S. economy, including school construction, roads and bridges, and highspeed rails. Congress is unlikely to appropriate the funding to meet the President’s call on these items. Companies in the Industrial sector have performed well so far this year, but do not appear to be pricing in increased domestic infrastructure spending.

Job growth is key to the President’s re-election chances. As you can see in Chart 2, inflation-adjusted, after-tax income growth of about 3% appears to be the threshold for incumbents to get 50% of the popular vote. Currently, this measure of per capita income is only growing at 0.1%.

While factors other than jobs have a bearing on the election, job creation may be the key measure by which Obama’s presidency will be judged. However, much like infrastructure initiatives, measures to stimulate job growth presented in the SOTU are unlikely to be funded.

The President will likely address eliminating the so-called Bush tax cuts for higher earners, especially those making $1 million or more a year. In addition, given the recent attention to Mitt Romney’s tax filings, the President may call for applying income taxes to carried interest. With the President due to release his budget on February 6, he may also address overseas corporate tax breaks. However, with the House in Republican hands, none of these tax proposals will pass this year.

What Could Happen

This SOTU may foreshadow the President tilting his focus away from domestic politics to foreign affairs over the course of 2012. In doing so, he is shifting from the area where the President is institutionally weak (domestic policies) to the place where the President is institutionally strong (foreign policy). A Congress divided into two houses, a Supreme Court, and the states limit the President dramatically in domestic politics. However, the Constitution and American tradition give the President tremendous power in foreign policy. The President will surely highlight the U.S. withdrawal from Iraq and the winding down of the war in Afghanistan. Another foreign policy matter that may move the oil markets will be his discussion about Iran and the potential impact of U.S., Japanese, and European sanctions on Iranian oil.

Obama’s re-election strategy may be one of opposition to Congress. Essentially, this was Bill Clinton’s strategy in 1996 with a Republican Congress and it worked. Going into opposition against Congress could energize the President’s base, but that base is in the low to mid-40s. By itself, this may not be enough. Instead, over the next 10 months, Obama’s strategy may be to shift from the domestic aspects of the presidency where he is weaker to the stronger part, foreign policy, where a president can generally act decisively without congressional backing.

The critical issue for post-Iraq war foreign policy may be the U.S. relationship with Iran. An often rumored “October” surprise is the idea of attacking Iran’s nuclear facilities. But a precise strike can be messy since it carries the risk of Iranian retaliation in the Strait of Hormuz through which a meaningful percentage of the world’s oil travels. An approach with less chance for global economic disruption is a generalized air campaign against both Iran’s nuclear and military sites. But, in our view, starting a war is a huge risk. Setting aside all other considerations, from a political point of view, it would alienate Obama’s political base, many of whom supported him because he would not undertake the unilateral military moves of his predecessor. This is not intended to imply President Obama would consider starting a war for political ends, but merely to show that even if it were a consideration it is unlikely to be a successful strategy.

However, there is another foreign policy option, one that would appeal both to Obama’s political philosophy and to his political situation: pulling a Nixon. In February 1972, the last year of his first term as he ran for reelection, President Richard Nixon visited China in a grand diplomatic gesture
even while Chinese weapons were being used to kill American soldiers in Vietnam. In another interesting parallel that rings with echoes of the themes of Obama’s SOTU address, President Theodore Roosevelt did the same thing with the Soviets in 1941. A diplomatic engagement with Iran would seem to appeal to the President and his political base and rejuvenate some of the energy around a theme that helped him win the election in 2008.

We will be listening to the SOTU for clues as to the President’s foreign policy initiatives. If the President were to pursue this foreign policy choice, it may have the effect of sharply lowering oil prices — and help to stimulate the U.S. economy — as geopolitical risk fades and added supply returns with
the potential for a lift of the long-running embargo that has blocked critical parts and equipment needed to ramp up Iranian oil output. While a gesture by no means guarantees a resolution, the markets may welcome news of a potential arrangement with Iran.

To download the pdf version of this week’s market commentary, click here.

Jeffrey Kleintop, CFA
Chief Market Strategist
LPL Financial

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.

On Friday, Standard & Poor’s Ratings Services, one of the three major U.S. ratings agencies, downgraded France and Austria from AAA to AA+ and downgraded seven others (Malta, Slovakia and Slovenia by one notch and Italy, Spain, Portugal and Cyprus by two notches). The downgrades contributed to the second down day for the S&P 500 Index in 2012. However, the S&P downgrades are likely to have a limited impact for a number of reasons:

ƒƒ The warning on December 5 by S&P that a downgrade of European countries was coming helped to keep it from being a surprise.

ƒƒ The downgrade is a lagging indicator of credit risk in Europe the markets had already priced in. For example, AAA-rated France and Austria had 10-year yields that were over 100 basis points higher than AAA-rated Germany.

ƒƒ Not all downgrades are created equal when it comes to their market impact. The downgrade of the United States was a major blow to confidence in a political environment of inaction. Not true in Europe where confidence has been affected by its fiscal situation for some time, and now new governments are taking substantive actions to address it.

ƒƒ France continues to hold AAA ratings from Fitch Ratings and Moody’s Investors Service.

ƒƒ The headline impact of the downgrade of France may weigh on FrenchRepublic President Nicholas Sarkozy’s bid for reelection in April. He is already trailing the Socialist party candidate, Francois Hollande. The uncertain impact of a major shift in France’s leadership during this critical transition for the eurozone may weigh on the markets, but this is not new news for the markets since Sarkozy has been trailing in the polls for some time now.

ƒƒWhile largely priced in, there was some risk to the stock market that the European Financial Stability Facility (EFSF) would be downgraded due to the downgrade of some of the six EFSF guarantor members currently rated AAA (Germany, France, the Netherlands, Finland, Austria and Luxembourg) before steps toward greater fiscal integration occur.

The last point may warrant further explanation. The leaders of the eurozone decided this past fall to leverage the available resources of the EFSF in part by using it to provide insurance for bond investors. The idea is that the EFSF will take on the first losses, up to a maximum, that investors would face in the event of a sovereign default. The insurance would apply to newly issued debt sufficient to cover debt newly issued by many troubled European nations over the next few years. A downgrade does not change the overall amount of guarantees provided or the amount of debt issuance covered; but it does suggest a change in the risk profile of these guarantees and a smaller recovery value. Consequently, the yield markets demand may be higher to reflect the higher credit risk of the guarantees. However, the markets are
way ahead of the rating agencies on this, and these impacts have alreadybeen felt for some time.

S&P’s downgrade overshadowed meaningful developments over the past two weeks in Europe, which we would call an upgrade to the efforts to deal with the debt problems.

ƒƒ Last week’s meeting between Italian Prime Minister Mario Monti and German Chancellor Angela Merkel was significant. In exchange for Monti’s passing recent austerity measures, Merkel agreed to an early implementation of the bailout fund known as the ESM (European Stabilization Mechanism), successor to the existing and temporary EFSF, which had been planned to go into effect in July of this year. The key to
getting it up and running is German funding, which seems to have been secured this week.

ƒƒ A second draft of the Merkel-Sarkozy designed “fiscal compact” was presented on Friday, January 6. This agreement on tighter fiscal integration, to be signed no later than March 25, 2012, will establish a credible and enforceable budget discipline across the eurozone in an effort to avoid future debt problems. The second draft of the original German/French-crafted agreement defines key provisions such as what constitutes a “balanced budget” (a deficit of less than 0.5% of GDP), a target of 60%
debt-to-GDP ratio (and a pathway to get there of as slow as one-twentieth per year), and allows for an appeals process for those member countries found in violation of the treaty.

ƒƒ Recent bond auctions in Europe have gone well. Italy auctioned bills and bonds this week at much lower yields than just a month ago. Spain and Germany also had solid auctions last week and received more bids than the amounts they targeted in their debt sales. This is encouraging since Italy alone needs to issue 220 billion euros of bonds this year.

The events of the past week show that the rating change at S&P, while warranted, is a lagging indicator of a situation that has been something less than AAA-rated for a long time, but has been improving in recent months with more progress made in the past two weeks. With little move in the stock or bond market on the news of the downgrades, it is clear that markets had already made the credit adjustment and are now recognizing improvement. The irony is that the downgrade comes just as the debt situation in Europe is now getting better — not worse.

S&P has assigned more than a dozen European countries a negative outlook,
indicating at least a one-in-three chance of a further downgrade in the next two years. The key will be for the eurozone to continue to respond with actions. European leaders are set to meet at a summit on January 30 to discuss how to boost growth and jobs, and Merkel’s words on Saturday suggest she will also be looking for faster progress on tighter common fiscal rules.

While we have become more positive about the path Europe is taking, these efforts virtually assure a mild recession for Europe in 2012, and reinforce our belief that better investment opportunities lie in the United States and Emerging Markets.

To download the pdf version of this week’s market commentary, click here.

Jeffrey Kleintop, CFA
Chief Market Strategist
LPL Financial

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.