Weekly Market Commentary | Week of January 17, 2011

Highlights

•The microeconomics depicted in earnings reports this week are improving as companies report higher profits and stronger balance sheets. However, the durability of the gain in the market is dependent, in part, on how the macroeconomic risks are developing.

•The top five risks investors are focused on for 2011 are: European debt problems, municipal budget woes, inflation concerns, weak bank lending, and Federal Reserve rate hikes.

•Overall, the key risks of 2011 have been receding lately, helping to boost the markets. However, the evolution of these risks is unlikely to be in a straight line. We will continue to monitor these risk measures closely in 2011 for the opportunities they may provide to profit or help protect portfolios.

Measuring the Risks

While the stocks of the large companies tracked by the major U.S. stock market indexes have extended their gains to make new two-year highs, mid- and small-cap stocks have fared even better. In fact, mid-cap stocks, measured by the S&P 400 Mid-Cap index, hit a new all-time high on Friday, January 14, 2010.

The S&P 500 has been less worried about risks over the past several months as the economy rebounded in the fourth quarter of 2010 from weakness over the summer months. In addition, the microeconomics depicted in earnings reports this week are improving as companies report higher profits and stronger balance sheets. However, the durability of the gain in the market is dependent, in part, on how the macroeconomic risks are developing. We believe the top five risks investors are focused on for 2011 are:

• European Debt Problems
• Municipal Budget Woes
• Inflation Concerns
• Weak Bank Lending
• Federal Reserve (Fed) Rate Hikes

We will take a look at key measures of each of these risks to the markets and an update on their developing status.

European Debt Problems

While business conditions have been improving for Europe's largest economy, Germany, the peripheral economies have been showing financial strains. Measuring the yields of the debt of troubled European countries relative to those of Germany provides a gauge of whether the debt problems for those countries are improving or worsening.

The credit spread is the yield the corporate bonds less the yield on comparable maturity Treasury debt. This is a market-based estimate of the amount of fear in the bond market Bass-rated bonds are the lowest quality bonds that are considered investment-grade, rather than high-yield. They best reflect the stresses across the quality spectrum.

The stabilization in European credit spreads in recent months has helped lift stocks, commodities, and other markets. However, these spreads remain high and bear watching closely.

Municipal Budget Woes

The states' budget woes have raised concerns in the municipal bond market, but have broader impacts to other markets as well. The cutbacks and/or tax hikes also affect state economies and growth to a degree that can be felt nationally. To some degree, cuts in spending and tax hikes at the state level are neutralizing Federal stimulus and tax cuts. Watching the growth of state tax receipts provided by the U.S. Census Bureau is important to measuring the pace of improvement or deterioration in state finances and whether additional spending cuts or tax hikes will be necessary.

Fortunately, the economic rebound has led to a rise in tax receipts over the past year, narrowing the gap with spending.

Inflation Concerns

Investors and central bankers alike worry about too little and too much inflation. Too little inflation, called deflation, can be bad for markets since falling prices and wages can cause consumers to defer purchases resulting in a weaker economy. A lot of inflation is bad for the markets as it erodes purchasing power and raises borrowing costs. A little inflation is the most favorable for the markets. While inflation is very low now, markets react to the evolving outlook for inflation.

Current inflation expectations have returned to be in line with pre-crisis history and suggest deflation concerns have lifted for the markets. While inflation expectations have recently stabilized at about 2.7%, a further rise could ignite concern. Inflation expectations rose to 3.5% in 2004 prompting the Fed to start to hike rates in the summer of that year to cool the economy and avoid the negative consequences of much higher inflation.

Fed Rate Hikes

The Fed has been very aggressive in fighting economic weakness by cutting the federal funds rate effectively to zero and by providing additional stimulus through trillions of dollars in bond purchases. Looking at the forward federal funds rate tells us when market participants believe the Fed may begin to rein in stimulus. Stocks typically perform poorly around the first in a series of rate hikes, so it is worth monitoring when a Fed rate hike is expected to take place. A component of the LPL Financial Current Conditions Index (CCI) is the difference between the implied yield of the six-month forward federal funds contract and where the federal funds rate stands today. This measures the changes in the federal funds rate priced in over the next six months - a time frame likely to affect the markets. Monitoring the outlook over the next 12 months can provide insight as to what is on the horizon that may soon affect the markets.

Over the next six months there is little expected Fed tightening. However, the outlook for a rate hike in the next 12 months has picked up slightly in recent weeks.

Weak Bank Lending

Bank loans are often used to finance inventory or buy new equipment. Business loan growth tells us whether the economic stimulus is beginning to take root as businesses demand more funding for growth and banks are more willing to make loans, or not. We consider them so timely and important these C&I (Commercial and Industrial) loans are a component of the CCI.

Business loans have shown some acceleration beginning in December. Whether that was merely holiday sales driven inventory stocking or a longer-term commitment to growth remains to be seen.

Overall, the key risks of 2011 have been receding lately helping to boost the markets. However, the evolution of these risks is unlikely to be in a straight line. We will continue to monitor these risk measures closely in 2011 for the opportunities they may provide to profit or help protect portfolios.