While moving away from the drastic extremes will be a welcome environment for whipsawed investors, the center offers its own distinct challenges and opportunities. In 2012, finding a middle ground, or Meeting in the Middle, is going to be key for growth in the markets and economy. We believe that:

• Soft sentiment and hard data find middle ground. We expect the U.S. economy to grow about 2%, while emerging markets post stronger growth and Europe experiences a mild recession. U.S. gross domestic product (GDP) is likely to produce below-average growth of about 2% in 2012, supported by solid business spending and modest, but stable, consumer spending.
• Stocks are supported by a converging outlook for earnings growth. The U.S. stock market is likely to post a high single-digit to low double-digit gain, supported by earnings growth and a boost from a slight improvement in valuations as the pessimistic outlook for profits reflected in the markets rise to converge with a slide in the lofty expectations for earnings projected by Wall Street analysts.
• The government and corporate bond yield gap narrows. The performance gap between government and corporate bonds reverses in 2012 with corporate bonds outperforming as they post modest single-digit gains as interest rates rise and credit spreads narrow. Bond yields may be volatile, but we expect them to rise over the course of the year, with the yield on the 10-year Treasury ending the year around 3%.
• Major policy-driven events will converge on the financial markets in 2012. We believe a mild recession emerges in Europe and the debt dilemma continues to grab headlines and move markets as will the outlook for growth and financial stress in China. In addition, the 2012 elections are likely to hold major consequences for investors. The party that emerges in control following the November 2012 elections will forge the decisions that will represent one of the biggest shifts in the federal budget policy since World War II.

Consumer sentiment, business leaders, policymakers and geopolitics are going to have a significant impact on the investment environment in 2012. While volatility is likely to remain elevated, the market and its economic backdrop may begin to migrate from the extremes toward a more normalized period where investor sentiment, economic activity and the market’s direction start to move increasingly in alignment.

Important Disclosure

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 me 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.

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.

Past performance is no guarantee of future results.

This research material has been prepared by LPL Financial.

The declines were not restricted to the U.S. markets as the concerns remain focused on the European debt problems. Based on the MSCI All-Country World Index, stock markets around the world lost over $3 trillion last week (by comparison, all of Greece’s government debt totals about $200 billion) and entered a bear market as fear of default among some troubled European nations increased once again. This was the third largest weekly decline since the global recovery began in March 2009.

It is no surprise that the market appears to be demanding a policy response to the debt problems in Europe. All of the major European stock markets are in a bear market, having declined by about 30% from the peak in early May. However, many of the world’s largest markets have avoided a 20% or more decline defined as a bear market, such as those of the United States, United Kingdom, Canada, Singapore and New Zealand. The losses in Europe have been, in general, twice as large as those in non-European nations. They are more severe than even the 21% decline from the peak in Japan which suffered a devastating earthquake and tsunami earlier this year.

While stock values have been affected by the negative sentiment, analyst earnings estimates, in contrast, have remained resilient. In fact, there is not a single nation among the largest 24 whose companies are expected by analysts to produce a loss in aggregate during the coming fiscal year. For example, in the United States, the estimated earnings growth rates for the S&P 500 for the coming four quarters are in the double-digits: 14%, 15%, 11% and 15%. Even in Europe any losses are expected to be temporary and give way to double-digit earnings growth in the coming fiscal year.

While U.S. stocks have fallen 15%, analysts’ earnings estimates have only been trimmed by about 2%. While we continue to believe, as we have all year, that earnings estimates are a bit too high, we do not believe the major decline priced in by the market is likely. The earnings outlook remains supported by company guidance and world industrial output that remains close to all-time highs. In Europe, earnings growth also remains positive. Market participants have priced in an expectation that earnings will suffer double-digit declines as a recession and financial crisis erupts, rather than double-digit gains in the coming year as a crisis is averted.

The sovereign debt problems in the eurozone require policy actions to get peripheral countries on the right fiscal path and ensure their funding until the European banks are sufficiently insulated and a partial default for Greece can take place. We assessed this situation in detail earlier this year in a blog, entitled “Greece Fire”. In that publication, we noted that European banks have taken actions to reduce their exposure; in total, German banks exposure to Greek debt is about 1.2% of consolidated cross-border debt holdings and for France it is 1.8%. But the question of whether or not Greece’s default can be orderly is complex. The fear among some market participants is that the default or restructuring of Greece’s debt will trigger a series of financial institution defaults and a financial crisis throughout Europe and beyond similar to what happened in the fall of 2008 after Lehman Brothers unexpectedly declared bankruptcy. While our analysis suggests this is not likely to be the case, no one knows for sure unless it happens.

The near-term uncertainty over the outcome of the European debt problem, and the fragile state of the U.S. economy, has kept individual investors scared and prompted them to sell their holdings of stocks at the fastest pace since the peak of the financial crisis in 2008. We can see this in the monthly money outflows from U.S. stock mutual funds totaling $35 billion in August [Chart 1].

Fortunately, the long-term outlook offers a clearer picture for investors. Though past performance is not an indicator of future results, we believe that history has made it clear that the most consistently accurate predictor of long-term stock market returns is the S&P 500 Index price-to-earnings ratio (P/E). The P/E is obtained by taking the price level of the Index and dividing it by the earnings per share over the past four quarters. Essentially, the P/E is how many dollars investors are currently willing to pay per dollar of earnings. It makes sense that the price you pay when you buy a stock can have a big impact on your return. The level of the P/E and the annualized return on stocks over the next 10 years has a very close relationship, as you can see in Chart 2. In essence, the lower the P/E, the higher the return over the next 10 years. Currently, this relationship predicts that high single-digit gains are likely, on average per year, for the stock market over the next 10 years.

Despite the fact that the P/E has a nearly perfect track record of forecasting long-term performance, many investors have been selling and believe that it is different this time given the troubled banks, European credit problems, geopolitical tensions, concerns over both inflation and deflation, the U.S. budget deficit, threat of rising tax rates, and uneven economic data, among other concerns. We do not dismiss these issues. However, the P/E has demonstrated consistent success predicting long-term returns over the entire history of the S&P 500 Index — going all the way back to the 1930s.

Investors have always faced challenges. Since 1928, the S&P 500 has weathered massive bank failures, a dozen European countries defaulting, a world war, double-digit inflation, top marginal income and dividend tax rates of about 90 percent, the percentage of U.S. government debt-to-GDP at double the current level, not to mention the Great Depression. And yet, through all of these unprecedented events the P/E remained a consistently accurate forecaster of future long-term returns.

The annualized loss for stock market investors during decade of the 2000s was the result of the record high 30 P/E 10 years ago in early 2000. However, we believe the current P/E of about 12 forecasts a better decade for performance ahead. The current P/E of around 12 suggests a 7 – 8% price return for the S&P 500. The addition of a 2% dividend yield may result in a total return of 9 – 10% [Chart 2].

Based on this relationship between future returns and P/E, the stock market’s lowest valuations in 20 years suggests this the best time in 20 years for long-term investors to consider buying, not selling, stocks.

Often, investing can be emotional, and the near-term clouds of uncertainty too often obscure what we may feel more certain of over the long term. This simple predictive relationship between P/E and future returns gives us hope that it is not different this time. It is easy to focus on all that could go wrong and assume it is insurmountable, but history shows us that what really matters is the price we pay and not so much what happens along the way.

On the policy front this week, the Fed will release the minutes of the August 9 FOMC meeting, and perhaps more importantly, German Chancellor Angela Merkel holds a key policy conference with her own caucus as the market continues to wait for a policy response from Europe. Japan’s ruling party will choose a new Prime Minister from its own ranks, after the current Prime Minister resigned on Friday, August 26. As with elsewhere around the globe, the path of future fiscal and monetary policy in Japan is crucial to the outlook for the global economy.

Further out on the horizon for markets on the policy front is the now two-day long September Federal Open Market Committee (FOMC) meeting on September 20 and 21, some type of policy actions in Europe (see this week’s Weekly Market Commentary), a jobs proposal from President Obama, and ongoing work by the so-called congressional “super committee” tasked with finding at least $1.5 trillion in budget savings by the end of this year.

Potential Economic Impact from Hurricane Irene

Another, shorter term concern for markets is Hurricane Irene, which made its way up the East Coast over the weekend of August 27 – 28. As of Monday morning, August 29, damage estimates were in the $5 to $10 billion range. Table 1 shows the costliest hurricanes in United States history in terms of economic damage. Although the damage from Irene was less than feared, it caused major disruptions in a very heavily populated area of the country, keeping businesses closed and consumers at home for several days in the key back-to-school shopping season. The high frequency economic data (i.e. initial claims, shipping and rail traffic, weekly retail sales, consumer confidence, auto production, etc.) we, other market participants, and policymakers track may be difficult to interpret for a few weeks due to the impact of the storm. This potential lack of clarity on the underlying health of the economy arrives at a particularly inopportune time, as markets and policymakers try to gauge the true underlying strength of the economy and the risk of recession.

Although several major public transportation systems from the Metro in D.C., to the MBTA in Boston were closed for all or part of the weekend of August 27 – 28 (and some remain partially closed as of Monday morning, August 29), it appears that most of the other major economic infrastructure (ports, roads, airports, railways, refineries, utilities, etc.) related assets in the path of the storm were largely spared. Flooding remains the largest concern in the aftermath of the storm, especially in New Jersey, New York, and Vermont. If authorities take longer than now expected to repair the infrastructure, the hurricane may have a longer lasting impact on the economy in the region, and would push the United States economy closer to recession. Prior to the storm, we place the odds of recession at around one-in-three, up from a few weeks ago, but well below the odds financial markets seem to be placing on a recession.

As previously noted, very preliminary estimates put the economic cost of Irene at between $5 and $10 billion, In terms of economic damage (adjusted for inflation), at $108 billion, Katrina (2005) was the costliest hurricane ever to hit the United States. Andrew (1992) at $45 billion was next costliest, followed by Ike (2008), Wilma (2005), Ivan (2004), Charley (2004), Hugo (1989), Rita (2004) and Agnes (1972). These storms (again in 2010 dollars) caused between $10 and $20 billion in damage. Irene may end up in the lower end of that $10 to $20 billion category in terms of economic cost, although the true cost of the storm may not be known for weeks. Three storms that took the same track as Irene — up the East Coast — and were roughly the same magnitude as Irene: Floyd (1999), Bob (1991) and Gloria (1985) were the 14th, 30th, and 30+ most costly storms in history. For perspective, the size of the United States economy is around $15 trillion dollars.

Table 1
Costliest Hurricanes to Hit the United States (In 2010 dollars)
Rank Name Year Cost (Billions) Area Impacted
1 Katrina 2005 $105 Gulf Coast
2 Andrew 1992 $45 Florida/Louisiana
3 Ike 2008 $28 Texas/Louisiana
4 Wilma 2005 $20 Florida
5 Ivan 2004 $20 Florida/Alabama
14 Floyd 1999 $9 Mid Atlantic/Northeastern US
30 Bob 1991 $3 North Carolina/Northeastern US
30+ Gloria 1985 ~$1 Northeastern US
Source: National Hurricane Center

To say last week was volatile for the markets would be a major understatement. The stock market posted one of its most volatile weeks ever with swings of greater than 4% during each of the first four days of the week, changing direction with each day. This pattern of performance has never before been seen in the 83-year history of the S&P 500 index. By Friday, stock market turbulence slowed. For the week, the S&P 500 was down 1.6% adding to the losses that now total 13% since the recent peak on July 7.

While the U.S. debt downgrade in the week before last grabbed a lot of attention and added to the lingering pessimism heading into last week, one of the primary drivers of last week’s volatility was that eurozone leaders, while making some successful efforts, have not gone far enough to resolve the debt problems in the eurozone. Investors feared a downgrade to France, and another banking crisis stemming from some French banks noted by Moody’s,as at risk of a downgrade due to their exposure to troubled debt.  Another key driver was the better-than-expected economic data on retail sales and the labor market along with the Fed confirming they intend to keep short-term interest rates low until mid-2013. This optimism that the U.S. economic softspot was firming vied with the concern that the pace of economic growth in the United States may soften further as stimulus begins to fade.

While last week’s volatility is unprecedented, we can take some comfort that the overall moves and sentiment in the market this summer are familiar; they echo those of last summer.„

• At the low point of last week, the S&P 500 was down 17%, similar to last summer’s volatile 16% peak-to-trough decline.„„
• The 10-year Treasury note yield has fallen 1.6 percentage points from the high of the year, similar to last summer’s 1.6 percentage point decline from the high of the year.„„
• The drivers of the decline are similar to last summer, as well. Last year, Europe’s debt problems were a main cause of the market’s decline, as was an economic soft spot in the United States as stimulus began to fade when the Federal Reserve ended the QE1 bond buying program andstate and local governments were cutting back on spending.

So, maybe we have been on this market roller coaster before, and, if so, we might be near the end. Last year, the roller coaster did not leave the track and the summer plunge turned into a steep climb as stock and bond yields rose to new post-recession highs. We continue to believe this summer’s drop will end with similar results and ultimately produce a modest single-digit gain for the S&P 500 in 2011. We believe the fundamental underpinnings of solid corporate earnings growth (up 19% year-over-year in the second quarter), low valuations (the price-to-earnings ratio fell to levels not seen since 1989 during the lows of last week), and firming economic data (as Japan’s economy rebounds from recession) will combine to support stocks, high-yield bonds, and other business cycle-sensitive investments.

Friday’s news that one of the three U.S. rating agencies was downgradingthe U.S. credit rating from AAA to AA+ hit the markets and sapped thegains fueled by the report of better-than-expected job growth in themonth of July (and positive revisions to prior months). As the rumorsof a downgrade hit, stocks slumped. Is this a killing blow for a market and economy already suffering from a series of disappointments or adisappointing but lagging indicator of the pressures already reflected in themarket’s path and level of recent years? We favor the latter assessment.

Here we will present our views on the downgrade from; why it happenedand what it means for investors and policymakers, and what is next forthe markets. For more insight, please see the Bond Market Perspectivespublications from July 19 and August 2 where we discussed the details surrounding the pending downgrade.

Why did it happen?

While the imbalance in the U.S. long-term fiscal situation is no mystery,the reasoning for the downgrade at this time is best left in the words ofStandard and Poor’s. The first news of a near-term potential downgradecame on April 14 of this year. Standard and Poor’s rating agency stated,“We believe there is a material risk that U.S. policymakers may not reach anagreement on how to address medium- and long-term budgetary challengesby 2013; if an agreement is not reached and meaningful implementationis not begun by then, this would in our view render the U.S. fiscal profilemeaningfully weaker than that of peer ‘AAA’ sovereigns.”

On July 14, the outlook for a downgrade became even clearer as Standardand Poor’s clarified their position with the statement: “The CreditWatchWeekly Market Commentary LPL Financial Member FINRA/SIPC Page 2 of 6placement of the U.S. sovereign ratings signals our view that, owing to thedynamics of the political debate on the debt ceiling, there is at least a one-intwolikelihood that we may lower the long-term rating on the U.S. within thenext 90 days.” Standard and Poor’s cited $4 trillion in savings as part of thedebt ceiling bill as the number that would be a trigger to avoid a downgrade.As it became apparent that a “grand bargain” of around $4 trillion was off the table, a downgrade by Standard and Poor’s became likely.

On Friday, August 5, the rumor of a downgrade announcement negativelyimpacted the markets. The announcement of the downgrade was delayed bythe Treasury pointing out an error to Standard and Poor’s in their calculationsof $2 trillion as it related to the size of the total debt-to-GDP ratio which was aprominent component of their economic justification for the downgrade. S&Packnowledged the error and removed that component and focused on thepolitical environment for the justification for their downgrade

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