2012 Market Outlook

LPL Financial Research


Outlook 2012

The year 2012 will be one where the wide divergences of the prior year converge to meet in the middle while candidates seek to attract the middle voter. Over the last four years, the market declined in excess of 2% in a single day around 100 times, more than any other four-year period since the S&P 500 Index’s formation in 1957. On the flip-side the market also recorded a 2% of greater gain in a single day more than any other four-year period.

While the last few years have been highlighted with record swings in market returns and widely oscillating economic data, we expect 2012 will be less about the fringes and more about the middle. While volatility is likely to remain elevated, the market and its economic backdrop may begin to migrate from the extremes — oftentimes even polarized extremes — toward a more normalized period where investor sentiment, economic activity and the market’s direction start to move increasingly in alignment. While moving away from the drastic extremes will be a welcome environment for whipsawed investors, the center offers its own distinct challenges and opportunities. The key hurdle for the market in 2012 will be finding the right balance.

Recently we have experienced a market of extremes. In 2012, finding a middle ground, or Meeting in the Middle, is going to be key for growth in the markets and economy. Consumer sentiment, business leaders, policymakers and geopolitics are going to have significant impact on the investment environment. We believe that:

• Soft sentiment and hard data find middle ground. We expect the U.S. economy to grow about 2%, which is below the consensus forecast, 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 supported by converging outlook for earnings growth. The U.S. stock market is likely to post an 8 – 12%* gain, supported by mid-to-high single digit earnings growth when 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. Stocks may receive a boost from a slight improvement in valuations from the current 20-year low as confidence that the business cycle will continue.

• 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 within a 1.7 – 3% range, 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%. Ongoing economic growth will help to normalize interest rates as will a continuation of Federal Reserve (Fed) policy, stable inflation and tightening fiscal policy. The wide gap between yields on government bonds and those of other borrowers is likely to converge some in 2012.

• Major policy-driven events will converge on the financial markets in 2012. We believe a mild recession emerges in Europe, in contrast to the consensus forecast for continued growth, and the debt dilemma continues to grab headlines and move markets, while the outlook for growth and financial stress in China will also garner attention from investors. In addition, the 2012 elections in the United States are likely to hold major consequences for investors. The key fight this election is over those in the middle. 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.

Sluggish U.S. Economic Growth

We believe 2012 will be another year of sluggish growth for the U.S. economy. GDP is likely to average about 2% in 2012, supported by solid business spending and modest, but stable, consumer spending. While inflation may recede early in the year, by year-end it may begin to re-emerge as the impact of a falling dollar, rising commodity prices and the record-breaking monetary stimulus by the Fed begins to be reflected in prices. We expect global growth in 2012 to be supported by solid emerging market growth including the consensus of 8 – 9% growth in China, the world’s second largest economy, while Europe experiences a mild recession.

We believe there is a one-in-three chance of entering a recession in 2012. However, provided we avoid a shock from unforeseen events, interest rates do not surge above 5% and oil prices do not soar to record highs, we believe the business cycle likely lasts until around 2015 — the average cycle duration of five years experienced since 1950. This leaves 2012 as a mid-cycle year of continued, though sluggish, growth.

Many investors fear the U.S. economy is poised for a business cycle much shorter than the average of eight years seen in recent decades. The fear of a return to recession just three years after emerging from the Great Recession of 2008 – 2009 is driven largely by the concerns over a lack of job growth and the fiscal budget and debt problems here in the United States and overseas. While we recognize the challenges posed by unsustainable government budget deficits and relatively high unemployment rates, we believe the support of strong business productivity and a corporate spending boom are being overlooked by investors.

The Gap Between Facts and Feelings

Rather than an economic recession, we seem to be experiencing a recession in confidence. This belief is quantified by comparing the very soft sentiment reading to the hard economic data. There is noteworthy divergence between consumer confidence, measured by the widely watched University of Michigan Consumer Sentiment Index, and the Index of Leading Economic Indicators from the Conference Board.

The market clearly believes the headlines that the fall of business and consumer confidence to historical lows will inevitably lead to an economic recession — no matter what positive signs the data brings. Market participants are placing a high probability that businesses will not merely slow their rate of hiring and investment, but actually make cuts despite strong sales and rising profits. They also expect that consumers are in the process of shutting down their spending, despite the fact that retail sales have remained solid coupled with the credit card delinquency rate declining further to near record lows.

During the second half of 2011, consumer and investor feelings and confidence plunged to levels only seen one other time in the past 30 years: during the financial crisis of 2008 – 2009. However, the economic data that measures the actions of consumers and businesses indicated moderate economic growth. This growth actually translated to the third quarter 2011 GDP of 2.0%. Typically, how consumers and businesses feel and act are aligned, but they periodically diverge. In the past, when they have diverged it has been sentiment rather than the data that has closed that gap, which is likely to be the case in today’s environment.

The last time we saw such a wide gap between facts and feelings, in the late 1990s and early 2000s, it was the reverse of the current situation with sentiment too optimistic relative to the data. At the end of the 10-year economic expansion (1991– 2001), confidence was high amidst booming financial and housing markets and the backdrop of relative quiet on the domestic and international policy fronts. However, the data on the economy, including business spending, new orders, rail traffic, auto and truck sales, and hours worked, among others, were all pointing to a less rosy fundamental economic environment. A similar episode occurred in 2005 – 2007, when consumer sentiment remained strong — as the stock market and housing prices hit all-time highs — even though the data suggested a deteriorating economy.

Markets seem to believe the odds of a recession are well over 50%. This is after sentiment has rebounded some from the summer of 2011 — when investors priced in odds of a recession approaching 100% as measured by stock market valuations and bond yields falling to or below the levels seen in prior recessions. However, we believe actions speak louder than surveys. We place the odds of recession at just one-in-three, substantially lower than what the markets are placing on such an event. The market is often said to climb a wall of worry. History shows that it does not take much for the market to turn from agonizing over a wall of worry to climbing it. This occurs when confidence is high that impediments to growth — both real and imagined — will be overcome no matter how bad they may seem at the time causing the market to trend upward. Importantly, the risks do not need to be resolved, merely confidence needs to return that the risks will be overcome.

Looking ahead to 2012, we believe the data and sentiment gap will converge. 2011 had a lot of unusual factors — many of which were not directly related to markets — that weighed on investor sentiment including:

• Civil and social unrest in the Middle East
• Soaring consumer energy and food prices
• Unprecedented discord among policymakers in the United States
• Stubborn inaction among policymakers in Europe
• The devastating earthquake and tsunami in Japan which disrupted the global supply chain for more than half a year
• A series of severe natural disasters globally

The memories and impacts of these events have already begun to fade and will continue to do so. At the same time, the Fed’s actions to stimulate the economy overall and the housing market in particular may help to further stabilize that sector. The ongoing stagnation in the housing market has played a key role in driving consumer sentiment to 30-year lows. In addition, there will certainly be an uptick in political rhetoric over the course of the year as we approach the 2012 presidential and congressional elections. The convergence of facts and feelings will be largely driven by consumers feeling more confident in continued growth as the labor market improves, and the unusual factors that negatively impacted 2011 are unlikely to repeat. However, the economic data may also soften relative to the second half of 2011, when U.S. and global economic activity was artificially boosted as the global supply chain recovered from the Japanese earthquake and tsunami.

Business Rather Than Consumer Spending to Drive U.S. Economic Growth

It is during times like these that we are often reminded that 70% of U.S. economic growth is driven by consumer spending. This dependency has raised worries that a persistently high unemployment rate and low sentiment levels will make a recession self-fulfilling as consumers rein in their spending. However, there is much more to this story beyond the headline.

• Most consumer spending is not discretionary. While it is true that consumer spending accounts for about two-thirds of GDP, two-thirds of consumer spending — and most of consumption growth — comes from services and staples, such as healthcare, housing, education, food, energy and others. These categories of spending do not change much from year to year; instead they tend to steadily rise at the pace of inflation. Actual discretionary consumer spending, which is made up of more flexible, voluntary categories of spending, such as travel, electronics and autos, makes up only one-third of the total.

• Most spending is done by those with the largest capacity to spend. The top 5% of income earners make up 37% of consumer spending, and the top 20% make up 60% of all consumer spending. These groups have continued to spend as indicated by retail sales, which is more discretionary, having risen by 7.3%year-over-year as of October 2011. Because of these spending dynamics and anticipated job gains of about 150,000 per month, we believe the U.S. economy will experience modest consumer spending growth in 2012 despite the high unemployment rate and sluggish income growth.

We forecast U.S. business spending to grow at several times the pace of consumer spending in 2012. Business spending has been strong in 2011, as demonstrated by third quarter 2011 capital spending by businesses on equipment and software rising at an annualized rate of over 17%. One of the reasons that businesses were able to achieve record profits in 2011 despite employing fewer workers is because businesses have become more productive and are doing more with less and investing in productivity enhancing technologies. 2011 marked a change from an extended period of under investing by U.S. companies. Businesses are hesitant to invest when their costs are hard to forecast. The sweeping regulatory and legislative changes, and prospects for additional changes, affecting industries, such as Financials, Energy, Utilities and Health Care, that took place in 2010 are fading and may even be reversed — with the outcome of the 2012 election. Therefore, in 2012, business spending may continue to enjoy what may be a new multiyear cycle supported by this clearer regulatory and legislative environment.

The S&P Decouples from GDP

Even in an environment of sluggish GDP growth the S&P 500 can produce solid gains. We believe the S&P 500 will post a gain of 8 – 12% in 2012. This is based on our economic outlook unfolding as forecasted, interest rates staying benign (10-year Treasury below 4%), and oil staying below prior record prices. Although our outlook is for U.S. economic growth of about 2%, we expect solid, but volatile returns for the S&P 500. We believe these gains are driven by earnings growth in the mid to high single digits and a modest rise in valuations from recession-like levels as the gap between soft sentiment and hard data begins to converge.

Over the past 40 years, the S&P 500 median return is 10% when real GDP grows less than 3% it is important to recognize that the S&P is not GDP. S&P 500 companies have different drivers for earnings than the components the drive GDP.

• Two-thirds of S&P 500 profits are from manufacturing, while two-thirds of U.S. consumption in GDP is services.
• While 70% of GDP is consumer spending, only one-third of it is from discretionary categories, While and even lower 15% of S&P 500 profits come from consumer discretionary spending. A more significant 20 – 25% of S&P 500 earnings come from business spending.
• International trade only accounts for 10% of GDP and acts as a drag since the United States imports more than it exports. Today, about 40% of S&P 500 profits come from overseas — with about half of that from rapidly emerging market economies. This makes S&P 500 earnings less dependent upon U.S. growth than just 15 years ago, when 20% of S&P profits were foreign-sourced, and 30 years ago when only a small portion of earnings came from overseas.
• While higher commodity prices weigh on GDP, they benefit S&P 500 companies, in general, because most of the S&P 500 companies producers with equipment (Industrials) or do not heavily use commodities (Information Technology, Health Care, Financials, Telecommunications).

Given the backdrop of solid business spending in the broader context of low GDP growth and mixed global demand, we expect mid-to-high single digit earnings growth for S&P 500 companies in 2012. The typical mid-cycle earnings growth rate for the S&P 500 over the past 80 years of business cycles has been around 10%. Slower revenue growth based on sluggish global economic growth will weigh on earnings leading to slightly-below average mid-cycle growth. This expectation is supported by our model of earnings growth using key drivers of earnings as inputs: commodity prices, the yield curve, labor costs and global leading economic indicators.

The consensus for earnings growth among Wall Street analysts may come down — especially for the fourth quarter 2012 forecast of a 19% year-over-year increase. But, with investors pricing in flat, at best, earnings per share (EPS) in 2012 relative to 2011, stocks may post gains as confidence in earnings growth rises, with investors and analysts meeting in the middle.

What if Weak Economic Growth Turns into a Recession?

An analysis of the S&P 500 earnings cycles presented in the table below reveals that, typically, earnings grow for five to ten years, averaging about 6% a year from the prior peak before they pullback. As of mid-2012, there will have been only three years since the last recession ended. However, if we did enter a recession in 2012, earnings would likely fall rather than grow in 2012. During a recession, EPS typically falls about 12 – 24%. The only exception to this 12 – 24% range was in 2008 when the companies in the Financial sector, the largest sector by earnings at the time, were forced to write off a decade of profits in just one quarter.

If the economy deteriorates further and the United States enters a recession, we believe earnings would only fall roughly 12% from current levels. We believe the pullback would be at the lower end of the historical range for several reasons.

• First, we have not had the buildup of corporate debt levels. This steady build up of leverage typically inflates earnings in the later years of a business cycle and then rapidly deflates them over just a few quarters and acts as a multiplier on the earnings pullback. The opposite has been taking place in recent years, as corporations have continued to reduce debt after the downturn ended, leaving much less leverage to exacerbate the downside to earnings in a recession.

• Second, S&P 500 companies now get about one-quarter of their sales from fast-growing emerging markets. These areas of the market are relatively unaffected by a recession in the developed markets and their growth may continue regardless of the U.S. economic backdrop. This is one of the key reasons profits have boomed at a double-digit pace despite the very sluggish economic growth in the United States in the first and second quarter of 2011.

• Third, businesses have not yet done a lot of hiring this business cycle. The vast majority of corporate costs are labor. Businesses have not reached the point where a pullback in demand from a recession would result in them being suddenly overstaffed and forcing them to suffer high costs associated with early retirement, mass layoffs or retaining excess workers as demand falls.

• Fourth, earnings as of the third quarter of 2011 have now just exceeded the prior peak. In general, earnings pullbacks are proportional to the gain they achieved during the cycle. The fact that earnings have experienced below-average gains is likely to result in a below-average pullback. For example, in 1959, the cycle was short; earnings never grew above the prior peak and, during the correction, earnings fell just 12%.

If a recession develops and earnings fall 12%, the total EPS of the past four quarters, which now stands at a little over $95 for S&P 500 companies (as of November 2011), would fall to about $84. This would return EPS to a level first achieved only five years ago. If we assume a recession EPS of $84 and multiply that by the average recession price-to-earnings ratio of 13.4, we get a level where recession is fully priced in to the stock market at about 1120 for the S&P 500. This level is roughly where the Index bottomed out four times during the summer and fall of 2011.

The Rise of the PE

In 2012, we believe the investment environment will transition from an early cycle environment of EPS recovery to a mid-cycle environment of PE recovery. The S&P 500 PE may begin to climb back toward the long-term average of 15. Improving confidence in the outlook for continued economic and profit growth will be the key to lifting valuations. Investors’ lack of confidence in economic growth, corporate profit forecasts and the actions of policymakers is likely already fully reflected in the markets and creates the potential for valuations to rise as confidence rebounds from multi-decade lows. Volatility, a major characteristic of 2011, is likely to remain present in 2012 as macroeconomic and policy drivers result in market swings. However, we see a greater potential for gains in 2012. Our base case is for stocks to post a solid gain in 2012 of around 8 – 12%.

Bond Market Under Pressure

A number of factors will likely keep bond yields relatively low in 2012 and my translate into a low return environment for the bond market. For 2012, we expect low-to-mid single-digit total return for the high-quality bond market as different segments of the bond market meet in the middle. We believe the economy will avoid slipping back into recession in 2012, which should pressure yields higher and benefit more economically sensitive band sectors at the expense of the U.S. Treasuries. The risk-on, risk-off trading environment that characterized bond market performance in 2010 and 2011 is likely to persist in 2012.

We expect yields to remain relatively rangebound in 2012, but end the year higher. Economic soft spots or periods of financial market turmoil will likely spark bouts of safe-haven buying, pushing bond prices higher and yields lower. We expect the 10-year Treasury yield to fluctuate between 1.7% and 3% in 2012. Although a wide range, it is narrower than the 1.7% to 3.7% range the 10-year Treasury yield fluctuated within during 2011. Ultimately, we expect bond yields to finish the year at the high end of the range, around 3.0%, as fears of recession fade and the passage of the presidential election portends fiscal changes in the United States.

Federal Reserve Helps Keep Yields Rangebound

A number of factors should support a range-bound market and keep Treasury yields low relative to history. The most important of these is the Federal Reserve’s (Fed) monetary policy.

The Fed’s commitment to keeping short-term interest rates on hold through the middle of 2013 removes a key source of interest rate risk from the market. This unprecedented step by the Fed may continue to encourage investors to consider moving out of lower-yielding short-term bonds and into higher-yielding intermediate- and long-term bonds. Historically, the Fed has been one of the primary drivers of interest rates, but with the Fed on the sidelines, interest rate risk is reduced which will help keep yields lower than in the absence of such a promise.

Furthermore, the Fed surprised investors twice in 2011. First, in August, by announcing the aforementioned commitment to remain on hold; and secondly, in September, by announcing a bolder-than-expected Operation

Twist, a program to sell short-term Treasuries and buy long-term Treasuries to pressure long-term interest rates lower. In late October 2011, Fed officials discussed so-called Quantitative Easing 3 (QE3), or another round of large scale securities purchases, perhaps this time in the mortgage-backed securities market. While we think another program of stimulus from the Fed faces high hurdles, it is clearly leaning towards keeping rates low, which is generally a positive for the bond market.

However, the Fed may find itself increasingly between a rock and a hard place as 2012 matures. Too little growth and the fear of deflation is the “rock” that the Fed has been aggressively focused on avoiding. The Fed is much less concerned about the “hard place,” or all of the stimulus it has provided leading to too much inflation. Now, the distance between the two risks is far apart. However, the Fed may find itself in an increasingly narrow gap between a rock and a hard place as 2012 matures leading to higher yields in the bond market by year-end.

The Fed has pumped a record-breaking amount of dollars into the financial system, much of which is sitting on bank balance sheets waiting to be lent out to stimulate economic growth. Demand has cooled and the extra money in the system is not yet resulting in too many dollars chasing too few goods and services leading to generally higher prices. But, the Fed has piled up so much kindling in the form of stimulus that when the spark of growth finally ignites it may start a raging fire that will quickly stoke inflation. This abrupt shift from too little growth to too much inflation could happen relatively quickly.

Even though the Fed has committed to keeping rates low until mid-2013, inflation worries may begin in 2012, gradually pressuring yields higher and, commensurately, bond prices lower. This may also mean that the Fed will not have the luxury of slow 0.25%-at-a-time interest rate hikes in 2013 and instead may have to slam on the brakes with much larger rate hikes. The potential for aggressive rate hikes from the Fed in 2013, combined with the negative consequences it would have for housing and borrowing, may limit the rise in yields in 2012 to under 3% on the 10-year Treasury note.

While the Fed may have to scramble in 2013 to begin to take up some of the extraordinary amount of monetary stimulus now in the system, in the meantime it is likely that the economy will fail to live up to the Fed’s relatively lofty expectations for growth. The Fed’s economic projections released from the November 2011 Fed meeting call for 2.5 – 2.9% GDP growth in 2012, well above our estimate of 2%, and an even more robust 3.0 – 3.5% pace of growth in 2013.

The slow pace of growth and high unemployment rate will continue to widen the output gap. The output gap is the difference between the economy’s long-term growth rate and the economy’s current growth trajectory. In general, the wider the output gap, the greater the slack in the economy, such as high unemployment, high vacancy rates and low rates of resource utilization. The greater the slack in the economy, the lower the risk of inflation and the higher the risk of deflation, or falling wages and prices. While a severe bout of deflation is unlikely, the Fed has to guard against this outcome. As the economy fails to produce growth on par with the Fed’s expectations, they may consider adding even more policy stimulus to the system, including QE3, once the current Fed stimulus program, Operation Twist, concludes in June 2012. In 2012, the Fed may also communicate its forecast for the Fed Funds Rate in order to give the public, as well as financial markets, even more clarity on interest rates and monetary policy and seek to make any moves in interest rates gradual.

Other Factors Help Keep Yields Rangebound

Beyond the critical issue of Fed policy in 2012 there are a number of additional factors that should support a range-bound bond market and keep Treasury yields low relative to history including: sluggish economic growth, tightening fiscal policy, stable inflation and European debt developments.

• Sluggish Growth: The bond market became priced for recession during 2011. Avoiding recession is likely to lift yields, but our outlook for below average U.S. economic growth in 2012 keeps a lid on upward pressure on interest rates. Low growth means slack demand for borrowing (at least for the private sector) and less income growth to contribute to a broad rise in inflation.

• Tightening Fiscal Policy: Stimulus enacted in 2010 will begin to fade in 2012. Congress still needs to act in order to extend payroll tax cuts and unemployment benefits which are set to expire at the end of 2011. Furthermore, the Bush tax cuts are slated to expire at the end of 2012. And finally, the over $1 trillion in deficit reduction over the next 10 years, mandated by the August 2011 debt ceiling deal, would trigger broad based cuts to discretionary spending starting in 2013. The increasing economic drag from a slowing pace of government spending, combined with less need to finance a growing deficit, will likely be a factor throughout 2012 and help support bond prices and keep yields low. Stable Inflation: The pace of inflation more than doubled from late 2010to late 2011. While bond market pricing indicates a deceleration in inflation, we believe inflation rates are likely to simply stabilize at current levels. This may lift yields from current levels in 2012, but it would likely take continued acceleration to push yields sharply higher. Still, stable inflation should erode the premium embedded in Treasury valuations.

• European Debt Developments: The European summit in late October 2011 produced measures that were clearly a positive and remove the extreme risks in our view. However, details will be slowly forthcoming over the next several months and implementation risks remain. Bouts of safe haven buying of Treasuries may occur if delays or disruptions undermine market confidence or if European economic growth becomes weaker than expected and investors deem recently agreed upon safeguards as insufficient causing peripheral European government bond weakness. All of these factors lead to Treasury yields remaining low relative to history. The real, or inflation-adjusted, yield of the 10-year Treasury is likely to remain below the average of the past decade. However, as Chart 4 reveals, Treasury valuations remain more expensive than during the peak of the financial crisis — such a valuation is not warranted and is consequently unsustainable. Therefore, we expect the safety premium in Treasuries to slowly erode causing the 10-year Treasury yield to finish 2012 at the upper end of our 1.7 – 3% yield range. Assuming core inflation remains stable at 2%, a 3% 10-year Treasury yield results in a 1% inflation-adjusted yield. This is still more expensive than average, but far less extreme than the current valuation, relative to the period average.

Getting Credit

After stronger performance by the highest credit quality bonds in 2011, we believe the best potential for fixed income investors in 2012 remains in higher-yielding, more economically sensitive bonds, in particular High-Yield Bonds. Corporate bond valuations, both investment grade and high yield, still reflect a very high probability of recession, something that we believe only has a one-in-three chance of taking place. High-yield bond pricing reflects an expected surge in defaults, which we believe is unwarranted. After the typical once-per-decade surge in defaults in 2008 and 2009, we have seen the default rate plunge. Corporate bond credit quality is solid, with high cash balances on corporate balance sheets and solid profit growth supporting interest payments. Furthermore, we believe the impact of credit contagion from Europe is much less than feared. We believe that corporate bonds, both investment grade and high yield, could outperform Treasuries in 2012 by a substantial margin as they offer relatively high yields and rising prices — the opposite of what we are likely to see from Treasuries in 2012. This may lead to some convergence in yields among different bond sectors in 2012, as they meet in the middle.

Rising Yield Range and Converging Sector Yields

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 within a 1.7 – 3% range, but we expect them to rise over the course of the year, with the yield on the 10-year Treasury ending 2012 around 3%. The impact of ongoing economic growth will help to normalize interest rates as will a continuation of Fed policy, stable inflation and tightening fiscal policy. The wide gap between yields on government bonds and those of other borrowers is likely to converge in 2012.

Market-Moving Events in 2012

Major policy-driven events will converge on the financial markets in 2012. Europe’s debt dilemma will continue to grab headlines and move markets. The 2012 elections in the United States are likely to hold significant consequences for investors. And the outlook for growth and financial stress in China will garner attention from investors.

European Debt Dilemma: Better, but Not Over

The fear among some market participants is that a default by a European government will trigger the collapse of financial institutions and a crisis throughout Europe and beyond. This potential path echoes the chain reaction that followed the bankruptcy of Lehman Brothers in September 2008 that led to a global financial crisis.  In late October 2011, European policymakers crafted a ground-breaking agreement that addressed recapitalizing the banking system, created an orderly default by Greece and provided financial buffers against losses on future bond issuance among euro-zone members. All of these steps were in an effort to reverse the tide of money that flowed out of the European sovereign bond market and pushed up borrowing costs. These actions have averted a 2008-like financial crisis. However, over the long term, concerns remain about the outlook for economic growth in Europe and the ability of some countries to meet budget targets.

As hurdles to implementation of the debt plan are materializing, bond yields of some European nations have risen to levels that make progress on balancing budgets very difficult. There are seven European countries with yields over 6%. Italian and Spanish 10-year borrowing costs are near the 7% threshold that forced Greece, Ireland, and Portugal to seek bailouts in 2010.

The long-term success of these efforts is dependent upon European nations taking additional steps to adhere to their plans for achieving financial stability and deficit reduction. It is no coincidence that Greece, Italy and Spain have seen a change to their governments in 2011. Lack of enforcement of budget rules is a big part of what drove Europe to the current state. Going forward, the European policymakers want to ensure important steps are taken before extending additional support. We expect the passage of the difficult, but necessary, reforms among the troubled nations, including Italy, to return to a sustainable fiscal path as 2011 turns to 2012.

The concerns may be shifting from a crisis to a recession in Europe. It is likely that Europe will experience a mild recession next year. Some nations in Europe are already on the brink of, or have entered, mild recessions. However, European growth could be even weaker in light of the spending austerity and potential for less lending by the banks. The key to a successful European stabilization plan is for the European Central Bank to commit to the path of rate cuts established in November 2011 so as to promote growth and lending.

With every move in the stock market seeming to coincide with a headline coming out of Europe, it would be easy to conclude that this is the only issue that matters to investors. But stepping back from the day-to-day
and week-to-week trading, we can see a different, longer-term pattern of performance emerging — one that reflects a different focus entirely.

If we look back at the past five years, we can see that stocks have very closely tracked real-time economic data, as measured by the weekly tally of initial claims for unemployment benefits. It appears the issues in Europe over the past couple of years have merely created volatility around the true focus of investors on the fundamental economic backdrop that continues to slowly improve.

2012 Elections May Have Major Consequences

In 2011, the markets disliked the uncertainty and the bickering among a divided Congress. The elections in 2012 may bring a new Congress with a mandate for action and enough control by one party to accomplish it.

The key fight this election is over those in the middle. While those that identify with a party are unlikely to shift allegiance, independent voters are the swing factor. For example, 80% of Democrats approve of the job President Obama is doing, while only 12% of Republicans do. In the middle is the independent voter whose approval rating of the President has been fading and now stands at only 37%.

Before we share our insights into what is unique to this particular election for investors, we will present the typical pattern of performance in election years. Historically, the four-year presidential cycle of stock market performance has been driven largely by changes in monetary and fiscal stimulus to the economy. These changes are evident again in this cycle. In fact, the S&P 500 again traced much of its average performance during the presidential cycle.

However, there has been a deviation from the pattern with the decline in stocks in mid-2011. Stocks have begun to close this gap, but are unlikely to reconnect with the historical pattern of performance.

As we look out to the next year, it would seem that a flat year for stocks is in store, based on the presidential pattern. However, what is important to note is that while it is true that the first three quarters of a presidential election year are usually pretty flat, the fourth quarter is not and tends to break out. This breakout was to the upside in 1992, 1996 and 2004 and to the downside in 2000 and 2008.

Most often the breakout is to the upside as the uncertainty surrounding the fiscal and regulatory policy environment resolves. However, 2008’s dismal fourth quarter performance — as the global financial crisis erupted from the failure of Lehman Brothers — lowered the long-term average to reflect a fourth quarter dip.

The 2012 election is likely to be consequential for investors. There is a growing consensus that a plan to save about $4 – 5 trillion over the next decade is necessary to stabilize the debt-to-GDP ratio in the United States.  Despite the efforts of the “super committee” tasked with finding the $1.5 trillion agreed to in the terms of the debt ceiling deal crafted in early August 2011, a package this size is unlikely to become law before the election.  Since Congress is unlikely to pass a major deficit reduction bill before the 2012 election, the outcome will have major implications 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 WWII. While it is still early, it appears that the GOP will retain control of the House and may pick up enough seats to take control of the Senate by a modest margin, based on polling data and the fact that two-thirds of the seats up for election in the Senate are currently held by Democrats. Having both chambers in the hands of one party greatly increases the odds of policy action.

Failure to pass a major deficit reduction package in the wake of the 2012 election, regardless of what the rating agencies do, will likely result in a loss of faith by investors that the federal government will get on a fiscally sustainable path absent a financial crisis. Of course, this loss of faith could create a crisis, with major implications for the markets, and force a major deficit reduction deal.  Regardless of the details of the plan — and we have many proposals to choose from blending a mix of tax increases and spending cuts — most proposals phase in the impact so it is not until five years from now that the full impact would be felt. The cuts would likely be equivalent to about 3% of GDP, or about 14% of the federal budget. This would be one of the biggest policy shifts in modern U.S. history. While the markets may welcome a resolution of the uncertainty and a path to fiscal sustainability, certain areas of the market may feel the brunt of the cuts, such as Health Care and the Defense industry. Other asset classes may be impacted as well if changes are made to the tax advantaged status of municipal bonds for some taxpayers.

As we look out to the next few years, the old adage that the market likes “gridlock,” or balanced government between the two parties, may not hold. It is apparent in recent market performance that investors recognize that substantial, defining fiscal policy changes — difficult to forge in a divided Congress — are needed. We will be watching as the election battle heats up to gauge the market impact of what will likely be a very consequential election year.

Growth and Financial Stress in China

The outlook for China is important to the markets in 2012 on two fronts. First, China’s growth trajectory and composition is important to world growth. Second, the risk of a banking collapse in China may grab investor attention. China will likely grow about 8 – 9% in 2012, and avoid the “hard landing” scenario (5 – 6%) feared by some market participants. The slowdown they have planned and executed through what were originally thought to be crude means were remarkably effective. China is likely to shift from slowing speculative growth and inflation pressures to looking to maintain core growth in 2012.

Additionally, China’s transition to become more consumer driven may be evident in 2012. China derives one-third of its growth from consumer spending, but this is likely to gain share as a percentage of GDP over
the coming years as more urban consumers will desire more household appliances, electronics, healthcare and personal products. Rising city residency and steady full-time jobs are likely to lead to greater consumer credit availability and debt growth as the consumer economy matures.

However, on the negative side, Congress risks starting a trade war with one of our largest trading partners. There is already a bill that has passed the Senate that would impose tough tariffs on certain Chinese goods in the event of a finding by the Treasury that China was improperly valuing its currency to gain an economic advantage. The renewed trade pressure on China from the United States may result in more rapid currency appreciation versus the dollar further spurring a desire to grow domestic consumption in China.

A risk that may garner market attention is an overheated property market and overextended banking system in China. In some areas, China’s property markets are extended well beyond what is supported by the fundamentals. Bad loans in the Chinese banking system are on the rise and may increase sharply over the next several years. The Chinese banking system, for the most part, is the Chinese government. And the Chinese government has plenty of capital to help recapitalize the Chinese banking system if it becomes necessary. In fact, China has periodically recapitalized portions of its banking system several times in the past decade in order to continue to finance growth and avoid the social unrest that can come from rising unemployment. We do not expect a banking crisis to emerge in China in 2012, yet the headlines may provoke volatility.

There is the potential for many market-moving events in 2012 — either to the middle or the fringes. 2012 will be a year to watch how these events develop abroad and in our own backyard.

Investing in 2012

Rather than looking for a rock to hide under, investors should be looking under rocks to find investment opportunities in unusual places in 2012. While rising interest rates generally mean bonds should be avoided, not all bonds behave the dame way. Fortunately, other sectors such as high-yield corporate bonds are likely to provide solid returns. Also, it is natural to think that if global economic growth is going to be weak then stocks are to be avoided. However, investors may find attractive returns by investing in U.S. stocks, particularly cyclical, mid and small caps, and emerging market stocks.

Fixed Income Investing in an Environment of Rising Interest Rates

It would be easy to assume that the inverse relationship between bond prices and yield coupled with our forecast for modestly higher Treasury yields in 2012 would prompt us to recommend avoiding fixed income. Not all bonds behave the same way, however, and the potential to generate positive relative and absolute returns in a rising rate environment still exist. With the Fed on hold, the catalysts for higher rates will likely be modest growth prospects and rising inflation expectations. While negative for Treasuries, these drivers are positives for more economically sensitive highyield bonds. The prospect of rising rates, attractive valuations and improving fundamentals contribute to our thesis that high-yield bonds represent one of the best opportunities for fixed income investors in 2012.

High-yield bonds tend to demonstrate much less sensitivity to changes in interest rates than most high-grade fixed income sectors. Since 1983, the start of the Barclays Capital High-Yield Bond Index, the trajectory of Treasury yields has been a downward path, albeit with bouts of volatility. The 5-year Treasury yield, which shares about the same duration as high-yield bonds, has finished the year higher in just 11 of those 27 years. In each of those years, high-yield bonds generated excess returns over the Barclays Capital Aggregate Bond Index, with an average excess return of 6%. During the 16 years in which the 5-year Treasury yield finished lower, high-yield bonds underperformed by an average of 4% and outperformed 7 times. History suggests that if our forecast for higher Treasury yields at the end 2012 proves accurate, high-yield bond investors are poised to take advantage.

Since emerging from the financial crisis in 2009, fundamentals for high yield companies have steadily improved. Leverage ratios, measuring the indebtedness of U.S. corporations, have declined for eight consecutive quarters and may stabilize in 2012, similar to past credit cycles. Improved earnings results and a focus on de-risking balance sheets will enable companies to better meet their debt obligations going forward. Highly leveraged companies at the start of the Great Recession have either defaulted and are no longer operating or have restructured their debt and reduced their interest burden. The result is that surviving high-yield companies are better positioned to withstand an economic soft spot and should thrive in a slow to moderate growth environment.

Valuations on high-yield bonds are attractive in our view and appear to more than compensate for default risk. The average yield premium of high-yield bonds to Treasuries of roughly 7.5% implies a default rate of between 7 – 8%, a sharp increase from the 1.8% trailing 12-month default rate reported by Moody’s at the end of November 2011. While yield spreads may prove volatile and spike during periods of market stress, the default rate has historically been more stable and “double spikes” in the default rate have never occurred. Credit cycles last for several years and sharp downturns are followed by long periods of stability during which default rates have remained low.

Capital markets have proven extremely receptive to high-yield borrowers over the last three years and companies have taken advantage by refinancing their debt. Low rates on Treasuries have enabled companies to reduce their borrowing costs despite above-average yield spreads. Back in 2008, the impending wall of maturities coming due for high-yield companies raised concerns that the default rate could remain elevated for several years. High-yield companies responded by refinancing their debt and extending the maturity several years into the future. More than $200 billion of new issuance has come to market in 2011, second only to the record pace of 2010. Rather than engaging in shareholder friendly activity, 65% of the proceeds from new issuance have been used to refinance debt. 

The segments of the bond market that we believe may deliver the best rewards are: High-Yield Corporate Bonds, Municipal Bonds and Emerging Market Debt.

• High-Yield Corporate Bonds: We believe the best opportunities for fixed income investors remain in higher-yielding, more economically sensitive bonds, in particular high-yield bonds. Corporate bond valuations, both investment grade and high yield, still reflect a very high probability of recession; something that we believe only has a one-in-three chance of taking place. The high-yield bond sector reflects an expected surge in defaults, which we believe is unwarranted. Furthermore, we believe the impact of credit contagion from Europe is much less than feared. Corporate bond credit quality is solid with substantial cash balances in corporate America, coupled with strong profit growth supporting interest payments and continuing a low default rate.

• Municipal Bonds: We continue to find municipal bonds attractive for 2012. Top-quality municipal bond yields exceed those of Treasuries and have led to some of the most attractive valuations since spring 2009. However, the now lower level of yields suggests a slower pace of performance going forward and investors should temper expectations. We expect a mid-single-digit return for Municipal Bonds in 2012. A repeat of 2011’s high-single-digit return, which was fueled by panicky valuations at the start of 2011 and higher yields, is unlikely.

• Emerging Market Debt: Among global bonds, we find Emerging Market Debt attractive but would avoid foreign bonds, which contain exposure to Japanese and European government bonds. We still expect emerging market (EM) economic growth to be two or three times stronger than that of developed countries and find market concerns over a recession among emerging market countries as vastly overstated. While we find a greater opportunity in High-Yield Bonds, EM Debt valuations remain attractive — offering a greater than 3% yield advantage to comparable Treasuries. While we acknowledge that Treasury yields will continue to experience bouts of volatility during 2012, our bias is that they are unlikely to remain near record low levels and will ultimately finish the year higher. Rising rate environments do not necessarily translate into lackluster returns for all types of fixed income investments and high-yield bonds are likely to benefit. High-yield companies are well positioned to withstand a backdrop of below trend growth, given actions taken to reduce leverage and extend maturities. Default rates may increase modestly, but valuations more than compensate. High-grade bond investors may have to accept low single-digit rates of return, but high-yield investors have more reasons for optimism.

Stock Market Investing in a Sluggish Global Economy

It is natural to think that if global economic growth is going to be weak then stocks are to be avoided. However, despite our outlook for sluggish U.S. economic growth of about 2% and a mild recession for Europe in 2012, we expect high single-to low-double-digit returns for the S&P 500. We expect these gains to be driven by earnings growth in the high single digits and a modest rise in the PE ratio from recession-like levels as sentiment begins to rebound. Domestically, we expect stocks to decouple from U.S. GDP growth, as corporate profits are driven more by business spending and manufacturing than the more consumer spending-driven GDP. Overseas, while Europe is likely to experience a mild recession in 2012 and Japan struggles to rebound from recession, solid growth is expected in emerging economies benefitting a substantial 25% of U.S. corporate revenues. The net result is slow growth, rather than a contraction that would not favor stock market exposure.

Slow growth is not bad for the stock market. In fact, over the past 40 years, the S&P 500 median return is 10% when real GDP grows less than 3%. More important for stocks than domestic GDP growth is business spending, which we forecast to grow at several times the pace of consumer spending in 2012. In the third quarter of 2011, capital spending by businesses on equipment and software rose at a strong annualized rate of over 17%.

As the business cycle matures, growth often becomes variable. With the official end of the last recession in mid-2009, mid-2012 will mark three years of expansion. GDP and corporate profits have rebounded to an all-time high. As we progress from the early stage of rebound to the middle stage of slower and more variable growth, stocks still tend to provide solid returns — although lower than in the early years of the rebound. Looking back at mid-cycle years during the last two business cycles, 1995 and 2006, they experienced slower than-average economic growth but produced double-digit gains for the stock market. During those years, business spending increased at high single-digit to low double-digit rates, while consumer spending grew at a modest pace between 2 – 3%, similar to what we expect in 2012.

The stage of the business cycle can also be a guide as to where to invest within the equity market. Periods in the middle of business cycles tend to favor the most economically sensitive, or cyclical sectors, such as Industrials. Although there may be opportunities to move into defensive sectors in 2012 tactically over the course of what we expect will be another volatile year, we expect better returns from the more economically sensitive sectors. Stocks continue to price in a very pessimistic growth and profit outlook. While we believe the Wall Street analyst consensus for earnings growth is a bit too high for next year, we agree with the analysts that companies in more cyclical sectors are likely to grow earnings at a more rapid pace than those in defensive sectors in 2012.

In 2012, stock market investors may benefit from focusing on areas that are likely to be rewarded by the strongest areas of growth driven by business spending and emerging market demand: Commodity Stocks, Small and Mid Caps, and Emerging Markets.

• Commodity Stocks: The stocks of commodity producers are well positioned heading into 2012 due to their exposure to fast-growing demand from emerging market economies as well as their cyclicality. Very simulative U.S. monetary policy, a weak dollar and emerging supply constraints in several key commodities, including copper, should also be supportive. We believe these stocks will perform well if China‘s growth stabilizes (a soft landing) after deliberately slowing in the past couple of years. Commodity stocks are trading at below-average historical relative valuations despite the favorable, middle stage of the U.S. business cycle that has historically favored these stocks along with strong growth prospects in emerging market countries.

• Small- and Mid-Cap U.S. Stocks: We expect Small- and Mid-Cap U.S. stocks can provide attractive returns for investors in 2012. Smaller capitalization companies tend to perform better after the economy emerges from mid-cycle soft spots and credit markets improve. We expect Small and Mid Caps to benefit from increased merger and acquisition activity in 2012 due to the significant amount of cash, north of $1 trillion, on non-financial company balance sheets. Potential headwinds include less exposure to fast-growing emerging market economies. We believe Mid Growth is particularly well positioned due to the concentration in cyclical sectors.

• Emerging Markets: We see attractive return potential in 2012 for Emerging Markets as economic growth far exceeds that of the developed world. In addition, monetary policy is becoming more positive with central banks beginning to reverse course and cut interest rates. We see China averting a hard landing, growing in the 8 – 9% range rather than 5 – 6% as some fear. Emerging market economies in aggregate should only slow marginally in 2012 and still grow at about a 6% pace. A weaker US dollar may add to attractive Emerging Market returns in 2012.

In general, we caution investors not to ignore valuations to chase yield. We do not expect an emphasis on yield to be as rewarding in 2012 as it has been in 2011, since interest rates will likely rise and valuations for the highest yielding sectors leave less room for valuations to rise than the lower yielding, more cyclical sectors. Through November 2011, stocks in the S&P 500 yielding more than 3% have returned 4%, while those yielding less than 1% have matched the S&P 500 with essentially break-even returns.
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IMPORTAN T 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.
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.
Stock investing may involve risk including loss of principal.
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.
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. However, the value of fund shares is not guaranteed and will fluctuate. Corporate bonds are considered higher risk than government bonds but normally offer a higher yield and are subject to market, interest rate and credit risk as well as additional risks based on the quality of issuer, coupon rate, price, yield, maturity and redemption features.
Municipal bonds are subject to availability, price, and to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rate rise. Interest income may be subject to the alternative minimum tax. Federally tax-free but other state and local taxes may apply.
Credit quality is one of the principal criteria for judging the investment quality of a bond or bond mutual fund. As the term implies, credit quality informs investors of a bond or bond portfolio’s credit worthiness, or risk of default.
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.
Default risk is when companies or individuals will be unable to make the required payments on their debt obligations. Lenders and investors are exposed to default risk in virtually all forms of credit extensions. To mitigate the impact of default risk, lenders often charge rates of return that correspond to the debtor’s level of default risk. The higher the risk, the higher the required return, and vice versa.
High-yield spread is the yield differential between the average yield of high-yield bonds and the average yield of comparable maturity Treasury bonds.
Health Care Sector: Companies are in two main industry groups—Health Care equipment and supplies or companies that provide health care-related services, including distributors of health care products, providers of basic health care services, and owners and operators of health care facilities and organizations. Companies primarily involved in the research, development, production, and marketing of pharmaceuticals and biotechnology products.
Moody’s Inc. is an independent, unaffiliated research company that rates fixed income securities. Moody’s assigns ratings on the basis of risk and the borrower’s ability to make interest payments. Moody’s backs its ratings with exhaustive financial research and unbiased commentary and analysis.
Financials Sector: Companies involved in activities such as banking, consumer finance, investment banking and brokerage, asset management, insurance and investment, and real-estate, including REITs.
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.
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.
Information Technology Sector: 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.
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.
Utilities Sector: Companies considered electric, gas or water utilities, or companies that operate as independent producers and/or distributors of power.
The Federal Open Market Committee action known as Operation Twist began in 1961. The intent was to flatten the yield curve in order to promote capital inflows and strengthen the dollar. The Fed utilized open market operations to shorten the maturity of public debt in the open market. The action has subsequently been reexamined in isolation and found to have been more effective than originally thought. As a result of this reappraisal, similar action has been suggested as an alternative to quantitative easing by central banks.
Quantitative easing is a government monetary policy occasionally used to increase the money supply by buying government securities or other securities from the market.
Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity.

The Role of Insurance in Your Financial Plan

Insurance is an important element of any sound financial plan. Different types of insurance protect you and your loved ones in different ways against the cost of accidents, illness, disability and death. Generally speaking, the insurance decisions you make should be based on your family, your age and your economic situation.

Following is an overview of various types of insurance along with suggestions to make sure you are adequately covered.

Auto Insurance

Auto insurance protects you from damage to your vehicle and/or from liability for damage or injury caused by you or someone driving your vehicle. It can also help cover expenses you or anyone in your car may incur as a result of an accident with an uninsured motorist.

Auto liability coverage is necessary for anyone who owns a car. Many states require you to have liability insurance before a vehicle can be registered. However, state-required minimum coverage often does not provide adequate protection.

Suggested minimums are $100,000 for medical expenses per injured person, $300,000 for the total per accident and $50,000 for property damage. Collision, fire and theft coverage are also advisable for a vehicle having more than minimal value.

The cost of auto insurance varies greatly depending on many factors: the company and agent, your choice of coverage and deductible limits, where you live, the kind of vehicle to be insured and the ages of drivers in the family. Discounts are often available for safe drivers, nonsmokers and those who commute to work via public transportation.

Homeowner’s Insurance

Homeowner’s insurance should allow you to rebuild and refurnish your home after a catastrophe and insulate you from lawsuits if someone is injured on your property. Coverage of at least 80% of your home’s replacement value, minus the value of land and foundation, is necessary for you to be covered for the cost of repairs. There are several grades of policies, ranging from HO-1 to HO-8, with increasingly comprehensive coverage and cost. As a baseline, most homeowners’ policies cover the contents of the house for 50% to 75% of the amount for which the house is insured. The liability coverage in many homeowners’ policies is $300,000.

Life Insurance

Life insurance, payable when you die, can provide a surviving spouse, children and other dependents with the funds necessary to maintain their standard of living. It can also be used to help repay debt and fund education costs. The amount you need depends on your situation. If you make $100,000 a year, have a sizable mortgage and two kids headed to an expensive college, you could need $1 million in coverage.

Talk with an insurance agent who offers policies from companies whose financial strength is ranked high by rating agencies. And remember that you can shop around.

Helpful Resources:

• A.M. Best (908) 439-2200 ext. 5742

• Standard & Poor’s (212) 438-2400

• Moody’s (212) 553-0377

These agencies rank and rate insurance companies and can give you information about an insurance company’s financial strength. A small fee will be charged for these services.

Disability Income Insurance

When you are unable to work for an extended period, a long-term disability policy is activated, replacing a portion of your lost income. Some employers offer some form of company-paid disability income insurance. Typically, such coverage is only partial and/or short-term in nature. Thus, many people seek to purchase an individual disability income insurance policy. When shopping around for disability insurance, try to get a noncancelable policy with benefits for life, or at least to age 65, and as much salary coverage as you can afford.

Insurers will usually cover up to 65% of your salary. Generally, you should have total coverage equal to two thirds of your current pretax income.

Health Insurance

Most people enjoy medical insurance as an employee benefit, often with their employers paying whole or part of the premiums. Many employers offer a choice between HMOs (health maintenance organizations) and traditional fee-for-service care. Rates for HMOs are usually cheaper but have more constraints. Privately purchased health insurance is much more expensive — often by several hundred dollars a month — depending on such things as deductibles, coverage choices and where you live.

Long-Term Care Insurance

With an aging population and uncertainty about the future of Social Security and Medicare, insurance to cover the high cost of nursing home or at-home health care is becoming more widespread. Medicare pays very little of the cost of long-term care in the United States. Medicaid will pay for the care, but only for patients whose assets are almost completely depleted.1

With Congress always debating the future funding of these programs, financial planning for long-term care is more crucial than ever.

Medigap insurance can help pay medical expenses of the elderly not covered by Medicare. However, it does not cover custodial nursing home costs. In fact, about half of all nursing home residents pay for the care with personal savings.1


This article was is not intended to provide specific investment advice or recommendations for any individual. Consult your financial advisor, or me, if you have any questions.



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1Source: www.Medicare.gov.

Managing Cash Flow in Retirement: Careful Budgeting Is Still the Key

When retirement planning goes into reverse, shifting from accumulating assets to living off investment and other income, cash flow becomes critical.

The ultimate goal for most retirees is making sure their assets last as long as they live. And because of increasing longevity, managing cash flow is more critical than ever. A typical American electing to retire in his or her mid-60s may expect to live 20 or more years after retirement.

While many variables come into play depending on your income level, lifestyle and health considerations, there are a number of planning moves that can help retirees live within their means and make appropriate adjustments in response to changes in income and expenses.

Tools for the Task

If you are retired or about to retire, you will need to gather and organize key information before you can tackle the ongoing tasks of monitoring and managing your cash flow in retirement. The purpose is to give you a clear and complete picture of your current financial situation, as well as any significant changes you expect. Two sources will provide this information:

• An up-to-date net-worth statement, which provides a snapshot of your assets, debt and cash reserves.

• A monthly or annual budget, with itemized breakdowns of your income and expenses.

If you haven’t retired yet, it is a good idea to prepare a projected budget of your retirement income and expenses. Be sure to account for all expenses, including those that occur infrequently, such as insurance bills, college tuition and membership fees. They should be reflected in your monthly budget on a prorated basis. If you need assistance creating your net-worth statement and budget, you may want to consult a financial advisor, a book on the subject or resources that are available online.

Analyzing this information will reveal any major problems that you need to address, such as insufficient cash reserves for an emergency or an income shortfall compared with current or projected expenses. It may also point out areas for improvement. For example, you may be able to free up cash by reducing debt or eliminating nonessential expenses.

Regular Monitoring

Plans and projections are always subject to change. Even with reasonable assumptions about investment returns, inflation and living costs in retirement, it is likely you will encounter numerous changes to your cash flow over time. Frequent monitoring of your income and expenses will detect changes that you can address in a timely fashion to prevent significant problems down the road. Experts often recommend a monthly review of your budget, as well as a comprehensive annual review of your financial situation and goals. While you can keep track of your situation with paper and pen, specialized software may make the task easier.

What to Look For

What should you look for as you monitor your finances? Following are potential developments that could affect your cash flow and require adjustments to your plan.

• Interest rate trends and market moves may result in an increase or decrease in income from your savings and investments. For example, if interest rates decline, you may have to reduce your expenses if you are periodically withdrawing a fixed percentage from your investment assets. Or, you might consider adjusting your investment mix to pursue other sources of income aside from traditional fixed-income investments—such as dividend-paying stocks, for instance.

• Changes in federal, state and local tax rates and regulations. This factor may come into play if you relocate after retiring. The state you move to may impose higher income or property taxes, for example.

• Inflation and health care costs are two “unknown” variables that can have a dramatic impact on living costs and, hence, your retirement planning assumptions.

• Life events—such as marriage, the death of a spouse or the addition or loss of a dependent—may also affect your cash flow.

• Other factors that could have a bearing on your retirement cash flow include changes in Social Security and Medicare benefits or eligibility, as well as rules affecting employer-provided retiree benefits and private insurance coverage.

Cash flow is also a matter of personal preferences and decisions, and here you will be in control of the many small and not-so-small choices likely to be made over the course of your retirement. How much you spend on travel, entertainment, recreation and whether you live in a low- or high-cost locale are examples of factors that can have a significant effect on cash flow—and how long your retirement assets are likely to last.

These are many of the reasons why it is worth paying close attention to cash flow, making sure you budget carefully, monitor income and expenses frequently and take action whenever you see significant changes in income and expenses.

This article is not intended to provide specific investment advice or recommendations for any individual. Consult your financial advisor, or me, if you have any questions.

Your Retirement Checklist

Planning for retirement is a lifelong process. Whether you are just starting to invest or you are well into your working years, this checklist can serve as a starting point to help prepare you for this important financial goal.


Tips for Your Working Years …

One of the first and most important steps you can take is to estimate your retirement income needs. This task involves identifying your potential retirement expenses, as well as the amount you might receive from various sources of retirement income (e.g., Social Security, pensions, personal investments, etc.).

For Social Security, you should be receiving a personal statement of estimated benefits each year. If you aren’t receiving these statements, visit the Social Security website at www.ssa.gov. Of course, the exact amount of your Social Security benefits will depend on your earnings history. For information about your pensions, 401(k)s and other employer-sponsored retirement benefits, contact your company’s human resources or benefits administration department.

Calculating your estimated income from various sources will give you an idea of how much you may need to accumulate during your remaining working years to fill any income gaps. Do not be surprised if the numbers add up to a large sum—after all, this money may need to support you for 20 or 30 years. Fortunately, there are ways to make the most of your savings and investments.

Starting early and contributing as much as possible to employer-sponsored retirement plans and IRAs may help you to potentially accumulate more money. Why? Because investing in these tax-advantaged accounts means your money will work harder for you. The longer the money sits untouched, the more it can potentially compound.

Another vital step: Determine an appropriate asset allocation—how you divide your money among stocks, bonds and cash—for your portfolio. This should be based on your financial goals, tolerance for investment risk and time horizon. Be aware that your asset allocation will need to be adjusted periodically in response to major market moves or life changes.

… and for Those Approaching Retirement

Once you are nearing retirement, you will want to craft a solid plan for distribution of your assets. Do you know one of the greatest risks that retirees face? According to the Society of Actuaries, it is the possibility of outliving their money. That is why it is essential to determine an appropriate annual withdrawal rate. This amount will be based on your overall assets, the estimated length of your retirement, an assumed annual rate of inflation and an estimate of how much your investments might earn each year.

Another consideration: After age 70½, you will have to begin taking an annual withdrawal (also known as a required minimum distribution, or RMD) from some tax-deferred retirement accounts, including traditional IRAs. Preparing for this in advance may help reduce your tax burden—especially if your annual RMD may push you into a higher tax bracket.

Likewise, this is the time to make sure your final wishes are accurately documented and estate strategies are established to help minimize your heirs’ tax burden.

As you can see, planning for the different phases of retirement is a lifelong process. Following is a list that can help you along the way.

Retirement Planning Checklist

Find the category that best describes you, then answer the questions and bring the list to a qualified financial professional who can help make sure your retirement plan is on track.

Saving for Retirement

1. Have you performed a comprehensive retirement needs calculation?

2. Are you contributing enough to potentially reach your financial goal within your desired time frame by maximizing contributions to tax-advantaged retirement accounts, such as your employer-sponsored retirement plan and an IRA?

3. Is your asset allocation aligned with your retirement goal, risk tolerance and time horizon?

4. Have you determined if you might benefit from contributing to a traditional IRA or a Roth IRA?

5. Do you review your retirement portfolio each year and rebalance your asset allocation if necessary?

Nearing Retirement

1. Do you know the payout options available to you (e.g., annuity or lump sum) with your employer-sponsored retirement account, and have you reviewed the pros and cons of each option?

2. Have you considered your health insurance options (i.e., Medicare and various Medigap supplemental plans or employer-sponsored health insurance), out-of-pocket medical expenses and other related health care costs?

3. Have you contacted Social Security to make sure your benefit statement and relevant personal information are accurate?

4. Should you purchase long-term care insurance? If so, have you investigated which benefits are desirable?

5. Is your asset allocation properly adjusted to reflect your need to begin drawing income from your portfolio soon?

6. Have you determined an appropriate withdrawal rate of your assets to help ensure that your retirement money might last 20 or more years?

7. Have you figured the amount of your RMD and developed a strategy to reduce your tax burden once you are required to begin taking RMDs?

8. Have you appointed a health care proxy and durable power of attorney to take charge of your health and financial affairs if you are unable to do so?

9. Have you reviewed all your financial and legal documents to make sure beneficiaries are up-to-date?

10. Are you making effective use of estate planning tools (such as trusts or a gifting strategy) that could reduce your taxable estate and help you pass along more assets to your heirs while also benefiting you now?


Consult your financial advisor, or me, if you have any questions.

Comments by Burt White, Chief Investment Officer, LPL Financial, "Raising the Debt Limit"

The clock continues to tick towards the August 2, 2011 deadline when the United States debt ceiling limit will be reached. This limit is a key element of U.S. Government financial management. The U.S. Government is expected to receive about $175 billion in tax revenues for the month of August, but has $310 billion in monthly obligations that it needs to meet. As a result, the $135 billion in monthly shortfall is usually borrowed via the issuance of U.S. Treasury bonds. However, once the debt ceiling is met, the U.S. Government will not be able to issue new debt and will therefore, have to make significant decisions as it relates to what $135 billion or 44% of its “bills” it will delay payment on. That is, of course, if the debt ceiling limit is not raised by Congress and signed into law by the President.


While the rhetoric coming out of Washington has certainly transitioned from compromise to contention, it should not be overlooked that the divided parties are aligned on a few very important criteria that should bring a resolution closer to happening—namely that spending cuts should be enacted and that a more responsible government spending policy should be put in place to get a handle on the nation’s soaring national debt. In addition, both sides seem to now understand that the polarizing political view of revenue increases (the Democrats’ wish) and significant entitlement reform (the Republicans’ wish) are too significant a gap to overcome over the short term and are now virtually off the table.
Now, the only (and it is a big “only”) things that the two sides have to work out are: where the cuts in spending should come from, how long they will take to implement, and how much money they will save. The reality is that the two divided sides are not as far apart on the terms of a deal as they are from an ideological and political posturing perspective. Said another way: the two sides sound and act a lot further apart than their competing plans actually are.

We expect that the debate in Washington will continue over the next few days as the game of political ideological “chicken” plays out. However, our base case is that a compromise will be forged over the coming days and will result in either a short-term extension of the debt limit or, more likely, an agreement to raise the borrowing capacity of the United States Government until well into next year.

More importantly, even if a bill is not agreed upon and signed into law to raise the debt ceiling by August 2, we do not foresee the United States Government defaulting on its obligations. A default will occur if the government failed to pay the interest due on its debt. For the month of August, the interest due on Treasury bonds accounts for only $29 billion, which is easily met by the $175 billion in tax revenues that are expected. However, while a default would be avoided, the significant impact of dialing back $135 billion that could not be borrowed for other Federal services and obligations would have serious economic impacts.

While the debt ceiling debate has grabbed the headlines and is currently the most significant risk to the market, the underlying strength of the global economy remains solid. Moreover, several of the open-ended issues that have lingered for months are finally getting substantively addressed, including a plan for a second bailout of Greece, a stabilizing European debt crisis, and the re-emergence of Japan’s economic infrastructure from its terrible natural disaster in early spring. In addition, company earnings continue to be very strong as corporate America continues to benefit from a resurgent business reinvestment climate and a resilient consumer.

In the meantime, the current conditions support a cautious stance as the market is singularly focused on Washington. We expect that a resolution on extending the debt ceiling will ultimately be agreed upon, but not until the deeply divided government drags the nation and the market even further through the mud. But, on the other end of this self-imposed crisis stands an economic climate where businesses are earning near record profits, employment is improving, housing has stabilized, and consumers are once again revisiting the malls to spend. While the turmoil in Washington will invariably offer up several more nervous days as the debate lingers on, we believe that a relief rally for the market is around the corner once compromise replaces contention and unity trumps division.

As always, if you have questions, I encourage you to contact me.





__________________________________________________________
LPL Financial Member FINRA/SIPC


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Copyright 2011 – LPL Financial. All Rights Reserved.

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.

This research material has been prepared by LPL Financial.

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Coverdell, Custodial or 529? How to Choose

First the grim news: The cost of a college education has continued to increase at rates well above the general inflation rate in recent years. Now the good news: Your options for setting aside college money in tax-efficient investment accounts have increased as well. We’ll examine three of the most popular: 529 plans, custodial accounts and Coverdell accounts.

The Lowdown on 529 Plans

Created in 1996 and named after the section of the federal tax code that governs them, 529 plans are generally sponsored by individual states, but in some cases may also be sponsored by qualified educational institutions.

College savings plans—a type of 529 plan. Many of these plans are national plans: no matter which state or school sponsors them, residents of any state can participate.

The potential advantages of 529 plans include:

• Tax-free earnings — Earnings in a 529 plan accumulate free from taxes, and qualified withdrawals are federally tax free. Withdrawals may be exempt from state taxes as well (tax rules vary from state to state). Nonqualified withdrawals from a 529 plan may be subject to income taxes and a 10% additional federal tax.
• Gift tax benefits for contributors — A contribution to a 529 plan is considered a gift for federal tax purposes. Tax rules currently let you give up to $13,000 in 2011 to as many individuals as you choose, free from federal gift taxes. Gifting schedules can also be accelerated through a lump-sum contribution of $65,000 to a 529 plan in the first year of a five-year period.
• Generous contribution rules — Lifetime contribution limits on 529 plans vary from state to state, but often exceed $200,000 per beneficiary, including earnings. In addition, there usually are no income restrictions on contributors to a 529 plan.
• Account control — The individual who creates a 529 plan account on behalf of a beneficiary generally maintains complete control over the account. This is not the case with Coverdell Education Savings Accounts or certain types of custodial accounts. Account owners may also change beneficiaries.

Finally, contributions to 529 plans may provide a state tax deduction for residents of the sponsoring state. As with all tax-related decisions, consult your tax advisor. Withdrawals for expenses other than qualified education expenses are subject to income tax and an additional 10% penalty on earnings. You should consider a 529 plan’s fees and expenses such as administrative fees, enrollment fees, annual maintenance fees, sales charges and underlying fund expenses which will fluctuate depending on the 529 plan invested in and the investments chosen within the plan. You should also consider the inherent risks associated with investing in 529 plans, such as investment return and principal fluctuation, which will also vary based on the investments made within the plan. More information is available in each plan’s official statement, which should be read carefully before investing.

UGMA/UTMA Accounts: Awarding Custody

Of course, not all college savings strategies require the involvement of a college or a state government. For example, by following the guidelines established under the Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA)—each state uses one or the other—adults such as parents and grandparents can establish and contribute to a custodial account in a minor's name without having to establish a trust or name a legal guardian.

Contributing to an UGMA/UTMA account can accomplish two goals simultaneously: helping a future student prepare for college costs and reducing the value of a contributor's taxable estate. UGMA/UTMA accounts also offer favorable tax treatment of investment earnings. For example, the first $950 of earnings is tax free each year. If the minor is under 19, earnings in excess of $950 but not above $1,900 are taxed at the child's rate. If earnings exceed $1,900 for children under 19, the income is taxed at either the parents' rate or the child's rate, whichever is higher. If the child is older than 19, all income is taxed at his or her rate. Note that the age limit increases to 24 for a full-time student if the child doesn't have earned income in excess of half of his or her annual support.

Despite the obvious appeal of UGMA/UTMA accounts, it's worth noting that the assets in the account belong to the child, not to the contributor. When the child reaches legal adulthood at age 18 or 21, depending on the state, he or she is free to spend the money with no restrictions. In other words, contributors cannot force that individual to use the money for college costs.

Coverdell Benefits

Coverdells are qualified investment accounts that allow nondeductible contributions of up to $2,000 annually per beneficiary. Earnings in the account are not taxed, and as long as withdrawals are used for qualified education expenses, they are tax free as well. Assets in a Coverdell must be used before the beneficiary's 30th birthday. Keep in mind that the designated beneficiary of a Coverdell account is free to take withdrawals at any time, but any amount in excess of his or her qualified education expenses will be taxable as income. A 10% additional federal tax may also apply.

Coverdells also have a special feature unavailable with 529 plans: Qualified withdrawals may be used to pay for an elementary, secondary, or college education. Withdrawals from 529 plans can only be used for college expenses. Unlike 529 plans, Coverdells impose income eligibility limits on contributors. Single filers with modified adjusted gross incomes of more than $110,000 and joint filers with incomes of more than $220,000 cannot contribute.

The deadline to contribute to a Coverdell is generally April 15, the same deadline that applies to IRAs. Before making a decision about a Coverdell, evaluate the investment options, fees, and services offered by competing financial institutions that provide the accounts. Also, bear in mind that rules governing the Coverdell Education Savings Account will revert to 2001 rules in 2013 unless Congress reenacts them.

Finally, when choosing a college investment vehicle, remember that it may not be a “one or the other” decision. It may make sense for you to contribute to more than one type of account simultaneously. Speak with a financial and tax advisor about your particular needs.

Nearing Retirement? Financial Advice Is Critical

Retirement planning has become an uncertain—and much more stressful—exercise for most Americans.  Millions of workers watched their retirement nest eggs decline sharply in value in recent years, and “safe” investments such as money market investments and CDs have continued to offer relatively low short-term interest rates since then.  Aside from current market uncertainties, there are other more constant issues to consider, such as inflation and taxes.


Investors planning for retirement need to begin addressing some important questions well in advance of their actual retirement date: How much will retirement cost?  How will I pay for it?  How much can I spend each year and not run out of money?  Can I plan for retirement while also meeting other financial goals, such as educating children and paying off debt?

While it may be necessary to adjust your financial expectations for retirement or even postpone your retirement date, you can still achieve retirement security.  But to do so, you’ll want to engage the services of a financial planning expert.  Once retained only by the wealthy, financial advisors now assist all types of investors in making decisions about retirement.  In fact, perhaps one of the most common reasons for people to begin financial planning is to build a retirement fund.

Countdown to Retirement

Have you begun your countdown to retirement?  If so, a financial advisor can help you make a successful transition to the next stage of your financial life.  Following are some critical areas to address with your advisor a few years before you expect to retire.

• Determine what retirement will cost.  Many people enter retirement without the slightest clue as to what they want to do with their time or whether they have enough money to do it.  Will you continue to work part time?  Travel?  Maintain a second residence?  Make improvements to your existing home?  Be sure you plan how you’ll spend your time because that decision will have a direct impact on how much retirement will cost you.

• Assess your sources of retirement income.  Estimate the income and savings you can rely on during retirement.  How much will you receive from Social Security, a company pension, a 401(k) plan, or other employee-sponsored retirement accounts?  Contact the Social Security Administration at www.ssa.gov and or your employer’s retirement benefits representatives to obtain a report listing the estimated income from these sources.  In addition, you’ll want to confirm amounts in other accounts.  Do you have retirement assets accumulating in an IRA or a taxable investment account?  If your anticipated income does not equal or exceed your projected expenses, develop a plan to bring these two into alignment.

• Arrive at a spending limit.  Once you have a handle on expected income and expenses, calculate how much you can withdraw from your accounts each year without spending down your principal.  Your advisor can create various withdrawal scenarios based on forecasted investment returns, inflation expectations and other practical financial planning considerations.

Accounting for Uncertainty

In the past, calculating annual withdrawal amounts was done by means of simple spreadsheet analysis.  Fast forward to the present where sophisticated computer forecasting models, have become the preferred tools for dealing with the uncertainty around retirement planning. With more attention being paid to retirement planning, forecasting tools have enjoyed a renewed popularity in investment analysis. In an uncertain world, detailed financial planning tools can help provide peace of mind to investors by addressing some of the toughest retirement planning challenges. But remember, any forecasting tool, no matter how sophisticated, cannot predict the future. What’s more, forecasts are hypothetical, do not reflect actual investment results and are not guarantees of future performance. For this reason, you should think of forecasts as a starting point for discussion with your advisor, not as your ultimate planning solution.

Consult your financial advisor or me if you have any questions.

Tips for Maintaining a Good Credit Rating

For most Americans, debt is an essential financial tool for achieving a desired lifestyle. Therefore, it is important to establish and maintain a good credit rating if you intend to make substantial debt-financed purchases in the future.

Why Credit Is Important

It is important to establish credit if you plan to buy a home or automobile some day. Credit cards also provide a means of reserving a hotel room or obtaining cash while traveling.

If you are a college student, recent graduate or nonworking spouse, you can begin to establish credit by opening a savings or checking account in your own name. You can then apply for a department store credit card. Having someone else cosign a loan for you will also get you started.

Creating a positive credit history for yourself requires using your credit card intelligently. Following are some dos and don’ts to help you manage credit effectively:

• DO NOT charge more than you can easily pay off in a month or two.
• DO NOT be fooled into paying just the low minimum payment amount listed on a bill. Credit card issuers make money on interest; there is nothing they would like more than to have you stretch out payments.
• DO consistently pay your bills by the due date.
• DO use credit for larger, durable purchases you really need, rather than nondurables, such as restaurant meals that are better paid in cash.

Missing Payments

When you miss a payment, the information goes into your credit report and affects your credit rating. If you are judged a poor credit risk, you may be refused a home mortgage or rejected for an apartment rental. In addition, a prospective employer looking for clues to your character may dismiss your job application if your credit report reflects an inability to manage your finances. In most states, an auto insurer may put you into its high-risk group and charge you 50% to 100% more if your credit record has been seriously blemished within the last five years. Many property insurers also review credit histories before they issue policies.

How Credit Reporting Works

Credit reporting agencies gather detailed information about how consumers use credit. Businesses that grant credit regularly supply credit information to credit agencies that then compile this information into credit reports, which are sold to banks, credit card companies, retailers and others who grant credit.

Your credit report helps others decide if you are a good credit risk. This information should be supplied only to those parties who have a legitimate interest in your credit affairs, including prospective employers, landlords or insurance underwriters, as well as others who grant credit. The Fair Credit Reporting Act (FCRA), the federal statute that regulates credit agencies, requires anyone who acquires your credit report to use it in a confidential manner.

The following information is likely to appear in your credit report:

• Your name, address, Social Security number and marital status. Your employer’s name and address and an estimate of your income may also be included.
• A list of parties who have requested your credit history in the last six months.
• A list of the charge cards and mortgages you have, how long you have had them and their repayment terms.
• The maximum you are allowed to charge on each account; what you currently owe and when you last paid; how much was paid by the due date; the latest you have ever paid; and how many times you have been delinquent.
• Past accounts, paid in full, but are now closed.
• Repossessions, charge-offs for bills never paid, liens, bankruptcies, foreclosures and court judgments against you for money owed.
• Bill disputes.

Be Credit Smart

Like other areas of your life, your credit history requires maintenance. Even if you pay your debts on time, do not assume that your credit rating is flawless. Mistakes do occur.
FCRA entitles you to review information in your credit file. If you have been denied credit, the company denying credit must let you know and give you the name and address of the credit agency making the report. Once you have this information, you can send a letter to the agency and you will receive the information in your credit file, at no cost, within 30 days.

Obtain a copy of your credit report periodically and check it for accuracy. Federal law entitles you to a free credit report from each of the three national credit reporting companies—Equifax, Experian and TransUnion—once a year. To get yours, visit annualcreditreport.com. (Keep in mind that other websites claiming to offer “free” credit reports may charge you for another product or service if you accept a “free” report.) If you wish to dispute any information in your file, write the agency and ask them to verify it. Under the law, they are required to do so within a “reasonable time,” usually 30 days. If the agency cannot verify the information, it must be deleted from your file.

Consult your financial advisor, or me, if you have any questions.