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LP L FINANCIAL R E S E AR C H

Weekly Economic Commentary October 3, 2011

Does Data Matter? John Canally, CFA Economist LPL Financial

Highlights „„

Policy matters continue to trump actual data.

„„

Might this week’s batch of economic data actually matter?

Economic Calendar Monday, October 3 Construction Spending Aug

Challenger Layoff Announcements Sep

ISM Manufacturing Sep

Thursday, October 6 Initial Claims wk 09/30

Domestic Light Vehicle Sales Sep Tuesday, October 4 Factory Orders Aug

Friday, October 7 Private Sector Payrolls Sep

Bernanke Testimony

Unemployment Rate Sep

Wednesday, October 5 MBA Mortgage Applications Index wk 09/30 ADP Employment Change Sep ISM Nonmanufacturing Sep

Chain Store Sales Sep

Nonfarm Payrolls Sep Wholesale Inventories Aug Consumer Credit Aug

Since the mid-summer 2011 debate over the debt ceiling in the United States, policy at home and abroad (both fiscal and monetary) has dominated the investment landscape. During that time, financial markets here in the United States and across the globe have largely priced in a recession, with equity prices (as measured by the S&P 500 Index) down 15% since mid-July. While policy remains key (markets are still calling out for bold, coordinated policy actions here and abroad), economic and corporate data are likely to dominate the headlines this week, although there are plenty of policy events on tap as well. As we have noted in our recent commentaries, the U.S. economy remains fragile and vulnerable to an exogenous shock (i.e. an oil price spike, a massive natural disaster, large-scale terror attack, 2008-style credit crunch, a trade war, etc.) and to policy mistakes, both at home and abroad. However, our forecast remains that the economy will continue to sputter along, with growth in the third quarter better than the second quarter, in part, due to a rebound in auto production and auto sales. Our view remains that real gross domestic product (GDP) growth in the recently completed third quarter of 2011 will be between 2.0 and 2.5%, more than double the meager 0.8% annualized growth rate seen in the first half of 2011. Consumer spending, business capital spending, construction of nonresidential buildings and exports should help to boost GDP in the third quarter. Construction of housing and state and local government spending will continue to be drags on growth in the third quarter. Last week’s (September 26 – 30) relatively favorable economic and corporate data in the United States supported our view of slow growth but no recession and 14% year-over-year gains in profits in the third quarter. The S&P 500 Index was unchanged on the week, and was on course for a decent weekly gain until the last few hours of trading on Friday, September 30, the last trading day of the tumultuous third quarter of 2011. Over the next week, financial markets will digest key reports for September on consumer spending (vehicles sales, chain store sales), manufacturing (ISM), the service sector (non-manufacturing ISM), housing and construction, and the labor market (ADP, Challenger and the government's job report). With the market having already priced in a recession, the bar is relatively low for this set of data. Although data is likely to dominate this week, policy is not going away as a potentially market moving force. On the monetary policy front, Fed

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Chairman Bernanke is set to deliver testimony before the Joint Economic Committee of Congress on Tuesday, October 4, the very same day that Congressman Ron Paul of Texas, who chairs the committee in the House of Representatives that oversees the Fed, will hold a hearing entitled “Auditing the Fed.” In addition, there are six other public appearances by Fed officials on the docket this week. The Fed will release the minutes of its September 20 – 21 Federal Open Market Committee (FOMC) meeting next Tuesday, October 11. The next Beige Book, a qualitative assessment of business and banking conditions conducted in each of the 12 regional Federal Reserve districts prior to every FOMC meeting, is due out on October 19. The next FOMC meeting is on November 2. It is also a busy week for monetary policy outside the United States. The Reserve Bank of Australia (RBA), the Bank of England (BOE), the European Central Bank (ECB), the Bank of Japan (BOJ) and the central banks of Peru, Poland, Serbia, Kenya and Ghana all meet this week to set policy. Of these, only Serbia is expected by market participants to cut rates, but bold coordinated policy action (unexpected rate cuts, more quantitative easing, etc.) from the BOE, BOJ and ECB would be embraced by market participants. As we have noted for several weeks in the Weekly Economic Commentary, central banks that have been tightening policy over the past two years have either stopped raising rates, or begun to cut rates, as inflation risks fade amid a sharp slowdown in economic activity and prospects for future growth wane. Examples in this group include the central banks in Brazil, Russia, New Zealand, Israel and Australia, as well as the ECB. Most notably, China’s central bank has hinted in recent weeks that it is close to the end of its rate hike regime. China’s central bank does not meet on a set schedule, and a change in policy direction by the Peoples Bank of China (PBOC), China’s central bank, could come at any time. Meanwhile, central banks that have been cutting rates are looking to do more. Examples here include the Fed, the BOE and the BOJ. Two of these three central banks meet this week.

We expect that worries surrounding European debt will continue to weigh on market and economic sentiment for many months.

Fiscal policy remains at the heart of the ongoing market turmoil. Despite a vote in the German legislature last week to approve the European Financial Stability Fund — essentially a European version of the Troubled Asset Relief Program (TARP) — that will be used to recapitalize banks in Europe and help to forestall a default in Greece, financial markets remained worried. News over the weekend that rating agency Standard and Poor’s has reaffirmed the United Kingdom’s AAA rating will likely increase calls here in the United States for more budget cuts. Although the Greek government passed another round of budget cuts over the weekend of October 1 – 2, it also said that the cuts were not enough to effectively reduce the deficit to the level required by the European Central Bank, the European Union and the International Monetary Authority, known as “the troika”, so that Greece could secure its troika-led aid payout and avoid default. We expect that worries surrounding European debt will continue to weigh on market and economic sentiment for many months.

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Does Data Matter?

1 The ISM Report Continues to Point to Economic Growth, Not Recession

67.5

As previously noted, this week is chock full of key economic data in the United States for September. The two most important reports, the September Institute of Supply Management report on manufacturing (ISM) and the September employment report, bookend the week.

ISM Manufacturing: PMI Composite Seasonally Adjusted, 50+=Increasing Consensus Estimate

60.0 52.5 45.0 37.5 30.0

90

95

00

05

10

Source: Institute for Supply Management, Haver Analytics 10/03/11 (Shaded areas indicate recession) The ISM index is based on surveys of more than 300 manufacturing firms by the Institute of Supply Management. The ISM Manufacturing Index monitors employment, production inventories, new orders, and supplier deliveries. A composite diffusion index is created that monitors conditions in national manufacturing based on the data from these surveys. Purchasing Managers Index (PMI) is an indicator of the economic health of the manufacturing sector. The PMI index is based on five major indicators: new orders, inventory levels, production, supplier deliveries and the employment environment.

As this report was being prepared one of the many key economic reports due out this week was released. The September ISM reading was 51.6, an improvement from the August reading of 50.6, and well above the consensus estimate of 50.5. In fact, only 10 of the 82 economists surveyed by Bloomberg News expected the ISM to be above 51.5. As a reminder, a reading above 50 on the ISM report indicates that the manufacturing sector is expanding, while a reading above 42.0 indicates that the overall economy is expanding. Year to date, the ISM has averaged 56.2, consistent with GDP growth of 4.8%. All of the key components of the report (employment, new orders, production, and export orders) were also solid, suggesting further growth in the manufacturing sector in the months ahead and, importantly, no recession. The other key report due this week is the monthly labor market report from the United States Bureau of Labor Statistics (BLS). This report is due out on Friday, October 7. Proceeding that report the market will also digest September reports on private sector employment from ADP and layoff announcements from outplacement firm Challenger, Gray and Christmas. The BLS report is actually two reports in one. A survey of households is used to calculate the nation’s unemployment rate, which stood at 9.1% in August. The consensus expects that the unemployment rate will remain at 9.1% in September. The unemployment rate is calculated by dividing the number of people who are unemployed (roughly 14 million) by the number of workers (153 million). The high unemployment rate intensifies the spotlight on the Fed, Congress and the Obama administration to enact policy and/or remove regulatory constraints to help foster a better backdrop for job creation. While the unemployment rate data is culled from a survey of households, the monthly job count is calculated from a survey of 140,000 businesses and government agencies representing approximately 410,000 worksites throughout the United States. Recall that the private sector created just 17,000 jobs in August, below the consensus estimate of a 95,000 gain. In addition, a strike at Verizon (which has since settled) subtracted 46,000 jobs in August, meaning the August result was more like +63,000, still a deceleration from the +156,000 gain in July. The consensus for the September report is that the private sector economy created 90,000 jobs in September, with about half of the gain coming as a result of the end of the strike at Verizon. The low end of the consensus range calls for a 20,000 gain in jobs. While the returning workers at Verizon are likely to add to the private sector job count in September, the overall payroll count (public and private sector) will again be weighed down by hiring (or lack thereof) at state and

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The bottom line is that the labor market is stalled out, a hostage to a great deal of economic and policy uncertainty both in the United States and overseas.

local governments, and more specifically, teachers. On balance, the recent data on employment — hours worked, initial claims for unemployment insurance, the employment readings of the various regional Federal Reserve surveys and the employment component of the September ISM report — continue to suggest that the labor market remains stagnant, but is not falling off a cliff as it did in 2008 and 2009. The bottom line is that the labor market is stalled out, a hostage to a great deal of economic and policy uncertainty both in the United States and overseas, leaving the labor market vulnerable to further shocks.

IMPORTANT DISCLOSURES The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. Stock investing involves risk including loss of principal. An obligation rated 'AAA' has the highest rating assigned by Standard & Poor's. The obligor's capacity to meet its financial commitment on the obligation is extremely strong. Challenger, Gray & Christmas is the oldest executive outplacement firm in the United States. The firm conducts regular surveys and issues reports on the state of the economy, employment, job-seeking, layoffs, and executive compensation. The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. International investing involves special risks, such as currency fluctuation and political instability, and may not be suitable for all investors.

This research material has been prepared by LPL Financial. The LPL Financial family of affiliated companies includes LPL Financial and UVEST Financial Services Group, Inc., each of which is a member of FINRA/SIPC. To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial is not an affiliate of and makes no representation with respect to such entity. Not FDIC or NCUA/NCUSIF Insured | No Bank or Credit Union Guarantee | May Lose Value | Not Guaranteed by any Government Agency | Not a Bank/Credit Union Deposit

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Weekly Market Commentary October 3, 2011

The Pink Swan Jeffrey Kleintop, CFA Chief Market Strategist LPL Financial

Highlights A “black swan” event — a rare, unexpected event that has a major impact — is most often referred to as something with negative consequences. Investors have sharply discounted the odds of a positive surprise, or “pink swan” event. While investors fret over black swans, there are a number of potential pink swans that could take place and grab investors’ attention in the weeks ahead. While they may be hard to see at the moment, there are potential pink swans that could result in stronger-than-expected growth over the longer term: a clear path to U.S. fiscal sustainability could emerge in the next few years; China’s consumers could begin to become a powerful force and drive global demand growth; and new technologies could greatly improve resource productivity.

A “black swan” event — a rare, unexpected event that has a major impact — is most often referred to as something with negative consequences. The near-record low investor confidence readings and double-digit decline in the stock market during the third quarter reflect concern that the odds have sharply increased that a black swan event may take place. It is easy to cite a few of them: a European financial crisis; a U.S. recession; a fiscal debacle in Washington. However, investors have just as sharply discounted the odds of a positive surprise, or “pink swan” event. Given the pessimistic tone of investors, the pink swan may have the bigger potential market impact. Last week the U.S. economic data came in better than expected and progress was made on the European debt problem with Germany’s ratification of the expansion of the European Financial Stability Facility. However, this provided little relief to investors as stocks were basically unchanged on the week and remained near the low end of the 1100 to 1200 range the S&P 500 Index has been stuck in for the past two months. While investors fret over black swans, there are a number of potential pink swans that could take place and grab investors’ attention in the weeks ahead: ƒƒ The employment report is released this week and could surprise to the upside. Recent economic data has been better than expected, with the index of leading indicators rising for the fourth consecutive month and initial claims for unemployment benefits falling below 400,000 last week for the first time since April. These indicators may surprise investors braced for weak data. ƒƒ Next week the third quarter earnings reporting season gets underway. Corporations were able to post double-digit earnings per share gains in the first and second quarters despite U.S. gross domestic product (GDP) growth that averaged less than 1%. Third-quarter GDP may have been more than twice the first half average, supporting continued solid earnings growth despite low expectations by investors priced into stock valuations. ƒƒ Further signs may emerge in the coming weeks that Germany is supporting the euro zone as evidenced by the wide margin of passage on the German vote for the expansion of the European Financial Stability Facility (EFSF). Based on the success in Germany of the EFSF vote, the European Commission may introduce a proposal for so-called eurobonds

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to the parliament. The potential for the adoption of a long-term solution to the European debt problems would be a confidence boost where it is needed most.

1 Median Home Prices Have Been Relatively Unchanged Since the Drop in 2009 240 230 220 210 200 190 180 170 160 150 02

U.S. Median Existing Home Price (in Thousands)

03

04

05

06

07

08

09

10

11

ƒƒ China may surprise by cutting rates. After hiking rates and restraining growth and inflation pressures over the past couple of years, China has recently declared victory over its inflation problem and could return to a more pro-growth policy after economic growth slowed from about 12% to 9% in the past year and a half. This would be a surprise positive for the markets — particularly commodities.

12

Source: LPL Financial, National Association of Realtors data 10/02/11

S&P 500 Double-Digit Quarterly Losses Usually Followed By Solid Gains Quarter of S&P 500 Double-Digit Decline

Magnitude of S&P 500 Double-Digit Decline

S&P 500 Performance in the Following Quarter

2Q 1962

-21.3%

2.8%

2Q 1970

-18.9%

15.8%

4Q 1973

-10.0%

-3.7%

3Q 1974

-26.1%

7.9%

3Q 1975

-11.9%

7.5%

3Q 1981

-11.5%

5.5%

4Q 1987

-23.2%

4.8%

3Q 1990

-14.5%

7.9%

3Q 1998

-10.3%

20.9%

1Q 2001

-12.1%

5.5%

3Q 2001

-15.0%

10.3%

2Q 2002

-13.7%

-17.6%

3Q 2002

-17.6%

7.9%

4Q 2008

-22.6%

-11.7%

1Q 2009

-11.7%

15.2%

2Q 2010

-11.9%

10.7%

3Q 2011

-14.3% Average

5.6%

Average ex-losses

9.4%

Source: LPL Financial, Bloomberg data 10/02/11

ƒƒ The Federal Reserve’s last effort to help the economy, the so-called Operation Twist, could spur home buying as it creates the lowest mortgage rates in history. Already low rates helped to lift existing home sales 18% over the past year and new home sales are up 6%. A rise in home prices, with median home prices basically unchanged since the freefall ended in early 2009 [Chart 1], would be a welcome surprise. ƒƒ It is possible that the “super committee” tasked with finding the minimum of $1.5 trillion in deficit reduction by the end of this year as part of the debt ceiling legislation passed in August may succeed and recommend real fiscal reform. The bar is low. Many political pundits expect the group to fail by only finding a fraction of the intended deficit reduction, resulting in an automatic sequester to discretionary spending, the outcome largely reflected by markets. ƒƒ Over the past 50 years, when stocks post a double-digit decline in a quarter they typically rebound 6% during the following quarter. Out of the 16 times the S&P 500 has registered a double-digit loss during a quarter, 13 of those times — or over 80% of the time — the following quarter posted a gain and those gains averaged 9%. It is worth noting that the month of October is historically the month that typically ends stock market slides as the market begins to reverse declines. ƒƒ Looking beyond the next several weeks or months, we continue to expect a below average growth environment in the years ahead. However, while they may be hard to see at the moment, there are potential pink swans that could result in stronger-than-expected growth. ƒƒ A clear path to U.S. fiscal sustainability could emerge in the next few years. The current political gridlock may give way to action after the 2012 elections as rising interest costs force broad fiscal reforms. ƒƒ China’s consumers could begin to become a powerful force and drive global demand growth rather than just the growth in the global supply of goods. Employment and incomes are rising sharply in China. While domestic consumer spending currently only accounts for about one-third of China’s GDP it is rising quickly. The United States is the world’s largest manufacturer. U.S. companies would benefit from solid growth in Chinese consumer spending.

The S&P 500 is an unmanaged index, which cannot be invested into directly. Past performance is no guarantee of future results.

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2 Rise in Patent Grants May Boost Productivity 150 140 130 120 110 100 90 80 70 60 50 40 30 20 66

Non-Farm Productivity (Left Axis) U.S. Patents (Shifted Forward 3 Years) (Right Axis)

250,000 200,000 150,000 100,000 50,000

71

76

81

86

91

96

01

06

11

0

Source: LPL Financial, Bureau of Labor Statistics, U.S. Patent Office data 10/02/11

ƒƒ New technologies could greatly improve resource productivity. There is a correlation between patent grants and productivity a few years later [Chart 2]. The United States is currently saddled with a backlog on new patent requests; however, this logjam is beginning to break. If recent efforts at patent reform are combined with an increased emphasis on providing protection to new ideas we could see an explosion of efforts driving innovation and creating new products. With consumer, business, and investor confidence readings near historic lows it is hard for negative black swan events to surprise an unprepared marketplace. Alternatively, with so few expecting positive developments it is more likely that a pink swan event is the true outlier with the most potential market impact.

IMPORTANT DISCLOSURES The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful. Debt-to-GDP is a measure of a country’s federal debt in relation to its gross domestic product (GDP). By comparing what a country owes and what it produces, the debt-to-GDP ratio indicates the country’s ability to pay back its debt. The ratio is a coverage ratio on a national level. Correlation is a statistical measure of how two securities move in relation to each other. Correlations are used in advanced portfolio management. 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. International and emerging markets investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors. The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

This research material has been prepared by LPL Financial. The LPL Financial family of affiliated companies includes LPL Financial and UVEST Financial Services Group, Inc., each of which is a member of FINRA/SIPC. To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial is not an affiliate of and makes no representation with respect to such entity. Not FDIC or NCUA/NCUSIF Insured | No Bank or Credit Union Guarantee | May Lose Value | Not Guaranteed by any Government Agency | Not a Bank/Credit Union Deposit

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Does Data Matter