LP L FINANCIAL R E S E AR C H

Weekly Market Commentary
January 20, 2009
v4

The First 100 Days
Jeffrey Kleintop, CFA
Chief Market Strategist LPL Financial

Although the S&P 500 is down 6% so far this year, it remains solidly within the range it has been in over the past three months. We expect that the stock market may remain range-bound over the next 100 days or so, but we have noted some positives amid the gloomy economic reports: Credit markets continue to heal – corporate bond credit spreads have narrowed, mortgage-backed bond spreads have also narrowed, corporate bond issuance over the past two weeks was the strongest in eight months, LIBOR has narrowed to Treasuries, and commercial paper activity has increased. Volume is returning to the market and volatility is subsiding. Even intraday volatility is down. The 5-10% intraday swings have subsided as buyers and sellers are coming closer to agreeing on a fair value price for stocks – a sign that fundamental analysis, rather than panic, is beginning to return to Wall Street. The number of advancing stocks less those that are declining on the NYSE remains on an uptrend reflecting more signs of health even as the overall index remains in the bottom half of the trading range. This suggests that it has been a relatively small number of stocks (Financials are down 22% this year) weighing on the index recently. These positives are balanced by the challenges in the weeks ahead including the fourth quarter earnings reports and the gloomy economic data on employment, consumer spending and manufacturing. In addition, the new president faces many challenges and his response will shape the performance of the markets. That said, the next 100 days we will likely see a flurry of legislative activity that may impact the markets. While this may include market-moving legislation making it easier to unionize and expand the State Children’s Health Insurance Program (including a tobacco tax hike), the most significant piece of legislation in the next few weeks will be the fiscal stimulus program. It may bolster confidence in the economy and markets or it may fall short and disappoint the market by not being put to work quickly enough. Most of the priorities on the spending and tax stimulus have been communicated. The initial stimulus will be about $800 billion over two years, with about a 70/30 breakdown between spending and taxes. Spending will go toward infrastructure, aid to state governments, and more benefits to unemployed workers. The main component of the tax cut will come as a refundable tax credit for most workers to be delivered through lower payroll tax withholding. There has been a lot of talk from policymakers in recent weeks about what changes in the bank rescue plan Obama will pursue. Last week’s
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Highlights
Following on the heels of the inauguration the next 100 days will likely be a flurry of legislative activity that is likely to impact the markets. We expect the stock market may remain range-bound over the next 100 days or so, but we have noted some positives amid the gloomy economic reports. The uncertainty and potential for negative consequences as a result of new policy actions may weigh on the market. The last time a President was inaugurated with similarly aggressive and wideranging stimulus plans - it was March 1933, during FDR’s term, in which the stock market gained about 80% within the first 100 days. Beyond domestic concerns, there are many geopolitical issues confronting the new president and congress that may affect the markets including Iran’s nuclear program, tensions between nucleararmed India and Pakistan, and Russia’s expanding sphere of control, among others.

W E E KLY MARKE T COMME N TAR Y

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Healthy Trend
Cumulative Advance-Decline Line for NYSE

moves to inject more capital into Bank of America and guarantee assets, the mortgage “cramdown” restructuring at Citigroup, and the Senate’s failure to reject the second half of the TARP programs $700 billion suggests an increasingly active response with the potential for some form of nationalization for some banks, an increase to the size of the TARP and , a return of the plan to purchase distressed assets from the banks. Obama is likely to propose measures to help the housing market; however, how aggressive they will be is unknown. Targeting lower mortgage rates through purchases of agency mortgage-backed securities and explicitly guaranteeing GSE debt, giving financial assistance to homebuyers, using TARP money for foreclosure relief, and changes to bankruptcy laws are possible. There may be a focus on protectionist policies and others that weaken the dollar in order to encourage aggressive policy actions to address the crisis in Europe and Asia rather than allowing those nations a free-ride on the U.S. stimulus program. Notably, the Obama team economists have projected that the stimulus program will boost GDP by 3.7% over two years and result in the net creation of 3.7 million jobs by the end of 2010 resulting in a peak unemployment rate of 8%, not too far from the current 7 .2%. Uncertainty and potential for negative unintended consequences of the policy actions may weigh on the market. I think it is worth looking back to the last time that a President was inaugurated with similarly aggressive and wide-ranging stimulus plans - it was March 1933 in the midst of the Great Depression. In 1933, FDR’s spending drove the budget deficit to 7 .8% of GDP In 2009, the Congressional Budget Office estimates that Obama’s . deficit spending will total an even larger 8.3% of GDP During the first . 100 days after his inauguration, a record number of bills were passed in congress. In addition, he addressed the banking crisis through guarantees by proposing deposit insurance. During the first 100 days of FDR’s term the stock market gained about 80%. Beyond the domestic concerns, there are many geopolitical issues confronting the new president and congress that may affect the markets: Obama has made it clear he intends to follow General Petraeus’ surge strategy in Afghanistan. The intention is to increase the number of troops in Afghanistan and intensify the pressure on the Taliban to give up more militant elements. This may result in the inclusion of the Taliban in a coalition government similar to the strategy in Iraq with the Sunni insurgents. The potential for a wide range of outcomes in this first thrust of Obama’s foreign policy may impact markets. President Obama has reiterated publicly that he intends to engage Iran. Obama said there would be a “a new emphasis on respect and a new emphasis on being willing to talk, but also a clarity about what our bottom lines are. In mentioning clarity on the bottom line, Obama signaled that ” he would continue the Bush administration’s policy on opposing Iranian nuclear weapon development. Obama appears to be signaling a shift in approach to Iran without changing policy goals. What will Obama offer the Iranians in return for their compliance?

Jul-08 Aug-08 Sep-08 Oct-08 Nov-08 Dec-08 Jan-09 Source: Bloomberg, LPL Financial Research

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W E E KLY MARKE T COMME N TAR Y

The tensions are high between India and Pakistan over the links to the Mumbai attacks. This could lead India and Pakistan to exchanging nuclear threats as they did in 2002 after an attack on the Indian parliament. Military action could topple the weak Pakistani government. Not only is Pakistan the home of the al Qaeda leaders, it also is home to a number of jihadist groups including the Afghan Taliban. This type of anarchy could give the jihadists an opportunity to exert political control as they have in Afghanistan and Somalia – the difference is that Pakistan is nuclear-armed and may require some form of U.S. intervention. Russian aggression in Eastern Europe is focused on Ukraine and other former Soviet states. Georgia proved that Russia is serious in taking control of border states. Russia may make another land grab in early 2009 as the transition to the new U.S. administration leaves U.S. foreign policy potency at its weakest. Escalating drug cartel violence in Mexico has resulted in the assassination of high level government officials. If Mexican President Calderon is killed, the stability of Mexico could dramatically deteriorate. No one would be in charge because the constitution does not explicitly give any one person power over the country during the time between a president’s incapacitation and the senate’s election of an interim president. The division between the two parties may result in a significant delay before a new president was elected. Given the military’s weakness it would likely be hard-pressed to maintain comprehensive control over the country in the face of massive, country-wide protests. According to a recent U.S. Forces Command report, if the political chaos in Mexico spiraled out of control the United States could be forced to intervene. With crude prices having plummeted and international credit unavailable, Venezuela will have to start making some difficult decisions. Higher taxes, cuts to social programs, and fewer subsidies and unrest could result. The potential for strife could have the potential to disrupt U.S. energy supplies. While there are some uncertainties regarding the President’s first 100 days, much of the intended actions have been communicated already. It is more likely the responses to the unexpected events and information that are likely to shape the investment environment for better or worse.
IMPORTANT DISCLOSURES Investing in international and emerging markets may entail additional risks such as currency fluctuation and political instability. Investing in small-cap stocks includes specific risks such as greater volatility and potentially less liquidity. Stock investing involves risk including loss of principal Past performance is not a guarantee of future results. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rate rise and are subject to availability and change in price. 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.
This research material has been prepared by LPL Financial. The LPL Financial family of affiliated companies includes LPL Financial, UVEST Financial Services Group, Inc., Mutual Service Corporation, Waterstone Financial Group, Inc., and Associated Securities Corp., each of which is a member of FINRA/SIPC.
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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