LP L FINANCIAL R E S E AR C H

Weekly Market Commentary
April 21, 2008
v4

What Does Climate Change Mean For Investors?
Jeffrey Kleintop, CFA
Chief Market Strategist LPL Financial

Highlights
April 22 is Earth day, which marks the anniversary of the birth of the modern environmental movement. While environmental regulations are nothing new, the next major round of environmental regulations has the potential for far more sweeping effects on businesses than those already in place. The broad market impacts of climate change initiatives include: potentially higher inflation; advantages for large-cap stocks over smallcap stocks; rising commodity prices; favorable influences for the Industrial, Information Technology, and Financial sectors; and negative influences for Consumer Staples and Utilities sectors along with the Automobile industry. Climate change is a market force that will be shaping decisions for years to come, and markets are beginning to react now. However, climate change exposure should not be the sole reason for making any investment, especially since these initiatives remain in their early stage and are likely to have only a minor influence on the performance of the underlying companies, industries, sectors, or asset classes. We will continue to actively monitor climate change initiatives for the potential impact on investors.

Last week’s 4% gain in the stock market has helped the S&P 500 recover much of the year-to-date losses with a 10% rebound from the lows of midMarch. The Dow Jones Industrial Average hit a three month high on Friday. The gains were driven by the solid earnings results and guidance from a number of key companies, and increasing signs that the worst of the credit crisis is over. Market participants are beginning to shift their attention to future improvement in business trends and away from lagging indicators like last week’s weak economic reports on housing and employment. The stock market continues to follow the pattern of past financial crises where steep declines were followed by sharp rebounds, such as those experienced in 1990 and 1998. [chart 1] As investors begin to look forward to the second half of the year, we are inspired to look even further to the horizon to see what changes may affect the markets in the coming years. Climate change stands out as a market force that will be shaping decisions for years to come. April 22 is Earth day, which marks the anniversary of the birth of the modern environmental movement. This movement can cite some important successes. Environmental efforts established many years ago are paying off with: Cleaner air measured by fewer smog days in cities, and lower levels of ozone, sulfur dioxide, and carbon monoxide – Toxic chemicals like dioxin and PCBs are down more than 90% since 1980. Cleaner water, with municipal water supplies showing ongoing improvement – Lead, mercury, and arsenic levels have declined sharply. The return of some species from endangered status due to the restoration of natural habitats. The regulatory changes of the environmental movement had positive consequences for citizens. They also had material impacts on businesses. Costs rose as businesses were forced to clean up wastewater, scrub emissions, and adopt more sustainable operating procedures. Many companies embraced the changes and invested in community projects intended to restore natural environments, which helped to improve corporate image. The movement also led to the development of new energy efficient products and technologies and gave birth to alternative energy companies. The next major round of environmental regulations has the potential for far more sweeping effects on businesses. With each of the three major U.S. presidential candidates proposing climate change initiatives and states already leading the way, climate change is a market force that will be shaping decisions for years to come, and markets are beginning to react now. Policy

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W E E KLY MARKE T CO MME N TAR Y

1

Stocks Tracking 1990 Pattern
S&P 500 Pattern of Performance During 1990-91 Decline and Current
7/6/90 - 2/8/91 10/4/07 - present

5% 0% -5% -10% -15% -20% -25%

makers and business leaders are increasingly embracing climate change initiatives, and we believe the political support of climate change mitigation and adaptation policies is gaining momentum. Because our research is focused on the financial markets and not on environmental science, we do not debate the rights and wrongs of the science. We focus on what matters to investors: the response of markets, sectors, legislative policies and companies to the opportunities and risks that will be posed by climatechange initiatives in the coming years. Many elements factor into evaluating the long term net impact of climate change for the markets overall, including the effectiveness and cost of the initiatives, the impact of climate change on economic growth, and the lengthy time period over which success must be measured. However, in the shorter-term, we can assess the positive and negative impact across asset classes, sectors, and industries. The broad market impacts of climate change initiatives include:

10-4-07

10-25-07

11-15-07

12-7-07

12-31-07

1-23-08

2-13-08

3-6-08

3-28-08

4-18-08

5-9-08

5-30-08

6-20-08

Source: Bloomberg, LPL Financial

Higher potential inflation – Inflation may result as indirect costs formerly borne by the environment become incorporated into the direct costs of goods and services. The magnitude of rising prices and the offsetting forces are difficult to gauge. Rising inflation pressures are a negative for all financial assets, but more negative for bonds, growth stocks, and smaller caps. Advantages for large-cap stocks over small-cap stocks – The marginal cost of adopting climate change initiatives for larger companies is lower than for small to medium-sized firms. The benefits of scale and global sourcing when implementing environmentally-friendly packaging, fuels, raw materials, and processes are significant. Larger firms are better able to sustain start-up costs and leverage first-mover brand advantages. Rising commodity prices – While the impact of technology and innovation to spur increased production and high quality yields of crops, produce, and livestock should not be underestimated, commodity prices may rise further, given the added costs of environmentally friendly cultivation, the impact of changing weather patterns, and water supply issues. Favorable influences for the Industrial, Information Technology, and Financial sectors – More stringent environmental standards work as a positive for companies that will be involved in producing more efficient and cleaner industrial equipment and technologies along with alternative energy solutions. Also, investment banks should benefit from new trading markets such as carbon emissions and weather futures. Negative influences for Consumer Staples and Utilities sectors along with the Automobile industry - Higher agricultural input costs for ingredients such as cocoa, sugar, and corn due to more erratic weather patterns may negatively affect costs for producers of consumer products. In addition, companies may have to increase spending for environmentally friendly equipment and vehicles. The emerging markets are a key source of growth for beverage companies, but challenges to access to clean water supplies may continue to crop up. With the highest proportion of costs attributed to energy of any industry, utilities

In the shorter-term, we can assess the positive and negative impact across asset classes, sectors, and industries.

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are the most exposed to changing regulations on greenhouse gases. Automakers’ efforts to achieve the new standards for fuel efficiency come at a higher cost. In addition, the dominance of U.S. automakers in the larger, less fuel-efficient categories may act as a negative as they cede more market share to the generally smaller, more fuel-efficient vehicles of foreign auto makers.

Climate change exposure should not be the sole reason for making any investment

Climate change exposure should not be the sole reason for making any investment, especially since these initiatives remain in their early stage and are likely to have only a minor influence on the performance of the underlying companies. Also, investments opportunities focused purely on climate change tend to be small, single product companies that come with high risks. We have prepared a special report on climate change with additional insights for investors, available upon request. In the report we look at: The impact of tighter environmental standards and the influential framework in which those standards are imposed. The impact of likely climate-change initiatives on the broad financial markets and specific industries. Investments that may provide exposure to climate change initiatives. We will continue to actively monitor climate change initiatives for the potential impact on investors.

Important Disclosures
This report has been prepared by LPL Financial from sources believed to be reliable but no guarantee can be made as to its accuracy or completeness. The opinions expressed herein are for general information only, are subject to change without notice, and are not intended to provide specific advice or recommendations for any individuals. Please contact your advisor with any questions regarding this report. Investing in Mutual Funds involve risk, including possible loss of principal. Investments in specialized industry sectors have additional risks, which are outlines in the prospectus. 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. Indices are unmanaged and cannot be invested into directly. High yield/ junk bonds are not investment grade securities, involve substantial risks, and generally should be part of the diversified portfolio of sophisticated investors.

Required Disclosures
Neither LPL Financial nor any of its affiliates engage in investment banking services nor has LPL Financial or its affiliates or the analyst(s) been compensated during the previous 12 months by any company mentioned in this Report for any non-investment banking securities-related services and non-securities services nor has any company mentioned been a client of LPL Financial or its affiliates within the past 12 months.
This research material has been prepared by LPL Financial. The LPL Financial family of affiliated companies includes LPL Financial, UVEST Financial Services Group, Inc., IFMG Securities, Inc., Mutual Service Corporation, Waterstone Financial Group, Inc., and Associated Securities Corp., each of which is a member of FINRA/SIPC. Not FDIC/NCUA Insured Not Bank/Credit Union Guaranteed May Lose Value Not a Bank/Credit Union Deposit

Not Guaranteed by any Government Agency

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