LP L FINANCIAL R E S E AR C H

Weekly Economic Commentary
October 31, 2011

What a Surprise
John Canally, CFA
Economist LPL Financial

Highlights
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This week is an extraordinarily busy one for economic data and policy events. How much longer can the economic data continue to surprise?

As is often the case during the first week of the month, this week is an extremely busy one for economic data. But the data, which includes key reports on ISM, chain store sales and the labor market in October, may be reduced to a side show, given all of the other potentially market moving events on tap this week. Last week’s batch of economic data — including the third quarter gross domestic product (GDP) report-marked yet another week that the economic data in the United States surprised to the upside. How much longer can the data continue this pattern? This week (October 31 through November 3) is chock full of key economic reports in the United States. But the data itself may only be a side show given the myriad of policy and corporate events also competing for the market’s attention this week. The key reports this week include the Institute of Supply Management’s (ISM) report on manufacturing for October, the chain store sales data for October and of course the October employment report. However, there are several other potentially market moving events on tap, including:
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Economic Calendar
Monday, October 31 Chicago Purchasing Managers Index Oct Dallas Fed Survey Oct Tuesday, November 1 Construction Spending Sep ISM Manufacturing Oct Domestic Light Vehicle Sales Oct Wednesday, November 2 MBA Mortgage Applications Index wk 10/28 ADP Employment Change Oct Challenger Layoff Announcements Oct FOMC Decision Bernanke Press Conference Thursday, November 3 Productivity Q3 Initial Claims wk 10/29 ISM-Non Manufacturing Oct Factory Orders Sep Chain Store Orders Oct Friday, November 4 Unemployment Rate Oct Nonfarm Payrolls Oct

Vehicle sales for October Challenger layoff announcements for October ADP employment change for October Initial claims for unemployment insurance for the week ending October 29 Weekly retail sales for the week ending October 29 The ISM’s non-manufacturing survey for October

In addition, the October ISM report for China is set to be released late Monday night, October 31, as fears continue to swirl in the marketplace about a so called “hard landing”— a sharp and unwanted slowdown in economic growth in China to around 5 or 6% from the current growth rate around 9%. Our view remains that China can achieve a soft landing, and that Chinese authorities are close to taking steps to stimulate the Chinese economy. The ISM report in the United States is expected to show that manufacturing sentiment improved slightly in October, but remained well below its early 2011 peak. The ISM peaked above 60 (a reading above 50 suggests that the manufacturing sector is expanding, while a reading below 50 suggests that the manufacturing sector is contracting) in early 2011. But the ISM almost never stays above 60 for very long. In fact, during the middle part of expansions (mid-1980s, mid-1990s and mid-2000s) the ISM often dips below

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1

The ISM Continues To Point To Further Expansion in the Economy
ISM Manufacturing: PMI Composite Index Seasonally Adjusted, 50+=Increasing

50 for a month or two without signaling a recession. Historically, a reading on the ISM below 42.5 is consistent with a recession in the United States. The consensus for the October ISM report (based largely on the October readings from the various regional Fed manufacturing surveys that have already been released) is for the ISM in October to move slightly higher to 52.0 from 51.6 in September. The low estimate (among the 82 estimates compiled by Bloomberg) is 50.5 while the high estimate is 53.7. Thus, it would likely take a reading below 50 or above 54 to substantially move markets when the data are released at 10 AM eastern time on Tuesday, November 1. The market will also want to pay close attention to the new orders and employment components of the ISM report. The new orders component is a solid indicator of future manufacturing activity, and the employment reading can provide some insight into the labor market in the manufacturing sector. The employment reading within the ISM has been above 50 in each of the past 24 months dating back to October 2009. Jobs remain a key concern for markets, and the October employment report will provide a comprehensive look at the labor market in the month. Our view remains that the labor market is stuck in neutral. The economy is growing just enough to produce some job growth, but not quickly enough to substantially lower the unemployment rate or the number of people filing for new unemployment benefits each week. In short, the economic, policy and regulatory uncertainty that is restraining the rest of the economy is still clearly being felt in the labor market, and only a resolution of that uncertainty will lead to an improved labor market in the months and quarters ahead. The unemployment rate — which is derived from a survey of 60,000 households — is expected to remain at 9.1% in October. The unemployment rate is calculated by dividing the number of unemployed persons seeking work (about 14 million) by the number of people in the labor force (about 154 million). A 9.1% reading in October would mark the fourth consecutive month at 9.1%, demonstrating some stability in the labor market, but no improvement. The unemployment rate peaked at 10.1% in October 2009, but was as low as 4.4% as recently as early 2007. The monthly job count is derived from a survey of businesses (140,000 businesses representing more than 400,000 worksites) and has been conducted each month for more than 60 years. The market is expecting an increase of 125,000 private sector jobs in October, a slight deceleration from the 137,000 private sector jobs created in September. Year-to-date through September, the economy has created an average of 150,000 private sector jobs per month. This is about the same pace at which the labor force increases each month, which helps to explain why the unemployment rate has remained around 9.0% this year. While the private sector is expected to have added about 125,000 jobs in October, the public sector (federal, state, and local governments) is expected to see another drop in jobs. In particular, the state and local government sector has shed jobs in eight of the nine months in 2011 and in 30 of the past 38 months. In all, state and local governments have shed 597,000 jobs since mid-2008, an average of about 15,000 per month. We expect this pace of downsizing in the state and local

70 60 50 40 30

85 90 95 00 05 10 Source: Institute for Supply Management, Haver Analytics 10/31/11

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. (Shaded areas indicate recession)

Our view remains that the labor market is stuck in neutral.

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government sector to persist for the foreseeable future as they struggle to realign costs with revenues. This week also features a Federal Open Market Committee (FOMC) meeting — accompanied by a press conference and a new economic forecast by Federal Reserve (Fed) Chairman Bernanke, and central bank meetings in Australia, Iceland, and in Europe. The market is expecting a rate cut in Australia, and the European Central Bank (ECB) under the new leadership of Mario Draghi, may also cut rates. The G-20 is set to meet this week, where the details of the European rescue plan are likely to be discussed, and 116 other earnings reports and outlooks from S&P 500 companies are scheduled for this week.

Lowered Expectations Opened the Door for the Economic Data to Beat Expectations
Last week’s batch of data in the United States — which included third quarter gross domestic product (GDP), along with data on housing, consumer spending and sentiment — marked another week in which the economic data in the United States surprised to the upside. How much longer can the data continue this pattern? If the past three years are any guide, we may only have a few more weeks of better-than-expected economic data, as economic expectations continue to move higher. The Citigroup Economic Surprise Index (CESI) measures whether or not incoming economic data are beating economists’ expectations. There have been three distinct periods since 2008 in which the United States economic data has exceeded expectations, including the current period. The first came as the market first priced in (and then priced out) another Great Depression in late 2008 and early 2009. This episode of better than expected data lasted 23 weeks. 2 Economic Data in the United States Has Been Better Than Lowered Expectations Since June
United States Economic Surprise Index (When line is rising,
United States Economic Data is Beating Expectations)

150 100 50 0 -50 -100 -150 -200 Oct 08 Feb 09 Jun 09 Oct 09 Feb 10 Jun 10 Oct 10 Feb 11 Jun 11 Oct 11

The next wave of better than expected economic data came in late 2010 through early 2011, just after market fears of a European debt crisis-induced double-dip recession pushed economic expectations sharply lower in the spring and summer of 2010. This wave of good news (relative to lowered expectations) began just after Fed Chairman Bernanke hinted at another round of quantitative easing — Fed purchases of Treasuries in the open market — in late August 2010, and lasted until just prior to the Japanese earthquake in mid-March 2011. This episode lasted about 28 weeks. According to the CESI, the current run of better-than-expected economic data in the United States began in early June 2011, as economic expectations washed out after a post-Japanese earthquake improvement in the United States economic data fizzled and fears of a European debt contagion increased. This prelude was remarkably similar to (and caused by the some of the same fears) as the period just before economic expectations began to rebound in late 2010. Since early June 2011, more often than not, the United States economic data has surpassed these lowered expectations. But now 19 weeks into this run of better than expected data, we are closing in on the average of the prior two episodes of better-than-expected economic data. Thus, if the past three years

Source: Citigroup Global Markets 10/28/11

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are any guide, we may only have another few weeks of better-than-expected economic data, as market participants continue to revise up their economic forecasts, after revising them down while pricing in a recession between the Japanese earthquake in March 2011 and early June 2011. Our view remains that the United States economy will avoid recession, but that growth is likely to remain tepid, at best, over the next year or so, with the economy growing near its long term growth rate of around 2.0 to 2.5%. This pace of growth would be enough to avoid recession, but not enough to push the unemployment rate meaningfully lower.

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. Citigroup Economic Surprise Index (CESI) measures the variation in the gap between the expectations and the real economic data. 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. The Group of Twenty (G-20) Finance Ministers and Central Bank Governors is the premier forum for our international economic development that promotes open and constructive discussion between industrial and emerging-market countries on key issues related to global economic stability. By contributing to the strengthening of the international financial architecture and providing opportunities for dialogue on national policies, international co-operation, and international financial institutions, the G-20 helps to support growth and development across the globe.

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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LP L FINANCIAL R E S E AR C H

Weekly Market Commentary
October 31, 2011

Trick or Treat
Jeffrey Kleintop, CFA
Chief Market Strategist LPL Financial

Highlights
Investors were treated to powerful gains last week as European policymakers crafted a deal to avoid a 2008-like financial crisis and economic and profit reports in the United States reflected solid growth. We believe last week’s European rescue deal is more treat than trick, but the devil is in the details. Over the long-term, concerns remain about the tricky outlook for economic growth in Europe and the ability of some peripheral countries to meet budget targets. While the stock market is likely to hang on to the powerful gains made in October, there are still a few of scares coming in November that may spook the markets and reintroduce some familiar volatility.

Was last week’s market rally a Halloween trick or a treat for investors? European leaders announced a deal last week that produced a sigh of relief felt around the world as markets welcomed the news of a breakthrough in what had been the biggest threat to the global economy and markets since the 2008 financial crisis. In general, markets last week provided a treat to investors:
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The S&P 500 climbed 4% putting the gain for the month of October on track to be the best month since October 1974 [Table 1]. Stocks rose sharply in Europe and Asia, led by the banks. High Yield corporate bonds rose 2%. Commodities surged with oil rising 7% and copper surging 15%. Reflecting a mostly positive outlook for growth, the yield on the 10-year Treasury note rose 12 basis points and traded as high as 2.40% for the first time since early August.

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We believe the deal is more treat than trick, but the devil is in the details — many of which remain undisclosed in the statement released by European policymakers last week. There are three broad components of the rescue package:
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Greece’s debt burden is reduced by a 50% “haircut” on Greek bonds. European banks will be required to raise 106 billion euros to temporarily maintain a higher buffer against additional losses on their bond holdings. The rescue fund will provide guarantees against the first 20 – 25% of losses on about one trillion euros of European government debt.

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Over the long-term, concerns remain about the tricky outlook for economic growth in Europe and the ability of some peripheral countries to meet budget targets. Reflecting these lingering concerns and fearing a trick, many investors in European government bonds sold their positions pushing Italian and Spanish bond yields higher for the week. Europe appears headed for a recession as seen in last week’s data included weak readings on employment, economic growth (as measured by GDP), and heavy truck sales in Europe. The long-term success of the European rescue is dependent upon the members of the Eurozone taking additional steps to adhere to their plans for achieving financial stability and deficit reduction. Skepticism lingers

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1 Ten Best Months for S&P 500 in Past 50 Years
Month October 1974 October 2011* January 1987 January 1975 August 1982 December 1991 November 1982 August 1984 November 1980 November 1962 * through October 28, 2011 Source: LPL Financial, Bloomberg data 10/28/11 The S&P 500 is an unmanaged index, which cannot be invested into directly. Past performance is no guarantee of future results. S&P 500 Price Gain % 16.3 13.6 13.2 12.3 11.6 11.2 11.0 10.6 10.2 10.2

that some nations will successfully hit the targets they have set especially in light of the recession that many European countries are likely to experience next year. Despite the long-term concerns, the stock market may hang on to the gains it has achieved in the month of October which were supported by other positive news that continued last week:
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The string of solid and better-than-expected economic data in recent weeks was capped by last week’s third quarter GDP coming in at 2.5% and a new all-time high in real GDP. (See this week’s Weekly Economic Commentary for details). Strong and better-than-expected corporate earnings reports are on track for a 16.3% year-over-year increase with revenues up 10%. Of the 315 companies in the S&P 500 that have reported earnings to date for the third quarter, 71% have reported earnings above analyst expectations. Additional policy actions outside of Europe also helped lift markets. Japan boosted economic stimulus, Turkey cut reserve requirements, and China pushed lending support for small firms as they prepare to reverse efforts undertaken in the past couple of years to tighten credit.

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We expect these trends to continue into November. As November gets underway, this week there are several potentially positive drivers for the markets:
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Important economic data is due to be released including the October readings on jobs (employment report from the Department of Labor), business sentiment (ISM), and consumer spending (vehicle sales and retail chain-store sales). This data should be solid — certainly relative to investor and consumer confidence readings, but it is getting harder to surprise to the upside after so many weeks. (See this week’s Weekly Economic Commentary for details). On November 3, the European Central Bank (ECB) is set to meet. The next step in a successful plan to stabilize Europe is for the European Central Bank to cut rates soon to promote growth and lending and reverse the two rate hikes they made earlier this year. A rate cut by new ECB head Mario Draghi would be welcomed by markets. In addition, the Reserve Bank of Australia, Australia’s central bank, may cut rates this week. Small components of President Obama’s jobs bill with a higher likelihood of passing Congress may be proposed this week. The government is funded through a continuing resolution that runs out November 18 and will result in a government shutdown if not extended. The November 23 deadline is looming for the super-committee to vote on a plan with $1.5 trillion in deficit reduction.

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However, there are some potential negatives on the calendar for November.
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So there are still a few scares coming in November that may spook the markets and reintroduce some familiar volatility.

LPL Financial Member FINRA/SIPC

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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. 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 and emerging markets investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors. 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.

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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