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Market Commentary - 4th Quarter 2010

Economic Overview and Outlook

The U.S. economic recovery that began back in the third quarter of 2009 continued to gain momentum as 2010 came to a close. The most recently released U.S. GDP figures showed an annualized increase of 2.6 percent for the third quarter of 2010, up from the second quarter’s 1.7 percent increase. Fears of a "double dip" recession that briefly surfaced during the summer amidst concerns that the European debt crisis would spark another global economic slowdown have been all but dismissed as the debt crisis appears to be contained and the U.S. economic recovery continues to move forward.

Inflation remains below historical averages and inflation levels are expected to stay muted in 2011, as two key drivers of higher inflation, high capacity utilization rates and wage growth pressure, are both currently absent. With unemployment still hovering over 9% there is little concern that wage growth pressure will be an issue in 2011, and economists generally agree that GDP growth rate needs to be well in excess of 3% before the unemployment rate starts to decline. With expectations for U.S. GDP growth generally in the 2.5-4.0% range, it does not appear that the unemployment rate will drop significantly in 2011.

As we head into 2011, most signs point to the U.S. economic recovery continuing. In the fall of 2010 the Federal Reserve announced a plan for a second round of quantitative easing – also known as QE2 – where the Fed intends to inject up to an additional $600 billion into the financial system. Furthermore, Washington recently announced that the Bush-era tax cuts that were set to expire at the end of 2010 would be extended for two more years. Through these actions, the Fed and the U.S. Government have sent a clear signal to the markets that they will do whatever is necessary to prevent the U.S. from falling into a second "double dip" recession.

The Federal Reserve projects the 2011 US GDP to range between 3-3.6%, while Barron’s recently surveyed 71 economists, whose 2011 U.S. GDP forecasts ranged from 2.5-4.0%. Key factors that should drive the economy forward in 2011 include increased business investment and productivity improvements from U.S. companies, and higher demand for U.S. goods from the fast growing emerging market economies. However, economic growth will likely be somewhat restrained by relatively tight retail credit conditions in some markets and households’ ongoing desire to improve their personal balance sheets.

Equity Markets Review

Global equity markets posted strong positive returns again in the fourth quarter and finished the 2010 calendar year well into positive territory for the second consecutive year. The continuing global economic recovery, strong corporate earnings and strengthening investor confidence were the primary factors driving equity markets forward for the fourth quarter and the year. Equity markets did experience another brief bump in the road in November, however, as fears surrounding the European debt crisis surfaced once again with Ireland becoming the second EU member (after Greece earlier in the year) to receive financial aid. But as the European debt concerns eased in December, equity markets responded in kind by finishing the quarter and year strong.

In the U.S., the S&P 500 Index finished the fourth quarter with a healthy positive return of +10.8%, and for the year gained +15.1%. The fourth quarter’s performance was strong across the board but was led by more growth oriented stocks and smaller capitalization stocks. Energy and Materials were the top performing sectors for the quarter, returning 21.5% and 19.0% respectively, while Utilities and Health Care were the bottom performing sectors, but still posted modestly positive returns. Small capitalization stocks, as measured by the Russell 2000, also posted strong returns for the quarter, returning +16.3%.

Equity markets outside the U.S. posted positive but less robust performance as compared to their U.S. counterparts for the quarter. Developed non-U.S. equity markets returned +6.7% as measured by the MSCI EAFE Index, but were weighed down by the lingering sovereign debt concerns in Europe for the quarter. The Euro region posted a modest +3.8% gain, but driving returns forward for the quarter outside the U.S. was Japan, which posted a very strong 12.1% gain. Emerging markets also posted positive but more subdued returns for the quarter, as the MSCI Emerging Markets Index returned +7.4%. Among the big four emerging market countries, commonly known as the BRIC countries (with BRIC standing for Brazil, Russia, India and China), performance was very strong in Russia as the country returned +16.1% for the quarter, but China, India and Brazil lagged, posting relatively modest returns between +1 to +4%.

Fixed Income Markets Review

Fixed income markets fell in the fourth quarter as interest rates, which had been falling steadily throughout the year, reversed course and rose during the quarter (all else being equal, as interest rates fall, bond prices rise and vice versa). The Federal Reserve’s second round of stimulus and the extension of the Bush-era tax cuts bolstered confidence that the economic recovery would be sustained, helping push interest rates higher. The Barclays U.S. Aggregate Bond Index fell –1.3% for the fourth quarter but still returned a healthy +6.5% for 2010. Municipal bonds, as measured by the Barclays Municipal Bond Index, had an even more challenging quarter, returning –4.2%, but also still positive for the year, up +2.4%. In addition to a general rise in interest rates, municipal bonds were pressured by demand/supply imbalances due to a combination of uncertainty surrounding the extension of the Build America Bond (BAB) program and increasing questions surrounding the health of select municipalities, making for a technically driven selloff in the asset class during the quarter. High yield bonds (junk bonds) on the other hand were positive for the fourth quarter, aided by the news of a strengthening economy and additional stimulus, posting a return of +3.2% for the quarter as measured by the Barclays U.S. Corp High Yield Index. For 2010, high yield bonds posted a very strong +15.1% return.

Capital Markets Outlook

As we move into 2011, equity markets don’t appear cheap following the strong run witnessed in the fourth quarter and the entire year, but they don’t seem expensive either. Common market valuation metrics such as price-to-earnings (P/E ratio), price-to-book (P/B ratio), and price-to-cash-flows (P/CF) are all still slightly below longer-term historical averages. Furthermore, equity markets also have strong positive momentum heading into 2011 and look comparatively more attractive versus fixed income.

U.S. interest rates stand near all-time lows following a fairly steady 30-year secular decline, having recently reached levels not seen since the 1950’s. But with the U.S. economy stabilizing and the federal funds rate near 0%, signs indicate we may be entering a period where U.S. interest rates may begin rising once again, providing a headwind for fixed income assets. Given the current interest rate levels and prospects of rising rates in the future, investors should consider further diversifying their core fixed income assets across other non-core fixed income assets such as floating rate notes, non-U.S. bonds, Treasury inflation protection securities (TIPS), and short-term bonds. Additionally, investors should consider more absolute return oriented investment strategies that have similar risk profiles to fixed income, but seek to add value in any market environment and are less influenced by the general direction of equity or fixed income markets. Examples of absolute return strategies include equity long/short market neutral, global macro, and arbitrage strategies.

Prepared by:

Alex Kaye, CFA, Head of Research
Research Department, Cetera Financial Group

The views are those of Alex Kaye, CFA, Head of Research, Research Department, Cetera Financial Group, and should not be construed as investment advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. All economic and performance information is historical and not indicative of future results. Investors cannot invest directly in indices. Please consult your financial advisor for more information.

While diversification may help reduce volatility and risk, it does not guarantee future performance.

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