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Market Commentary - October 15, 2010

Economic Overview

Over the course of the third quarter, macroeconomic discussions slowly shifted away from the “double dip” recession scenario, but market expectations continue to be quite muted for near term growth for the U.S. economy. Final GDP for 2Q 2010 came in at a modest 1.7% annualized rate, but slightly above market expectations. The GDP growth experienced throughout the economic recovery has been driven primarily by strengthening business investment, but the fading effects of inventory rebuilding is weighing on the future growth outlook. Along with tepid economic growth prospects, the lack of job creation continues to plague the economic recovery, as unemployment remains stubbornly high at 9.6% through September, and the so-called “U6” measure (also including discouraged and underemployed workers), stood at a daunting 16.7%. One bright spot in the current economic recovery is core inflation remains benign, and given the sluggish economy, should not pose a threat over the near-term. CPI rose a modest 0.3% in August and 1.2% on a year-on-year (seasonally adjusted) basis.

Given the considerable challenges facing the sustainability of the economic recovery, the Federal Reserve recently announced plans for a second round of quantitative easing to help spur additional economic growth. The plan – being dubbed “QE2” – would involve the Fed purchasing large amounts of long-term Treasury bonds in order to inject additional capital into the system. Equity markets reacted favorably to the announcement, believing that the Fed continues to signal that it will provide whatever support necessary to keep the economic recovery on track. And while the economic recovery continues to fight through fits and starts, corporate America stands fairly healthy. Solid profits, clean or improving balance sheets, easily available credit with low interest rates, large cash balances and reasonable valuations are all positives to point to amidst the challenging economic backdrop. The prospects of “QE2” coupled with corporate America eventually “spending” its large cash reserves – either through capital expenditures, share buybacks or mergers & acquisitions – provide assurance that the economic recovery should continue forward.

U.S. Equity Markets

The global equity market recovery that began back in March 2009 continued to march forward in the third quarter of 2010. U.S. equity markets, as measured by the S&P 500 Index, finished the quarter with a strong return of +11.3%. However, the quarter was yet again characterized by heightened levels of uneasiness, and corresponding heightened market volatility. The quarter started off on a strong note as the European debt fears that plagued equity markets in the second quarter eased and equity markets responded in kind, posting a +7.5% gain for July. However, markets promptly gave most of that return back in August, falling -5.5%, as fears of a double dip recession resurfaced following a series of disappointing economic news releases. But double dip recession fears quickly abated in September, and on top of merger & acquisition (M&A) activity picking up to levels not seen in over two years, equity markets responded with a +8.9% return in September. And with September’s strong rebound, the S&P 500 Index returned to positive territory for the year, up +3.9%.

With concerns of a U.S. double dip recession abating during the third quarter, sectors that typically benefit from an expanding economy - namely Technology, Industrials, Materials, Energy, Consumer Discretionary - all outperformed the broader market’s +11.3% return. However, one additional sector conspicuously absent from that list was Financials, which actually was the bottom performing sector for the quarter, returning just +4.3%. The Health Care sector also lagged the broader market for the quarter, posting a +8.9% return. The quarter was led by the Telecom sector, which posted a +21.0% gain, followed by the Materials and Consumer Discretionary sectors, which returned +17.8% and +15.2% respectively.

Non-U.S. Equity Markets

Equity markets outside the U.S. posted even stronger returns during the third quarter, benefitting from both rising equity prices and a falling U.S. dollar. Developed non-U.S. equity markets, as measured by the MSCI EAFE Index, returned +15.8% for the third quarter, but even with the strong quarterly return the index is still slightly negative for the year, down -1.3%. The top performing region for the quarter was Asia ex-Japan, which posted an exceptional +22.2% return, but over half of that performance was due to the U.S. dollar’s steep decline versus the Asian currencies. In looking at the performance in local currency terms, the region posted a much more modest +10.6% return. The United Kingdom (U.K.) and Europe Ex-U.K. also posted strong returns for the quarter, returning 19.8% and 19.2% respectively. And as was the case with Asia Ex-Japan, the majority of the returns from Europe came via the depreciating U.S. dollar, as the U.K. and Europe Ex-U.K. returned a more modest +13.7% and +6.9% respectively in local currency terms. Japan posted the worst (although still positive) return for the quarter, returning +5.9%.

Emerging market equities posted similar strong returns in the third quarter, as the MSCI Emerging Markets Index posted a very strong return of +17.2%. Emerging markets are now up +8.7% for the year. As was the case with developed non-U.S. equities, emerging market equity markets also benefitted from both price appreciation and a falling U.S. dollar during the quarter. And despite continued strong performance from emerging markets, valuations in the region remain fairly reasonable, with a forward P/E multiple standing at roughly 12.5.

Fixed Income Markets

U.S. Treasury yields continued to “obey” gravity in the third quarter and continued their precipitous descent. Rates fell across the entire yield curve, particularly in the “belly” or middle part of the curve, with rates at several maturity levels approaching or reaching all-time lows. And since bond prices move inversely to interest rates, the fixed income market saw another quarter of strong positive gains. The Barclays U.S. Aggregate Bond Index returned +2.5% for the third quarter and is up a solid +7.9% for the year. High yield bonds were also aided by easing fears of a double dip recession and posted a strong +6.7% quarterly return as measured by the Barclays U.S. Corp High Yield Index. Fixed income markets outside the U.S. posted even better third quarter returns as they reaped the additional benefits of a falling U.S. dollar on top of falling interest rates. The Citigroup Ex-U.S. World Government Bond Index returned 10.5% in the quarter and the J.P. Morgan Emerging Market Bond Index returned an even stronger +14.1%.

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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