Quarterly Investment Commentary – September 30, 2011

The S&P 500 Index endured its worst quarter in nearly three years during the third quarter of 2011. Investors had to deal with a number of issues — ongoing European debt concerns, the drawn-out debate on the debt ceiling, a downgrade of the U.S. credit rating — and embraced safe-haven assets as a result.

Despite those concerns, the U.S. economy continued to expand, albeit at a slow pace. Investors are more pessimistic now, however, than at any point in the recent past, as reflected in consumer sentiment surveys, yet they continue to spend at a healthy pace. Such is the environment facing the market as the fourth quarter arrives — a tug-of-war between how investors say they are feeling and what they are actually doing. In the third quarter, sentiment dictated performance. With high-quality bonds recording a second consecutive strong quarter and the 10-year Treasury yield hitting record lows, significant gains likely will be hard to come by. But, with the S&P 500 Index near the lows for the year, we see more potential upside return than downside risk in equities between now and year-end, given the likelihood that a credible European rescue plan emerges. Any plan is likely to be accompanied by the solid fundamental backdrop in the United States with corporate earnings remaining strong and supported by attractive valuations with the forward price-to-earnings ratio near 30-year lows.

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.

Please note all return figures are as of September 30, 2011, Unless otherwise noted.

Stock Markets

The U.S. stock market, as measured by the S&P 500 Index, posted its first quarterly loss since the second quarter of 2010 and its largest quarterly decline since the depths of the Great Recession in the fourth quarter of 2008 with a loss of 13.9% in the third quarter of 2011. The Index had increasingly larger declines in each month of the third quarter, with the 7.0% decline in September, marking the fifth consecutive monthly decline for the Index and the largest one-month decline since the 8.0% decline in May 2010; the Index declined 2.0% in July and 5.4% in August [Chart 1]. Some of the same issues that impacted the market during the second quarter of 2010, notably the European debt problems, had a similar impact in the third quarter of 2011. For the year thus far, the S&P 500 Index has posted a -8.7% return.

The third quarter was a battle between the strongest quarter of economic growth this year and the increasingly negative investor and consumer sentiment. Economic data, while not pointing to robust economic growth, suggested the economy continues to expand, albeit at a painfully slow pace that is well below historical averages at this point in an economic recovery. In that sense, the slow pace of growth probably feels like a recession to many investors. Those feelings were reflected in consumer and investor sentiment surveys that were decidedly pessimistic in the third quarter. However, the gap between what investors say they are doing (i.e., consumer sentiment) and what they are actually doing (i.e., consumer spending) is wide. On balance, negative sentiment overwhelmed the market in the third quarter and remains an overhang for investors as the fourth quarter begins.

In dissecting sector performance of the U.S. equity markets, defensive sectors generally outperformed cyclical sectors in the third quarter. Utilities was the only sector to post a gain in the third quarter with a return of 1.6% [Chart 2]. Utilities is the best-performing sector in the S&P 500 Index year-to-date with a return of 10.7%. With the stock market lower and interest rates below 2.0%, investors have looked to the Utilities sector, given its defensive nature and healthy dividend yield of approximately 4.4% (as of September 30, 2011). The notable outperformer among cyclicals in the third quarter on a relative basis was the Technology sector, which posted a decline of -7.7%. The performance was notably worse among the other cyclical sectors — Energy, Materials, Industrials, Financials — which all declined more than 20% in the quarter on concerns of a global economic slowdown. Materials was the worst-performing sector in the third quarter with a drop of more than 24%.

From a market capitalization perspective, large-cap stocks outperformed their mid-cap and small-cap counterparts as large caps tend to be more defensive in nature. From a style perspective, there was not much of a distinction in returns between growth and value. The Russell 1000 Growth Index, a proxy for Large Growth stocks, was the best-performing domestic asset class in the third quarter with a return of -13.1%, as Technology stocks significantly outperformed. The Russell 2000 Growth Index, a proxy for Small Growth stocks, had the biggest decline among the nine style boxes with a drop of 22.3% in the quarter.

For the second consecutive quarter, U.S. stocks outperformed their Large Foreign and Emerging Market counterparts on a relative basis, though the magnitude of outperformance was far greater in the third quarter. The MSCI EAFE Index, a proxy for developed foreign markets, declined 19.0% in the quarter due in large part to the woes in Europe. France and Germany each witnessed declines of more than 25% in their domestic stock markets during the quarter and now reside in “bear market” territory with declines of more than 20% in 2011. Similar to the second quarter, the MSCI Emerging Markets Free Index had the worst returns of the major world indexes in the third quarter, declining 22.5%. Brazil’s stock market declined 17.5% in the quarter and is down 24.5% year-to-date, while China declined 14.5% in the quarter.

Economy

Much like the second quarter, economic reports in the third quarter were again uneven, introducing fears of a global economic slowdown, which contributed to market volatility and overwhelmingly negative sentiment. While many of the reports came in below expectations, they did not suggest a return to recession.

With regard to economic growth, gross domestic product (GDP) continued to hit new all-time highs in the second quarter [Chart 3]. Second quarter GDP was revised higher late in the third quarter from 1.0% to 1.3% annual growth. The third quarter is on pace to grow at a 2 – 2.5% rate, the strongest growth rate so far this year. The second quarter revision was due in part to better-than-expected consumer spending, which remains robust with 4.6% year-over-year growth in same-store sales as of the end of August [Chart 4]. The Index of Leading Economic Indicators (LEI), which is a grouping of several economic statistics that are usually predictive of future economic conditions, continued to suggest slow growth and not a double-dip recession. In fact, LEI posted a solid and better-than-expected gain in September — the fourth straight month of re-acceleration in the year-over-year growth of the LEI — which suggests that a recession is unlikely. Despite the lack of recessionary indicators, however, consumer sentiment was near 30-year lows in the third quarter, as measured by the University of Michigan Consumer Sentiment report [Chart 5].

Over time, these consumer spending and consumer sentiment measures are highly correlated as the more confident consumers feel, the more likely they are to spend money. However, the recent periods have seen a near historic disconnect, as consumers are filling out surveys suggesting a dismal outlook, but not significantly adjusting spending. Consumers are acting differently than they are feeling. The fundamental data shows that consumers, which make up nearly 70% of the U.S. economy, are going to the malls and spending at levels not seen since 2007. However, that fundamental data flies in the face of the sentiment data, which suggest consumers are as gloomy and pessimistic as they were at the depths of the 2008 recession.

Commodities Asset Classes

Broad commodity prices declined for the second straight quarter, as the Commodity Research Bureau Index fell 7.7%. Much of the decline occurred late in the quarter, following a downgrade of the economy from Federal Reserve (Fed) Chairman Ben Bernanke at the September Federal Open Market Committee (FOMC) meeting. Bernanke cited “significant downside risks” to the Fed’s more optimistic view of the economy and a more benign inflation view going forward. Given mixed economic data, the assessment was not surprising and partially served to justify the Fed’s launch of “Operation Twist,” a program intended to stimulate growth by keeping interest rates low through the purchase of longer-dated Treasury securities.

However, not all commodities asset classes moved in lockstep during the quarter, leading to divergent performance. Commodities like oil and copper, which are typically more sensitive to economic activity, continued to move lower on concerns of an economic slowdown. West Texas Intermediate crude oil started the quarter near $98, and climbed as high as $101 in late July before falling sharply in early August and settling into a range between $79 and $90 [Chart 6]. With oil prices at their lowest level in nearly a year, consumers are seeing some relief in the percentage of spending dedicated to energy costs.

On the other hand, precious metals, generally viewed as a safe haven in times of uncertainty, were mixed during the quarter. The ride for gold was again volatile, as the yellow metal surged to yet another all-time high in late August near $1,900 [Chart 7]. Gold was moving back to the $1,800 range in early September before a precipitous decline late in the month to near $1,600. Despite the late-quarter decline, gold still increased 7.8% in three months.

Silver also fell sharply following the downgrade of the economy from the Fed. Silver began the month near $35, rallied as high as $43 in late August and finished the quarter near $30 [Chart 8].

Fixed Income

The broad bond market, as measured by the Barclays Capital Aggregate Bond Index, followed a strong second quarter with a solid gain of 3.8% in the third quarter, the best quarterly return since the fourth quarter of 2008. July was a particularly strong month for high-quality bonds, as the Index gained 1.6%, the best month for the Index in exactly two years. For the second consecutive quarter, investors generally avoided riskier sectors of the bond market and sought the comfort of high-quality bonds. As was the case in the second quarter, the 10-year Treasury yield again moved lower in the third quarter, hitting an all-time low of 1.7% in late September before ending the quarter near 1.9% [Chart 9].

Long-term, high-quality bonds, as measured by the Barclays Capital Government/Credit Long Index, posted a 15.6% return in the third quarter. Among other high-quality bond sectors, Treasury Inflation-Protected Securities (TIPS) posted strong returns in the quarter (4.5%), as did Mortgage-Backed Securities (2.4%). Given the flight-to-safety rally in the bond market, more credit-sensitive areas of the market underperformed the broad Aggregate Index. Notably, high-yield bonds had their worst quarter since the fourth quarter of 2008 and fourth worst quarter in the past decade with a return of -6.1%, as measured by the Barclays Capital High Yield Index. Other credit-sensitive fixed income sectors, such as Bank Loans (-4.4%) and Preferred Securities (-4.2%), struggled in the third quarter, as did Emerging Market Debt (-1.8%).

Mortgage-Backed Securities are subject to credit, default risk, prepayment risk that acts much like call risk when you get your principal back sooner than the stated maturity, extension risk, the opposite of prepayment risk, and interest rate risk.

Treasury Inflation-Protected Securities (TIPS) help eliminate inflation risk to your portfolio as the principal is adjusted semiannually for inflation based on the Consumer Price Index – while providing a real rate of return guaranteed by the U.S. Government.

High-Yield/Junk Bonds are not investment-grade securities, involve substantial risks, and generally should be part of the diversified portfolio of sophisticated investors.

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