Adviser Market Outlook Fourth Quarter 2010

The third quarter of 2010 ended with a 7.7% surge as the Dow Jones Industrial Average
had its best September result in over 70 years. This was particularly satisfying because September is
historically one of the worst, if not the worst month for stock market investors.
The last time the Dow saw a gain of this magnitude That was not (and still isn’t) the message that was broad-
was 1939, at the tail end of the Great Depression. The cast. August’s reversal, which erased much of the gain
parallel to our more recent history is uncanny; hav- earned in July, stoked pessimism. Headlines, even in the
ing just weathered the roughest economic and market usually less frothy New York Times, declaring “The DOW
ride since then, and having also benefitted from the 1000” and “The Third Depression” did little to allay such
marked rebound of 2009, many pundits and most fears. Yet despite consumer and investor confidence stall-
individual investors remained chary of any chance for ing and falling, as previously noted, September’s markets
such gains inside the whole of 2010, let alone packed were above average, to say the least.
into one month. The MSCI Broad Market index gained 11.6% during
Our investment philosophy is founded in the belief the third quarter, a tad more than it lost in the second
that “time in the market, not market-timing” is one quarter, while the S&P 500 gained 11.3%. Smaller and
key to long-term investment success. This view, hewn mid-cap stocks performed a bit better, but it was the
by our investment management experience, stands in foreign markets, aided by a declining dollar, that shined
direct contrast to those who make their living from in the July-to-September period. A rebound in Europe,
talking about investing rather than managing money particularly for the euro, boosted returns. The MSCI
day in and out. Such headline-grabbing pundits EAFE index returned 16.5% while the MSCI Emerging
remain in high demand from media outlets in need Markets index gained 18.0%. Of the more than 50 global
of shock value to sell their wares. But the investment
value of such impending doom rhetoric does a dis- Dialing Up Profits
service to investors and their portfolios. If you had
Domestic Market Sector Q3 ‘10 12-Mo
acted in accordance with any one of the host of bearish
Telecom 20.1% 19.1%
proponents, you would have missed out on one of the
Material 18.2% 13.2%
most remarkable year-and-a-half market gains in his- Consumer Discretionary 15.6% 24.2%
tory. But, we’ll get to that in a moment. Industrial 13.6% 18.3%
Energy 13.5% 4.4%
Third Quarter Review REITs 13.2% 30.5%
The third quarter exhibited two of the strongest Technology 12.4% 11.8%
months in the equity markets and one of the more try- Utility 11.9% 12.1%
ing ones. This ‘stair step’ pattern is consistent with our Consumer Staple 10.8% 13.0%
view of what we see as a typical, cyclical recovery from an Health Care 8.7% 9.3%

atypical recession in both the economy and the markets. Financial 5.4% 0.6%

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 benchmarks that we track, not one lost money in the
quarter, or over the past 12 months. While many were
decrying the failure of the “Summer of Recovery,” the
market clearly saw one—as did our clients’ portfolios.
The bond market notched a 2.5% gain during the
quarter as measured by the Barclays Aggregate Bond
index. Cash, which has almost no yield, but which is the
most stable of all asset classes on a nominal basis, earned
0.004% (no, that’s not a typo), and by our estimate has
returned 0.02% over the past 12 months.
Domestically, telecom stocks have rebounded strong-
ly, in part due to investors’ search for yield. Both AT&T
and Verizon, for instance, sport yields of almost 6%,
which, when compared to a 30-year Treasury bond
yielding 3.69%, looks awfully appealing.
At the other end of the spectrum, financial stocks
were laggards during the quarter as worries and uncer-
tainty about financial regulation took hold. Also, there
are conflicting signs that all is not well with many of the
big banks and their overloaded mortgage portfolios. It
should be noted, however, that financial stocks, as well
as many of the large pharmaceutical stocks in the health
care field also offer sumptuous dividend yields.
Confidence Gap
We believe the market’s gyrations are a response
to the continued and widening gap between credible
evidence for recovery, and confidence in that out-
come. That’s ironic, given that we have yet to see any
evidence for no growth, let alone negative growth. By
now you know our stated view: Slow growth is not no
growth. And so far, evidence supports our slow growth
view here, and faster growth in some other parts of the
globe, Asia in particular.
Consider the following evidence and the way we
assess its significance:
Despite the relatively high levels of unemploy-
ment, U.S. personal incomes continue to grow, having
increased in every month since Sep. 2009. We’re mind-
ful of the fact that there are fewer consumers currently,
and that the emotional ripple effects of high unemploy-
ment are taking a toll on spending patterns. But, even at
recessed levels of employment here, spending has been
persistent and consistent with our view that consumers
may feel down but they’re not out.
Consumption is growing as well, hitting a new peak
in August. Such peaks follow valleys, but while the
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media continues to focus on fearful shadows, it’s hard
to find headlines that celebrate such climbs.
Household balance sheets are improving as savings
rates have been holding steadily in the 5% to 6%
range, a far cry from the 2%-plus levels seen during
the last expansion. Savings do serve as a drag on spend-
ing. But, at this point in the cycle, we think that the
increased savings serve as a cushion for spending rather
than an impediment to it. With safe money set aside,
spending can and has ensued.
Chain stores sales are improving, having risen in every
month since Nov. 2009. We know that such sales initially
came as a result of deep discounts that were punitive to
profits. However, we’ve seen a correspondent benefit
to consumers being forced to streamline their bottom
line; stores and businesses in general are running leaner,
meaner and more profitably than prior to the recession.
GDP continues to expand. The just-finalized num-
bers for the second quarter of 2010 indicate that our
economy is, on an inflation-adjusted basis, just 1.3%
away from its peak. We know that for jobs to recover
we’ll need to arrive at an annualized growth rate of
about double our current one; it’s hardly a bullish
moment for our GDP, but it’s also not as bearish as
many would have investors believe.
Finally, and maybe most importantly for investors
like us, corporate profits continue to expand. At $1.6
trillion dollars pre-tax during the second quarter, cor-
porate profits have grown by 62% from their fourth
quarter 2008 lows. If businesses can make a buck in
this still recession-like environment, investors can do
so as well, and in future quarters too.
In light of the challenges and uncertainties that
the near-term earnings season and midterm election
assumptions and results could pose, we remain as
focused on risk management as on return potential for
our clients’ portfolios.
Outlook
As we look ahead, we see two near-term hurdles that
must be overcome for the stock markets to move appre-
ciably higher. We believe there is one hurdle that is in
everyone’s sights (the November midterm election) and
one that few seem to be paying much attention to (third
quarter earnings results and forecasts for 2011).
First, let us be clear; we are not political prognos-
ticators. We don’t know how the Nov. 2 election will
fall out but we do know that expectations are for a attention. We think there are reasons for both optimism
gridlocked Congress, which according to legend is and caution as these numbers tumble forth.
good for the markets. As noted earlier, corporate profits have staged a
Fortunately (or unfortunately), this myth is just remarkable comeback. We expect earnings growth to
that. Historically, the U.S. stock market has performed continue. However, comparisons with year-ago quarters
best on the days when Congress was out of session, are going to become more difficult given the fact that we
and relatively worse when Congress was in session. are now more than a year into the recovery. Our hope is
The makeup of Congress, gridlocked or not, has had that investors are not expecting that the huge percentage
very little correlation with market moves. It appears gains seen earlier this year are going to be repeated. We
that the mere presence of our elected representatives in think the assumptions that are priced into the market
session, and the uncertainties this engenders, is what currently are for fairly robust growth; consequently the
has the greatest impact on market performance. (That possibility for disappointment is higher than normal.
said, we would not recommend moving into, and out At the same time, the bond market is pricing in
of the market based on Congress’ calendar, however unreasonable pessimism. On a risk/return scale, we
tempting that might be.) believe stocks still offer extremely good values, par-
Setting aside the tragic-comic fact that the best ticularly if you know where to find them. Hence, our
investment days appear to be when politicians have confidence in the managers we’ve selected to run the
gone home, just because a trend has proven the case pieces of our clients’ portfolios.
historically doesn’t mean we should or will bank on
it. September’s market surge is a very recent reminder. Asia and the Emerging Markets
Instead, it is instructive to note that even some of the On a global scale, in a place where our votes don’t
bigger assumptions of how the market will react are like- count, one economy increasingly matters. China’s suc-
ly to be priced into expectations and the markets alike. cessful stimulus and remarkable economic rebound
Our view (assuming there are no contested elections, continues to lead rather than follow more established
which may be a big assumption), is that the best news Western economies, including our own. In part, we
that can come from the election is that a large measure credit China’s ability to fund whatever project it wants
of uncertainty will be removed from the market. to fund without having to answer to its own people.
China’s growth into the world’s second largest econo-
Forecast Earnings my serves as a collective vote for global trade and the
The pace of our recovery will come into sharp relief global marketplace that increasingly matters to its own
when third quarter earnings reports begin to trickle in politburo’s vested interests and bottom line.
during the first full week of October. The flood of news What we don’t think can be discounted is that
will come in the following two weeks, notably ahead China is growing from within, creating millions of
of the midterm elections that seem to have everyone’s employed consumers for the global economy. Australia
and New Zealand, which are gateway countries into
China, have been raising short-term interest rates to
U.S. Corporate Profits temper their correlated economic growth. And China’s
$1,800
$1,600 steadily increasing import demands are creating jobs
$1,400 and profits here as well.
$1,200 Of course, the risks of owning securities from foreign
$1,000
lands remain relatively higher than our homegrown
$800
$600
ones. As a consequence, we take a measured approach
$400 to investing overseas, even when it comes to a now-pop-
Profits (pre-tax)
$200 Profits (after-tax) ular sleeve such as the emerging markets. For example,
$0 rather than own a stake in a China fund outright, we
6/00
12/00
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6/05
12/05
6/06
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6/08
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6/10

look for diversified investment instruments that offer

Sources: Bureau of Economic Analysis and Adviser Investments. China-specific and China-related plays.
 On the ‘safer’ side of the street, it would be hard
to argue that companies like AT&T, Chevron, Exxon,
IBM, Johnson & Johnson, JP Morgan Chase, Microsoft
and Wal-Mart don’t benefit from China’s growth. All
of those names are found in the top-10 holdings
of BlackRock Global Allocation and/or Vanguard
Dividend Growth. More directly, consider that the
Vanguard Emerging Market (VWO) exchange-traded
fund has China Mobile as its top holding, and both
China Construction Bank and China Life Insurance
are also significant positions.
In addition, it’s worth noting that our preferred
equity instruments in the emerging markets are the
exchange-traded funds from iShares or Vanguard;
they enable us to “buy” these markets in a diversified,
liquid and low-cost manner. Moreover, we constantly
run comparisons between actively-managed emerging
market stock managers and ETFs, and continue to
find them wanting in terms of performance, fees and
liquidity (many funds impose redemption fees).
We go a step farther than most advisors by temper-
ing the equity risks with the inclusion of one of the best
income-focused emerging markets vehicles in the mutual
fund market. Fidelity New Markets Income’s manager,
John Carlson, has been investing in emerging market debt
since 1995. He has seen disastrous times (like the 1998
emerging market meltdown) and sunnier spells. By using
his fund in a pairing strategy with our favored emerging
markets equity fund, we are better able to manage and
mollify the various risks of the overall marketplace, and
in so doing, stay focused on some of the best long-term
growth stories and the debt needed to finance the cor-
related and requisite booms in agriculture, infrastructure,
transportation, healthcare and technology.
Euro-zone Worries Persist
If we are recovering slowly, unevenly but still surely,
and Asia is growing more quickly, Europe remains on
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We have produced two new Special Reports that are available online. One report focuses on our manager selection process and
is titled Buying The Manager, Not The Fund™—a phrase that, as you can see, we have trademarked. You can view this report by visiting
www.adviserinvestments.com/reports/BuyingTheManager.pdf.
The second report exhibits the outcome of our process; it’s an exclusive interview with Dennis Stattman, the lead manager of the Black-
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its tenterhook of having to curtail some of the benefi-
cent socialist policies that are leading to unsettling
images of social unrest. The global markets remain
prone to Europe’s malaise, but they’re increasingly less
beholden to it. What this means from our perspective
is that when Euro-zone worries escalate, their nega-
tive impact on the markets will be felt. But such welts
won’t likely be long-lasting so long as fundamental evi-
dence for slow recovery remains intact. We would note
that MSCI’s Europe index gained 19.4% during the
third quarter compared to the 11.5% gain for MSCI’s
Pacific index, which is heavily weighted towards Japan,
again confirming that trying to “time” any market,
even Europe’s, is a lost cause. In the final analysis, we
are less worried about Europe’s inability to right itself
over time and more focused on the pace of recovery
here and in Asia.
Manager Focus, Not Media Focus
Managing risk, while continuing to participate in
the stock and bonds markets, is key. While many were
critical of what they termed “buy and hold” investing,
we believe our active allocation process, based in part
on our proprietary and superior manager selection
process has continued to reward us in both up and
down markets.
This is a far cry from a static buy-hold-forget index-
ing approach. Instead, our discipline reflects a dynamic
approach to asset allocation, manager selection and sector
weighting that bespeaks an actively managed approach to
the ever-changing economic and market landscapes.
We remain cautiously optimistic. After a remarkable
quarterly performance and spectacular September, and
with expectations high for earnings season, we think the
first half of the final quarter of the year could be trying.
But, if the fundamental evidence for slow growth, not
no-growth prevails, we could benefit from a year-end
rally that complements the one we just enjoyed.