Market Update for the Quarter Ending June 30, 2012

A strong month at the end but losses for the quarter

• For equities, June was a strong month to end a weak quarter.
  • For the month, the S&P 500 Index (S&P 500) gained 4.12 percent, while the Nasdaq showed a smaller gain of 3.81 percent.
  • For the quarter, the S&P 500 was down 2.75 percent, while the Nasdaq was down even more, at 5.06 percent.
  • Extremely weak May results dominated the quarter, despite small gains in April and a strong June.
• Technically, the indices recovered from their brief dips below the 200-day moving averages—a good sign.
• The S&P 500 jumped above its 50-day moving average but remains below the 200-day, and the Nasdaq recovered to just below its 50-day moving average.
• Fundamental factors showed deterioration.
  • Seventy-three of the S&P 500 companies (up from 67 in the first quarter) issued negative earnings guidance for the second quarter, while only 29 (down from 44) lifted guidance.
  • Analysts now expect a 0.6-percent decline in earnings, down from a 6.2-percent gain in the first quarter.
    • This is the worst growth rate since the third quarter of 2009 and shows that the corporate sector is slowing down.
• International markets did somewhat better for the month but worse for the quarter.
  • The MSCI EAFE Index gained 7.01 percent for the month but lost 7.13 percent for the quarter.
  • The MSCI Emerging Markets Index gained 3.43 percent for the month but lost 10 percent for the quarter.
    • Again, a weak May was the primary culprit, with market expectations for growth eroding and for political instability increasing.
    • Technicals remain weak, with both indices edging close to or slightly above the 50-day moving average but well below the 200-day moving average.
    • For both indices, the 50-day crossed below the 200-day, a sign of potential weakness, in early June.
• Fixed income had a relatively weaker month compared with equities.
  • The Barclays Capital U.S. Aggregate Bond Index was up 0.04 percent for the month.
    • Despite a weak June, the index was up 2.06 percent for the quarter.
  • U.S. Treasury rates rose across the board in June, albeit by a relatively small amount, but remain well below rates at the start of the quarter.
  • Mortgage rates continued their long decline throughout the quarter.
  • Corporate spreads were relatively unchanged in June and up a bit over the quarter, while municipal spreads widened over both periods.
• Overall, the results this quarter showed the resurgence of uncertainty in the markets.
  • As corporate results and the general economy exhibit slowing growth or outright decline, expectations are taking a similar hit and investors are seeking more safety and less risk.
    • An excellent reflection of this is the fact that, for only the second time since the 1950s, the dividend return on the S&P 500 is above the 10-year U.S. Treasury bond yield (see chart).

Small gains for workers and housing

• In the general economy, growth continued but at a slower and slowing pace, and, in terms of gauging the strength of the American consumer, the data released in June was mixed.
  • At the beginning of the month, investors learned that employment growth had slowed substantially.
  • In May, payrolls grew much less quickly than had been expected, and the previous relatively strong results reported for April were revised downward.
  • The unemployment rate rose slightly, from 8.1 percent to 8.2 percent.
• Other factors suggested a better outlook for consumer.
  • Home prices rose 0.67 percent in April—the third positive month in a row—according to the Case-Shiller 20-City Home Price Index.
    • Prices had improved temporarily a few years ago during the First-Time Homebuyer Credit program; this time, however, home values are increasing without the aid of artificial government intervention.
    • Another potential catalyst for the consumer comes from reduced inflation, with a stronger U.S. dollar and lower oil prices.
• Manufacturing appears to be on track, at least according to the national ISM Manufacturing Index.
  • But there has been unusual weakness in some areas of the country, particularly in the Philadelphia region.
  • Inventory build-up has also remained reasonably robust, implying support for gross domestic product growth in the second quarter.
• Overall, the U.S. economy appears to be on track for continued growth, although at a slower rate than in the first quarter.
  • The slowing rate has introduced additional uncertainty about future gains, and this has contributed to the loss of investor risk appetite.

Small or no gains for Europe and the world

• Europe continues to attempt to resolve its problems.
  • In Greece, elections for a new government raised the risk of repudiating the bailout deal.
  • The rejectionists were marginally defeated, but the clear fact that Greece remained in play unsettled markets.
• Spain’s government requested a bailout of its banking system.
  • The bailout was done quickly and with apparently adequate funding.
  • Markets were unimpressed; Spanish interest rates spiked to dangerous levels.
• Cyprus became the fifth eurozone country to request a bailout.
• At quarter-end, Europe remained unsettled, with major heads of state scheduled to meet to discuss the means to resolve the crisis once and for all.
  • Unexpectedly, a deal was announced that included significant provisions aimed at addressing both the symptoms and the causes of the crisis.
  • Equity markets rose sharply, and bond yields in peripheral economies fell.
  • The measures don’t solve the problem, but they are good steps along the way.
• Other areas of the world showed decelerating growth, but in these cases there is more room for governmental stimulus that could help.
  • The central banks of China and Brazil both cut rates, by 0.25 percent and 0.5 percent, respectively.
  • Economic growth has slowed considerably in Brazil and moderated China, which has led to concerns about the ability of emerging markets to be the growth engine of the global economy.
    • Still, the central banks of both countries have lots of room to maneuver in their efforts to keep growth on track.

Small help from the Federal Reserve

• The response of the Federal Reserve (the Fed) in this quarter was modest.
• Given weaker employment and consumer spending reports, the Fed announced a plan to extend its Operation Twist purchasing program and moderated the language in its monthly Federal Open Market Committee statement in June.
  • This was less than market participants had hoped for—and much less than the full quantitative easing that had been posited in the media.
  • The Fed downgraded its expectations for the economy in its statement, supporting the market’s lowered expectations.
  • The combination of less-than-expected stimulus and lowered expectations further depressed market sentiment.

A slow end to a difficult quarter

• While the first quarter of 2012 was strong, the second quarter has been a struggle.
  • Expectations have been scaled back across the board.
  • Many very difficult issues—Europe, the U.S. budget problems, and a slowing recovery in the U.S.—received extensive coverage.
• Even though growth in the U.S. has slowed, we continue to grow.
  • Europe is finally facing its problems, and the uncertainty there will, it is hoped, decrease when it does.
  • Finally, as expectations decline, it becomes easier to meet them, suggesting that current expectations may be more in line with reality.
• Although the quarter was slow, and May particularly disappointing, we continue to work through our problems and expect that the current slow improvement will continue.

Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets. All indices are unmanaged and investors cannot invest directly into an index. The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. The Nasdaq Composite Index measures the performance of all issues listed in the Nasdaq Stock Market, except for rights, warrants, units, and convertible debentures. The MSCI EAFE Index is a float-adjusted market capitalization index designed to measure developed market equity performance, excluding the U.S. and Canada. The MSCI Emerging Markets Index is a market capitalization-weighted index composed of companies representative of the market structure of 26 emerging market countries in Europe, Latin America, and the Pacific Basin. It excludes closed markets and those shares in otherwise free markets that are not purchasable by foreigners. The Barclays Capital Aggregate Bond Index is an unmanaged market value-weighted index representing securities that are SEC-registered, taxable, and dollar-denominated. It covers the U.S. investment-grade fixed-rate bond market, with index components for a combination of the Barclays Capital government and corporate securities, mortgage-backed pass-through securities, and asset-backed securities.