LP L FINANCIAL R E S E AR C H

Weekly Economic Commentary

May 7, 2012

License to Spend
John Canally, CFA
Economist LPL Financial

Highlights
Corporate cash flows are at all-time highs. We continue to expect solid capital spending in 2012. Weather and legislation likely affected businesses spending decisions in the early part of the year.

In our 2012 Outlook we wrote, U.S. gross domestic product (GDP) is likely to produce below-average growth of about 2% in 2012, supported by solid business spending and modest, but stable, consumer spending and that U.S. business spending would grow at several times the pace of consumer spending in 2012. With data on GDP now in hand for the first quarter of 2012, it appears that business capital spending has plenty of catching up to do over the final three quarters of 2012. While businesses have been generating record profits, leaving corporate cash flows close to all-time highs, they have been reluctant to add to staff or do much capital spending in early 2012, preferring other uses for their cash.

The Skills to Pay to the Bills

Acquire other companies. Merger and acquisition (M&A) activity, while nowhere near as robust as it was prior to the Great Recession, has ramped up quickly since the end of the recession. Global M&A activity has increased by close to 40% since the middle of 2009, according to Bloomberg data.

Fight for Your Right. Corporate revenue is again growing strongly and is generating large amounts of free cash that is available to finance investment. Yet, tight credit markets are limiting the ability of small and medium-sized companies, those generally without access to financial markets, from taking on new investment projects.

Initiate or increase dividend payments to shareholders. According to Standard & Poors Index Services, 677 companies either initiated or increased dividends to shareholders in the first quarter of 2012, the most in any first quarter since 2007 S&P 500 companies paid out $240 billion . in dividends to shareholders over the four quarters of 2011, the best four quarters for dividends since the four quarters ending in the third quarter of 2008, when many financial institutions slashed or eliminated their dividends as the Great Recession worsened. As we have noted in prior commentaries, corporate dividend strategies face uncertainty at the end of this year as the Bush tax cuts (which put the tax rate on dividends at 15%) are set to expire. Many firms may want to issue special dividends ahead of this date, thus diverting funds that could be used for capital spending. Buy back shares. According to Standard & Poors Index Services, share buybacks, another way companies can deploy cash to shareholders, totaled $409 billion for S&P 500 companies in 2011, a 40% increase from the $299 billion in buybacks in 2010. The year 2011 saw the most buyback activity since mid-2008, prior to the onset of the worst of the Great Recession in the fall of 2008. Although share prices have increased 25% since the fall of 2011, making it more expensive for corporations to buy back shares, share buybacks should at least match 2011 levels in 2012.

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LPL Financial Research Weekly Calendar

U.S. Data
2012 7 May

Fed

Global Notables

Consumer Credit (Mar) Congress Back in Session

Lacker*

French Presidential Elections (Sunday 5/6) Greek Parliamentary Elections (Sunday, 5/6) Indonesia: GDP (Q1) Netherlands: Debt Auction

8 May

Small Business Optimism (Apr) JOLTS (Mar) U.S. House of Representatives Holds Hearings on Overhauling the Fed

Fisher Lacker*

9 May

Kocherlakota Pianalto* Plosser

Germany: Debt Auction Brazil: Central Bank Meting Brazil: Inflation (Apr) Mexico: Central Bank Meeting China: Imports and Exports (Apr) China: Money Supply (Apr) U.K.: Bank of England Meeting South Korea: Central Bank Meeting Indonesia: Central Bank Meeting Norway: Central Bank Meeting China: CPI (Apr) China: Industrial Production (Apr) China: Retail Sales (Apr) Malaysia: Central Bank Meeting Belgium: Debt Auction

10 May

Merchandise Trade Deficit (Mar) Initial Claims (5/5) Monthly Budget Deficit (Apr)

Bernanke* Kocherlakota

11 May

PPI (Apr) Consumer Sentiment (1H May)

Fisher

Hawks: Fed officials who favor the low inflation side of the Feds dual mandate of low inflation and full employment Doves: Fed officials who favor the full employment side of the Feds dual mandate * Voting members of the Federal Open Market Committee (FOMC) Gross Domestic Product (GDP) is the monetary value of all the finished goods and services produced within a country's borders in a specific time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments and exports less imports that occur within a defined territory. Job Openings and Labor Turnover Survey (JOLTS) is a survey done by the United States Bureau of Labor Statistics to help measure job vacancies. It collects data from employers including retailers, manufacturers and different offices each month. Respondents to the survey answer quantitative and qualitative questions about their businesses' employment, job openings, recruitment, hires and separations. The JOLTS data is published monthly and by region and industry. The Producer Price Index (PPI) program measures the average change over time in the selling prices received by domestic producers for their output. The prices included in the PPI are from the first commercial transaction for many products and some services. LPL Financial Member FINRA/SIPC Page 2 of 5

W E E KLY E CONOMIC CO MME N TAR Y

After Dropping Precipitously in the Great Recession Corporate Profits Are Back to All Time Highs
250 200 S&P 500: Operating Earnings, 4 Quarter Sum

Legislation and Weather May Have Sabotaged Business Capital Spending in Early 2012
Part of the slowdown in business capital spending in early 2012 relative to the robust pace seen in 2011 (and to the pace of consumer spending) may have been related to legislation and the weather. As we have discussed on several occasions in these pages, the much warmer-than-usual weather in the first three months of 2012 likely pulled forward some consumer spending into the winter months from the spring months, artificially boosting consumer spending, which grew at a 2.9% annualized rate in the first quarter. Business capital spending, which is not as weather sensitive, grew at just a 1.7% annualized rate in the first quarter of 2012. The slow pace of business capital spending growth in the first quarter of 2012, in part, reflects the strength in capital spending in late 2011 which, in turn, may be related to legislation. Business spending was strong in 2011, especially in the final two quarters of the year, as spending rebounded from the supply chain disruptions triggered by the devastating earthquake, tsunami, and nuclear disaster in Japan in March of 2011. Business capital spending surged by 16% and 8% in the final two quarters of 2011, respectively, and increased by 10% over 2011. The year 2011 marked the second consecutive robust year of business spending, after business spending all but dried up in 2007 before declining sharply in both 2008 (4%) , and 2009 (-16%). Business capital spending surpassed its previous all-time high (set just prior to the onset of the Great Recession) in the third quarter of 2011, and continued to set new all-time highs in both the fourth quarter of 2011 and the first quarter of 2012. As noted above, part of the surge in business capital spending in late 2011 may have been related to legislation passed by Congress in December 2010, which allowed businesses to fully expense (for tax purposes) capital equipment purchased before the end of 2011. This probably pulled some capital spending that would otherwise have occurred in early 2012 into the latter half of 2011. The law allows companies to expense only 50% of capital equipment purchased before December 31, 2012 and, as the law stands now, even this provision would expire at the end of 2012, as part of the fiscal cliff we have discussed in recent weeks. This uncertainty may have the same impact on business spending this year, especially as we approach the 2012 Presidential and Congressional elections.

Billions of $

150 100 50 0

01 02 03 04 05 06 07 08 09 10 11 Source: Standard & Poor's Index Services, Haver Analytics 05/07/12

-50

Shaded areas indicate recessions. The S&P 500 is an unmanaged index, which cannot be invested into directly. Past performance is no guarantee of future results.

Dividend Payments by S&P 500 Companies to Shareholders Are Almost Back to Pre Recession Highs, And Have Increased Sharply Over the Past Two Years
Dividends Paid By S&P 500 Companies, 4 Quarter Sum 300 250

Billions of $

200 150 100 50 0 Q4 Q4 Q4 Q4 Q4 Q4 Q4 Q4 Q4 Q4 Q4 01 02 03 04 05 06 07 08 09 10 11

Source: Standard & Poor's Index Services 05/07/12

Risk Factors For Robust Capital Spending in 2012: Sluggish economic growth in the United States, the ongoing uncertainty in Europe, the slowdown in China, as well as the large range of outcomes for business capital related legislation in the wake of the upcoming Presidential and Congressional elections in the United States, among other factors, are likely to continue to weigh on businesses willingness to commit to more capital spending in 2012.
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Check it Out: What May Boost Business Capital Spending Throughout 2012
Moving beyond legislation, many of the factors we forecast would be in place in 2012 to continue to boost capital spending remain in place. They include:
Record cash levels. The aforementioned record level of cash and corporate profits, combined with very low rates of return on these cash assets, is forcing corporate boards to ask corporate managements to put the cash to a more productive use.

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Business Capital Spending Surpassed Its Pre-Great Recession High in Late 2011, and Is at an All-Time High
Real Private Nonresidential Investment: Equipment & Software, Seasonally Adjusted Annual Rate, Tril. Chn. 2005$

1.2 1.1 1.0 0.9 0.8

Near-record low financing rates for businesses. The Federal Reserve (Fed) has promised to keep rates at exceptionally low levels until at least 2014. In addition, the Feds Operation Twist has kept long-term rates lower for longer, aiding both business and consumer borrowers. Steadily increasing loan growth. Commercial and industrial loans by banks to businesses, a key weekly metric of bank lending activity, is at a three-year high, and is up more than 13% from a year ago, the strongest pace of growth in nearly four years. Gradually easing lending standards. Lending standards for loans by banks to finance capital spending, especially for commercial real estate, are easing, though still tight. As noted above, corporate revenue is again growing strongly and is generating large amounts of free cash that is available to finance investment. Yet, tight credit markets are limiting the ability of small and medium-sized companies, generally those without access to financial markets, from taking on new investment projects. Equity prices. The 100%-plus gain in equity prices over the past three years and the 25%-plus gain in stocks over the past six months are notable. No sector of the economy is more highly correlated with movement in equity prices than business capital spending. Further gains in equity markets should fuel more capital spending over the remainder of the year. Onshoring trend. We have observed ongoing anecdotal evidence of onshoring of jobs, especially in the manufacturing area. Aided by: 1) poor quality control in China, 2) relatively high unemployment, and lowered wage and benefit demands in the United States, and 3) the low cost of fuels like natural gas to help run the plants, an increasing number of big and small companies have moved production back to the United States in recent quarters. Political considerations are also hastening this trend. Capital for labor. An ongoing substitution of capital for labor is occurring, as businesses continue to compete globally using the latest in technology and production processes. In addition, adding new workers often involves paying benefits along with salaries. New machinery, of course, does not require benefits like health care. Average age of productive infrastructure at multi-year highs. The average age of the nations productive infrastructure is at multi-year highs, especially in traditional manufacturing, but in many other areas as well. Industries including transportation and warehousing, wholesale trade, retail trade, accommodation, and food services all have seen the average age of their productive infrastructure hit new multi-decade highs since the onset of the Great Recession, as businesses cut investment to protect their shareholders in the downturn.

01 02 03 04 05 06 07 08 09 10 11 Source: Bureau of Economic Analysis, Haver Analytics 05/07/12

Shaded areas indicate recessions. Nonresidential real estate: Commercial structures constructed for use as factories, office buildings, warehouses, utilities, hospitals, retail stores, etc.

The Average Age of Manufacturing Infrastructure Rose Sharply During the Great Recession and Is at an All-Time High
Average Age, Private Fixed Assets: Manufacturing, Years

16 15 14 13 12 11

25 30 35 40 45 50 55 60 65 70 75 80 85 90 95 00 05 10 Source: Bureau of Economic Analysis, Haver Analytics 05/07/12

10

Shaded areas indicate recessions.

The sweeping regulatory and legislative changes and prospects for additional changes, affecting sectors such as Financials, Energy, Utilities, and Health Care, that took place in 2010 are fading and may even be reversed with the outcome of the 2012 election. Therefore, in 2012, business spending may continue to enjoy what may be a new multi-year cycle supported by this clearer regulatory and legislative environment.

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LPL Financial Research 2012 Forecasts

GDP 2%* Federal Funds Rate 0%^ Private Payrolls +200K/mo.

Please see our 2012 Outlook for more details on LPL Financial Research forecasts.

IMPORTANT DISCLOSURES The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. * Gross Domestic Product (GDP) is the monetary value of all the finished goods and services produced within a country's borders in a specific time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments and exports less imports that occur within a defined territory. ^ Federal Funds Rate is the interest rate at which depository institutions actively trade balances held at the Federal Reserve, called federal funds, with each other, usually overnight, on an uncollateralized basis. Private Sector the total nonfarm payroll accounts for approximately 80% of the workers who produce the entire gross domestic product of the United States. The nonfarm payroll statistic is reported monthly, on the first Friday of the month, and is used to assist government policy makers and economists determine the current state of the economy and predict future levels of economic activity. It doesnt include: - general government employees - private household employees - employees of nonprofit organizations that provide assistance to individuals - farm employees 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.

This research material has been prepared by LPL Financial. To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial is not an affiliate of and makes no representation with respect to such entity.
Not FDIC/NCUA Insured | Not Bank/Credit Union Guaranteed | May Lose Value | Not Guaranteed by any Government Agency | Not a Bank/Credit Union Deposit

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LP L FINANCIAL R E S E AR C H

Weekly Market Commentary

May 7, 2012

The Wall Street Election Poll

Jeffrey Kleintop, CFA
Chief Market Strategist LPL Financial

Highlights
The biggest event for investors over the next six months is likely to be the November elections in the United States. The outcome of the elections will define the political context and leadership for the policies that address the looming fiscal imbalances coming to a head in early 2013. Based on the relative performance of legislationsensitive industries that may react more favorably to one party, we have created two indexes to help us track the markets implied forecast of the election outcome reflected in the performance of these industries. While there are other factors that may influence the relative performance of these indexes, as time goes on the election consequences may become paramount as investors increasingly vote with their money.

The biggest event for investors over the next six months is likely to be the November elections in the United States. The outcome of the elections will define the political context and leadership for policies that address the looming fiscal imbalances coming to a head in early 2013. We have explored this budget bombshell in prior commentaries and what it could mean for the markets and economy. This week we will take a look at what the market is pricing in regarding the election outcome. As we explore the issue of what the market is pricing in when it comes to the outcomes of the November elections, it is important to be aware of the shortcomings of overly simplistic election analysis. An illustration of this can be seen in Figure 1, where we plot the odds of President Obamas re-election (measured by contracts traded on Intrade.com) and the movements in the stock market, measured by the S&P 500 Index. Is the stock market going up because of the rise in Obamas re-election odds, or are Obamas re-election odds going up because the stock market is rising or, more likely, are both tied to something else?

Odds of Obama Re-election and S&P 500

1500 1450 1400 1350 1300 1250 1200 1150 1100 1050 Jan 11 Mar 11 May 11 Jul 11 Sep 11 Nov 11 Jan 12 Mar 12 May 12
S&P 500, Left Scale Odds of Re-election, Right Scale

70 65 60 55 50 45 40

Source: LPL Financial, Intrade.com 05/04/12

The S&P 500 is an unmanaged index, which cannot be invested into directly. Past performance is no guarantee of future results.

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Attempting to draw simple conclusions about what the market is saying about the election is fraught with the potential for misinterpretation. Instead, there is a better, more analytical way for investors to attempt this kind of potentially rewarding analysis. Analyzing the market by the industries most impacted one way or another by the election outcome can provide more precise insight into what the market is pricing in regarding the election. For example, the components of the 10 stock market sectors are impacted in different ways by election outcomes:
Health Care is the biggest driver of the long-term budget problems at the Federal level. States are already cutting Medicaid to balance their budgets. A sweeping win for the GOP holds the most promise for Managed Care providers as risks decline and investors increase the odds for a repeal of all or part of the Affordable Care Act. Diagnostic labs, generic drug makers, hospitals, and nursing homes may benefit if the Act is upheld and from Democrats leadership, given expanded health care coverage and an emphasis on preventative care and legislation to speed up the introduction of generic drugs to market. We may see a relief rally among the banks in the legislation-sensitive Financial sector. If the GOP takes the Senate it will result in the change of chairmanships of key committees. While major changes to the financial reform law, Dodd-Frank, are unlikely, an all GOP Congress might influence regulations implementing the law. On the other hand, Republicans would likely look to address Fannie Mae and Freddie Mac conspicuously left out of the Democrat-led financial reform law, which could have negative ramifications on home loan originators. Democrats may also provide more housing support programs benefitting home builders and construction materials providers. As previously mentioned, the potential extension of Bush tax cuts would mean the dividend tax rate may remain closer to 15% instead of going to 43.4%, a plus for companies with lots of cash to distribute. High dividendpaying sectors such as Telecommunications Services, Consumer Staples, and Utilities may benefit. Cash-rich companies in other sectors may also benefit as they introduce or substantially increase their dividend payout as they look to attract a new class of investor seeking yield. Alternatively, some food and staples retailers may benefit from potential for a further extension of unemployment benefits. Companies in the Energy sector may be impacted by a strong election for the GOP in a number of ways. Regulations on drilling would be more favorable as would EPA regulations. We could see lower regulatory costs for producers in the Materials sector and users of coal such as Utilities. Gas may benefit from stricter coal regulations under the Democrats. On the other hand, alternative energy companies would face a less supportive outlook for subsidies under a GOP outcome.

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S&P 500 Industries Likely to React More Favorably to One Party

Democrats S&P 500 Health Care Facilities S&P 500 Food & Staples Retailing S&P 500 Gas Utilities S&P 500 Health Care Services S&P 500 Life Sciences Tools & Services S&P 500 Construction Materials S&P 500 Homebuilding

Republicans S&P 500 Coal & Consumable Fuels S&P 500 Diversified Financial Services S&P 500 Oil & Gas Exploration & Production S&P 500 Oil & Gas Drilling S&P 500 Managed Health Care S&P 500 Electric Utilities S&P 500 Specialty Retail Source: LPL Financial 05/07/12

Sectors highly sensitive to trade, including Technology, may benefit from a strong showing by the GOP The Consumer Discretionary sector could . also benefit from the diminished risk of China trade protectionism a plus for retailers dependent on low-cost imports and U.S. exporters of capital equipment fearing Chinese retaliation. The election could hold positives and negatives for companies in the Industrial sector. At 20% of the budget, defense spending will likely see cuts next year, but would likely see a more shallow trimming under the GOP than Democrats. On the other hand, transportation funding will likely be smaller under GOP leadership, resulting in fewer government dollars for engineering and construction companies.

While there are many man on the street polls, what matters most to investors is what is priced in on Wall Street rather than what people are saying on Main Street. A stock market based election poll is useful in that it highlights what the market is pricing in about the outcome of the election that is more refined than merely looking at the overall market. Based upon these legislation-sensitive industries, we have created two indexes to help us track the markets implied forecast of the election outcome reflected in the performance of these industries. Each index is composed of an equal weighting among seven industries that combined total about 100 S&P 500 stocks. To track what the market has priced in for the Democrats odds of retaining the White House and Senate we have taken the Democrats index and divided it by the Republicans index. An upward sloping line suggests the market may be pricing in a rising likelihood of the Democrats retaining the White House and their majority in the Senate, while a downward sloping line suggests improving prospects for the Republicans. While other factors may influence the relative performance of these indexes, as time goes on the election consequences may become paramount as investors increasingly vote with their money. As you can see in Figure 3, already this year Obamas re-election odds on Intrade.com are generally tracking the relative strength of our Democrat vs. Republican indexes. If you elect to follow our Wall Street election poll index, we pledge to continue to keep you informed as to how these issues are likely to affect the markets. We will update this index frequently as the election becomes an increasingly important driver of the markets over the coming six months. n

LPL Financial Research Wall Street Election Poll: Relative Strength of Democrat vs. Republican Indexes Reflect Election Odds
Obama Re-election Odds, Left Scale Relative Strength (Dem. vs. Rep.), Right Scale 108 105 102 99 96 93 01/09 01/23 02/06 02/20 03/05 03/19 04/02 04/16 04/30

70 64 58 52 46 40

Source: LPL Financial, Intrade.com, FactSet Research Systems 05/07/12

IMPORTANT DISCLOSURES The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. 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. Stock investing may involve risk including loss of principal.

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The Standard & Poors 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. Consumer Discretionary Sector: Companies that tend to be the most sensitive to economic cycles. Its manufacturing segment includes automotive, household durable goods, textiles and apparel, and leisure equipment. The service segment includes hotels, restaurants and other leisure facilities, media production and services, consumer retailing and services and education services. Consumer Staples Sector: Companies whose businesses are less sensitive to economic cycles. It includes manufacturers and distributors of food, beverages and tobacco, and producers of non-durable household goods and personal products. It also includes food and drug retailing companies. Energy Sector: Companies whose businesses are dominated by either of the following activities: The construction or provision of oil rigs, drilling equipment and other energy-related service and equipment, including seismic data collection. The exploration, production, marketing, refining and/or transportation of oil and gas products, coal and consumable fuels. Financials Sector: Companies involved in activities such as banking, consumer finance, investment banking and brokerage, asset management, insurance and investment, and real estate, including REITs. Health Care Sector: Companies are in two main industry groups Health Care equipment and supplies or companies that provide health care-related services, including distributors of health care products, providers of basic health care services, and owners and operators of health care facilities and organizations. Companies primarily involved in the research, development, production, and marketing of pharmaceuticals and biotechnology products. Industrials Sector: Companies whose businesses manufacture and distribute capital goods, including aerospace and defense, construction, engineering and building products, electrical equipment and industrial machinery. Provide commercial services and supplies, including printing, employment, environmental and office services. Provide transportation services, including airlines, couriers, marine, road and rail, and transportation infrastructure. Manufacturing Sector: Companies engaged in chemical, mechanical, or physical transformation of materials, substances, or components into consumer or industrial goods. Materials Sector: Companies that are engaged in a wide range of commodity-related manufacturing. Included in this sector are companies that manufacture chemicals, construction materials, glass, paper, forest products and related packaging products, metals, minerals and mining companies, including producers of steel. Information Technology: Companies include those that primarily develop software in various fields such as the Internet, applications, systems and/or database management and companies that provide information technology consulting and services; technology hardware & Equipment, including manufacturers and distributors of communications equipment, computers and peripherals, electronic equipment and related instruments, and semiconductor equipment and products. Telecommunications Services Sector: Companies that provide communications services primarily through a fixed line, cellular, wireless, high bandwidth and/or fiber-optic cable network. Utilities Sector: Companies considered electric, gas or water utilities, or companies that operate as independent producers and/or distributors of power. Because of their narrow focus, sector investing will be subject to greater volatility than investing more broadly across many sectors and companies.

This research material has been prepared by LPL Financial. To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial is not an affiliate of and makes no representation with respect to such entity.
Not FDIC or NCUA/NCUSIF Insured | No Bank or Credit Union Guarantee | May Lose Value | Not Guaranteed by any Government Agency | Not a Bank/Credit Union Deposit

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