Market Commentary

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Market Commentary Spring 2010

Table of Contents 2009 Year-to-Date in Review

4th Quarter 2009: The Stock Market Rally Starts to Cool: What Next?

1



2009 Major Index Performance Summary

3



2009 U.S. Style Index Performance Summary

3

2010 Market Outlook

2010: A Year of Transition

4



Unemployment

5



Consumer Spending

6



Gross Domestic Product (“GDP”) / Economic Growth

7



Inflation

8



Interest Rates

9



Portfolio Management Ideas to Consider

10



Conclusion

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2009 Year in Review 4th Quarter 2009: The Stock Market Rally Starts to Cool: What Next? The fourth quarter of 2009 marked the end of a year that was a dramatic reversal from the devastation that took place in the capital markets during 2008. However, we all should not forget the shaky ground upon which the year started. In fact, the 1st quarter of 2009 marked the single worst quarterly performance, in percentage terms, of the Dow Jones Industrial Average (“DJIA”) since 1939. Yet, since the bottom of this most recent bear market was reached on March 9, 2009, every component of the capital markets machine has churned full speed ahead resulting in some of the most significant gains the stock market has seen in quite some time. In the process, we, at Hennion & Walsh, believe that investors have conveniently overlooked some concerning economic data, or rather the lack of consistent, positive data, in the hopes of trying to quickly recover what many investors lost during the 15 month period starting in January 2008. This belief, along with the cooling off of the red-hot stock market rally that took place in the 4th quarter, suggests to us that we are now heading into a transition year where economic and stock market growth will likely be muted and stock market volatility heightened. In terms of the major equity indices, the S&P 500 index (“S&P 500”) gained 6.04% in the 4th quarter on top of the 15.61% that it returned in the 3rd quarter. For the year, the S&P 500 advanced 26.46% as of December 31, 2009. This level of performance certainly is not enough to offset the S&P 500 index loss of 37.00% in 2008 but it does represent significant progress in the right direction. Similarly, the DJIA gained 8.10% in the 4th quarter and posted a 22.68% return for the year. Interestingly, the technology heavy NASDAQ lead all of the major U.S. equity indices with an advance 45.32% return for 2009.

...growth will likely be muted and stock market volatility heightened. In terms of asset classes, outside of Convertible and High Yield Bonds, Equities outperformed Bonds in the 4th quarter of 2009 as well as for all of 2009. Defying their historically noncorrelated relationship, Bonds and Equities both advanced during 2009 which highlights the apparent trepidation among investors with respect to what amount of risk they are comfortable assuming in the market following the historic declines of 2008. Convertible Bonds, which basically represent an Equity/Bond hybrid investment, perhaps best embody an appropriate investment for this type of sentiment. The Merrill Lynch Convertible Securities index returned 5.58% in the 4th quarter and gained 47.19% in 2009. Following a similar path of bond strategy specific outperformance, the Merrill Lynch High Yield Master II index returned 57.51% for the year. Municipal Bonds were also a noteworthy story for fixed income securities in 2009 and returned 12.91% for the year based on the performance of the Barclays Capital Muni Bond Index.



Commodities are an often overlooked asset class by individual investors. This was not the case in 2009 as commodities, notably Gold investment strategies, were frequently in the headlines throughout the year. Specific commodities, such as Steel and Coal, based on the performance of their associated ETFs; Market Vectors Coal (Ticker: KOL) and Market Vectors Steel (Ticker: SLX), led the commodity markets through their triple digit positive returns for the year and stand poised, in our opinion, to offer additional opportunities for growth in 2010. In terms of sub-asset classes, Mid-Cap beat out its Small Cap and Large Cap counterparts in the 4th quarter of 2009 and for the year 2009. To better understand the often-cited differences between these different capitalizations, and associated benchmark indexes, please refer to the chart below. Sub-Asset Class Large Cap Mid-Cap Small Cap

Market Capitalization Greater than $10 Billion Between $2 Billion and $10 Billion Less than $2 Billion

Benchmark Index S&P 500 Index Russell Mid-Cap Index Russell 2000 Index

Additionally, during the 4th quarter of 2009 as well as for the entire year of 2009, Growth outpaced Value. These are both positive indicators pointing towards a building market recovery, as smaller capitalized companies generally tend to outperform larger capitalized companies during recovery periods, as do growth-oriented companies when compared against valueoriented companies. As we look to the different geographies of the world, there was clearly one frontrunner: International - Emerging Market Equities. Emerging Markets, notably the BRIC countries, which include Brazil, Russia, India and China, significantly outperformed International – Developed Markets and U.S. Equities in 2009. To help better illustrate this outperformance, consider that the MSCI Emerging Market index (in U.S. Dollar Terms) gained 8.55% in the 4th quarter of 2009 and rose 78.51% for the year. International Emerging Markets present investors with a different set of risks to consider in comparison to International Developed Markets. For the year of 2009, this risk premium appears to have equated to around 47% as the MSCI EAFE index (in U.S. Dollar Terms) gained 31.78% for the year as of December 31, 2009. Finally, in terms of sectors, all sectors generally moved upward in 2009 but the Information Technology sector, in particular, stood out for its stellar performance. In general, technology is one of the sectors that tend to lead economic recovery efforts.

...the Information Technology sector, in particular, stood out for its stellar performance.



Here’s a recap of how the major indexes performed in 2009:

2009 Major Index Performance Summary Index S&P 500 Index Dow Jones Industrial Average Index NASDAQ Composite Index MSCI EAFE Index (Net) MSCI EM Emerging Markets Index (Net) Barclays Capital U.S. Government/Credit Bond Index Barclays Capital Aggregate Bond Index Barclays Capital U.S. Municipal Bond Index

2009 Year-to-Date % Rate of Return 26.46% 22.68% 45.32% 31.78% 78.51% 4.52% 5.93% 12.91%

Source: Wells Fargo Advisors. Performance data is as of December 31, 2009. Past performance is not an indication of future results.

2009 U.S. Style Index Performance Summary Index Russell 1000 Index Russell 1000 Growth Index Russell 1000 Value Index Russell Midcap Index Russell Midcap Growth Index Russell Midcap Value Index Russell 2000 Index Russell 2000 Growth Index Russell 2000 Value Index

Asset Class 2009 Year-to-Date % Rate of Return U.S. Large-Cap Core 28.43% U.S. Large-Cap Growth 37.21% U.S. Large-Cap Value 19.69% U.S. Mid-Cap Core 40.48% U.S. Mid-Cap Growth 46.29% U.S. Mid-Cap Value 34.21% U.S. Small-Cap Core 27.17% U.S. Small-Cap Growth 34.47% U.S. Small-Cap Value 20.58%

Source: Wells Fargo Advisors. Performance data is as of December 31, 2009. Past performance is not an indication of future results



2010 Market Outlook 2010: A Year of Transition We would characterize our outlook for 2010 as cautiously optimistic. We believe that the most likely scenario for 2010 involves a transition year which often follows an initial recovery year and is characterized by an extended pause in the market recovery cycle, increased volatility and general uncertainty across the capital markets. The outcome of the mid-term elections that will take place this year in addition to the passage of key legislation such as Health Care and Financial Services Reform will add to investor uncertainty each quarter. We contend that economic growth will be muted in the U.S. in 2010 and that a significant dent into the historically high level of unemployment will not be accomplished. As a result, the Federal Reserve will find it challenging to raise interest rates although inflationary concerns may present cause for them to do so. Low interest rates will continue to hold the U.S. Dollar down and create opportunities overseas – particularly in certain emerging markets. For these reasons, investors should consider a wide range of asset classes as part of their annual portfolio review and rebalancing process in order to provide for downside protection during days of heightened volatility while still advancing towards their specific growth and income investment goals.

We would characterize our outlook for 2010 as cautiously optimistic. In this regard, we drill down into some critical areas (listed below) that have shaped our own current market outlook while also sharing additional scenarios that we have modeled into our annual portfolio reconstitution process. • • • • •

Unemployment Consumer Spending Gross Domestic Product (“GDP”)/Economic Growth Inflation Interest Rates

We will then finish this market commentary with some portfolio management ideas for your consideration, including an update on the growing popularity of Exchange-traded Products (“ETPs”), and a reminder of the importance of asset allocation and rebalancing in a long-term portfolio strategy.



Unemployment According to the Bureau of Labor Statistics, the current official unemployment rate is 10%. The official unemployment rate, often referred to as the U-3 rate, represents the total unemployed as a percentage of the civilian labor force.

Unemployment Rate (1999 – 2009) 10

8

6

4

01/99

01/00

01/01

01/02

01/03

01/04

01/05

01/06

01/07

01/08

01/09

Source: Bureau of Labor Statistics, Data extracted on January 20, 2010

However, the statistic does not include all Americans that are currently unemployed. For example, the statistic that we often look to for a broad assessment of the employment picture in the United States is the U-6 rate which measures the total unemployed, plus all marginally attached workers, plus total employed part time for economic reasons, as a percent of the civilian labor force plus all marginally attached workers. At present the U-6 rate stands at 17.5%, which according to Jeff Cox of CNBC.com in a Nov, 19, 2009 article entitled, “The ‘Real Jobless Rate: 17.5% of Workers are Unemployed,” is the highest this rate has been since becoming an official labor statistic in 1994. Hence, the question becomes where will all of the new jobs come from to put America back to work again? As this question is pondered, we should remember that America is no longer defined by its manufacturing prowess. Rather, the U.S. economy is now more of a service oriented economy driven on the heels of innovation. As a result, we will not be able to depend on a surge in manufacturing jobs that historically have accompanied economic recoveries. New jobs will likely just be recycled finance industry jobs or completely new jobs resulting from innovative companies focusing on developing areas such as alternative energy. Regardless, we do not expect to see a significant dent made into unemployment in 2010 and it may take several years and a major shift in the global economy to get America back to full employment – which many academics believes lies somewhere between a U-3 unemployment rate of 3% and 4%.



Consumer Spending While consumer attitudes towards spending seemingly increased in 2009 according to a recent ChangeWave Research survey, 37% of the individuals surveyed still expect to spend less over the first 90 days of 2010 than they did over the same timeframe last year while only 25% believe that they will actually spend more.

Overall Consumer Spending Results Last 3 Years Comparisons Nov ‘06 - Dec ‘09 ‘Would you say your overall spending over the next 90 days will be more than last year, less than last year or the same as last year?’ Spending Less Spending More 70% 60% 50% 40% 30% 20% 10% 0% N J M M J A S N J F A M J A S N D J F M A M J J A S O N D ‘06 ‘07 ‘07 ‘07 ‘07 ‘07 ‘07 ‘07 ‘08 ‘08 ‘08 ‘08 ‘08 ‘08 ‘08 ‘08 ‘08 ‘09 ‘09 ‘09 ‘09 ‘09 ‘09 ‘09 ‘09 ‘09 ‘09 ‘09 ‘09 Source: ©2009 ChangeWave Research

From our perspective, the equation that leads to an economic recovery is rather simple. Companies cannot grow unless their sales and revenues grow. While companies can (and have over the past year) improve their revenues through workforce reductions and efficiency gains, sales essentially can only be increased as a direct result of individuals purchasing more of their goods or services. Individuals will not purchase more goods or services from a company if they are either out of work or fearful of their future job prospects. Following these described chain link relationships, unless there is a material improvement in our nation’s unemployment rate, consumers will not spend more and company sales will not increase. Since 70% of our economic growth, as measured by Gross Domestic Product (“GDP”), comes from consumer spending, this forecast does not bode for any potential intensification of the U.S. economic recovery in 2010.

...the U.S. economy cannot build a sustainable recovery without the U.S. consumer. We are not alone in our less than glowing consumer spending forecast as a recent Nielson Company survey concluded, “Consumers will continue to be cautious with their spending in 2010. With unemployment still a concern, buyers will spend but with great restraint.” We have said it before and we will say it again now, the U.S. economy cannot build a sustainable recovery without the U.S. consumer. 

Gross Domestic Product (“GDP”) / Economic Growth For many of the previously cited reasons, we expect U.S. economic growth to be weak this year. We are not alone in the prediction. The Financial Forecast Center is currently forecasting, with a timeframe going out to the middle of 2010, that U.S. Real GDP Growth will not return until the 2nd quarter of 2010 and when it does return, the actual initial growth will be minimal.

U.S. Real GDP Growth Rate Forecast Year over Year Change in U.S. Real GDP. Percent per annum Month 0 1 2 3 4 5 6 7 8

Date Oct 2009 Nov 2009 Dec 2009 Jan 2010 Feb 2010 Mar 2010 Apr 2010 May 2010 Jun 2010

Forecast Value -1.50 -1.5 -1.5 -0.5 -0.5 -0.5 0.2 0.2 0.2

Source: The Financial Forecast Center, Updated Monday, November 30, 2009

These projections should not imply that we do not believe that the U.S. economy has already started to improve nor imply that we do not believe that the U.S. economy is on a path to a sustainable recovery as we, in fact, believe that both statements are valid. In fact, a review of U.S. Real GDP Growth Rate trends since October of 2007 supports this point of view.

U.S. Real GDP Growth RateEconomic Recovery Progression Past Trend Present Value & Future Projection. Year over Year Change. Percent per year. 4 3 2 1 0 -1 -2 -3 -4

Source: The Financial Forecast Center, Updated Monday, November 30, 2009



May 10

Feb 10

Oct 09

Jul 09

Apr 09

Forecast Jan 09

Sep 08

Jun 08

Mar 08

Actual Dec 07

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We are not, however, as optimistic as many with respect to the potential for GDP growth in 2010, including the Federal Reserve who recently revised their forecast to an annual growth rate between 2.5% - 3.3% for the new year. In fact, for this type of economic growth to be achieved, we believe that unemployment would likely have to fall by at least 25% accompanied by a similar uptick in consumer spending.

Inflation Many contend that the threat of inflation is not on the near-time horizon and, perhaps, should not be a major point of emphasis for 2010. We could not disagree more. It is true that inflationary pressures are being tempered by the overall tightness in the credit markets. It is also true that current Real G.D.P. Growth rates are not introducing any additional inflationary pressures into the system. However, it is also evident that an enormous amount of money has been introduced into the system over the last two year period and, up until this point in time, there has been no concrete plan established, or at least communicated, by the Federal Reserve to get this money back out of the system.

Many contend that the threat of inflation is not on the near-time horizon and, perhaps, should not be a major point of emphasis for 2010. We could not disagree more. It may be helpful at this juncture to clarify the exact definition of inflation, which is often measured by the change in the Consumer Price Index (“CPI”) on a year-to-year basis. According to YourDictionary.com, inflation occurs “as an increase in the amount of money and credit in relation to the supply of goods and services. Often, inflation is erroneously defined by the effect that it has on the economy. When people notice that gas, food, and lodging is getting more expensive, they often label that phenomenon inflation. Rising prices, however, are really just the result of the inflation.” In other words, inflation has already been introduced into the system so it is no longer a question of if inflation will occur but rather to what magnitude and for how long will its effects be felt. We believe that we are now starting to see some of its effects in rising commodity prices, albeit that some of these price increases are being driven by the “re-emergence” of certain emerging markets. The chart below from MarketBrowser supports our belief as it shows that the steady upward trend of inflation abated in 2008 but started to pick up again in 2009.

We believe that we are now starting to see some of its effects in rising commodity prices...



CPI For All Urban Consumers (1999 – 2009) 220 210 200 190 180 170 2001

2002

2003

2004

2005

2006

2007

2008

2009

Source: MarketBrowser, 2010

We also believe that the timing of when the Federal Reserve starts to remove excess liquidity from the system through actions such as reverse repurchase programs or interest rate hikes will be critical to stave off the potentially devastating impacts of high inflation on an economy that is struggling to rise and stand on its own two feet again.

Interest Rates Using the Effective Federal Funds Rate as a proxy for interest rates, it is reasonable to conclude that interest rates are at historic lows and likely to only go higher.

Effective Federal Funds Rate (1954 – 2009) 20 18 16 14 12 10 8 6 4 2 0 1956

1960 1964

1968

1972

1976 1980

1984

Source: MarketBrowser, 2010



1988

1992

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2008

With the understanding that interest rates will not/cannot go any lower (i.e. the Effective Federal Funds Rate now stands at close to 0%), the question then becomes when will interest rates start to creep upward again? We do not believe that the Federal Reserve will raise interest rates in 2010 due to their publicly stated position of continuing to prioritize the stimulation of the economy, lingering difficulties in the credit markets, and the political effect of mid-term elections along with the expected low levels of economic growth.

...when will interest rates start to creep upward again? However, there is a chance that the Federal Reserve may raise rates in a measured fashion by the end of the year if, in fact, their own Real GDP Growth rate forecasts come to fruition and, in so doing, put economic growth over the unofficial Federal Reserve inflation target of 1.5% - 2.0%. If this does not occur, record low interest rates will continue to serve as an anchor to the strength of the U.S. dollar and present investors with intriguing overseas and alternative investment opportunities. With all of these points in mind, we suggest the following portfolio management ideas for careful and thoughtful consideration remembering that any investment portfolio should be custom tailored to an investor’s specific financial goals, income needs, investment timeframe and tolerance for risk.

Portfolio Management Ideas to Consider •

Future Growth may take place outside U.S. Borders

The prospects for sustainable and consistent GDP growth in the short-intermediate term within the U.S. seem challenging at best. As a result, having some allocation to International Equities – both Developed and Emerging Markets – seem worthy of consideration recognizing that international investments have their own unique set of risks that should be understood before considering any potential investment within these asset classes.

•

Find a Place for Smaller Capitalized Companies in Your Portfolio

While we believe there is also risk adjusted return potential in U.S. Large Cap stocks in 2010 and that a reduction in pre-existing U.S. Small and Mid-Cap allocations may be appropriate for the New Year, we still feel that there is a case to be made for including allocations to U.S. Small-U.S. Mid cap investment strategies in most diversified growth portfolios. In fact, with respect to U.S. Small Cap stocks in particular, according to a First American Funds research report entitled, “Post Recession Opportunities in Small Caps,” between 1982 and 2001, most economists generally believe that three recessions have

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taken place (and used recession end dates of November 1, 1982, November 1, 1991 and November 1, 2001 for these purposes). According to their research, 1 year following each of these reported recessions, U.S. Small Cap Stocks outperformed U.S. Large Cap stocks on a cumulative basis by a margin of 20.23% to 10.44%. Furthermore, 3 years following the end of each of these recessions, Small Cap stocks continued their outperformance over Large Cap stocks on a cumulative basis by a margin of 56.98% - 39.23%. While we do not know if the recovery from this particular recession will defy historical standards, we do not believe that there is any reason to think that U.S. Small and U.S. Mid-Cap stocks will not continue to provide value on a relative basis either.

•

Bonds can Provide for Safety, Income and Growth

For income-oriented investors, we have always strongly believed that single-issue bonds offer the best avenue for predictable streams of income and principal protection when held to maturity. For growth-oriented investors, fixed income securities can provide investors with downside protection and diversification within a growth portfolio. Bonds can usually find a home in most investment portfolios throughout most market cycles.

•

Look for ways to help Inflation-proof your Portfolio

Having some allocation to certain commodities or baskets of commodities in your portfolio could not only help with return potential in the months ahead but also serve as an inflation hedge. Other potential inflation hedges include Treasury Inflation Protected Securities (“TIPS”) and diversified growth portfolios, which often include allocation to equities.

•

Be Creative

Having a portfolio of only U.S. large cap stocks (as many investors seem to have these days) may present unnecessary concentration risk to the growth portion of an investor portfolio following a decade where the DJIA lost 9.3% in the 2000’s – the second worst decade performance in history. Investors should consider adding a wider range of asset classes including available alternative and hybrid investment strategies, as we have, to their portfolios given the uncertainty in the markets in the months and quarters ahead.

Conclusion Asset allocation decisions can be critical to the long-term success of an investment portfolio. The landmark “Determinants of Portfolio Performance” study conducted in 1991 by Brinson, Singer and Beebower, as published in the Financial Analysts Journal, identified asset allocation as being responsible for more than 91% of portfolio performance – many times greater than the selection and timing of individual security transactions.

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Some have suggested that traditional forms of asset allocation strategies failed during the global credit crisis of 2008 and perhaps will not play as significant of a role in portfolio management techniques going forward. We suggest that the benefits of asset allocation were exemplified over the global credit crisis of 2008 and asset allocation itself will likely play an even more significant role in portfolio management in the months and years ahead.

...and maintaining an appropriate strategic asset allocation can help provide comfort and direction to investors during periods of great volatility. Asset allocation remains of the upmost importance, from our point of view, and should always be constructed in accordance with one’s investment objectives, investment timeframe and tolerance for risk. While past performance cannot guarantee future results, and asset allocation cannot ensure a profit or protect against a loss, applying a historical perspective and maintaining an appropriate strategic asset allocation can help provide comfort and direction to investors during periods of great volatility. When implementing asset allocation strategies, we have found that it is becoming increasingly more common to utilize Exchange-traded Products (“ETPs”) for certain asset classes, styles and sectors. ETPs consist of Exchange-traded Funds (“ETFs”) and Exchange-traded Notes (“ETNs”). ETPs themselves continue to grow in popularity among portfolio managers, financial advisors and individual investors. According to the Investment Company Institute (“ICI”), as of August 2009, there are now 735 ETPs with over $656 billion in assets. ETPs are now available for a wide range of equity asset classes, sub-classes, styles and sectors as well as fixed income, commodity and foreign currency categories on a long and short basis. However, as with other security types, investors should educate themselves on the intricacies of the ETP marketplace and consult a professional advisor as appropriate.

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Our mission at Hennion & Walsh is to be the advocate for individual investors, and we believe educating investors is a significant part of this mission. Please let us know if there is anything that we can do to help with your understanding of the market as a whole or your investment portfolio in particular. From our family at Hennion & Walsh to yours, best wishes for a happy and healthy holiday season. Sincerely,

Kevin Mahn Chief Investment Officer

Bill Walsh Partner

Rich Hennion Partner

For more information on our Firm and the many products and services that we offer, please visit www.hennionandwalsh.com. To read frequent updates on our market and economic insights throughout the quarter, please visit our blog at www.portfoliostrategynews.com.

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2001 Route 46, Waterview Plaza, Parsippany, NJ 07054 (973) 299-8989 • (800) 836-8240 • Fax (973) 299-0692 www.hennionandwalsh.com Securities offered through Hennion & Walsh Inc. Member of FINRA,SIPC.