Market Commentary

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Market Commentary Winter 2009

Table of Contents 2009 Year-to-Date in Review

3rd Quarter 2009: Has the Recovery now been validated?

1



2009 Year-to-Date Major Index Performance Summary

3



2009 Year-to-Date U.S. Style Index Performance Summary

3

2009 Remaining Market Outlook

Unemployment

5



Consumer Confidence

6



Corporate Earnings

7



Economic Recovery Progression

8



Interest Rates and the Value of the U.S. Dollar

10



Inflation

12



Portfolio Management Ideas to Consider

13



Conclusion

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2009 Year-to-Date in Review 3rd Quarter Performance: Has the Recovery now been validated? Each Thanksgiving season, certain professional golfers compete in the annual “Skins Game” golf tournament. In this unique tournament format, golfers accumulate winnings by not only beating all of the other golfers in the foursome on a given hole but going further to “validate” their victory by essentially not losing to the winning golfer on the next hole. The comparisons of this golf event to the current state of the equity markets seem appropriate seeing that the third quarter of 2009 saw the equity markets continue to build upon, or rather “validate”, the recovery momentum that was established during the second quarter. Investors seemed to be encouraged by the prospects of an improving U.S. economy which was evidenced by more than 70% of companies reporting better than expected earnings at the end of the 2nd quarter. Yet, the equity markets have rallied so far and so fast in such a relatively short period of time, that a pullback, while it may be brief and shallow, seems inevitable and necessary. In terms of the major equity indices, the S&P 500 index (“S&P 500”) gained 15.61% in the 3rd quarter on top of the 15.93% that it returned in the 2nd quarter. For the year, the S&P 500 has now advanced 19.26% as of September 30, 2009. This level of performance certainly is not enough to offset the historic S&P 500 index loss of 37.00% in 2008 but it is certainly progress in the right direction. Similarly, the Dow Jones Industrial Average (“DJIA”) gained 15.82% in the 3rd quarter and has now posted a 13.49% return for the year with one quarter remaining. Interestingly, the technology heavy NASDAQ continues to lead all of the major U.S. equity indices with an advance of 15.91% in the 3rd quarter and an impressive 35.60% return thus far in 2009. There was a slight pullback, or rather pause, in the equity markets at the end of September but it was not sustainable as the bulls are seemingly digging in their heels following the belief that the worst is now behind us. In terms of asset classes, outside of Convertible Bonds, Equities outperformed Bonds in the 3rd quarter of 2009 as well as year-to-date in 2009. Defying their historically non-correlated relationship, Bonds and Equities both advanced in the 3rd quarter which highlights the apparent confusion among investors with respect to where the economy and markets are heading at this juncture. Convertible Bonds, which basically represent an Equity/Bond hybrid investment, perhaps best embody this confusion. The Merrill Lynch Convertible Securities index returned 15.89% in the 3rd quarter and has gained 39.41% year-to-date in 2009. Municipal Bonds continued to outperform investment grade corporate and government bonds. Evidence of this outperformance can be found after comparing the Barclays Capital Muni Bond index with the Barclays Capital U.S. Aggregate Bond index.

...a pullback, while it may be brief and shallow, seems inevitable and necessary.



Index Name 3rd Quarter 2009 % Return 2009 Year-to-Date % Return Barclays Capital U.S. Aggregate Bond 3.74% 5.72% Barclays Capital Muni Bond 7.12% 14.00% In terms of sub-asset classes, Mid-Cap beat out its Small Cap and Large Cap counterparts in the 3rd quarter of 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

During the 3rd quarter, Value outperformed Growth, although, for the year, Growth is still ahead of 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 value-oriented companies. As we look to the different geographies of the world, there is clearly one frontrunner: International - Emerging Market Equities. Emerging Markets, notably the BRIC countries, which include Brazil, Russia, India and China, have significantly outperformed International – Developed Markets and U.S. Equities thus far in 2009. To help better illustrate this out performance, consider that the MSCI Emerging Market index (in U.S. Dollar Terms) gained 20.91% in the 3rd quarter of 2009 and is up 64.45% for the year thus far. International Emerging Markets present investors with a different set of risks to consider in comparison to International Developed Markets. Thus far in 2009, the risk premium appears to equate to around 35% as the MSCI EAFE index (in U.S. Dollar Terms) has gained 28.97% year-to-date as of September 30, 2009. Finally, in terms of sectors, Financials and Information Technology continued to lead the way in the 3rd quarter of 2009 while Utilities and Healthcare lagged suggesting that perhaps cyclical stocks are now more appealing to investors than defensive stocks – yet another sign that this equity market recovery may be for real. Here’s a recap of how the major indexes have performed in 2009 through September 30th:

As we look to the different geographies of the world, there is clearly one frontrunner: International- Emerging Market Equities.



2009 Year-to-Date Major Index Performance Summary Index S&P 500 Index Dow Jones Industrial Average Index NASDAQ Composite Index MSCI EAFE Index MSCI EMF (Emerging Markets Free) Index 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 19.26% 13.49% 35.60% 28.97% 64.45% 4.74% 5.72% 14.00%

Source: Wachovia Securities. Performance data is as of September 30, 2009. Past performance is not an indication of future results.

2009 Year-to-Date 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 21.08% U.S. Large-Cap Growth 27.11% U.S. Large-Cap Value 14.85% U.S. Mid-Cap Core 32.63% U.S. Mid-Cap Growth 37.12% U.S. Mid-Cap Value 27.57% U.S. Small-Cap Core 22.43% U.S. Small-Cap Growth 29.12% U.S. Small-Cap Value 16.36%

Source: Wachovia Securities. Performance data is as of September 30, 2009. Past performance is not an indication of future results.



2009 Remaining Market Outlook We would characterize our outlook for the remainder of 2009 as cautiously optimistic. We contend that the markets, notably U.S. large-cap equities which may, in fact, now be considered overvalued in certain cases, have rallied too far, too fast and any growth that has occurred thus far in the U.S. economy has likely been government led as opposed to consumer led. Consumers, whose spending makes up over 70% of the Gross Domestic Product (“GDP”) of our country, have yet to return to the stores in any meaningful fashion and likely will not return any time in the near future given the high levels of unemployment. In our view, a doubledigit positive return for the S&P 500 in 2009 is still highly likely although the S&P 500 will likely finish the year behind the other noteworthy equity indices such as Mid-Cap, Small Cap, International Equity-Developed Markets and International Equity-Emerging Markets indexes. In this regard, we drill down into critical areas that have shaped our current market outlook and factors that could cause us to alter our outlook. • • • • • •

Unemployment Consumer Confidence Corporate Earnings Economic Recovery Progression Interest Rates and the Value of the U.S. Dollar Inflation

We will then finish this quarter’s 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.

We would characterize our outlook for the remainder of 2009 as cautiously optimistic.



Unemployment We often find humor in the suggestions of some that we are currently witnessing a jobless recovery as we do not believe that a jobless recovery is sustainable or even possible. Hence, an employment rate near 10% and approaching the Post World War II high of 10.8% that was reached in December of 1982 gives us great pause when forecasting the pace and length of this particular recovery from what could be argued to be one of the most severe recessions of our lifetime. Keep in mind that just one year ago, as of September 30, 2008, the unemployment rate stood at just 6.1%.

...we do not believe that a jobless recovery is sustainable or even possible. Historical Unemployment Rate (1950 – 2009)

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7.5

5

2.5 1950

1956

1962

1968

1974

1980

1986

1992

1998

2004

Source: Bureau of Labor Statistics, Labor Force Statistics from the Current Population Survey

That means that in the past twelve month period, the unemployment rate increased by approximately 61%. Further, according to the Bureau of Labor Statistics, since the start of this recession in December of 2007, over 7 million additional persons became unemployed and the total number of unemployed persons now stands at over 15 million Americans. While the pace of job losses may now be decreasing, the degree to which businesses are hiring is still anemic. We tend to question whether or not the existing pool of unemployed persons in the U.S. has the skill set and motivation to succeed in the industries where new jobs will likely come from in this ever-changing global economy. For example, sectors that experienced the biggest reductions in workforce over the past year include construction, manufacturing and retail trade. It is hard to imagine that all of these industry sectors will recover to the extent necessary to allow for job opportunities for all of the existing unemployed persons from these industry sectors. It is thus reasonable to suggest that the employment picture may not improve to the levels seen prior to the 2008 credit crisis for many years to come.



This type of forecast presents a major concern as it relates to the prospects of a timely recovery for the U.S. economy. When individuals are out of work, or concerned about the prospects of future employment, they tend to cut back on spending due to the fact that they; a) have less to spend and b) have a desire to hold onto more of what they have to support their lifestyle throughout their period of unemployment. This type of consumer behavior could serve as an anchor to an economy trying desperately to find its legs again. We believe that there is a strong correlation between unemployment, consumer spending and consumer confidence. The increased likelihood for a sustained level of high unemployment leads to a depression in consumer confidence and a reduction in consumer spending. A jobless recovery is not possible and a sustainable economic recovery cannot take place without the U.S. consumer.

Consumer Confidence Consumer confidence in the United States appears to be waning after a recent wave of optimism. According to a recent Reuters/University of Michigan Survey of Consumers, consumer sentiment fell from 73.5 in September to 69.4 in October. Further, the Survey’s economic outlook index also decreased, falling from 73.5 in September to 67.6 in October.

Michigan U.S. Consumer Sentiment 100 90 80 70 60 50 40 30 20 10 0 Oct-04

Oct-05

Oct-06

Oct-07

Source: Reuters/University of Michigan Survey of Consumers, October 2009



Oct-08

Oct-09

This 6% decrease in consumer sentiment and 8% drop in economic outlook caught many by surprise but stands to reason given the high levels of unemployment, unclear direction of national health care policy, threat of inflation and sustained losses in household net worth stemming from the downfall in the 2008/2009 markets. They often say during political races, that politics are local. This analogy can also apply to investing as it relates to consumer confidence. While investors may feel a degree of confidence that the outlook for the economy or stock market, as a whole, may be improving, they still may have doubts or skepticism given their own financial situation. While investors remain concerned about their jobs or ability to recover from the real estate and investment losses that they suffered in 2008, their personal confidence level may be weak.

Consumer confidence in the United States appears to be waning after a recent wave of optimism. Consumer confidence is often closely associated with consumer spending and a drop in one of the indicators often leads to a drop in the other indicator. Low levels of consumer confidence have led to depressing forecasts for consumer spending. For example, Nigel Gault, Chief U.S. Economist at HIS Global Insight, predicts that consumer spending will only rise 1.5% in 2010 and will end 2009 with a 0.7% annual decline. If these forecasted levels of consumer spending hold true, corporate earnings will certainly be impacted.

Corporate Earnings According to Thomson Reuters, over 70% of companies beat their 2nd quarter estimates which marked the highest percentage of companies surpassing estimates since Thomson Reuters began tracking this type of data back in 1994. To put this in a historical perspective, in a typical quarter, approximately 61% of companies eclipse their estimates. One particular industry showing particular strength was Health Care which interestingly is also one of the only industries that has actually added jobs in the last twelve month period. However, we believe that some negative earnings surprises, in certain sectors, could be in store for the third quarter and further believe that this holiday season will likely disappoint and lead to lower fourth quarter earnings than many analysts are predicting at this point in time.

…negative earnings surprises, in certain sectors, could be in store for the third quarter and…this holiday season will likely disappoint…



...most economic progress and corporate earnings increases thus far in 2009 have been provided for by government stimulus and corporate layoff and efficiency gains. Recent data is supporting our stated beliefs above. For example, Thomson Reuters reported in a September 4, 2009 article entitled, “U.S. 3rd quarter company earnings seen falling 22 pct,” that the third quarter earnings from S&P 500 companies (i.e. U.S. Large Cap companies) are expected to decline over 22% from a year ago. Disappointing 3rd quarter earnings followed by lower than expected 4th quarter earnings could result in an initial pullback and later pause in the equity markets that many believe is inevitable. It would also suggest that most economic progress and corporate earnings increases thus far in 2009 have been provided for by government stimulus and corporate layoff and efficiency gains. For the economic recovery progression to continue to advance, corporate earnings must strengthen through increases in sales (i.e. not just revenue increases), which would be generated through increases in consumer spending.

Economic Recovery Progression For the purposes of this section, I will gauge the progression of this economic recovery in terms of U.S. Real Gross Domestic Product (“GDP”) while also using certain other economic indicators to help convey the many factors that influence economic growth. These indicators, and their current values, according to Russell Investments, as of September 30, 2009, are as follows: Indicator Unemployment Rate % 10-year Treasury Yield % Core Inflation % Gold $/oz Oil $/bbl Fed Funds Target Rate %

Value 9.8 3.22 1.40 $1,008 $70 0 - 0.25

Consumers, on the other hand, seem reluctant to open their wallets for several reasons. First, most consumers lost a considerable amount of personal wealth in 2008 in their investment portfolios, 401(k) plans and real estate holdings. Presumably, consumers are now looking to rebuild their net worth before considering making big-ticket purchases. Second, more and more Americans are now out of work or facing the prospects of potentially being out of work in the near future. The employment picture will take a while to improve due to the large inventory of individuals looking for work along with our belief that new jobs may be in areas of the economy where many of the unemployed do not have prior experience. This does not bode well for much needed increases in consumer spending despite recent advances in consumer confidence. The U.S. economy cannot recover without the U.S. consumer.



U.S. Real GDP Growth Rate Past Trend Present Value & Future Projection Year over Year Change. Percent per year. 4 Actual

Forecast

3 2 1 0 -1 -2

Dec-09

Sept-09

May-09

Feb-09

Nov-08

Aug-08

Apr-08

Jan-08

Jul-07

-4

Oct-07

-3

Source: The Financial Forecast Center, October 2009.

The chart above would seem to indicate that the outlook for GDP growth is promising. In fact, we would not be surprised to see a GDP growth rate between 3.0%-4.0% in the 3rd quarter. However, the rate of growth is below what is needed to signal “all clear” to the investment world. In fact, Russell Investments recently suggested that, “Sustainable & consistent GDP growth – not government enhanced – in the traditional range of 3-5% will be challenging to produce.” The Federal Reserve appears to be aware of these dismal GDP projections and continues to look for ways to stimulate the U.S. economy while maintaining a watch on inflation. Outside of monetary intervention programs, the Federal Reserve is also maintaining historically low interest rates with the Federal Funds Target Rate currently standing at close to 0%.

The impact of low interest rates and a weak U.S. Dollar ... on sustainable economic growth remains to be seen. This has all translated into historically low U.S. Treasury yields and a weak U.S. Dollar. The impact of low interest rates and a weak U.S. Dollar, along with the U.S. Treasury bond starting to lose its acclaim as a safe haven investment throughout the world, on sustainable economic growth remains to be seen.



Interest Rates and the Value of the U.S. Dollar The Federal Funds Target Rate has been residing within the 0.00% - 0.25% range for all of 2009. The Federal Reserve has maintained this target range with the hopes of providing additional credit opportunities to allow for economic stimulus.

Federal Funds Target Rate 12.0%

Interest Rate

10.0% 8.0% 6.0% 4.0% 2.0% 0.0% 1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

This in turn, has had a negative impact on bond yields and the value of the U.S. dollar. To understand the impact on Treasury Bonds, consider the following 12 Month Treasury average (“12MTA”) index which represents the monthly average yields of U.S. Treasury securities adjusted to a constant maturity of one year.

12 Month Treasury Average (12MTA) 12.0%

Interest Rate

10.0% 8.0% 6.0% 4.0% 2.0% 0.0% 1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

As the chart above illustrates, not only is the Federal Funds Target Rate at historically low levels but so too are 12 Month Treasury Average Rates. To understand the impact of these low interest rates on the U.S. Dollar, let’s look to the Exchange-traded Product (“ETP”) marketplace for potential answers.

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ETF Name CurrencyShares Euro Trust CurrencyShares British Pound Sterling Trust CurrencyShares Swedish Krona Trust CurrencyShares Japanese Trust CurrencyShares Canadian Dollar Trust CanadianShares Australian Dollar Trust WisdomTree Dreyfus Brazilian Real

ETF Ticker FXE FXB FXS FXY FXC FXA BZF

6 Month % Performance 10.5% 10.5% 17.6% 9.7% 17.6% 26.5% 34.4%

2009 YTD % Performance 4.5% 9.4% 11.9% 0.5% 13.2% 24.0% 30.1%

Source: Global Trends Investments, 9/30/09 ETF Performance Report

While not a perfect representation of the foreign exchange market, the above foreign exchange ETFs can serve as a sufficient proxy to understand how each underlying currency is trading relative to the U.S. Dollar. On this basis, one can reasonably conclude from the chart above that the U.S. Dollar has fallen versus each of the foreign currencies listed with particular downward momentum developing over the course of the last six months ending September 30, 2009.

…the U.S. Dollar has fallen versus each of the foreign currencies listed with particular downward momentum developing over the course of the last six months… Absent any significant changes in interest rate policies across the globe in the next 3-6 months, we do not see any of the trends discussed in this section reversing anytime soon as the Federal Reserve continues to provide stimulus to the economy with low interest rates while attempting to keep inflation in check. We would suggest that the inflationary consequences associated with not implementing monetary tightening policies, perhaps through measured reverse repurchases or sequential interest rate increases, soon will only intensify as each week passes.

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Inflation According to Russell Investments, as of September 30, 2009, core inflation is currently at 1.40%, below the Federal Reserve’s unofficial target range of 1.50% - 2.00%. Hence, many have concluded that inflation is not present and perhaps not an imminent threat. At Hennion & Walsh, we believe otherwise. We believe that the threat of inflation is upon us and the impact of inflation could have a significant impact on the economy and on the portfolios of individual investors.

We believe that the threat of inflation is upon us... The Federal Reserve still needs to find an exit strategy for the roughly $1 trillion that it has already pumped into the system. Getting money into the system seems to always be relatively easy. The difficulties arise in trying to get the money back out of the system. The timing of the exit strategy is critical and will likely be influenced by the timing of the return of economic growth. Additionally, if the Federal Reserve overestimates where U.S. economic growth should be in this new, and constantly changing, world economy, then they run the risk of keeping rates low for too long and over-stimulating the economy. With all of these points in mind, we suggest the following portfolio management ideas for careful and thoughtful consideration.

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Portfolio Management Ideas to Consider • Look for Small and Mid-Cap Stocks to Outperform During Market Recovery Small and Mid-Cap stocks have traditionally led bear market to bull market recovery efforts. During bear market recovery periods, credit is often cheaper, which allows smaller capitalized companies more affordable means by which to access the credit markets and advance their often-innovative product offerings. These innovative product offerings will likely be the catalysts of new rallies in the developing bull market.

•

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.

•

Residential Real Estate Continues to Rebound

Allocations to real estate investment trusts (“REITs”) were introduced into several of our managed portfolios for the first time earlier this year and we have been pleased with the effects that this asset class has had on our overall performance to date. We would suggest that the residential housing market has bottomed and begun its national recovery process, albeit at different speeds in different regions of the country. As a result, some very intriguing investment opportunities for consideration with respect to REITs and other residential real estate- oriented investments now exist.

•

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.

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•

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.

•

Growth Should Continue to Outpace Value during this Market Recovery

Growth oriented stocks (i.e. stocks, typically with higher Price-to-Earnings ratios, of companies which are growing earnings and/or revenue faster than their industry or the overall market) have outperformed Value oriented stocks (i.e. stocks, typically with a high dividend yields, low price-to-book ratios and/or low price-to-earnings ratios, that tend to trade at a lower price relative to their fundamentals and are thus considered undervalued) among U.S. stocks thus far in 2009. While slow U.S. growth over the medium term is still anticipated, we would suggest that an over-weighting towards Growth versus Value, or a neutral weighting at worst, as the market continues its rebound is still worthy of consideration for the balance of 2009.

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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. 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.

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