Q3-12 Update

The S&P 500 was up 5.8% in the third quarter. The Federal Reserve’s continuing effort to pump money into the financial system seems to be providing some support to equity investments. US equity markets were strong despite the skepticism over the longer-term implications of the Fed’s actions. High deficits and the fiscal cliff (automatic spending cuts and tax increases) are looming with the presidential election a month away. Also the debt crisis in Europe remains uncertain and the economy there is stagnating.

Corporate earnings grew to a record high in the second quarter of 2012. Third quarter earnings are expected to decline for the first time in three years. Companies in the S&P 500 are expected to show 2% lower profits in the third quarter than last year. Full year 2012 earnings will likely be up 7% and expectations still call for double digit increases in 2013. The current forward 12-month price to earnings (P/E) ratio for the index is about 12.8 (at closing price of 1,433.32 and forward 12-month EPS estimate of $111.86). This is below the prior ten-year average forward 12-month P/E ratio of 14.3.

Gross domestic product growth was 1.3% in the second quarter of 2012 (data released 09/27/2012). Projections for 2012 call for low growth around 2%.

The Index of Leading Economic Indicators has fluctuated around a flat trend for the last six months but does remain in growth territory due to positive contributions from the financial components including stock prices.

Commodities increased 8.1% in the third quarter. The price of Brent Crude increased 14.5% to $112.01 per barrel. Gold was up about 11% to close over $1,700 per ounce. Some agricultural commodities, such as corn, soybeans and sugar have fallen from summertime peaks.

The housing sector continues to post encouraging developments. Data through July 2012 show average home prices increased by 1.6% from June 2012. Single family housing starts are ahead of last year’s pace, existing home sales are up, the inventory of homes for sale is down, and foreclosure activity is slowing. Average home prices across the United States are back to their 2003 levels.

The unemployment rate declined to 7.8% according to the September jobs report. This is the lowest level since January of 2009. The decline in the main unemployment rate was driven by several factors including an increase in the number of part-time workers. There are more people working but the methodology of the calculation and the quality of jobs was called into question.

The Federal Reserve is signaling near zero interest rates indefinitely. The goal is to increase consumer sentiment, create wealth through housing and equities and get the economy moving via the consumer spending more money. This policy may not work and could have long-term inflationary effects.

Inflation remains low. August’s core consumer price index (released 09/14/12) shows annual inflation of 1.9%. Employment and deficits may play a prominent role in the future.

The yield on the 10-year Treasury note finished the quarter lower at 1.64%. Investors see US government bonds as the world's safest investment and believe that ultimately the country's long-term finances will be resolved. The low yields could be attributed to investors looking for a safe place to temporarily to ride out market turmoil. However, the yields could reflect a deteriorating outlook for the economy. Long-term yields tend to fall when investors expect slower growth or a recession and that the US economy faces tougher times ahead. Another factor that can move yields is inflation expectations—stronger economic growth often equals higher inflation, meaning investors will demand a higher return on investment. So a low Treasury yield means that investors foresee little inflation (and little growth). Cheap borrowing may enable or even encourage the government to borrow more money. The government is paying very low interest on recently issued debt.

Stocks were up almost everywhere across the world in the third quarter. Developed markets were up about 6% and emerging-markets gained about 5.6%. Note the European Union recorded a decline in GDP of 0.3% in Q2 2012. Economic growth in emerging markets has also been decreasing over the past year. Q2 2012 GDP growth rates for China, India, and Brazil had fallen to 7.6%, 3.0% and 0.3%. The International Monetary Fund expects the world economy to expand 3.3% this year and 3.6% in 2013. This is a revision lower as growth slows in nearly every major nation and political uncertainties threaten the US and euro zone.

Please let us know if you would like additional information on any of the above.

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