LPL FINANCIAL RESEARCH Sector Strategy · 2015-07-09 · LPL FINANCIAL RESEARCH. Sector Strategy. 2011: The Year of the Defensive Sector? ... outlook earlier in the year, ... Q4 2010

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LPL F INANCIAL RESEARCH

Sector Strategy

2011: The Year of the Defensive Sector? Not So Fast!Until very recently, this has been the year of the defensive sector. Double-dip recession fears in the U.S., the debt ceiling debate and downgrade of the U.S. credit rating, the European debt crisis and slowing growth in China have all pressured investor sentiment and growth expectations. Cyclical stocks have borne the bulk of the selling pressure, while depressed yields in high quality fixed income investments have fueled a massive flight to dividend paying stocks that are mostly found within the defensive sectors such as Consumer Staples and Utilities.

After leading the market for much of the year, defensive sectors have started losing relative strength in recent weeks while cyclicals have gained ground [Chart 1]. After cyclical sectors perhaps priced in an overly optimistic outlook earlier in the year, the pendulum swung too far in the other direction as the most economically sensitive sectors priced in a recession in the U.S. and Europe and a sharp slowdown in Asia. The turn began in early October as markets became more comfortable with the prospects for a comprehensive plan from European policy makers to contain their debt crisis while domestic economic data provided further evidence of continued, albeit moderate growth rather than recession.

Looking ForwardLooking forward, our preference for cyclical sectors is predicated, first and foremost, on where we think we are in the business cycle. Our view based on the hard data, not on sentiment, remains that the U.S. economy will avoid recession and continue to grow, albeit at a moderate pace as it did during the third quarter, based on the latest GDP data. Though there is no panacea for the European debt crisis, policy makers have taken positive steps with the latest plan from the European Union, thereby reducing the odds that contagion drags the U.S. and potentially other key economies outside of Europe into recession. When emerging from recession, whether real or perceived, investments most exposed to economic growth tend to perform best, as seen in the fourth quarter rally of 2010 which was led by Materials, Energy, Consumer Discretionary and Industrials [Chart 2]. Bottom line, when the market prices in recession and one does not occur, sectors most sensitive to economic growth normally perform better.

The other key driver of our preference for cyclical sectors over defensives is valuation. As shown in Chart 3, the cyclical sectors are quite a bit

November 2011

Overview

The Big Picture § Favor cyclicals to help take advantage of

excessive economic pessimism § Solid business spending drives Industrials and

Technology, while consumer continues to defy the skeptics

§ Natural Resources may benefit from improving Emerging Market growth outlook, weaker dollar

1 Cyclical Sectors’ Relative Strength vs. Defensive Sectors

9/23

/11

8/12

/11

7/1/

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5/20

/11

4/8/

11

2/25

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1/14

/11

12/3

/10

11/5

/10

9/24

/10

8/13

/10

7/2/

10

11/4

/11

1.351.301.251.201.151.101.051.000.950.90

Cyclical Sectors vs. S&P 500

Source: FactSet, LPL Financial 11/18/11

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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SECTOR STRATEGY: OVERVIEW

cheaper relative to their historical averages than the defensive sectors. For example, Technology is currently trading at a 4% premium to the S&P 500, compared to its long-term average of a more than 35% premium. Even when excluding the Internet bubble period in the late 1990s and early 2000, the average multiple is still north of a 25% premium, suggesting Technology is potentially undervalued by 20% or more. Conversely, Utilities historically trade at an 18% discount to the S&P 500, on average, but now trade at a 22% premium. Among defensive sectors, this analysis is supportive of Healthcare, though growth and reform challenges keep us on the sidelines. Among cyclical sectors, Consumer Discretionary appears most overvalued though we remain positive on the sector due to resilient consumer spending amid still low expectations. Reasonably valued and favored sectors include Energy, Materials and Industrials as well as Technology. Sectors currently not favored that appear overvalued include Consumer Staples and Telecom as well as Utilities.

In summary, we have become increasingly positive on the cyclical sectors in recent weeks, given the excessive level of pessimism reflected in valuations.

§ Our positive Industrials and Technology views reflect resilient earnings and our expectation for continued solid growth in business spending and emerging markets

§ Our positive Materials view is based on continued growth in the U.S. economy, an expected soft landing in China and the likelihood of renewed US dollar weakness

§ We expect higher oil prices to benefit the Energy sector through year-end

§ Our positive Consumer Discretionary view reflects resilient consumer spending trends amid excessively bearish sentiment

§ Our negative Financials view reflects the challenging interest rate and regulatory environment and constrained growth outlook, though the outlook is beginning to improve for Regional Banks

§ We continue to under-emphasize the four defensive sectors (Consumer Staples, Healthcare, Telecom and Utilities), as we expect investors to increasingly favor attractively-valued cyclicals in the months ahead as economic and profit growth exceeds market expectations

In addition to likely business cycle headwinds, each defensive sector faces fundamental challenges:

§ Consumer Staples – input cost pressures

§ Healthcare – austerity measures pressuring government spending

§ Telecom – risk of unwinding of consolidation premium

§ Utilities – clean energy push and interest rate risk

Earnings Season Much Better Than the Market Had Been Pricing InOne of the reasons our view of the equity markets and the cyclical sectors has become increasingly constructive in recent weeks has been the continued resilience of corporate America. The market correction in August

2 Sector Excess Returns During Fourth Quarter Rally In 2010 Vs. Fourth Quarter 2011 To Date

Heal

thca

re

Utili

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Tech

nolo

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Fina

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Cons

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Stap

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Tele

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Ener

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Mat

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Indu

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Cons

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Disc

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12.5%

7.5%

2.5%

-2.5%

-7.5%

-12.5%

Q4 2010Q4 2011 to date


Note: S&P 500 returned 10.8% during the fourth quarter, 2010. Quarter-to-date, the S&P 500 has returned 7.8%.

Excess Returns are the returns in excess of the risk-free rate or in excess of a market measure, such as an index fund.

3 Relative Forward PE by Non-Financial Sector vs. Long-Term Average Cyclical Sectors Are Cheaper Than Defensives Versus Long-Term Averages

Cons

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Utili

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Tele

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Cons

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Disc

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50%40%30%20%10%0%

-10%-20%-30%-40%

Cyclical SectorsDefensive Sectors

Source: LPL Financial 11/18/11

Note: Relative valuations are versus the S&P 500

Past performance is no guarantee of future results.

Financials are excluded due to book value being our preferred valuation metric. The sector is trading at a depressed price-to-book value multiple of 0.85 as of 11/18/11.



Consumer Discretionary Consumer spending growth accelerated in Q3 2011 amid historic lows in consumer confidence. Watch what consumers do, not what they say.

Consumer Staples Some input cost relief helps but rich valuation and market shift toward cyclicals are headwinds.

Energy Inventories have improved in recent weeks while prices are likely to be supported by improving economic data in the U.S. and Emerging Markets.

Financials Valuation, improving loan demand and easing interest rate pressure are positives but anemic job growth, European debt issues, and regulatory challenges remain.

Healthcare Growth is being challenged by government spending cuts and reform; continue to favor cyclicals over defensive sectors.

Information Technology Positive business spending outlook, resilient earnings performance and compelling valuations.

Industrials Expect business spending growth to continue to exceed market expectations; Emerging Market demand and valuations are supportive.

Materials Valuation reflects overly pessimistic global growth outlook; supply constraints and weak dollar are supportive.

Telecom Rich valuation, interest rate risk, potential removal of catalyst if regulators reject large acquisition.

Utilities Earnings weakness, rich valuations, interest rate risk and nuclear disruption may outweigh attractive yields

S&P 500 Sector Snapshots

and September, as well as valuations and commentary from market pundits suggested earnings were poised to stagnate, if not contract.

The numbers are impressive, as the S&P 500 has increased earnings per share (EPS) and revenues by 16% and 11%, respectively — 6% and 2% above estimates entering earnings season. More than 70% of companies have exceeded Wall Street’s EPS target, while over 60% have beaten revenue forecasts, both impressive even considering that the bar had been lowered. Importantly, guidance has generally been better than expected, leading only to modest 4 – 5% reductions in estimates for the rest of the year and early 2012, far less than had been priced in, and in line with our expectations.

Below is an overview of what we view as the key factors driving our sector views. The sector snapshots that follow go into further detail.

Our accompanying individual sector profiles are delivered as individual profiles or as a full report. Our sector views are outlined in the Portfolio Compass, which is published on a bi-weekly basis. It highlights the three components of our investment philosophy — fundamentals, valuation and technical analysis — for equity sectors as well as equity, fixed income and Commodities asset classes. For more details on our macroeconomic and market views, please refer to our soon-to-be published 2012 Outlook publication and our weekly market and economic commentaries. For help implementing our sector advice, please refer to our Exchange-Traded Product (ETP) models or the currently recommended sector funds.



IMPORTANT DISCLOSURES The opinions voiced in this material are for general information only and are not intended to provide or be construed as providing specific investment advice or recommendations for any individual. To determine which investments may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.

Stock investing involves risk including loss of principal.

Investments in specialized industry sectors have additional risk such as credit, regulatory, operational, business, economic and political risk which should carefully be considered before investing.

Investors should consider the investment objectives, risks, charges and expenses of the investment company carefully before investing. The prospectus contains this and other information about the investment company. You can obtain a prospectus from your financial representative. Read carefully before investing.Principal Risk: An investment in an Exchange Traded Fund (ETF), structured as a mutual fund or unit investment trust, involves the risk of losing money and should be considered as part of an overall program, not a complete investment program. An investment in ETFs involves additional risks: not diversified, the risks of price volatility, competitive industry pressure, international political and economic developments, possible trading halts and Index tracking error.

Consumer Discretionary: 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: 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: 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: Companies involved in activities such as banking, consumer finance, investment banking and brokerage, asset management, insurance and investment, and real estate, including REITs.

Healthcare Sector: Companies are in two main industry groups — healthcare equipment and supplies or companies that provide healthcare-related services, including distributors of healthcare products, providers of basic healthcare services, and owners and operators of healthcare facilities and organizations. Companies primarily involved in the research, development, production, and marketing of pharmaceuticals and biotechnology products.

Industrials: Companies whose businesses manufacture and distribute capital goods, including aerospace and defense, construction, engineering and building products, electrical equipment and industrial machinery. Also, companies that provide commercial services and supplies, including printing, employment, environmental and office services, or 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: 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.

Technology Software & Services: Includes companies 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: 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.


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This research material has been prepared by LPL Financial.

The LPL Financial family of affiliated companies includes LPL Financial and UVEST Financial Services Group, Inc., each of which is a member of FINRA/SIPC.

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.


International and emerging market investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.

The fast price swings in commodities and currencies will result in significant volatility in an investor’s holdings.

Precious metal investing is subject to substantial fluctuation and potential for loss.

International and emerging markets investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.

The Standard & Poor’s 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.

Earnings per share (EPS) is the portion of a company’s profit allocated to each outstanding share of common stock. EPS serves as an indicator of a company’s profitability. Earnings per share is generally considered to be the single most important variable in determining a share’s price. It is also a major component used to calculate the price-to-earnings valuation ratio.



Sector Strategy

� Consumer Discretionary is defying the odds yet again in 2011 and is poised to outperform the S&P 500 for the fourth consecutive year. We expect the sector to at least hold onto its excess return for the year and potentially add to it through year end as the key holiday selling season arrives. Year-to-date, the Consumer Discretionary sector has outpaced the S&P 500 by 400 basis points with a 2.4% return (as of November 18, 2011).

� Historically, Consumer Discretionary has been one of the best performing sectors coming out of recession. While we have not entered a double-dip recession, nor is one likely in the near-term, the market clearly priced one in this summer. Recent economic data has gone a long way to disprove the theory that recession is imminent, setting the stage for early cyclical sectors most sensitive to improving economic conditions such as Consumer Discretionary.

� Consumer pessimism is a good leading indicator of sector outperformance, and consumers are no doubt extremely pessimistic about the economic outlook. In fact, consumer sentiment surveys show a level of pessimism consistent with the worst crises and deepest recessions, but consumer spending continues to chug along. Last quarter, consumer spending in nominal terms rose at a roughly 5% annualized pace (year-over-year growth was similar). Despite the fact that in surveys consumers say they feel awful, they continue to spend at a fairly decent clip [Chart 1]. We believe this pessimism increases the likelihood that Consumer Discretionary companies will continue to surprise the market on the upside with sales and profits in the months ahead. The sector has historically performed very well when consumer confidence is depressed.

� Consumer Discretionary relative performance is inversely correlated to energy prices. Since crude oil prices peaked on April 29th, Consumer Discretionary has outperformed the S&P 500 by nearly 4% (As of November 18th). Although the recent increase in oil does reduce consumers’ discretionary income slightly, consumers continue to spend at a solid clip as they experience modest increases in income and dip into savings.

� Despite a still challenging consumer spending environment, the sector continues to grow profits at a solid double-digit clip. Current expectations are for the sector to grow earnings per share (EPS) by 16% in 2011 and 13% in 2012, both ahead of the S&P 500. While exceeding current sector expectations for high-teens earnings growth during the next several quarters will not be easy, going against the sector’s earnings performance has been a losing bet since the last recession ended.

November 2011

Consumer Discretionary

PerformanceS&P 500 Consumer Disc. Index S&P 500 Index

Q3 2011 -13.0% -13.9%2011 YTD 2.4% -1.6%1 month 4.3% 5.5%3 month -4.2% -5.2%12 month 9.4% 5.0%2011E EPS Growth 16.1% 14.9%NTM P/E 13.3 11.4Dividend Yield 1.5% 2.1%Beta 1.10 1.00S&P 500 Weight 10.9%

Sources: FactSet, LPL Financial Performance through 11/18/11

1 Consumer Sentiment has Disconnected from Consumer Spending

Source: CB, BEA, Haver, LPL Financial 11/22/11

(Shaded areas indicate recession)

90 95 0500 10

120

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40

20

10.0

7.5

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0.0

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-5.0

Conference Board: Consumer ExpectationsSeasonally Adjusted, 1985=100 (Left Axis)Personal Consumption Expenditures, % Change - Year to Year, Seasonally Adjusted Annual Rate, Bil.$ (Right Axis)

The Big Picture � Favor cyclicals to help take advantage of

excessive economic pessimism � Solid business spending drives Industrials and


� Natural Resources may benefit from improving Emerging Market growth outlook, weaker dollar

SECTOR STRATEGY: CONSUMER DISCRETIONARY


� Our primary concern about a positive Consumer Discretionary view is valuation. The sector currently trades at a 16% premium to the S&P 500 on a forward price-to-earnings (P/E) ratio basis, above its long term average of 12% and toward the high end of previous mid-cycle peaks between 20 – 25%. We do not believe fundamentals currently justify multiple expansion, therefore above-market earnings growth is the most likely driver of outperformance over the next quarter or two.

� Another potential risk associated with a positive sector view is that business spending growth is outpacing consumer spending growth, a trend we expect to continue. This comparison could support better performance of the business spending-driven cyclical sectors, namely Industrials and, to a lesser extent, Technology as opposed to Consumer Discretionary. During the third quarter, real consumer spending rose at a 2.5% annualized rate while business spending (non-residential investment in equipment and software) increased at a 17% annualized clip. Furthermore, while consumers have dramatically improved their balance sheets, they certainly cannot match the balance sheets of corporate America with north of $1 trillion in cash.

� Within the sector, we favor Media and are becoming increasingly constructive toward Retail. Media is poised to benefit from an improving advertising market, the election cycle and attractive valuations. The outlook for Retail has improved due to the improved stock market performance in October and continued resilience in retail sales data. Note that back-to-school sales (up a solid mid-single digit rate) and the stock market (up 7.8% quarter to date) are good indictors of holiday retail sales performance.


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SECTOR STRATEGY: CONSUMER DISCRETIONARY

IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide or be construed as providing specific investment advice or recommendations for any individual. To determine which investments may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.


The Standard and Poor’s 500 Stock Index (S&P 500) is an unmanaged index generally representative of the U.S. Stock Market, without regard to company size.

The S&P Consumer Discretionary Index is comprised of 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.

These indexes are unmanaged and cannot be invested into directly. Past performance is no guarantee of future results.


EPS: Earnings per share are calculated by dividing a company’s net income by its total number of shares outstanding. 2010E EPS Growth reflects Thomson’s consensus EPS estimate for 2010 divided by 2009. Earnings per share serve as an indicator of a company’s profitability. Earnings per share are generally considered to be the single most important variable in determining a share’s price. It is also a major component used to calculate the price-to-earnings valuation ratio.

Price to earnings multiples is a tool for comparing the prices of different common stocks by assessing how much the market is willing to pay a share of each corporation’s earnings. It is calculated by dividing the current market price of a stock by the earnings per share.

Dividend yield shows how much a company pays out in dividends each year relative to its share price.

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.

Beta: Beta measures a portfolio’s volatility relative to its benchmark. A Beta greater than 1 suggests the portfolio has historically been more volatile that its benchmark. A Beta less than 1 suggests the portfolio has historically been less volatile than its benchmark.



Sector Strategy

� The Consumer Staples sector has been a beneficiary of the market’s shift toward defensive sectors in 2011. As noted in the overview of this publication, that trend started to reverse in October after the market bottomed. In fact, since the S&P 500 low for the year on October 3rd, Consumer Staples has trailed the S&P 500 by 500 basis points (as of November 18, 2011). Still, the sector’s 8.1% return year-to-date is more than 900 basis points ahead of the S&P 500’s 1.6% loss.

� We view the current environment as unfavorable for defensive sectors such as Consumer Staples given the market has priced in a more pessimistic economic growth outlook than we believe will occur. Accordingly, we expect some, if not all of the ground gained by defensive sectors relative to the cyclical sectors from late July through early October — 15 percentage points on average — to reverse as the market’s economic and profit outlook improves from a high likelihood of double-dip recession to moderate growth. This dynamic started to play out in October and we believe will continue over the next couple of quarters.

� The defensive, or counter-cyclical, characteristics of Consumer Staples are evident by its relationship with business confidence, as measured by the ISM Manufacturing Index. Consumer Staples relative performance is closely inversely correlated to the ISM Index, which dipped to near 50 during heightened recession fears in July but has stabilized and started to increase since then with the October reading of 52. Going forward, we expect this index to move gradually higher as has been the case historically during the middle of business cycles.

� Our overall stock market view, based on our process of fundamentals, valuations and technicals, is positive. In this environment, the odds that the low beta (less market sensitive) Consumer Staples outperforms are low. As an example, over the past eight quarters, including fourth quarter to date, when the S&P 500 has a negative return the sector outperforms by an average of 550 basis points. When the S&P 500 rises, the sector trails the S&P 500 by an average of 240 basis points. In only one quarter out of past eight did the S&P 500 and the excess return for Consumer Staples move in the same direction (Q1 2010, excess return +40 basis points, S&P 500 return of 5.4%).

� Despite some modest relief in recent months, higher commodity prices continue to present challenges for consumer staples companies. Wholesale prices for intermediate stage of manufacturing are 10.8% higher than the year-ago period while wholesale prices of finished goods are 7.1% higher year-over-year. The sector’s operating profit margins

November 2011

Consumer Staples

1 Commodity Price Pressures Have Been Weighing On Consumer Staples Operating Margins

97 00 0603 0796 98 0401 0895 99 0502 1009 11

14

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9

8

Operating Margin (%)S&P 500 / Consumer Staples



PerformanceS&P 500 Consumer Staples Index S&P 500 Index

Q3 2011 -4.2% -13.9%2011 YTD 8.1% -1.6%1 month 3.4% 5.5%3 month 1.6% -5.2%12 month 11.3% 5.0%2011E EPS Growth 7.9% 14.9%NTM P/E 14.0 11.4Dividend Yield 2.9% 2.1%Beta 0.45 1.00S&P 500 Weight 11.1%







SECTOR STRATEGY: CONSUMER STAPLES

have been falling steadily for the past decade and are approaching record lows at 9%, compared to the long-term average of 10.4% [Chart 1]. Technology and Consumer Discretionary margins, conversely, have been rising steadily and are near record highs.

� Sector valuations are not particularly attractive, in our view, given a challenging fundamental outlook for the sector and constrained profit margins. Staples are currently trading at a 22% premium to the S&P 500 on a forward P/E basis, above historical average premiums near 13% and above a level we would view as fair given the current, middle stage of the business cycle.

� Within the sector, we favor the Food & Staples Retailing Group for its economic sensitivity as we believe the market’s view of consumer spending is overly pessimistic. Our view of the more defensive Household & Personal Products Group is negative.


RES 3387 1111Tracking #1-021782 (Exp. 11/12)





SECTOR STRATEGY: CONSUMER STAPLES




The S&P Consumer Staples index is comprised of 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.






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.

The fast price swings in commodities and currencies will result in significant volatility in an investor’s holdings.


The ISM Index is based on surveys of more than 300 manufacturing firms by the Institute of Supply Management. The ISM Manufacturing Index monitors employment, production inventories, new orders, and supplier deliveries. A composite diffusion index is created that monitors conditions in national manufacturing based on the data from these surveys.



Sector Strategy

� It has been an up and down year for the Energy sector. After outperforming the S&P 500 by over 1000 basis points during the first quarter as West Texas Intermediate (WTI) Crude Oil surged to well over $100 per barrel, the sector has since given back most of its excess returns. Since April 1, 2011, as oil prices have pulled back, Energy has underperformed the S&P 500 by about 600 basis points. Year-to-date, Energy has returned 1.7% compared to the 1.6% loss for the S&P 500.

� Oil prices are, of course, key to sector performance. We believe oil at around $95 (U.S. West Texas Intermediate) offers value, still reflecting overly pessimistic global growth expectations. Unfavorable seasonality and the pending resumption of Libyan oil production are offsetting factors over the next several months.

� We expect oil demand in the U.S.to increase, keeping global oil supply-demand balance tight over the rest of this year and into 2012. The International Energy Agency (IEA) forecasts an additional 1.3 million barrels per day of consumption in 2011 versus 2010, and an additional 1.4 million barrels per day of consumption in 2012 over 2011, increases of about 1.5%. U.S. data continues to point to economic growth in the fourth quarter in the 2 – 3% range, as measured by Gross Domestic Product (GDP), supporting increased oil demand.

� China is getting close to the end of its tightening campaign, in our view, and may soon begin to ease its monetary policy. Inflation may have peaked and the Chinese Purchasing Managers Index (PMI) remains near around the 50 level, a sign of a soft landing and only modest growth deceleration in our view rather than the hard landing and sharp slowdown some fear.

� The inventory picture has improved meaningfully in recent months after reaching elevated seasonal levels this summer. Overall domestic inventory levels have fallen below the midpoint of the five-year range for the first time in over three years. Though still near average levels, inventories spent the first nine months of the year at the high end of the five-year range.

� Energy valuations are attractive at 10 times forward earnings, a 13% discount to the S&P 500. We view this level as attractive relative to previous similar points in the middle of previous business cycles. However, this level is slightly above the long-term average relative valuation and the sector is expected to see a marked slowdown in earnings growth in 2012 to a mid-single digit pace from north of 30% in 2011.

� Of some concern for Energy sector investors, in addition to seasonal fourth

November 2011

Energy

PerformanceS&P 500 Energy Index S&P 500 Index







1 Energy Sector Relative Performance has Closely Followed Crude Prices in 2011

Jan Feb AprMar May Jun Jul SepAug Oct Nov

120115110105100959085807570

112110108106104102100989694

Price- Relative to S&P 500 (Right Axis)Oil-Light Crude (Left Axis)

S&P 500 / Energy




SECTOR STRATEGY: ENERGY

quarter weakness, is elevated natural gas inventories. Weekly inventory data has been consistently above seasonal averages in recent months. Moreover, the significant untapped, unconventional gas reserves in various shale deposits around the U.S. are putting downward pressure on gas prices. The acquisitions of several natural gas producers have helped support the exploration and production stocks in the face of these low prices.

� Within the sector, we favor the higher growth areas that are most leveraged to higher energy prices. Beyond higher prices, we expect consolidation to continue to benefit Exploration & Production, while untapped, unconventional reserves of oil and gas and strong demand overseas support Oil & Gas Services despite a still challenging domestic regulatory environment.


RES 3388 1111Tracking #1-021784 (Exp. 11/12)





SECTOR STRATEGY: ENERGY




The S&P Energy Index is comprised of energy companies that primarily develop and produce crude oil and natural gas, and provide drilling and other energy related services.



The fast price swings of commodities will result in significant volatility in an investor’s holdings.



China CPI: In total there are about 600 “national items” used for calculating the all-China CPI. The list of items is revised annually for representativeness based on purchases reported in the household surveys. The number of items can change from year to year, but rarely by more than 10 in any given year.


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.




Sector Strategy

� It has been another extremely difficult year for Financials. The sector is the worst performer in the S&P 500 with a 20.7% loss (as of November 18, 2011), compared to the 1.6% loss for the S&P 500. A number of factors have weighed on the sector’s performance, with the European debt crisis, mortgage securities and foreclosure debacle, and a challenging regulatory and interest rate environment chief among them. These factors along with sluggish growth have constrained sector profitability [Chart 1].

� The majority of this year’s weakness in Financials can be attributed to Capital Markets. The large diversified banks and capital markets companies are most exposed to the troubles in Europe, most sensitive to the credit markets which have been under increased stress much of this year, and are hurt most by financial regulatory reform.

� Outside of these areas, where performance has not been nearly as bad, a challenging interest rate environment has been a primary source of weakness. Lenders have been hurt by a flattening yield curve, which compresses the net interest margin, or the difference between the lender’s cost of funds and proceeds from loans. In addition, the profitability of a number of financial companies is hurt by low absolute interest rate levels, including insurers that are investing premiums at lower interest rates.

� Another source of weakness has been a weak housing market, including price declines, depressed housing starts, and ongoing foreclosure bottlenecks. Related to the weak housing market are still unsettled claims of fraudulent mortgage securities, which continue to weigh on loan demand and bank stock performance. Banks compose the biggest portion of the Financials sector at roughly 40%.

� Regulatory pressures on the largest financial institutions have intensified this year due to the implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The law’s components have caused large financial institutions to shed trading divisions, lose fee revenue and suffer profitability-constraining capital raises, to site a few examples. Many of the rules under Dodd-Frank are yet to be written, creating an overhang that is likely to continue to weigh on the sector in the coming months.

� While there are a number of reasons to be cautious toward the Financials sector, several positives are emerging that have us on watch for a potentially more positive view. First, we expect the European debt crisis to be contained. Positive steps have already been taken. Second, credit spreads are likely to continue to narrow, as they did in October, likely in

November 2011

Financials

1 Financial Company Profitability Being Constrained by Sluggish Growth As Well As the Challenging Interest Rate and Regulatory Environment


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

PerformanceS&P 500 Financials Index S&P 500 Index

Q3 2011 -22.8% -13.9%2011 YTD -20.7% -1.6%1 month 5.8% 5.5%3 month -15.1% -5.2%12 month -12.8% 5.0%2011E EPS Growth 3.9% 14.9%NTM P/E 9.0 11.4Dividend Yield 1.7% 2.1%Beta 1.32 1.00S&P 500 Weight 13.9%






03020100999795 96 98 0908 10 11070504 06

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Return On EquityS&P 500 / Financials


SECTOR STRATEGY: F INANCIALS

conjunction with further resolution in Europe. Third, the yield curve is starting to steepen. Finally, business lending has started to pick up in recent months. While these are all reasons to be hopefully, we are not seeing enough improvement fundamentally right now to warrant a more positive view.

� Sector valuations are tempting here but earnings estimates continue to fall and profitability is being impaired by the regulatory environment. Financials are trading at around book value overall, a level typically only reached during financial crises. The Federal Reserve has slowed the sector’s desire to return more capital to shareholders, preventing a number of financial companies from unlocking more value amid a constrained growth environment.

� Within the sector, we have become increasingly constructive on Regional Banks. The interest rate environment is beginning to improve, loan growth has started to pick up, housing is stabilizing, and regulatory challenges are more manageable. Lackluster job growth and volatility in the credit markets cause us to be neutral on REITs despite attractive yields in a low interest rate environment.


RES 3389 1111Tracking #1-021789 (Exp. 11/12)





SECTOR STRATEGY: F INANCIALS

IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide or be construed as providing specific investment advice or recommendations for any individual. To determine which investments may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.



The S&P Financials Index is comprised of a wide array of diversified financial service firms are featured in this sector with business lines ranging from investment management to commercial and investment banking.






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.

Yield Curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. The most frequently reported yield curve compares the three-month, two-year, five-year and 30-year U.S. Treasury debt. This yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates. The curve is also used to predict changes in economic output and growth.


The Dodd–Frank Wall Street Reform and Consumer Protection Act is a federal statute in the United States that was signed into law by President Barack Obama on July 21, 2010. The Act implements financial regulatory reform sponsored by the Democratically controlled 111th United States Congress and the Obama administration. Passed as a response to the late-2000s recession.



Sector Strategy

� The Healthcare sector has had a solid 2011, supported by investors’ preference for defensive sectors throughout much of the year, along with excessively pessimistic sentiment coming into the year due to the massive healthcare reform legislation. The sector’s 6.1% return year-to-date is a solid 770 basis points ahead of the 1.6% loss for the S&P 500 (as of November 18, 2011), ranking third among the 10 S&P sectors.

� The sector’s improved performance this year is due to a number of factors. First, news flow has been much better, regarding reform as well as new product development, capital allocation decisions and merger announcements. In addition, low healthcare utilization due to consumer spending pressures has helped prop up profit margins for health insurers, which have returned a stellar 26% year-to-date (as of 11/18/11), among the best industry groups in the entire market.

� The market’s increasingly favoring defensive investments much of this year played a key role in better sector returns. Between mid-February and the October stock market low, defensive sectors were flat, on average, while the cyclical sectors lost an average of 23%. Economic uncertainty and low interest rates fueled strong performance in defensive, higher yielding sectors including Healthcare.

� Our preference for cyclical sectors is the primary driver of our negative Healthcare view. We believe the market has priced in an overly pessimistic global growth and profits view, in large part due to uncertainly in Europe, setting the stage for the sectors most exposed to global growth to potentially outperform. Accordingly, our views of the defensive sectors are more cautious. Healthcare tends to perform best later in business cycles as the economy moves from a sustained growth path toward recession.

� Also cause for some caution for Healthcare investors is that healthcare companies are right in the cross hairs of global austerity measures, particularly in Europe. The government is the largest consumer of Healthcare globally, and a key target of deficit reduction efforts. The failure of the deficit cutting “Super Committee” removed some headline risk surrounding Medicare and Medicaid cuts, a modest positive for the sector.

� While reform has not hurt sector performance noticeably this year, the impact is no doubt negative. Profit margins for managed care companies are being capped. Fees are being assessed to Healthcare companies that are front-end loaded, as the millions of newly insured patients will not

“arrive” until 2013. As we enter 2012, reform may begin to move back into investors’ minds and hamper returns.

November 2011

Healthcare

1 Healthcare Has Had a Solid 2011 Relative to the Market Thanks to the Sector’s Defensive Characteristics and Less Negative News Flow Surrounding Reform

NovOctSepJun JulMayJan AprMarFeb Aug

1121101081061041021009896

Index Relative Strength vs. the S&P 500 IndexS&P 500 / Healthcare



PerformanceS&P 500 Healthcare Index S&P 500 Index








SECTOR STRATEGY: HEALTHCARE

� While we expect the sector’s defensive characteristics to be a drag on relative performance for the balance of the year and into 2012, the improved pace of innovation among biotech companies and to an extent big pharmaceutical companies is encouraging. Moreover, companies have responded to investor demand for more shareholder friendly capital allocation decision in terms of restructurings, dividends, buy backs and research and development spending.

� We would characterize valuations for the sector as fair at a modest 5% discount to the S&P 500 on a forward price-to-earnings (P/E) basis. Entering the year, the sector traded at a compelling discount of more than 15%, setting up strong returns so far in 2011. While historical premium valuations make the sector appear cheap, the slower growth profile of drug companies and profit margins that have been halved suggest a discount is warranted.

� Sector earnings are only expected to grow at a mid-single digit pace for the balance of this year and in early 2012, about half of consensus expectations for the S&P 500 at around 10%. However, revisions for the second half of the year have been positive since the start of the third quarter on July 1, one of only two sectors that can make such a claim (Technology is the other).

� Within the sector we continue to favor Biotech due to the potential for more consolidation, while our cautious view of the drug makers reflects a muted growth profile, despite attractive valuations and rich dividend yields.


RES 3390 1111Tracking #1-021791 (Exp. 11/12)





SECTOR STRATEGY: HEALTHCARE




The S&P Healthcare Index is comprised of companies in this sector primarily include healthcare equipment and supplies, healthcare providers and services, biotechnology, and pharmaceuticals industries.







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.

Precious metal investing is subject to substantial fluctuation and potential for loss.



Sector Strategy

� Industrials had a strong start to 2011, returning 8% during the first half of the year compared to 6% for the S&P 500. The second half, however, has been a struggle as global growth expectations have been reduced amid the European sovereign debt crisis and softening in economic data in both the U.S. and China. Year-to-date, the sector has lost 4.4%, versus the 1.6% loss for the S&P 500.

� We believe we are in the middle of a five-to-six year business cycle, a period that has historically been favorable for Industrials sector performance. The widespread economic pessimism adds to the near-term opportunity for the sector and further supports our positive view.

� Our positive outlook for business spending, which we expect to increase at several times the rate of consumer spending over the next year, supports our positive Industrials view. Business spending accelerated during the third quarter, rising at an annualized rate of 17%, providing one of the brightest spots for the U.S. economy in recent months. This pace compares to mid-single digit average growth rates during the previous three quarters. Business spending may get an additional boost from a more favorable policy environment in 2012.

� Strong demand from Emerging Market economies is also supportive of industrial companies’ growth. Although these countries may only represent an estimated 15 to 20% of sector revenues, they represent a disproportionate amount of sector growth. We expect China’s economy to grow at an 8%-9% rate in 2012, only a slight slowdown or “soft landing.” We expect only marginal deceleration in growth overall for the Emerging Markets, potentially down to a still robust 6%. A weak dollar is expected to add to growth.

� Strong growth in Emerging Market economies also benefits the Industrials sector through strong commodities markets. While higher energy costs are a drag on profit margins for transportation providers like airlines and trucking companies, companies in the Industrials sector transport raw materials, build energy infrastructure and manufacture mining equipment. This relationship is reflected in high correlations between Industrials and Materials, another favored sector.

� After consistently rising earnings estimates from the end of the recession in mid 2009, Industrials sector estimates have fallen recently. Since July, forward estimates have been reduced by about 5%, manageable but still meaningful. Even after these cuts, the sector is still expected to grow earnings in 2012 by 13%, about 2% faster than the S&P 500 and, we believe, very achievable.

Novermber 2011

Industrials

PerformanceS&P 500 Industrials Index S&P 500 Index

Q3 2011 -21.0% -13.9%2011 YTD -4.4% -1.6%1 month 8.4% 5.5%3 month -4.8% -5.2%12 month 4.2% 5.0%2011E EPS Growth 19.6% 14.9%NTM P/E 12.0 11.4Dividend Yield 2.3% 2.1%Beta 1.16 1.00S&P 500 Weight 10.5%






1 Business Spending Growth Accelerated During the Third Quarter

17% Annualized Increase in Q3 2011

04 060503 1107 10090802

40

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Real Private Nonresidential Investment: Equipment & Software% Change-Annual Rate SAAR, Bil.Chn.2005$

Source: Bureau of Economic Analysis, Haver Analytics 11/07/11

(Shaded areas indicate recession)


SECTOR STRATEGY: INDUSTRIALS

� The sector trades at an attractive 5% premium to the S&P 500, modestly above historical averages but compelling for the current middle stage of the business cycle. Valuations are attractive compared to the mid-cycle periods in the mid-1990s and mid-2000s.

� Within the sector we favor the Machinery and Capital Goods industry groups for exposure to the strong business spending, export and commodities markets. Defense spending cuts, which will be onerous if the sequestered cuts following the failure of the super committee holdup, drive our negative view of Aerospace & Defense.


RES 3391 1111Tracking #1-021798 (Exp. 11/12)





SECTOR STRATEGY: INDUSTRIALS




The S&P Industrials index is comprised of 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.

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.



International and emerging markets investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.




P/FE Multiple: A tool for comparing the prices of different common stocks by assessing how much the market is willing to pay a share of each corporation’s estimated future earnings. It is calculated by dividing the current market price of a stock by the earnings per share estimate for the future period.





Sector Strategy

� After a lackluster first half of 2011 in which Technology trailed the S&P 500 by roughly 400 basis points, the sector has ridden resilient earnings performance and powerful product cycles to outperform during the second half — though with only a flat total return. Since June 30, the sector’s zero total return is well ahead of the 7.1% loss for the S&P 500 and trails only Utilities and its 4.6% return (Consumer Staples is also flat during the second half of 2011, as of November 18). Year-to-date, the sector has returned 1.7%, versus the 1.6% loss for the S&P 500.

� Two of the biggest reasons for our positive Technology view also drive our positive view of the Industrials sector. Both sectors have heavy exposure to business spending, which makes up more than half of technology spending. Additionally, Emerging Markets are a key growth driver for these two global sectors. We expect business spending to increase at a high-single digit pace in the next several quarters, and for Emerging Markets to slow only modestly.

� The sector’s resilient earnings is a key reason for recent outperformance. Technology is the only cyclical sector not to have seen its second half earnings estimates cut since July 1. Among the reasons for the solid performance: strong spending in mobility, cloud computing, storage, the use of technology as a productivity enhancing tool, and impressive cost controls that have lifted Technology sector profit margins to record highs.

� The sector remains very attractively valued at a modest 4% premium to the S&P 500 on a forward price-to-earnings (P/E) basis, despite a solid profit outlook and record high profit margins. Over the last 15 years, the sector has traded at mostly above a 20% premium, excluding the Technology bubble in the late 1990s where the multiple was of course significantly higher. The low end of this range is a reasonable upside target, although commoditized technology products, stiff foreign competition and weakness in the PC market due in part to the prevalence of tablets are headwinds.

� Several performance patterns suggest Technology will finish the year strong. First of all, the sector enjoys favorable seasonal trends during the fourth quarter related to annual budget flushes for corporations. Second, the sector performs well during the third year of the Presidential election cycle (2011). And last, the sector tends to bounce back from down years, as it experienced in 2010 and not underperform two years in a row.

� One of the biggest risks to the sector earlier in the year, and a key reason for the lackluster performance in the first half, was supply disruptions in Japan as a result of the earthquake, tsunami and nuclear disaster. While key technology suppliers in Japan are back on line or have shifted

November 2011

Information Technology





PerformanceS&P 500 Information Technology Index S&P 500 Index



1 Technology Earnings Estimates Have Been Resilient

Source: Thomson Reuters, LPL Financial 11/18/11

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RES 3392 1111Tracking #1-021803 (Exp. 11/12)





SECTOR STRATEGY: TECHNOLOGY

production elsewhere, the Thailand flooding has impacted some disk drive manufacturers and disrupted some supply chains, though not nearly as much as the tragic events in Japan.

� Within the sector we favor the Software group, which is leveraged to business spending, tends to perform well during comparable mid-cycle periods and is well positioned for key trends in the sector. Our outlook for Semiconductors is positive due to very low expectations embedded in valuations and our view that order trends are bottoming.




The S&P Information Technology Index is comprised of stocks primarily covering products developed by internet software and service companies, IT consulting services, semiconductor equipment and products, computers and peripherals, diversified telecommunication services and wireless telecommunication services are included in this Index.



Price to book ratio is the stock’s capitalization divided by its book value. The value is the same whether the calculation is done for the whole company or on a per-share basis. This ratio compares the market’s valuation of a company to the value of that company as indicated on its financial statements.


The P/E ratio (price-to-earnings ratio) is a measure of the price paid for a share relative to the annual net income or profit earned by the firm per share. It is a financial ratio used for valuation: a higher P/E ratio means that investors are paying more for each unit of net income, so the stock is more expensive compared to one with lower P/E ratio.






Sector Strategy

� The Materials sector has staged a solid rally since the S&P 500 low for the year was set on October 3rd. Since that low, the sector has returned an impressive 16.4%, compared to the 11% return for the S&P 500 and trailing only Energy which has returned 18.7% during this period. The strong gains have not been nearly enough, however, to make up for the sector’s underperformance during the first nine months of the year on global slowdown fears. Year-to-date, the sector’s 11% loss trails the S&P 500 by nearly 1000 basis points and is ahead of only the embattled Financials.

� In the short term, we believe excessive economic pessimism, primarily due to the market pricing in a possibility of a disorderly default by Greece, sets the stage for sector expectations to improve and commodity prices and natural resources stocks to move higher. The sector’s behavior since the early October lows provides an example of the sector leadership Materials may provide in the market’s next move higher. Materials have outperformed during each market rally (50% or more moves in S&P 500) since the start of 2010.

� Materials stocks tend to follow commodity prices. For evidence, consider the high teens loss year-to-date for the Metals and Mining Industry group is right in line with the losses in copper and aluminum. Earnings are relevant, but the sector follows commodity prices. Accordingly, our positive Materials view is consistent with our expectation that commodities prices move higher, supported by a solid supply-demand picture.

� Relative performance tends to be strong for the Materials sector at this stage of the business cycle entering year three of an economic expansion emerging from an economic soft spot. At this point, commodities markets typically see solid demand and the potential emergence of supply shortages, driving commodity prices higher and, in turn, earnings and stock prices.

� Our outlook for growth in Emerging Markets economies is positive. China’s thirst for raw materials drives a significant portion of the market for key industrial metals such as copper, where global supplies are tightening. We continue to expect a soft landing in China, with growth in the 8 – 9% range over the next year, only a slight slowdown from the current pace. Easier monetary policy now that Chinese inflation has likely peaked [Chart 1] should put upward pressure on commodity prices.

� Our expectation for further US dollar weakness is also supportive of commodities prices and therefore the Materials sector. The Federal Reserve in keeping interest rates near zero until mid-2013 (at least) is putting downward pressure on the dollar, in addition to the pre-existing pressure from twin deficits and central bank diversification away from the greenback around the world.

November 2011

Materials

1 Chinese Consumer Inflation Likely Peaked In July

07 08 1009 11

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China: Consumer Price IndexNot Seasonally Adjusted, Year/Year % Change

Source: China National Bureau of Statistics, Haver Analytics 11/09/11

PerformanceS&P 500 Materials Index S&P 500 Index

Q3 2011 -24.5% -13.9%2011 YTD -11.3% -1.6%1 month 6.7% 5.5%3 month -11.5% -5.2%12 month -1.0% 5.0%2011E EPS Growth 32.7% 14.9%NTM P/E 11.0 11.4Dividend Yield 2.1% 2.1%Beta 1.32 1.00S&P 500 Weight 3.5%







SECTOR STRATEGY: MATERIALS

� We view valuations as fair to attractive at this point in the business cycle especially given the strong growth outlook and our belief that commodity prices are poised to move higher. The sector trades near its historical average relative forward price-to-earnings (P/E) ratio at a 40% discount. This level is reasonable when compared to the comparable mid-cycle periods in the mid-1990s and mid-2000s, with upside potential from above-consensus increases in commodity prices.

� Within the sector, we favor the Metals & Mining industry due to our positive outlook for industrial metals. We expect Chinese growth and continued pressure on the US dollar to support metal prices. We also favor Chemicals due to our positive views on agriculture.


RES 3393 1111Tracking #1-021804 (Exp. 11/12)





SECTOR STRATEGY: MATERIALS




The S&P Materials Index is comprised of companies that engage 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.



China CPI: In total there are about 600 “national items” used for calculating the all-China CPI. The list of items is revised annually for representativeness based on purchases reported in the household surveys. The number of items can change from year to year, but rarely by more than 10 in any given year.

International and emerging market investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.




The P/E ratio (price-to-earnings ratio) is a measure of the price paid for a share relative to the annual net income or profit earned by the firm per share. It is a financial ratio used for valuation: a higher P/E ratio means that investors are paying more for each unit of net income, so the stock is more expensive compared to one with lower P/E ratio.





Sector Strategy

� The Telecom Services sector is fractionally ahead of the S&P 500 in 2011 with a zero total return year-to-date, versus the 1.6% loss for the S&P 500 (as of November 18, 2011). The defensive income-producing sector has followed the predictable pattern of outperforming when the stock market falls, and lagging during rallies. From the start of the year through the October 3, 2011 low for the year, when the S&P 500 lost 11%, Telecom lost just 3%. Since October 3rd, the S&P 500 has rallied 11% while Telecom has been the worst performing sector with only a 3% return [Chart1].

� The Telecom Services sector has benefited from its defensive characteristics in an environment of economic uncertainty, as well as from lofty dividend yields as interest rates have declined substantially this year. At the same time, challenging fundamentals and rich valuations held the sector back, leaving it roughly even with the overall stock market this year.

� The primary reason for our cautious Telecom view, as with the other defensive sectors, is that we favor cyclicals during the middle stage of the business cycle, especially given our view that the market is pricing in overly pessimistic prospects for economic growth and profits.

� Another reason for our cautious stance, which has only recently started to drag down relative performance, is the sector’s interest rate sensitivity. Currently, the sector yield of 5.5% is more than twice the yield offered by 10-year Treasuries at near 2.0%, a very attractive near record high spread. If interest rates move higher as we expect, and this spread narrows, sector dividends become relatively less attractive, on the margin, which can negatively impact relative performance.

� Rising interest rates also tend to be associated with improving economic prospects, presenting a headwind for the more defensive sectors such as Telecom Services. Our expectation is for interest rates, as measured by the yield on 10-Year Treasury bonds, to move higher toward 2.5% in the near-term, followed by a return to the 3 – 3.5% range in 2012 as the bond market prices in better growth prospects and slightly more inflation. Chart 2 illustrates the tight relationship between the yield on the 10-year Treasury (inverted) and Telecom sector relative performance.

� A challenged growth outlook also tempers our enthusiasm for Telecom. Although the proliferation of smart phones, tablet devices and booming mobile data demand has helped the big national providers generate some revenue growth during the third quarter (low-single digits in aggregate), a secular decline in land line usage and falling wireless prices

November 2011

Telecommunication Services





Performance

S&P 500 Telecommunication Services Index S&P 500 Index




SECTOR STRATEGY: TELECOMMUNICATION SERVICES

are constraining growth rates. As a result, we prefer to take advantage of these favorable trends through the more attractively valued and faster growing Technology sector.

� The sector’s lofty dividend yield over 5% is very attractive especially in the current low interest rate environment. However, fundamental challenges and rich valuations prevent us from getting more constructive on the group. The sector is trading at a record 34% premium to the S&P 500 on a forward price-to-earnings ratio (P/E) basis. This valuation is the highest among all ten S&P sectors and well above its historical average relative valuation in line with the S&P 500.

� A wildcard for sector performance could come from consolidation. If the large proposed acquisition is approved by regulators, wireless pricing may benefit from reduced competition. The required divestitures to gain approval may be onerous, so a deal is anything but certain at this point.

� Within Telecom Services, we favor the large, integrated service providers with attractive dividends that make up the majority of the sector and benefit from wireless growth and potentially consolidation.

2 Telecom Sector Relative Performance Has Moved Inversely With Interest Rates

10 11

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10-Year Treasury Note Yield at Constant MaturityAvg. % (Left Axis, Inverted)Telecom Sector Relative Strength vs. S&P 500 (Right Axis)

Source: Haver Analytics, LPL Financial 11/22/11

1 Defensive Telecom Sector is the Worst-Performing S&P Sector since the October 3rd Stock Market Low

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Cyclical SectorsDefensive SectorsS&P 500



RES 3394 1111Tracking # 1-021807 (Exp. 11/12)





SECTOR STRATEGY: TELECOMMUNICATION SERVICES




The S&P Telecommunications Index is comprised of companies that provide communications services primarily through a fixed line, cellular, wireless, high bandwidth and/or fiber-optic cable network.









Sector Strategy

� Thanks to heightened economic uncertainty and falling interest rates throughout much of the year, Utilities is the best performing sector in 2011 by far. The defensive, income-producing sector has returned a stellar 14.1% year-to-date, well above the 1.6% loss for the S&P 500 (as of November 18) [Chart1].

� As with Telecom Services, our preference for cyclical sectors at this stage of the business cycle is the primary reason for our negative view of the Utilities sector. Rich valuations, a lack of growth, a challenging pricing environment and regulatory headwinds are also cause for caution in our view. Moreover, our bias remains for interest rates to continue to move higher, creating a headwind for Utilities relative performance.

� Utilities is the only sector expected to see a drop in earnings per share (EPS) in 2011, albeit a modest one of -1% compared to the low-double digit increase in EPS we expect the S&P 500 overall to deliver. The lackluster growth is attributable in large part to a slow recovery in power demand related to weak residential and commercial construction activity since the Great Recession. Housing starts are starting to show early signs of improvement and may provide a marginal boost to growth for utility companies in 2012.

� We do not believe the sector’s limited growth prospects justify a valuation above the S&P 500, especially not the more than 20% premium where the sector is currently trading. This valuation could be considered reasonable if the U.S. economy was indeed headed for recession and interest rates were going to resume their downward path. This is not our view, however, as we expect the bond market to price in better economic growth in the months ahead and put upward pressure on interest rates. Utility stocks are unlikely to outperform in this environment.

� A challenging pricing and regulatory environment is also constraining Utilities’ profit growth. Low natural gas prices and a tough regulatory pricing climate have pressured profit margins, which are down from 2010. Eventually legislation will likely be a further drag on profitability as Washington steps up its push for cleaner power.

� Utilities offer a nice dividend yield for income investors of 4.1%, newly double the level of the S&P 500 at 2.1%. The yield is attractive relative to high-quality bonds, with Long-Term Treasuries yielding near 3.0% and the 10-year yielding only about 2.0%. But with lofty valuations, essentially no growth and our expectation that interest rates will rise, we do not find this dividend yield particularly tempting. For income from equities, we prefer REITs for better fundamentals, although this is not among our favorite groups for the balance of the year.

November 2011

Utilities

1 Utilities have Ridden Economic Uncertainty and Low Interest Rates to the Top of the 2011 Sector Rankings

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Cyclical Sectors–Year-to-Date Total returnDefensive Sectors–Year-to-Date Total returnS&P 500–Year-to-Date Total return


PerformanceS&P 500 Utilities Index S&P 500 Index

Q3 2011 1.5% -13.9%2011 YTD 14.1% -1.6%1 month 3.7% 5.5%3 month 5.5% -5.2%12 month 14.1% 5.0%2011E EPS Growth -0.9% 14.9%NTM P/E 13.9 11.4Dividend Yield 4.1% 2.1%Beta 0.59 1.00S&P 500 Weight 3.7%







RES 3395 1111Tracking # 1-021810 (Exp. 11/12)





SECTOR STRATEGY: UT IL IT IES




The S&P Utilities Index is comprised primarily of companies involved in water and electrical power and natural gas distribution industries.





Investing in real estate/REITs involves special risks such as potential illiquidity and may not be suitable for all investors. There is no assurance that the investment objectives of this program will be attained.

Government bonds and Treasury Bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of fund shares is not guaranteed and will fluctuate



Because of their narrow focus, sector investing will be subject to greater volatility than investing more broadly across many sectors and companies.

� The damage from the nuclear disaster in Japan is still being felt by utility companies here in the U.S. The cost of delivering nuclear power in the U.S. will rise, with increasing regulatory scrutiny and project delays muddying the outlook for the leading nuclear power producers.

� Within the sector, for more conservative, income-oriented investors, we would favor the dividend-rich regulated and integrated utilities over the independent power producers because of greater pricing stability and lesser volatility.

2 Utilities Sector Relative Performance Has Moved Inversely With Interest Rates

10 11

0.158

0.150

0.143

0.135

0.128

0.120

1.6

2.0

2.4

2.8

3.2

3.6

4.0

Utilities Sector Relative Strength vs. S&P 500 (Left Axis)10-Year Treasury Note Yield at Constant MaturityAvg. % n.a. (Right Axis, Inverted)

Source: LPL Financial, Haver Analytics 11/22/11

Documents

LPL FINANCIAL RESEARCH Sector Strategy · 2015-07-09 · LPL FINANCIAL RESEARCH. Sector Strategy. 2011: The Year of the Defensive Sector? ... outlook earlier in the year, ... Q4 2010