What’s Ahead in 2010: Autumn Update

An Investment Perspective

Executive Summary:
} The Economic Backdrop: The risks of a double-dip recession continue to recede, but the
economy remains mired in a slow-growth environment. See page 2

} Quantitative Easing on the Way: The Fed has announced it will ramp up its asset purchases,
hoping to improve investor confidence. See page 3

} An Update on Our “10 Predictions for 2010”: With the global economy slowly improving,
corporate earnings still strong and inflation a non-threat, our predictions are mostly playing
out as forecasted. We still expect equity markets to post full-year gains, but acknowledge that Bob Doll
volatility will remain high. See page 4
Chief Equity Strategist
} The Outlook: We expect that both profits and earnings will continue to improve, especially if for Fundamental Equities;
economic growth is able to remain on track, which should help pave the way for equities to Lead Portfolio Manager,
continue to grind higher. See page 6 Large Cap Series

} Investment Opportunities: At this juncture, we recommend investors continue to focus on

high-quality stocks (with some allocation to cyclicals), and believe that US markets are more
attractive than other developed markets. We also continue to see opportunities in emerging
markets. See page 7

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[2]
Over the course of the last
month, however, data began
to improve, which served to
ease fears of a double-dip
recession and helped spark
a turnaround in risk assets,
including equities.
Over the next 12 months, we
expect real GDP growth to
come in somewhere between
the 2% and 2.5% levels.
The Fed has made it clear
that additional policy action
is needed.
The Economic and Market Backdrop
Double-Dip Scenario Fades, But the Recovery Remains Muted
It took quite a bit longer than many expected, but in late September, the National Bureau of
Economic Research told us the “Great Recession” ended in June of 2009. Spanning December
2007 to June 2009, this marked the longest reported recession since the Great Depression. Over
the 18 months of its existence, the history-making recession resulted in an annualized decline
in gross domestic product (GDP) of 2.8% and a loss of 7 million jobs.
As the third quarter began, economic data began to take on a more negative tone, as earlier
improvements in the labor market began to fade, housing trends continued to disappoint and
consumer confidence and spending levels remained anemic. Over the course of the last month,
however, data began to improve, which served to ease fears of a double-dip recession and helped
spark a turnaround in risk assets, including equities.
A closer look at the data, however, shows that many of the recent positive economic releases actually
reflect a lowering of expectations toward less optimistic levels, rather than a dramatic and genuine
improvement in the data. In other words, the outlook in the mid-summer timeframe became so dismal that
simply meeting expectations was enough cause for celebration. In absolute terms, we have yet to see
a strong acceleration in growth levels, leaving the economy mired in a slow-growth scenario. Recent
data on industrial activity, housing and employment, while better than they were a few months ago, remain
consistent with a sluggish economic recovery. Additionally, the cycle of inventory rebuilding, which
was a significant contributor to the positive growth levels over the past four quarters, has all but ended.
Looking out over the next three to six months, we see little reason to expect a pronounced acceleration
in US economic growth. At the same time, however, we do not believe growth will slow to the point
that the economy will sink back into recession. Over the next 12 months, we expect real GDP
growth to come in somewhere between the 2% and 2.5% levels.
A Return to Quantitative Easing
At the Federal Reserve’s September policy meeting, the central bank emphasized that it remains
committed to doing what it can in terms of using its balance sheet to reflate the economy. Mirroring
recent statements from the Bank of England and the Bank of Japan, the Fed made it clear that low
growth levels are not acceptable, nor are deflation risks, and that the central bank stands ready to
begin the next phase of quantitative easing. In its statement, the Fed admitted that it believes
inflation levels are too low, limiting its ability to promote stable prices. This was a significant statement;
until now, the Fed was more focused on the slow pace of growth and high unemployment. These
concerns obviously still remain, but by explicitly adding deflation risks to the list of problems, the
Fed has made it clear that additional policy action is needed.
At least initially, the new round of quantitative easing is likely to take the form of purchases of long-
dated Treasuries. The open question, of course, is whether such easing will work. The advocates
argue that by reducing the supply of Treasury bonds, Treasury yields will fall, which will “force”
investors to move to higher-risk and higher-yielding assets such as corporate bonds. The other side
of the argument is that the financial system is already flush with cash, with banks holding more than
$1 trillion in excess reserves, and that additional Fed purchases will do little to prompt additional buying.
 [3]

In any event, given the ongoing downside risks to the economy, the Federal Reserve is under The central bank is hopeful
pressure to help the economy break out of this phase. Much of the slow growth that is plaguing the that by using its balance
economy is due not only to the structural problems of ongoing deleveraging, but also results from sheet to reflate the economy,
the fact that companies and households are unwilling to spend in the current environment. The
confidence will be restored
central bank is hopeful that by using its balance sheet to reflate the economy, confidence will be
and spending will resume.
restored and spending will resume.

The Third Quarter By the Numbers US stocks posted third-

quarter gains that were
In contrast to the dismal tone of the second quarter of 2010 (when investors bid stock prices lower
as they grew increasingly concerned about the possibility of a double-dip recession), the third roughly equivalent to
quarter began with markets making some noticeable gains. The major short-term ambiguities that the losses they endured
kept market participants on the fence — the US financial reform bill, growth in China, the EU bank in the second quarter,
stress tests and European sovereign funding — abated to some degree, which allowed stocks to post leaving equities in positive
gains. Notwithstanding a market slide in August (which resulted from some weaker economic data —
territory for the year.
chiefly in the labor market), market conditions changed sharply as the quarter drew to a close, and
September brought a strong four-week run. The rally was fueled by a modest, but noticeable, upturn
The standout performers
in the tone of economic data as well as continued good news on the corporate earnings front. The
prospects for additional Federal Reserve asset purchases also contributed to the improved market for the quarter were the
sentiment. In the end, US stocks posted third-quarter gains that were roughly equivalent to the emerging markets, which
losses they endured in the second quarter, leaving equities in positive territory for the year. The Dow have been experiencing
Jones Industrial Average gained 11.1% for the quarter, leaving it up 5.6% for the year. The S&P 500 much more robust levels
Index advanced 11.3% for the quarter and is up 3.9% for 2010. The Nasdaq Composite rose 15.1% of economic growth.
for the quarter and is now up 8.0% for the year.

Outside the United States, the story was much the same, as markets advanced in light of some
improving economic conditions. Non-US developed markets were up, albeit to a lesser extent than
their US counterparts, given that the US recovery still appears to be relatively stronger. German
stocks advanced 4.4% for the quarter and are up 4.6% for the year, while UK markets experienced
a strong 12.9% gain, bringing that market back into positive territory with a 2.5% year-to-date gain.
Japan continues to face some deflationary pressures and is combating the rising value of the yen.
In that environment, Japanese stocks lost 0.1% for the quarter and are down 11.2% for the year.
The standout performers for the quarter were the emerging markets, which have been experiencing
much more robust levels of economic growth. Chinese stocks, which were some of the worst
performers in the first half of the year, rebounded in the third quarter to post a 15.2% gain (although
that market still is down 16.8% for the year). As a whole, emerging markets were up 18.0% for the
quarter and are ahead of most developed markets with a year-to-date gain of 10.8%.

In bond markets, yields continued to fall sharply through the third quarter, first as a result of weak
economic data and then due to the expectation of additional quantitative easing. The yield on the
10-year Treasury fell from 2.96% at the beginning of the quarter to 2.53% by September 30. In all,
the Barclays Capital US Aggregate Bond Index gained 2.5% for the quarter and is up 7.9% for the
year. Finally, cash investments, as represented by the 3-month Treasury bill, returned only a minor
fraction over 0% for the quarter, as short-term rates remain very low.
[4]
1
The US economy grows
above 3% in 2010 and
outpaces the G-7.
2
Job growth in the United
States turns positive
early in 2010, but the
unemployment rate
remains stubbornly high.
3
Earnings rise significantly
despite mediocre
economic growth.
4
Inflation remains
a non-issue in the
developed world.
5
Interest rates rise
at all points on the
Treasury curve,
including fed funds.
The Scorecard So Far
As we enter the last quarter of 2010, our predictions are mostly on track. The economy is
growing, albeit at a slow pace, corporate earnings are still strong and inflation is not on the
radar screen. The future direction of stock markets remains tricky, but we are still holding to
our view that the year will end with modest gains for most markets.
US GDP grew at an annualized 3.7% rate in the first quarter and at a much slower 1.7% rate in the
second. We’re expecting growth rates of around 2% to 2.5% for the second half of the year, which
may make it difficult for the economy to cross the 3% line we were calling for in January. In any case,
it seems clear that the United States will outpace most of the developed world for 2010 as a whole.
The pace of improvements has been slow, but we have seen increases in hiring over the course of
2010, a trend that should persist as the economy continues to recover slowly and as companies
begin to deploy their capital. Nevertheless, the unemployment rate remains over the 9% level, and
we expect that high rate to persist into 2011.
Corporate earnings have remained one of the bright spots in the macro environment through all of
2010. Thanks to cost-cutting measures and a focus on productivity, companies have been able to
boost their profits, revenues and bottom-line earnings despite a weak economic backdrop. Looking
ahead, we expect corporate earnings will remain strong, helping to pave the way for continued gains
in equity markets.
As the Fed’s recent statements have indicated, deflation in the developed world remains a more
significant threat than inflation, a scenario that is unlikely to change any time soon. We acknowledge
that in the years ahead, inflation may become a concern given high deficits and some of the structural
problems facing the United States, but such an environment is not likely to develop in the near future.
At this point, it is safe to assume that we’ll be marking this one as “incorrect” in our year-end
scorecard. The economic environment was slightly weaker than we anticipated at the beginning of
the year and lingering credit problems have kept rates low. With a new round of quantitative easing
in the cards, rates are likely to remain lower for some time, and we have no expectation that the
Fed will raise the fed funds rate at any point in the coming months.
 [5]

6
US stocks outperform US stocks managed to stage a recovery during the third quarter, and are back in positive territory
cash and Treasuries, and for the year. At this point, US stocks have outperformed most other developed markets and are
most developed markets. ahead of the close-to-zero returns of cash. Given the fall in Treasury yields that occurred this year,
however, Treasuries have so far outpaced stocks, with the 10-year Treasury having returned 14.3%
on a year-to-date basis. In any case, however, we expect that stocks will win out over the next two-
to three-year time horizon.
7
Emerging markets Over the past several months, emerging market economies have performed significantly better than
outperform as emerging the developed world. This has led some to revisit the “decoupling” theory, which posits that emerging
economies grow markets are not dependent on the rest of the world to generate growth. Whether one buys into this
significantly faster than premise or not, it is clear that the emerging world is becoming a larger and larger part of the global
developed regions. economy. From an equity perspective, emerging markets are again ahead of the developed world
thanks to a strong third-quarter showing.
8
Healthcare, information Telecommunications was the best-performing sector in the third quarter and is among the market
technology and leaders on a year-to-date basis. Meanwhile, both healthcare and information technology have been
telecommunications struggling in 2010 and, along with energy, are trailing the rest of the market. On the other side of
outperform financials, the ledger, all of our “less-favored” sectors have produced subpar returns so far this year on a year-
utilities and materials. to-date basis. On balance, a basket of healthcare, information technology and telecommunications
stocks has outperformed a basket of financials, utilities and materials stocks.
9
Strong free cash flow and Helped by strong corporate earnings and a difficult environment in which to grow organically,
slow growth lead to an companies have been putting their cash to work by ramping up merger-and-acquisition activity.
increase in M&A activity. Dividend increases and share buybacks have also increased this year, and we expect all of these
equity-friendly trends to continue in the coming months.
10
Republicans make The Democrats’ political fortunes have been dwindling, and Republican voters are certainly more
noticeable gains in the energized than their opponents. As this point, we doubt that the GOP will be able to pick up enough
House and Senate, but seats to take control of the Senate, but a Republican-led House is looking more and more likely.
Democrats remain firmly We have little more than a month to see how all of this ultimately plays out.
in control of Congress.
[6]
Although there are a number
of downside risks, we continue
to believe the United States
will be able to avoid a double
dip, assigning only a one-in-
five chance of that happening.
As long as corporate profits
remain healthy, equities and
other risk assets are likely
to grind higher, especially
in today’s environment of
ultra-low real interest rates.
We believe investors with
long-term horizons should
look past the short-term
tactical issues and focus on
the fact that equity valuations
appear attractive, especially
relative to bonds.
The Outlook
The future direction of the stock market will be highly dependent on the extent to which the
economy is able to avoid a double-dip recession. Although there are a number of downside risks, we
continue to believe the United States will be able to avoid a double dip, assigning only a one-in-five
chance of that happening.
Recessions typically occur when spending on cyclically sensitive sectors such as housing, capital
equipment and durable goods turns down. However, these sectors are already highly depressed in
the current environment and it is hard to see how spending can fall much further. Additionally, the
household saving rate has already moved up sharply, having increased from less than 2% prior to the
recession to about 6% at present, suggesting that consumers have already adjusted their budgets
and are unlikely to reign in spending any further. Finally, financial stress remains fairly low, and we
believe it would almost certainly take another financial crisis to trigger a new recession. Although
such a crisis is always possible, we think such an event is unlikely since the banking system is in
a much better position to withstand a financial shock than it was two years ago.
If our forecast is accurate, profit margins are unlikely to decline from current levels. Corporate
balance sheets remain healthy, as most companies have remained very conservative in terms of
managing their debt and spending levels. Corporate confidence remains somewhat shaky, but
should economic growth continue to improve, companies will likely become more aggressive in
deploying their high levels of cash on such activities as dividend increases, share buybacks, capital
expenditures, merger-and-acquisition activity and (hopefully) hiring. As long as corporate profits
remain healthy, equities and other risk assets are likely to grind higher, especially in today’s
environment of ultra-low real interest rates.
At present, there are a number of crosscurrents affecting financial markets, and many investors
lack conviction about how to position their portfolios in the current environment. Some are playing
“catch up” from the recent rally, while others are maintaining a defensive posture. In the short-term,
we believe continued caution is warranted given the high levels of uncertainty, especially
considering the rebound in investor sentiment we have seen, coincident with equities’ 10% rise from
their lows about a month ago. Still, assuming the United States does avoid a double-dip recession,
and that Europe continues to avert a renewed financial crisis, we believe investors with long-term
horizons should look past the short-term tactical issues and focus on the fact that equity valuations
appear attractive, especially relative to bonds.
 [7]

Opportunities For Investors

Remain Overweight in Equities Markets have improved over

Our call for slow-but-positive growth, continued strong corporate earnings, attractive valuations the past couple of months,
and low interest rates suggest that stocks should outperform cash and Treasuries over the coming although volatility remains
months and years.
high and many investors are
Focus on Quality, But Don’t Avoid Cyclicals unsure of how to position
On balance, we continue to advocate a focus on higher-quality stocks given that some companies their portfolios. As always,
are likely to struggle in an uncertain environment. Many investors, however, have already adopted
we encourage investors to
this posture and may have too little exposure to some of the cyclical segments of the market that
work with their financial
could benefit from improving economic conditions.
professionals to focus on
Rotate to Better-Positioned Sectors
their long-term objectives
From a sector perspective, we continue to like the telecommunications sector, and despite
and to find tactical investment
recent underperformance, we retain a positive view of healthcare stocks. At present, we have
strategies that work within
a more mixed outlook for information technology and still believe that financials are facing a
difficult environment. the context of their long-
term plans.
Look at Geography
Among developed markets, we continue to favor a higher weighting to the United States, since US
economic growth should be stronger and US stocks should continue to outperform. This is not to
say that international equities should be avoided, since they continue to represent a valuable
diversification tool, but simply that we see greater opportunities in US markets. At the same time,
the long-term case for investments in emerging markets remains intact. As a particular area of
opportunity, we suggest an emphasis on US multinational companies, which can benefit from
growth trends in emerging markets.

Selectivity Remains Key

As we said in the beginning of the year, 2010 is likely to be marked by ongoing volatility and heightened
dispersion among winning and losing investments. In this sort of environment, selectivity among
sectors and individual stocks will be critical.
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Source: BlackRock, Bank Credit Analyst. The opinions presented are those of the author on October 1, 2010, and may change as subsequent
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