Equity Market Comment

September 22, 2011 Portfolio Advice & Investment Research

Report Prepared by: Ryan Lewenza, CFA, CMT V.P. & U.S. Equity Strategist Highlights:

Rationale for a Defensive Portfolio Position

Heading into the summer we became increasingly concerned about the potential for a pullback in the equity markets due to a number of factors. Given this view, we recommended investors position portfolios with a defensive bias, to help better weather the storm. In this report we explain why we are maintaining a defensive position. Long-term Perspective Starting from a long-term or secular perspective, we believe the North American equity markets are likely to experience continued challenges in the years ahead, and are therefore likely to deliver lower returns, than were experienced in the last bull market of the 1980s and 1990s. The reason for this is simple: Historically stocks have experienced long-term bull and bear cycles that can last between 15 and 20 years. As illustrated in Exhibit 1, the Dow Jones Industrial Average has gone through periods of secular bull markets (late 1910s-20s, mid 1940s-60s, and early 1980s-90s) and secular bear markets (1930s-40s, 1960s-70s, and 2000 to present). Its our belief that the current secular bear market began in 2000 with the popping of the tech bubble and is likely to persist until the latter half of this decade before the next secular bull cycle begins. As proof of this long-term equity cycle thesis, we note that the S&P 500 Index (S&P 500) has returned a disappointing 0.53% annualized total return loss since the beginning of the millennium. While not comforting, investors armed with this knowledge will be better equipped to handle these challenging secular bear cycles. It is important to emphasize that money can still be made during these bear market cycles, but will require investors to be more nimble and employ active management strategies. Sector and stock selection take on greater importance in this type of environment. Exhibit 1: Stocks Trade in 15-20 Year Secular Cycles
log scale

The North American equity markets are likely to experience continued challenges in the years ahead, and deliver lower returns than were experienced in the bull market of the 1980s and 1990s. The reason for this is simple: Stocks go through long-term bull and bear cycles that can last between 15 and 20 years. From an intermediate perspective, which we define as 6-18 months, our defensive positioning is reinforced by: 1) weak U.S. economic growth, 2) high U.S. unemployment, and 3) continued weakness in the U.S. housing market. Over the technicals remain reinforce view. near-term, the and news flow negative and our defensive

100000

Dow Jones Industrial Average

10000

1000

This publication is for distribution to Canadian clients only. Please refer to Appendix A in this report for important disclosure information

100

Source: Bloomberg Finance L.P. As of September 16, 2011

10 '09 '14 '19 '24 '29 '34 '39 '44 '49 '54 '59 '64 '69 '74 '79 '84 '89 '94 '99 '04 '09

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Equity Market Comment

September 22, 2011 Portfolio Advice & Investment Research

Intermediate Perspective From an intermediate perspective, which we define as 6-18 months, our defensive position is reinforced by a number of considerations. First, U.S. economic growth has slowed considerably in recent quarters, and we expect much of the same slow growth over the next year. Historically, U.S. GDP has grown at an average of 3.3%. In the first half of 2011, the U.S. economy grew at an average rate of 0.7% despite accommodative U.S. monetary and fiscal policies (Exhibit 2). Our longheld view has been that the U.S. economy would muddle through with below trend growth in 2011 and beyond. Central to this view is the expectation for continued deleveraging by U.S. households as well as tighter fiscal policies, as the U.S. consumer and government reduce the massive amount of accumulated debt over the last few decades. Exhibit 2 illustrates how the total U.S. debt outstanding began to rise steadily during the 1990s, before going almost parabolic during the 2000s, resulting in a doubling of total debt over the last decade. We believe the U.S. will need to further reduce bloated balance sheets, which should provide a headwind to economic growth, and in turn, equity prices over the next few years. Exhibit 2: Expect Continued Slow Economic Growth Against the Backdrop of Further Deleveraging
%

6 4 2 0 -2 -4 -6 -8 -10
-8.9

U.S. GDP Q/Q Annualized

Source: Bureau of Economic Analysis As of September 19, 2011
1.3 1.7 3.8 3.9 3.8 2.5 2.3 0.4 1.0

(in billions)

U.S. Debt Outstanding Nonfinancial Total

As evidenced by this chart, the U.S. went on a debt binge during the 2000s, with total debt outstanding excluding financials, doubling over this short period. We expect a long and slow deleveraging process, taking the debt load closer to its long-term trendline.

$40,000 $35,000 $30,000 $25,000 $20,000 $15,000

Long-term trendline

-0.7 -1.8 -3.7

$10,000

-6.7

U.S. growth has slowed to stall speed, as evidenced by the 1H11 average growth of less than 1%

$5,000 $0 -$5,000 -$10,000 '70

Source: Bloomberg Finance L.P. As of September 19, 2011

Q1/08 Q2/08 Q3/08 Q4/08 Q1/09 Q2/09 Q3/09 Q4/09 Q1/10 Q2/10 Q3/10 Q4/10 Q1/11 Q2/11

'74

'78

'82

'86

'90

'94

'98

'02

'06

'10

Also key to our muddle through thesis is the pallid recovery in U.S. employment and the housing market, both key drivers of the U.S. economy. During the Great Recession the U.S. economy lost roughly 9 million jobs. With roughly 2.4 million jobs being created since the trough in the job market, the U.S. economy has only recaptured roughly 25% of the total jobs lost during the last recession. To put it mildly, this has been a jobless recovery, and given our view that many of the jobs (i.e. construction, finance) will never come back, it will likely be a very slow recovery in the U.S. job market and high unemployment is likely to persist (Exhibit 3). Historically, U.S. recoveries were largely driven by a rebound in the U.S. housing market, which has traditionally benefited from low interest rates typically seen during recessionary periods. Despite mortgage rates near-record lows, we have not witnessed any real improvement in the U.S. housing market, largely due to the speculative excesses from the previous cycle and high inventories of existing homes. Given the excesses from the previous cycle, we see no material improvement in this key sector for some time, resulting in another drag to the U.S. recovery. Exhibit 3: High Unemployment and Weak U.S. Housing Market Will be a Drag on Growth
%
(in thousands, annualized)

20 18 16 14 12 10 8 6 4 2 0

U.S. Unemployment Rate

Current Unemployment Rate: 9.1% Current U-6 Rate: 16.2%

Housing Starts

2500 2000 1500 1000 500

Source: Bloomberg Finance L.P. As of September 19, 2011
Source: Bloomberg Finance L.P. As of September 20, 2011

'94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11
Unemployment Rate U-6

0 '00 '01 '02 '03 '04 '05

Total starts

'06

'07
Single-family

'08

'09

'10

'11

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Equity Market Comment

September 22, 2011 Portfolio Advice & Investment Research

Short-term Perspective When determining our portfolio positioning over the very near term we focus on technicals and news flow. Currently, both remain negative and reinforce our defensive view. On the technical side we note that the S&P 500 broke through key support around 1,260 in the recent sell-off, and broke through the key 50 and 200-day moving averages. Often when support is broken it becomes resistance on the re-test so for us to get more constructive on equities on a short-term basis, we will need to see the S&P 500 break back above the key 1,260 level. News flows is clearly very negative with all eyes on Europe, and potential contagion affects if Greece defaults on its debt obligations. For us to get more constructive on equities in the short term, we would like to see a credible solution from European authorities to deal with the European credit crisis, with policymakers either implementing a long-term financing plan to address the PIIGS (Portugal, Italy, Ireland, Greece, Spain) funding problems, or recapitalizing the European banks, similar to what the U.S government did with TARP (Troubled Asset Relief Program). Exhibit 4: Both Technicals and News Flow Remain Negative for Equity Prices in the Short-term
1400 1350 1300 1250 1200 1150 1100 1050 1000 Sep-10 While recent price action signals a potential bottoming process, we will remain short-term cautious until the S&P 500 breaks above resistance of 1,260. Support Resistance?

S&P 500 Index

Source: Thomson. As of September 20, 2011

% 35 30 25 20 15 10 5

European Bond Spreads Continue To Widen

% 10

Will Italy and Spain follow Greece's lead?

2
Source: Bloomberg Finance L.P. As of September 14, 2011

Nov-10

Jan-11

Mar-11
S&P 500

May-11
50-DMA

Jul-11

Sep-11

0 Jan-11

Feb-11

Mar-11

Mar-11

Apr-11

May-11

Jun-11

Jul-11

Aug-11

0 Sep-11

Greece 5-Year Spreads (LHS)

Spain 5-Year Spreads (RHS)

Italy 5-Year Spreads (RHS)

Conclusion While weve painted a rather dour picture we need to balance the negatives we currently see with the positives that do exist. In particular stock valuations are quite attractive with the S&P 500 trading at 12x earnings, a steep discount to its long-term average of 16.5x. Stocks look attractive relative to government bonds with the 10-year U.S. Treasury yielding below 2%. Furthermore, dividend yields both in Canada and the U.S. are above their respective 10-year government bond yields. Finally, corporate earnings, for which we do expect to see negative earnings revisions, should hold up reasonably well during this weak economic patch. We will get through this difficult period, as we always do, but until then, continue to position portfolios defensively, by: 1) maintaining higher than normal cash balances; 2) overweighting defensive stocks relative to cyclicals; and 3) focusing on large-cap, high-quality companies that pay healthy and reliable dividend streams.

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September 22, 2011 Portfolio Advice & Investment Research

Appendix A Important Disclosures

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Equity Market Comment

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