Thursday, June 21st, 2012 at 6:30pm
Granite Links Golf Club
Quincy, Massachusetts
www.friendsofthevitellifamily.myevent.com

Dear Friends,
We are writing to you as a committee of friends who have joined together in an effort to support the Vitelli family. Michael and Jennifer (McCormack) Vitelli have been Marshfield residents for nine years. Along with Gino (9), Luca (8), Tony (6), and Sal (2), they have lived a normal and happy life with the hopes and expectations that we all have for our children. As a family, they have a love of the outdoors and are always on the go.

In the fall of 2011, however, this family’s life began to change. Gino went to bed on September 18th one child, and woke the next morning a completely different person. He woke crying, “yipping/yapping,” yelling/shouting, sputtering out inappropriate words, flapping his hands, spinning his body and at times banging his head. He was unable to do simple tasks such as dress himself or brush his teeth. Also, his voice inflection changed to a high pitched baby talk.

As one can imagine, this was frightening to Jennifer and Michael, and the ensuing six months have been extremely difficult. After seeing a host of medical professionals, Gino was finally diagnosed with Pediatric Auto-immune Neuropsychiatric Disorder Associated with Strep (PANDAS).

Six months after Gino’s first symptoms, Luca, who has had epilepsy since he was three years old, started displaying similar behavior and now has also been diagnosed with PANDAS. He suffers with debilitating stomach pains and unfounded fears. As if this isn’t enough, after further testing, it has been revealed that Gino, Luca and Sal all have immuno-deficiency disorders.

PANDAS is a pediatric disorder that triggers mental illness in children following an infection such as Strep, Walking Pneumonia, Mono or Lyme. Antibodies mistakenly attack a part of the brain, resulting in a sudden onset of acute, neuropsychiatric behavioral changes that can include: OCD, Tics, Age Regression, Separation Anxiety, Contamination fears, Paranoia, Insomnia, Anorexia, Violent Rages and Running Away.

This disease has taken a tremendous toll on this wonderful family emotionally and financially. Friends and family can testify to the courage that Gino and Luca exhibit in order to keep themselves “glued together.” They must take medication four times a day just to be able to go to school or even sit and read a book. Unfortunately, Gino is not responding to the medication; therefore, his next step is costly IVIG infusions at Mass General Hospital.

The Friends of the Vitelli Family are pleased to announce a wonderful event: “It Takes a Village: A Benefit for the Vitelli Family.” Our mission is to raise money to assist the Vitelli family with the extraordinary medical and other related day-to-day expenses the family is incurring due to Gino and Luca’s diagnosis with PANDAS so as to enable all the Vitelli children to continue to thrive physically and emotionally.

This event will take place at Granite Links Golf Club in Quincy, MA on June 21st, and will include food, raffles, live and silent auctions and entertainment. We are seeking donations (monetary or goods) to assist us in our fundraising effort. If you would like to participate in this remarkable event, please complete the attached sponsor payment form and return it with your donation to the address specified. Donations and goods can also be picked up for your convenience.

To learn more about PANDAS, meet the Vitelli family, purchase tickets, or make a donation, please visit www.friendsofthevitellifamily.myevent.com

We deeply appreciate any support that you can give in this effort to assist the Vitelli family in their time of need.

Very Truly Yours,
Friends of the Vitelli Family

A government shutdown by itself does not impact timely payment of principal and interest on U.S. Treasuries. Payment of Treasury obligations is a top priority and existing revenues are directed to service debt obligations even if it means delaying other Federal spending. State municipal bond obligations provide a precedent. For example, the state of California has failed to pass a budget on time the past two years. However, bond payments were made without incident. In 2009, the state of California went as far as issuing IOUs while still directing available cash to debt service. The U.S. Treasury could take a similar tack and redirect cash as necessary in order to maintain timely debt service.

Failure to raise the debt ceiling does not automatically imply a default on U.S. Treasuries. A default would arise from the inability to repay interest or principal to holders of U.S. Treasuries. However, the Treasury receives income from a variety of sources and interest payments consume only a small portion of Treasury revenues. Therefore, even in the absence of a debt ceiling increase, the Treasury can continue timely payment of bond interest. Payment of maturing bonds is more involved but the Treasury can still issue new debt to pay off maturing debt as long as the dollar amount of new debt does not exceed that of the maturing debt and the overall debt level is not increased. This latter scenario requires that investors maintain confidence in the U.S. government’s ability to service its debt and sell new debt, a risk, but a manageable one if investors view the disruption as short-term.

Making Room

The Treasury department can take proactive steps to delay bumping up against the debt ceiling. The Treasury can defer payments to non-marketable debt in order to direct available cash to make interest payments to Treasury bonds held by investors in the marketplace. In 2011, the Treasury has already begun to wind down a special T-bill issuance program, known as the Supplementary Finance Program (SFP), in order to delay hitting the debt ceiling. Issuance of State and Local Government Securities (SLGS) may be suspended and is typically one of the first options employed by the Treasury. SLGS are used by municipalities that have excess proceeds and wish to redeem bond maturities before maturity date. The tactics used can get very detailed but, for bond investors, the main point is that the Treasury department has several tools at its disposal to buy time and delay hitting the debt ceiling even as politicians squabble. We believe the debt ceiling may be reached anywhere from mid-May through mid-July depending on what tactics the Treasury pursues.

History

Under the Clinton administration the government shut down over select days in late 1995 and early 1996 as a Republican-led Congress argued for greater spending cuts before agreeing to approve a new budget, a similar situation to now. Furthermore, like today, the Treasury was simultaneously approaching the debt ceiling. In 1996 Republicans used the debt ceiling limit as a bargaining chip to obtain spending cuts from the President, a situation that may very well repeat itself in coming weeks and months. The delay in raising the debt ceiling back then prompted Moody’s to put $387 billion in Treasury debt on credit watch negative for a possible downgrade. It is important to note that Moody’s did not place the AAA rating of all Treasuries on watch for a downgrade but just those that would have been adversely affected over a 90-day period due to the potential inability of Congress to raise the debt ceiling.

In 1996, there was no bond market impact from Moody’s threat or delays to either raising the debt ceiling or approving a federal budget. Treasury prices increased and yields declined for much of 1995 and prices held relatively steady from December 1995 through the middle of February 1996. Bond investors saw through the political wrangling and kept calm despite the rhetoric. Ultimately, Moody’s warning coupled with President Clinton’s threat to delay social security checks (so that available cash was used to maintain timely payment of treasury obligations) sparked negotiation on both the budget and the debt ceiling.

Delays over approving the federal budget and over raising the debt ceiling have not impacted the bond market so far in 2011. Similar to the period in late 1995-early 1996, the bond market correctly, in our opinion, views any disruption to Treasury payments as highly unlikely. Treasury prices have increased over the past month on flight-to-safety related buying despite the possibility of a government shutdown or the inability to increase the debt ceiling. In addition, the cost to insure against a default on Treasuries remains very low as measured by credit default swap (CDS) spreads. CDS are an excellent gauge of perceived credit quality risks in the marketplace.

The debt ceiling is of greater importance for bond investors. A government shutdown could lead to safe-haven buying as bond investors may view any spending disruptions as anti-growth. Meanwhile, the debt ceiling issue can more directly impact Treasury securities.

Risks

Unlike 1996, the stakes are much higher now: sovereign credit risk is at the forefront of investors’ concerns, outstanding Treasury debt is much larger relative to the size of the economy, and foreign investors own a much larger share of the Treasury market. A delay in raising the debt ceiling and forcing the Treasury to undertake tactics such as withholding payments to trust funds or suspending state and local government issuance (SLGS) may undermine investor confidence in U.S. Treasuries. Whether ultimately realized or not, Treasury bond fears could ripple across the high-quality bond market.

Although we view debt ceiling-related risks as very low, it is another reason to consider reduced allocation to high-quality bonds. We believe safe-haven buying resulting from Middle East turmoil and, most recently, from uncertainty over the ramifications of the earthquake in Japan, may wane. A highly charged political debate and long delays are not what a Treasury investor needs.

IMPORTANT DISCLOSURESThe opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise, are subject to availability, and change in price.
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 a fund shares is not guaranteed and will fluctuate.
An obligation rated ‘AAA’ has the highest rating assigned by Standard & Poor’s. The obligor’s capacity to meet its financial commitment on the obligation is extremely strong.
A Credit Default Swap (CDS) is designed to transfer the credit exposure of fixed income products between parties. The buyer of a credit swap receives credit protection, whereas the seller of the swap guarantees the credit worthiness of the product. By doing this, the risk of default is transferred from the holder of the fixed income security to the seller of the swap.

Financial market participants will be pulled in several directions this week as January turns into February. Political developments in North Africa and the Middle East are likely to be top of mind this week and serve as a reminder that geopolitics are never too far removed from the headlines. (Please see this week’s Weekly Market Commentary, “Geopolitical Risks Return,” for more details). Policy — a key theme in markets last week (January 24 – 28) — lingers as a potential market-mover this week, as does Federal Reserve Chairman Ben Bernanke who will hold a press conference, a very unusual event for a Chairman of the Federal Reserve. Additionally, central banks in Australia, Iceland, India, the Czech Republic, Indonesia, as well as the European Central Bank (ECB) meet to set policy this week. Other than India, none of these central banks are expected to raise rates, although rising inflation in much of the developing world has put renewed focus on the actions of emerging market central banks in response to higher food and fuel prices.

 Back home in the United States, fiscal policy will continue to be at or near the top of the headlines, as the battle over the debt limit ceiling looms. In addition to the geopolitics and policy, a full slate of crucial economic data for December and January in the United States is due out this week. Data on consumer spending, inflation, manufacturing, construction and the labor market are all due out this week. The key report of the week is the employment report for January, on Friday, February 4. In China, a key report on manufacturing activity in January is set to be released late Monday night. Markets remained concerned about the pace of economic growth and, more importantly, inflation in China, and we continue to expect more policy tightening in China in the coming weeks and months.

Will The Rise in Energy Prices Short Circuit the Recovery?

As this publication was being prepared, December data on consumer spending, personal income, and the Fed’s preferred measure of inflation, the personal consumption expenditure (PCE) deflator, excluding food and energy, along with reports on manufacturing activity in Chicago, Milwaukee and Dallas in January were being released. Later in the week, the employment picture in early 2011 will come into focus, as first the Challenger layoff data for January, then the ADP employment report and finally the nonfarm payroll jobs report for January will be released. Unusually severe winter weather across large swaths of the United States in much of January is likely to have an impact on the employment data and indeed all the economic data for January.

The income, spending and price data for December largely reinforced the Fed’s case for continuing its program of quantitative easing. Income growth (at just 3.8% year-over-year) suggests that employment is growing too slowly, while the 0.7% year-over-year gain in the core PCE deflator in December remains well below the low end of the Fed’s unofficial comfort zone for this metric, +1.5 to 2.0%. The Fed’s decision to embark on a second round of quantitative easing was based on the idea that the Fed was not fulfilling either part of its dual mandate of low and stable inflation and full employment. The latest data on spending and inflation continues to show that while the economy is growing, and a recovery is underway, it remains tenuous. Our view remains that despite political pressure, the Fed will continue to pursue quantitative easing until it is slated to end in June 2011, but that the hurdle is high for the Fed to initiate yet another round of quantitative easing later this year.

One concern many market participants (and consumers) have had in recent weeks and months as oil and gasoline prices have moved higher is what impact these rising energy prices will have on the economy as a whole, and on consumer spending in particular. The data embedded in the monthly personal income and spending report released as this report was being prepared will likely shed some light on this. In December 2010, consumers spent $646 billion (on an annualized basis) on gasoline, electricity, home heating oil, natural gas, etc. That figure represented just over 6.0% of total consumer spending. Since hitting a low of 4.8% of spending in late 2008/ early 2009, energy spending by consumers as a percent of total spending has moved steadily higher, although it remains well below the peak hit in mid-2008 of 7.0%. [Chart 1] In dollar terms, U.S. consumers were spending $710 billion (annualized) in mid-2008 (versus the aforementioned $646 billion today) as oil prices hovered near $150 per barrel, gasoline prices were above $4 per gallon and natural gas was close to $14 per BTU.

Today, oil prices are just below $90 per barrel, gasoline prices are about $3 per gallon and natural gas is running between $4 and $5 per BTU. A “shock” in the form of a cut in oil production and resulting sharp rise in consumer energy prices was one of the preconditions for the double-dip recession in 1980 – 82, and played a big part in the economic slowdown in late 2007 and early 2008 ahead of the worst of the financial crisis in late 2008/early 2009 that was precipitated by the collapse of Lehman Brothers in September 2008. On balance, while we are watching the rise of consumer energy prices closely, our view is they have not risen far enough or fast enough to suggest that the economy is headed for a double dip. In 2008 (and 1981, when the second leg of the double-dip recession ensued), the labor market was deteriorating, real incomes were stagnating, inflation, interest rates and, most importantly, consumer debt levels were high and rising. Today, the labor market is improving, real incomes are accelerating, and inflation, consumer interest rates and, most importantly, consumer debt levels, are falling.

January Jobs Report Likely To Be Impacted By Weather, Revisions

In the second half of the week, markets’ attention will turn to the labor market. Reports on layoffs (as measured by the outplacement firm Challenger, Gray and Christmas) and private sector employment (as measured by ADP, the nation’s largest payroll processing firm) for January will set the stage for the monthly employment report from the U.S. Department of Labor on Friday, February 4.

Unfortunately, the most closely watched data is likely to be beset with distortions this time around, making it even more difficult to interpret. The weather is the key wildcard for the report and could have a significant impact on the headline job count. Much colder and wetter wintery weather in most of the country in January [Chart 2] will most likely hold down the job count in weather-sensitive industries like retail, construction and leisure.

In the month of January, the weekly data on initial filings for unemployment insurance was heavily influenced by the weather. The employment indices in the various regional manufacturing indices during January (Chicago, Philadelphia, Empire State, Dallas, Richmond, etc.) were mixed at best, and many of these surveys cited poor weather as an influence on economic activity in the month. Markets will try to look past the weather impact and hope that February brings more “normal” winter weather, which would allow markets to simply average January and February’s employment readings to get a better gauge of the underlying health of the labor market.

The January jobs report will also incorporate some methodological changes to the report, as well as the annual benchmark revision to the jobs data done each year to synch up tax records and payroll counts over the past several years. Both the establishment survey (which tallies the number of employees at businesses) and the household survey (which queries some 300,000 households about the employment status of the members of the household) are subject to revision. The revisions to the payroll survey are likely to show that 366,000 fewer jobs were created between March 2010 and December 2010 than was previously thought. Revisions and methodological changes may also impact the household survey, which is used to derive the nation’s unemployment rate.

John Canally, CFA

EconomistLPL Financial

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

Investing in international and emerging markets may entail additional risks such as currency fluctuation and political instability. Investing in small-cap stocks includes specific risks such as greater volatility and potentially less liquidity.

Stock investing involves risk including loss of principal Past performance is not a guarantee of future results.

Investing in alternative investment may not be suitable for all investors and involve special risks such as risk associated with leveraging the investment, potential adverse market forces, regulatory changes, potential liquidity. There is no assurance that the investment objective will be attained.

About $90 billion has been pulled from U.S. stock mutual funds since the “flash crash” on the afternoon of May 6, 2010, according to data from the Investment Company Institute. On that day, the Dow Jones Industrial Average experienced the biggest intraday point decline, 998.5 points, in its 114-year history. During every week since the flash crash investors have been withdrawing more money from U.S. stock mutual funds than they have been adding while strongly favoring bonds with their investment dollars. This net selling took place despite strong gains over the past six months in the major stock market indexes. Investors’ recent period of selling U.S. stock mutual funds while the stock market posted more than a 10% gain is unprecedented, and follows two years of net selling in 2008 and 2009.

The disconnect between the U.S. stock market gains and investor behavior has finally started to reconnect as it was reported last week that investors finally added a net $335 million into U.S. stock funds during the week ending December 21. While one week of inflows does not necessarily reflect a new resolution by investors to buy stocks, the net selling has been slowing over many weeks suggesting a gradual change in behavior that may be sustained in 2011.

The buying of U.S. stock mutual funds was not funded with cash. Money market funds saw a rise of $22 billion in assets during the week. Instead, investors sold bond mutual funds to fund their purchases extending the recent trend in bond fund selling. More than $20 billion has been pulled out of bond funds since mid-November 2010, with the last two weeks’ outflows marking the biggest in more than two years.

Concern over the integrity of the U.S. stock market after the flash crash was likely a contributing factor to investors’ avoiding U.S. stocks for so long even though stocks rose in value. However, several other factors likely contributed as well, including government policy uncertainty surrounding taxes, concern over the durability of the economic recovery, and market volatility. In December, many of these factors turned more positive for investors:

* In mid-December, the tax-cut extension was passed and signed into law.

* The U.S. Department of Labor reported last week that the number of
people applying for unemployment benefits fell to its lowest point in
nearly two and a half years.

*Stock market daily volatility eased with the gap between the high and
low of the day averaging 0.6% in December compared to 1.1% to 1.9% during the prior six months.

While these factors are helping investors begin to become more confident about stocks, relative performance may be an even more potent driver of behavior for investors. In December, the U.S. bond market, measured by the Barclays Aggregate Bond Index, fell 1.4% while U.S. stocks measured by the S&P 500 Index, provided a positive total return of 6.7%.

Losing money in bonds, where investors considered their money relatively safer than in stocks, finally prompted action by investors as stocks continued to climb in December. Fears of rising interest rates and further losses are likely prompting investors to shun bonds and reconsider stocks as they lengthen their time horizon and look out to 2011. Rather than view the emerging shift in sentiment by investors from a contrarian point of view that stocks are due for a fall now that individual investors are buying them once again, we see the end of the buyers strike as a modest positive for stocks in 2011. After all, in 2004, when individual investors began to buy stocks again after the bear market of the early 2000s the market continued to rise in the coming years. As presented in our Outlook 2011, we expect stocks to outperform bonds in 2011 and are encouraged by the return of the individual investor to the stock market with plenty of buying power and the highest savings rate in many years.

IMPORTANT DISCLOSURES

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.

An investment in a money fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although the Fed seeks to
preserve the value of your investments at $1.00 per share, it is possible to lose money investing in the Fund.

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

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

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. It is an unmanaged index which cannot be invested into directly. Past
performance is no guarantee of future results.

This Barclays Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated.
The index covers the U.S. investment-grade fixed rate bond market, with index components for government and
corporate securities, mortgage pass-through securities, and asset-backed securities. It is an unmanaged index
which cannot be invested into directly. Past performance is no guarantee of future results.

Investing in mutual funds involve risk, including possible loss of principal. Investments in specialized industry
sectors have additional risks, which are outlined in the prospectus.

High expectations for U.S. economic data leave room for disappointment. About 85% of next week’s economic data in the United States, which includes data on manufacturing, housing, retail sales, leading indicators and inflation, is expected to accelerate versus the prior month, setting the bar fairly high for market expectations.

In the first week of December, investors were willing to dismiss the much weaker-than-expected November employment report as an outlier and the November ISM index that was weaker than the prior month as just a brief pause. But if this week’s data is also mixed and confirms the uneven pattern of growth in the economy, it may shake investor confidence.

Investor confidence is high. Last week, as stocks reached new postrecession highs, investors were the most bullish in nearly four years. According to the American Association of Individual Investors survey, the
percentage of bulls exceeded the percentage of bears by over 30% for the first time since February 2007.

Beyond the economic data, the markets’ momentum may be tested by policy concerns as it relates to the tax cut extensions, European solvency issues, and the actions of the Federal Reserve (Fed).

• Investors may “sell the news” of the passage of the tax cut extension having already bought the rumor of passage earlier this month. Votes in the Senate and House are likely to take place this week. A compromise that results in a much larger impact on the deficit (and more potent economic stimulus) that could further bolster investor confidence is unlikely at this stage.
• The return of solvency questions surrounding a number of European nations may weigh on markets. The fiscal crash diet in Greece, Ireland and other troubled European nations is highly unpopular. Local protests are taking place daily. On Wednesday, December 15, there is a European Union-wide labor strike planned. In addition, Greece votes on its 2011 budget this week, which is likely to refocus attention on how little Greek government has done to shore up its fiscal imbalances.
• The Fed has faced political pressure on all sides since the last meeting on November 3 to do more, to do less, and to do nothing at all. Legislation was even introduced to change the Fed’s mandate. Debate surrounding the effectiveness of the Fed’s actions (given the recent rise in yields and the dollar) and how limited future actions to aid economic growth may be may dominate the headlines around the next Fed meeting on Tuesday, December 14. Investors may be disappointed by a status quo response from the Fed.

While the events of this week may result in a pullback, any weakness in the markets should be viewed as a buying opportunity for those who are not fully invested. While volatility can be expected, we believe 2011 will deliver modest, single-digit gains for stocks and bonds accompanied by trend-like economic growth.

• China PMI – The Purchasing Managers Index (PMI), released by the Beijing-based China Federation of Logistics and Purchasing and the National Bureau of Statistics, kicked off the better part of the week’s
  market rally on Wednesday morning. China’s manufacturing grew at a faster pace for a fourth straight month in November, exceeding economists’ estimates and indicating the economy can withstand higher
  interest rates.
• Beige Book – Released Wednesday afternoon, the Fed’s Beige Book, a qualitative assessment of economic, financial and business conditions across the United States, suggested the economy was rebounding from the summer soft spot. Ten of the twelve regions reported improving economic conditions. The Fed’s overall assessment that the U.S. economy “continued to improve” was strikingly different than it was back in September when they noted “widespread signs of deceleration”.
• Retail Sales – November same-store sales from retailers surprised to the upside when reported Thursday morning. Over 80% of retailers beat estimates by an average of more than 2 percentage points, for an average year-over-year increase of nearly 6% among the 25 national retailing chains that reported November sales results. This marked a strong improvement from October’s tepid growth of less than 2% with nearly 50% of retailers missing targets.

While these economic data points were the highlights of the week, the data has been so much better-than-expected, on balance, in recent weeks that investors dismissed the disappointing November employment report released on Friday, December 3, as an outlier. With a lack of any meaningful economic data this week here or abroad, market participants’ attention will turn to the policy headlines that are likely to be driven by:

• The debate over extending the Bush tax cuts due to expire at year-end.
• The ongoing fiscal and financing troubles in the eurozone, including Ireland’s vote on its 2011 budget (setting the stage for Greece’s vote on its 2011 budget the following week).
• The effectiveness of the Fed’s second round of quantitative easing (QE2) before the next Fed meeting on December 14.
• China may implement another rate hike ahead of its release of inflation data the following week.

None of this week’s headlines will likely result in as favorable an outcome for the markets (unless a quick deal is cut on taxes) as the data delivered last week. It is worth exploring each of these potential drivers.

Tax Cut Extensions

The debate over the tax cut extensions is likely to be contentious this week, following very partisan votes in the House this past week and the lack of public progress that has been made in the negotiation among Geithner, Lew, and the Republican and Democratic members of Congress. We look to the middle of the month as a more likely time for compromise and a vote in the Senate. On Saturday, Congress passed a continuing resolution that funds the federal government through Saturday, December 18. The end of that week leading up to the December 18 deadline is the most likely for a breakthrough agreement, with votes in both the House and Senate to immediately follow.

Fiscal and Financial Problems in the Eurozone

In the European Union (EU), the risk of a near-term liquidity crisis is being managed effectively, but the longer-term solvency problems remain almost untouched. News reports in recent days have focused on potential additional actions the EU may take to provide more demand for member nation debt (Spain and Portugal as the need for liquidity spreads from Greece and Ireland). The Greek government has so far received 29 billion euros as part of a rescue package intended to give them funding until 2013, enough time for the Greeks to fix their budget. The EU and The International Monetary Fund (IMF) approved the rescue package back in May in exchange for the Greek government agreeing to cut spending and raise taxes.
With the liquidity for their debt assured by the EU, how have the Greeks done over the past seven months addressing the solvency of their finances? Poorly. Higher taxes were introduced to boost tax receipts by 13.7% this year. That goal was trimmed to 8.7% in October and to 6% in November. So far, income has risen just 3.7% in 2010. The yield difference, or spread, between 10-year Greek bonds and German bunds was 8.86 percentage points yesterday, compared with a record 9.73 in May, reflecting the lack of material improvement in the solvency of Greece.The fiscal crash diet in Greece, Ireland and other troubled EU nations is highly unpopular. Local protests are taking place daily. On December 15, there is an EU-wide labor strike planned. Efforts at fiscal austerity are fading. It is likely to be longer and more expensive to get the EU over-spenders back in line with EU mandates. In addition, it may require a tougher stance from senior EU members Germany and France to ensure adequate action is taken. This raises the risk that these headlines surface this week and weigh on the markets.

Fed’s Quantitative Easing 2

The Fed implemented QE2 to keep borrowing rates low to encourage economic growth, in part, through low mortgage and other consumer borrowing rates. Since implementing the first round of QE2, rates have moved steadily higher. The national average 30-year mortgage fixed rate (tracked by Bankrate.com) rose from 4.24%, when QE2 was announced on November 3, to 4.71% this past Friday, reaching the highest level of the second half of 2010. In addition, the dollar, widely expected to decline and act as a boost to U.S. export growth, has instead moved higher.
The Fed has faced political pressure on all sides since the last meeting on November 3 to do more, to do less, and to do nothing at all. Legislation was even introduced to change the Fed’s mandate. Debate surrounding the effectiveness of the Fed’s actions and how limited future actions to aid economic growth may be could dominate the headlines this week ahead of its next meeting on December 14.

China Rate Hikes

Last week’s China PMI report showed surging input prices, reinforcing the case for the central bank to raise borrowing costs again. In October, the Chinese central bank pushed the one-year lending rate to 5.56%, its first increase since 2007. The Chinese government’s efforts to rein in the money supply also included two reserve-ratio increases for banks last month. At the same time, officials allowed the yuan to appreciate about 1.8% against the dollar in September, and since then gains have totaled another 0.3%.
These efforts are intended to contain inflation which has been rising nearly 5% year-over-year. Concern that monetary tightening in response to higher inflation will act as a drag on growth spurred a 10% sell-off in China’s Shanghai Stock Exchange Composite Index since the last inflation report that was released on November 11. As we approach the release of the next inflation data point, China may announce another rate hike, possibly sending markets lower.

Beyond This Week

Neither bulls nor bears in 2011, we expect the economy and the markets will be range-bound in 2011. Bound by economic and fiscal forces that will restrain growth, but not reverse it, we expect single-digit gains for stocks as earnings growth slows and valuations remain under pressure, and single-digit gains for bonds as yields remain range-bound.
We anticipate that:

• The job market will stage a comeback with nearly twice the pace of job creation experienced in 2010;
• GDP will be near the long-term average at 2.5 – 3%;
• Policymakers will deliver economic stimulus that turns to a drag on growth later in the year;
• Investors will play it safe as inflows to riskier markets will be anemic;
• The currency impact on investing will be pronounced in 2011.

Overall, 2011 will continue the economic and market volatility of 2010. The global economy remains out of balance, teetering back and forth between the soft spots that invoke a need for increasingly extended policy support and the growth spurts that provoke a desire to begin to pull back some of the record-breaking stimulus. The last time government spending comprised as much of GDP as it does today (1945 – 1960), the economy went through a period of heightened volatility driven by the swings in policy action.
The policy-driven themes of reflation, which is the intentional pursuit of modestly higher prices, and a broader U.S. foreign policy provide investment ideas that can thrive in a year where the performance of the major indexes is likely to be lackluster. Investors with a more opportunistic profile may benefit from a tactical approach to investing in order to find attractive opportunities and successfully take profits in volatile markets. Longer-term strategic investors should consider remaining broadly diversified.

Does Black Friday for retailers mean a green holiday season for investors? Not necessarily; there have been years where positive fourth quarter retail sales did not bring positive results for the stock market. In fact, there is not
even much of a relationship between how well holiday sales results fare against forecasts and stock market performance. To illustrate this point, over the past 18 years, the performance of the S&P 500 during the period from
Thanksgiving through year-end was actually worse when retailers exceeded the widely followed forecast from The National Retail Federation than when they missed or were in line.

So, clearly, the question of what Black Friday means for investors has the relationship backwards; it is instead the gain in the stock market over the prior two months that bodes modestly well for retail sales this holiday season.

There is a very consistent relationship between stock market performance in the months of October and November leading into the holiday season and the gain in retail sales in the fourth quarter. This makes sense since the stock market is one of the best barometers of consumer confidence and, if it is rising, it stands to reason that consumers are feeling a bit more confident and willing to spend. In fact, measured statistically, the performance of the S&P 500 in the months going into the holiday season and holiday spending (retail sales excluding food and autos) have a high 0.8 correlation (a perfect correlation is 1.0). If you are going to try to forecast holiday spending, it would be easy to make the case that there is only one thing you need to watch—stocks. This year the performance of stocks in October and
November point to a low-single-digit gain for holiday retail sales over 2009.

Early reports of sales this holiday season have been solid:

• The National Retail Federation reported Thanksgiving weekend sales up 6.4% over last year. Shoppers spent $45 billion over the weekend with the average shopper spending $365.34.
• Online sales trends have been very strong with sales estimated up 9% from last year on Black Friday. Tight inventories may have forced many to go online in search of favored styles and colors. Strong online sales have prompted shipping companies to issue upbeat outlooks with UPS predicting a 7.5% increase over last year and Federal Express forecasting a gain of 11% between Thanksgiving and Christmas.

Surveys show that more shoppers indicated they were also shopping for themselves. What is driving this pent up demand?

• „„ More jobs and bigger paychecks may have given consumers the confidence to boost purchases during the holiday season. „„
• U.S. consumer debt has fallen by about $1 trillion over the past two years, according to the Federal Reserve. Credit card debt is one of the most sharply contracting categories. „„
• As reported in last week’s Weekly Economic Commentary, the percentage of disposable income consumed by financial obligations, such as a mortgage, rent, auto and student loans has fallen to a level not seen since well before the financial crisis and is now below the longterm,30-year average.
• „„ Consumers have been saving more with the savings rate at 5.7%, up from the 1-2% averaged during the boom years of 2005-2007.
• Stocks, particularly those of the retailers, have reflected the improving consumer incomes and balance sheets and now sales may begin to reflect the release of pent-up demand. While stocks are already signaling gains in sales this holiday shopping season, the performance of retailer stocks and the overall Consumer Discretionary sector has been pointing to solid gains with those groups of stocks doubling the gain of 4.2% for the S&P 500 so far during the fourth quarter.

Retail sales have yet to break out. The widely watched weekly measure of retail sales from the International Council of Shopping Centers has averaged a relatively consistent year-over-year gain of 2-3% during the second half of 2010. If sales do begin to accelerate it may be good news for the economy. A more confident consumer leads to more  confidence in corporate America which may lead to brighter prospects for job and economic growth in 2011.

The uncertainty over the fate of the tax cuts, along with faster-than expected inflation in China, stoking fears of a rate hike, and the ongoing debt problems in the eurozone, contributed to volatility last week. Stocks, as measured by the S&P 500, gave back 2.1% after gaining 3.6% in the prior week. Last week also saw two markets that have been immune to these considerations, demonstrate higher volatility:

• Gold prices fell 1.8% after gaining 2.5% the week before (according to Bloomberg data).
• Gold prices fell 1.8% after gaining 2.5% the week before (according to Bloomberg data).

The return of volatility to gold and emerging market stock prices has raised a question among some market participants: is the relentless climb pushing gold and emerging market stock prices into bubble territory? We do not think so. If they are bubbles, historically they still have a long way to inflate before they burst.

Gold Prices

Gold prices have tracked the classic bubble pattern but have yet to enter the parabolic stage where the bursting of
the bubble and the ensuing sharp losses begin to become a risk. The investment bubbles of the past experienced far more inflation than what gold prices have experienced so far. The technology bubble of the 1990s (measured by the NASDAQ), the oil bubble of the late 1990s/early 2000s (measured by oil futures prices), and the housing bubble (measured by the S&P 500 Homebuilding Index) took 10 years and posted gains of about 1000% before they burst and quickly surrendered most of those gains.

What could push gold prices into historical bubble territory? While rising central bank demand, higher mining costs, and demand for gold as both a luxury and a savings vehicle from a rising middle class in China and India all help to support gold, the potential driver of a bubble would likely be driven by currency. Part of the rise in the price of gold is due to the decline in the value of the dollar. As the dollar goes down, the price of gold in dollars goes up. While gold has surged to an all time high over the past five months in dollar terms, gold denominated in euros remains below the levels reached five months ago. The move to record highs in the price of gold is more because we measure it in terms of a weakening US dollar. A sharp drop in the dollar would boost gold prices in dollar terms and may also result in upward
pressure on interest rates and slow economic, growth boosting demand for gold as a perceived safe haven. While we expect the Federal Reserve’s (Fed) program of stimulus will continue to weaken the dollar well into 2011, we do
not expect a sudden devaluation that would propel gold sharply higher.

Emerging Markets

Emerging markets suffered during the financial crisis of 2008-2009 when they experienced similar losses to developed markets. However, emerging market stocks have rebounded to prior peaks stoking fears of overvalued markets due for another sharp downturn.  Emerging market stocks have not yet entered the parabolic stage where the. bursting of the bubble historically becomes a risk.

What could push emerging market stocks into historical bubble territory? A flood of money has been pouring out of slow-growing developed economies into rapidly growing emerging market economies. As a result, the currencies
of emerging market nations have been rising, elevating the risk of their exports, and becoming less competitive in world markets. As emerging market countries succumb to increasing pressure to reduce the strength of their currencies asset bubbles may inflate due to the excessive stimulus from domestic actions in addition to inflows from abroad.

Volatility

While not in historical bubble territory, gold prices and emerging markets do have risks. For example, a contraction in growth in the emerging markets would weigh on both asset classes. And, importantly, if gold and emerging
market stocks continue to track the bubble pattern, they have reached the stage of the pattern where volatility picks up and sudden, sharp moves become more common as the bubbles inflate and risks build.

While the major headlines are out of the way, what happens in Washington during the remainder of the year will still hold influence over the markets. Some of the lame duck agenda items with potential market-moving impact include the expiration of unemployment benefits, government funding, and the Bush tax cuts.

Extended unemployment benefits will expire at the end of November if Congress fails to renew them in the coming weeks. People who exhaust their 26 weeks of regular state unemployment benefits can then receive up to 73 weeks of federally funded benefits, for a total of 99 weeks in high unemployment states. This summer, when the emergency benefits were last renewed, Republicans temporarily allowed extensions to expire for nearly two months. They objected to the extension because the cost to do so was not offset by other spending cuts and therefore added to the federal
deficit, in violation of the pay-as-you-go rules. Since Republicans gained seats in the Senate last week, it could be even tougher to pass a renewal of the program potentially leaving millions without benefits during the peak consumer spending holiday season, posing risks to retailers and overall economic growth.

Before the mid-term elections, Congress passed a resolution funding the government until December 3, setting up a showdown over spending in the lame duck session. Also, the fiscal commission established by President Obama is due to report on December 1. There are indications that leading Democrats on the panel are seeking to present major changes to Social Security intended to ensure the program is solvent for the long run.

The most important item facing Congress is the looming expiration of the Bush tax cuts. Congress is likely to address the tax cuts in some way. Both parties risk a huge backlash if no action is taken and all tax rates revert to higher levels, which puts pressure on the 70% of the economy that is driven by consumer spending. This is a concern given that current economic growth is already sluggish. We continue to believe it is likely that Congress will pass a one or two-year extension of all the Bush tax cuts during the lame duck session, but admit it is a close call.

The potential for extending the dividend tax rate at 15% (as opposed to reverting up to 39.6% for the top bracket) and the ability of the companies in the Financials sector to boost dividend payouts made the sector the best performer last week. Financial companies that received TARP money must get regulatory approval to boost their dividend which may soon be forthcoming. The first quarter of the year has traditionally been when companies announce increases to their dividend payments. Last week, the Energy, Materials, and Industrials sectors benefitted from the Fed’s actions on Wednesday that weakened the dollar.

Investors’ appetite for yield has prompted strong inflows into the high-yield bond market this year. Perhaps last week’s performance is a sign that investors may migrate from high-yield bonds toward high dividend-paying stocks, possibly ending the U.S. equity buyers’ strike that has resulted in outflows from U.S. equity mutual funds every week during the second half of 2010. We will be watching money flows closely to see how they react to the changes in Washington.