L P L F IN A NCI A L RESE A RCH

Weekly Market Commentary

September 17, 2012

Get to Work, Mr. Senator

Jeffrey Kleintop, CFA
Chief Market Strategist LPL Financial

Highlights
Last week, the Federal Reserve (Fed) put the ball back in Congress court as it relates to the economy and the upcoming scal cliff. The so-called lame duck session that takes place between the November 6 elections and January 1 holds some promise for getting a deal done. While the road travelled depends upon the elections outcome, it may be the journey not the destination on the way to the deal to mitigate the scal cliff that has the most potential to upset the markets and contribute to volatility in the coming months.

Get to work, Mr. Chairman, said Senator Chuck Schumer, wagging his nger at Federal Reserve (Fed) Chairman Ben Bernanke two months ago. Last week, Bernanke delivered and pointed back as if to say: Get to work, Mr. Senator. Last weeks announcement of another program of bond-buying by the Fed, known as quantitative easing (QE), delivered a boost to the markets, sending stocks sharply higher on Thursday as the Feds statement was released. With this action, the Fed put the ball back in Congress court. The Feds QE program may help mitigate some of the risks to the economy, but if we go over the scal cliff it is like getting a u shot before storming the beach at Normandy. Congress must address the more than $500 billion in tax increases and spending cuts equivalent to 3.5% of Gross Domestic Product (GDP) due to go into effect on January 1, often referred to as the scal cliff. The United States has never seen an economic drag of anywhere near that magnitude that did not quickly result in a recession and big drop for stocks. Despite Bernankes shifting of the economic burden back to Congress, there is almost no chance that the tax and spending issues get resolved before the elections. However, the so-called lame duck session that takes place between the November 6 elections and January 1 holds some promise for getting a deal done. Paths to a Lame Duck Deal
White House Status Quo Congress Unlocked GOP Sweep White House Flip Dem Sweep D D R R D D Other R R Source: LPL Financial 09/17/12 Senate D R R D D R R D House R R R R D D D D Odds of Outcome High High Moderate Low Low t0% t0% t0% Odds of Deal >50% >50% t0% <50% <50% ? ? ?

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Status Quo (Obama wins, Dem Senate, GOP House)

Polls, including LPL Financial Researchs TheWall Street Election Poll, increasingly Senate D point to this as a high probability outcome House R of the elections. (Please see our recent Odds of Outcome High Odds of Lame Duck Deal >50% The Wall Street Election Poll publication [09/13/12] for a description of our poll and methodology.) Although there would be no change in control, holding the White House and the Senate during adverse economic conditions could be considered a victory for the Democrats, and to top it off the GOPs majority in the House likely shrinks. A deal to mitigate the scal cliff would probably be reached in the lame duck session under this scenario, but it would likely be closer to the Democrats terms given their election victory, and primarily consist of higher tax rates.
White House D

Congress Unlocked (Obama wins, GOP Congress)

Although the battle for the Senate is looking closer than before, this is the scenario we believed was most likely all year. Congress House R goes from being gridlocked to unlocked as Odds of Outcome High Odds of Lame Duck Deal >50% the GOP takes the Senate, but by a very slim margin, and retains control of the House. Obama wins a narrow victory in the White House, but Republicans pick up the Senate and hold the House. A deal in the lame duck session is likely in this scenario where the Bush tax cuts get extended.
White House Senate D R

GOP Sweep (Romney wins, GOP takes Senate and holds House)
A big win for Republicans. Under this scenario, Republicans will be unlikely to Senate R compromise with Senate Democrats on House R Odds of Outcome Moderate only extending some of the Bush tax cuts in a lame duck session. In addition, it is Odds of Lame Duck Deal t0% unlikely that President Obama would sign an extension of the Bush tax cuts as his last ofcial act. With no deal in the lame duck session, the Bush tax cuts would expire at the end of the year. Republicans would try to renew them after President Romney takes ofce on January 20, but they will need 60 votes in the Senate to do it quickly, requiring the support of more than a handful of Democrats. As a result, Republicans may not be able to pass an extension of the Bush tax cuts for several months until they rst pass a budget resolution that would allow them to pass a tax bill through reconciliation requiring only 51 votes in the Senate.
White House R

White House Flip (Romney wins, Dem Senate, GOP House)

White House Senate House Odds of Outcome Odds of Lame Duck Deal R D R Low <50%

If Romney wins the White House, it is likely the GOP would ride his coattails in the Senate, but possible that they only pick up one or two seats, leaving the Democrats in control. Under this scenario, Romney wins a narrow victory, and the Senate remains

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closely divided in favor of the Democrats. A deal in the lame duck session to temporarily extend the Bush tax cuts is possible, but not probable.

Democrat Sweep (Obama wins, Dems hold the Senate and take the House)
This would be a huge win scenario for Democrats, given the large majority held by the GOP in the House. In the lame duck House D session, House Republicans may compromise Odds of Outcome Low Odds of Lame Duck Deal <50% on extending the Bush tax cuts only for those who make less than $250,000, or they refuse to compromise and go down ghting. In the scenario, the top dividend rate would likely go to 43% weighing on dividend-paying stocks, and bonds could be hurt by the potential for a downgrade to U.S. debt (the rating agency Moodys Investor Service warned of this last week) due to the unwillingness of Democrats to cut entitlement programs, given that they would likely owe their win in the House to a backlash to the Ryan budget plan.
White House Senate D D

There are three other possible election outcomes, but there is almost no chance of the Democrats taking the House if Romney wins, or of the Democrats taking the House while the GOP wins the Senate if Obama wins. It would be difcult at best to say what the lame duck session would yield in these odd scenarios. Therefore, there is a meaningful risk for the markets that Congress fails to craft a deal in the lame duck session and the U.S. goes over the scal cliff into recession. However, it is worth keeping in mind that Washington has a lot of experience in kicking the can down the road to avoid shortterm pain and will likely nd an eventual compromise. Instead, the real risk to the markets is what Congress may do in the lame duck session (or early next year) on the way to the compromise. We only have to look at the negotiations around the debt ceiling increase in August of 2011 to see how bad the process of negotiations can be for the markets. Back then we ultimately got the increase in the debt ceiling, but not without a 13% stock market decline in a week and the loss of the United States AAA credit rating by Standard & Poors rating agency. The economic impact of the many scheduled tax increases and spending cuts is likely to prompt action, as will the fact that we will again hit the debt ceiling in early 2013 and require legislative action to approve an increase. Also, further pushing things along, the rating agencies have warned that they will be watching U.S. actions to return to a path of scal sustainability. And, nally, the president and a newly elected Congress will have maximum political capital to make it all happen in early 2013. While the road travelled depends upon the elections outcome, it may be the journey not the destination on the way to the deal to mitigate the scal cliff that has the most potential to upset the markets and contribute to volatility in the coming months. We ultimately believe a deal will be forthcoming, but only after the elections can we expect Washington to get to work.

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IMPORTANT DISCLOSURES The opinions voiced in this material are for general information only and are not intended to provide specic advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your nancial 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 economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful. Standard & Poors Credit Rating: A credit rating is Standard & Poors opinion on the general creditworthiness of an obligor, or the creditworthiness of an obligor with respect to a particular debt security or other nancial obligation. Over the years credit ratings have achieved wide investor acceptance as convenient tools for differentiating credit quality. An obligation rated AAA has the highest rating assigned by Standard & Poors. The obligors capacity to meet its nancial commitment on the obligation is extremely strong. Quantitative Easing is a government monetary policy occasionally used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increases the money supply by ooding nancial institutions with capital in an effort to promote increased lending and liquidity. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise and bonds are subject to availability and change in price. Dividend paying stock payments are not guaranteed. The amount of a dividend payment, if any, can vary over time and issuers may reduce dividends paid on securities in the event of a recession or adverse event affecting a specic industry or issuer. Gross Domestic Product (GDP) is the monetary value of all the nished goods and services produced within a countrys borders in a specic time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments and exports less imports that occur within a dened territory.

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