FIRST QUARTER, 2012

ECONOMIC EXPECTATIONS FOR 2012

Happy New Year! The U.S. economy experienced many ups and downs in 2011 but we are optimistic in our outlook for 2012. Here is a synopsis of our current assessment of the global economy:

• The global economy should grow at a modestly improved rate next year as the euro-zone sovereign debt crisis is resolved and strong growth in emerging markets continues.
• China’s economy will continue to grow, but at a more modest rate, and a hard landing is not probable.
• Inflation will remain subdued in developed economies and monetary policy will remain accommodative and short-term rates will remain low in the U.S. and Europe.
• The U.S. stock market will outperform Europe until stability is restored to the financial system in Europe.
• Commodities should continue to remain strong in 2012.

Key economic data in the U.S. supports continued economic recovery:  According to the Institute for Supply Management’s recently released December report on business, the overall economy grew for the 31st consecutive month and economic activity in the manufacturing sector expanded in December for the 29th consecutive month.

*The Institute’s Purchasing Manager’s Index for manufacturers was reported at 53.9 percent, an increase of 1.2 percentage points from November, indicating expansion in the manufacturing sector for the 29th consecutive month. Readings above 50 indicate that the manufacturing sector is expanding. 

*The Production Index registered 59.9 percent, and has shown growth for four consecutive months. The New Orders Index registered 57.6 percent, indicating growth for the third consecutive month. 

*The ISM Customers' Inventories Index registered 42.5 percent in December, 7.5 percentage points lower than in November when the Index registered 50 percent. This is the 33rd consecutive month the Customers' Inventories Index has been below 50 percent, indicating that respondents believe their customers' inventories are too low at this time. 

*ISM's Employment Index registered 55.1 percent in December, which is 3.3 percentage points higher than the 51.8 percent reported in November.  Readings above 50.1 are indicative of increases in manufacturing employment.  The Prices Index registered 47.5 percent in December.  This is the third consecutive month of contraction in the Prices Index, after over two years of postings indicative of rising prices.

The U.S. economy continues to show signs of improvement.  However, if the economic climate in the euro-zone continues to deteriorate, it will likely put a damper on the domestic economic recovery.  The unemployment rate continues to trend down and is now 8.5% (December, 2011), though many workers have simply given up looking for jobs.  Consumer spending, especially on automobiles, is improving.  Business investment should continue to grow, though at a slower rate than the double-digit growth seen over the last two years.  The real estate sector appears to have reached a bottom and both construction and prices should improve in 2012.  

While the domestic economy shows signs of stabilizing, the European financial crisis still remains unresolved.  Austerity measures are needed to reduce debt in euro-zone countries or taxes imposed to provide relief because the amount of debt in question is too large for an ECB or German “bailout.”  The biggest risk to our economic recovery as well as the overall health of the global economy will be whether or not there is a resolution to the euro-zone debt crisis.  We think that the euro-zone will develop a plan that will alleviate the pervasive sovereign debt problems and hold the European Union together.

As indicated by the foregoing, our economy should continue to show modest improvement in 2012, barring a financial collapse in the euro-zone.  For all of 2012, we estimate that Real GDP will grow at a 2 – 2.5% annual rate.  Inflation, as measured by the Consumer Price Index, is expected to increase by 2.5 – 3.5% this year.  We are of the opinion that managing inflation will remain a priority for the Fed and will, therefore, continue to remain in check.

THE STOCK MARKET:  BEAR MARKET CONFIRMED IN OCTOBER BUT STANDARD & POOR’S 500 INDEX ENDS THE YEAR UNCHANGED

During the September, 2011 quarter, the Standard & Poor’s 500 Index (S&P 500) rose 11% and, remarkably, the Index started and finished 2011 at 1257.6.  To say that the Index was flat for the year is a gross misstatement.  A bear market was confirmed in October when three of the four major indices dropped more than 20% off their highs.  The market reached a low in October but continued on an upward trajectory for the remainder of the year; thus, erasing the decline during the quarter.

During the September, 2011 quarter, we purchased shares of two healthcare companies, an energy company, a specialty retailer of products for the home and an entertainment company.  We initiated positions in a household & personal care firm and a power sports vehicle company.  On the sell side, we eliminated a position in a food company.

The current position of the total managed assets of Harold Davidson & Associates, Inc. client portfolios is as follows: cash & cash equivalents - 7%; municipal bonds - 9%; corporate bonds - 4%; bond mutual funds - 9%; common stocks - 31%; equity mutual funds - 19%; real estate equities  - 10%; and real estate trust deeds - 11%.

While the fourth quarter proved to be a volatile time for the stock market, we are of the opinion that with a resolution to the euro-zone debt crisis, the stock market will move forward.  Corporate earnings should improve domestically in 2012, as our economy continues on the road to recovery, which should also support positive returns in the stock market.  Therefore, we have invested more funds in equities this year and we project an 8 - 10% gain in the S&P 500 during the entire year of 2012.

THE BOND MARKET:  MODEST ECONOMIC GROWTH PLUS EURO-ZONE CONCERNS KEEP BOND YIELDS NEAR HISTORICALLY LOW LEVELS

A combination of sub par economic growth, continued concerns over European debt, and loose monetary policy has kept rates on ten-year U.S. Treasuries near historically low levels.  Ten-year U.S. Treasury yields closed the year yielding 1.878%.  The Federal Reserve’s Federal Open Market Committee (FOMC) announced at its December 13th meeting that it intends to “keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.”

Corporate bond yields, with the exception of financials, continue to trade at historically low yields.  Municipal offerings, both taxable and tax free, offer comparatively better yields, albeit with some credit risk.  Interest rates are likely to remain low, by historical standards, for the next several months, though the possibility of higher inflation later this year may result in higher long-term yields.  Given the currently unattractive yields on high-quality corporate bonds, we have been focusing much our purchases on higher-quality municipal offerings, both taxable and tax-free.  Taxable munis currently offer higher risk-adjusted yields than comparable corporate bonds, while tax-free munis offer superior tax-equivalent yields.

THE REAL ESTATE MARKET:  THE REAL ESTATE SECTOR APPEARS TO BE REACHING A BOTTOM AND VALUES MAY BE POISED FOR INCREASE IN BOTH COMMERCIAL AND RESIDENTIAL SECTORS

During the second half of 2011 and heading into 2012, we see a real estate market that is stabilizing. Although we are significantly off the market peaks, the rate of decline seems to have decreased. Year-end statistics and 2012 projections for both residential and commercial markets vary broadly.

During 2012, we expect the commercial real estate market to see some increased volume as buyers continue to re-enter the market and deploy capital. However, we expect the great majority of these investments to be in high-quality commercial real estate projects and hence expect yields of “investment grade” real estate to contract as buyers continue to chase a limited supply of quality real estate investments.

The 2012 residential market should stabilize and possibly see a slight up-tick in values. We fully expect that the number of transactions will increase as homeowners and banks put more houses up for sale and sellers adjust their price expectations. This increase in sales volume will be further bolstered by interest rates remaining at record low levels.

SUMMARY & CONCLUSION: CONTINUED SLOW RECOVERY IN U.S. AND RESOLUTION IN EURO-ZONE SHOULD REDUCE STOCK MARKET VOLITILTY 

While the recovery in the U.S. has been slow, it appears that the health of the U.S. economy is improving.  The unemployment rate and personal income are improving slightly, corporations continue to invest in their businesses, consumers are spending and the housing market appears to have bottomed.  Bipartisan political dissension on key policy issues, such as the growing budget deficit, will only slow the progress currently in motion.  For all of 2012, we project a gain of 2 - 2.5% in Real GDP.  We expect corporate profits will improve and that this will have a positive impact on stock prices.  Therefore, we project a gain of 8 - 10% in the S&P 500 in 2012.

CLIENT REFERRALS

We greatly appreciate the referrals of new business that we continue to receive from our clients.

"'Economic Outlook & Investment Perspective' is designed to serve as a regular forum for the discussion of pertinent economic and market issues that are of concern to individual investors. However, this newsletter is not, and under no circumstances is to be construed as giving financial or investment advice and/or as an offer to sell any securities. Harold Davidson & Associates, Inc. and its officers and employees may have an interest in some or all of the investments, industries or securities, mentioned herein. The information set forth herein has been derived from sources believed to be reliable, but is not guaranteed as to accuracy and does not purport to be a complete analysis of the investment, industry or security involved."