THIRD QUARTER, 2010

THE ECONOMY: TEPID DOMESTIC ECONOMIC GROWTH LIKELY DURING THE NEXT FEW QUARTERS. LEADERS OF THE G20 NATIONS RECENTLY DISCUSSED GLOBAL ECONOMIC DIFFICULTIES

Real Gross Domestic Product (Real GDP) grew at a 2.7% annual rate in the first quarter of 2010, compared to a 5.6% gain in last year’s fourth quarter. Almost 70% of that increase was accounted for by inventory building. Major contributions to the gain were made by personal consumption spending, exports, nonresidential fixed investment, along with the aforementioned inventory building. Some offsetting negatives, which contributed to the decline in the rate of gain in Real GDP, came from residential fixed investment, state and local government spending and increased imports.

Positive items of note include:

• Personal consumption expenditures grew by 3.0% in the first quarter, up from a 1.6% rate of increase in the fourth quarter of last year.
  
  
• Nonresidential fixed investment increased 2.2% in the first quarter of this year.
  
  
• The equipment and software sector expanded by 1.4% in the first quarter.
  
  
• Exports of goods and services grew 11.4% in the first quarter.
  
  
• Federal government spending increased 1.2% in the first quarter. It was unchanged during the fourth quarter of last year.
  
  

On the negative side:

• Nonresidential structures decreased 15.5% in the first quarter.
  
  
• Residential fixed investment swung from a gain of 3.8% in the fourth quarter of last year to a decline of 10.3% in the first quarter.
  
  
• Imports of goods and services increased 14.5% in the first quarter.
  
  

The change in business inventories added 1.88 percentage points to the 2.7 percentage point gain in Real GDP in the March quarter.

Our economy is currently experiencing an uncomfortable combination of moderate consumer spending, a tepid housing market, and high unemployment. As much of this centers around consumers, it should be noted that mortgage and consumer debt ratios to income are historically high, while the savings rate is historically low. Therefore, it is likely that deleveraging by consumers will continue for some time to come. There are still many vacant properties in the housing industry, and mortgage default rates have been at high levels. These factors must improve in order for the housing industry to make significant progress. Job growth will be a catalyst for improved macroeconomic conditions. Presently, businesses are adding to the hours of those whom they already employ, instead of hiring new workers. Higher rates of Real GDP growth will create incentives for new job creation.

As cited previously, most of the globe is experiencing economic difficulties. Discussion and planning among nations will facilitate a global economic recovery. In order to promote this, the G20 recently held a summit meeting. (The G20 is a group of central bank officials and finance ministers from the European Union, and the nineteen largest national economies. A summit meeting of this group usually includes the heads of state of the countries represented.) At the time of the previous G20 summit meeting (15 months ago), the world was in a state of economic chaos. The G20 was united in its intention to halt the decline and provide a stimulus package for the purpose of promoting economic growth. That resulted in their adding trillions of dollars to the global economy. Reactions to that stimulus package by the different economies involved have been varied. Various countries came out of the downturn at different rates of growth, and therefore had different priorities at the G20 summit that took place in June. President Obama expressed the need to make sure that the recovery be maintained and given additional vitality by policies that will support economic growth. Some other G20 participants from the European Union spoke in terms of austerity measures for the purpose of reducing their deficits. Although there was less unanimity at this meeting, the fact that the G20 continues to discuss these issues is very positive for the global economy.

Some recent modest positives include an increase in the annual rate of consumption to about 3% during the last six months and a slight pickup in industrial production. Export growth is one of our major positive factors. On the other hand, the economies in many European countries are weak; additionally, there are concerns that increased taxes in the U. S. next year may prolong economic weakness. We are not in a V-shaped recovery, but rather a slowly developing one with below trend-line growth in Real GDP over the next few quarters. Federal Reserve Board officials deem deflation to be a risk. Credit growth may not be dramatic for a while and we estimate modest quarterly growth during the second half of this year. For all of 2010, we project that Real GDP will expand by 2 - 2% and do not expect the economy to grow vigorously next year either. High unemployment and low levels of plant utilization should prevent inflation from accelerating, and we estimate that the Consumer Price Index will increase by 1 - 2% for all of this year. The foregoing makes it unlikely that the Federal Reserve Board will raise the fed funds rate before the end of 2010.

THE STOCK MARKET: CONCERNS OVER DOMESTIC AND INTERNATIONAL ECONOMIC ISSUES CAUSE A SIGNIFICANT STOCK MARKET DECLINE DURING THE JUNE QUARTER

During the second quarter of 2010, the Standard & Poor’s 500 Industrial Average (S&P 500) declined 11.9%. A series of domestic and international concerns combined to produce jitters among equity investors. They include: fears of a return to negative Real GDP growth in the United States (we deem this unlikely), signs of further decline in our housing market, and a soft labor market. On the international front, some European countries appear to be focusing on deficit reduction and a leading indicator of the Chinese economy has been revised downward.

We engaged in a modest amount of trading activity during the second quarter of 2010. Shares of a food and snack food company were purchased. Sales were made of the shares of an international oil company, a builder of oil platforms, a generic pharmaceutical company, and a credit card company.

The current position of the total managed assets of Harold Davidson & Associates, Inc. client portfolios is as follows: cash & cash equivalents - 8%; municipal bonds - 10%; corporate bonds - 6%; bond mutual funds - 7%; common stocks - 26%; equity mutual funds - 16%; real estate equities - 10%; and real estate trust deeds - 17%.

The unsettled investor psychology cited above will probably not dissipate rapidly, especially in view of the below trend-line rate of growth anticipated over the next few quarters. Therefore, a dramatic expansion of price/earnings ratios during the remainder of 2010 is unlikely. On the other hand, low inflation and interest rates in the near future will have a positive impact on investor sentiment. Weighing the aforementioned offsetting factors, we estimate that the S&P 500 will have a modest single digit gain during the next six months.

THE BOND MARKET: CONCERNS OVER STRENGTH OF U.S. ECONOMY DRIVE U.S. BOND YIELDS LOWER

An unexpectedly weak May employment report, combined with concerns over high European debt levels and a 32.7% decline in new single-family home sales last month, led investors to seek the relative safety of municipal and corporate bonds. Yields on 10-year U.S. Treasuries (having reached a 52-week high of approximately 4% on April 5, 2010) are now trading at a 52-week low of approximately 3%. Shorter-term U.S. Treasuries have shown an even sharper decline in yields, declining to approximately 0.59% on June 29th. The Federal Reserve, at its June 23rd FOMC meeting, kept its target range for the fed funds rate at between 0 and 1/4 percent stating that “the pace of economic recovery is likely to be moderate for a time.” Employers, while increasing hourly earnings and hours worked, are reluctant to add additional employees until there is greater confidence as to the strength of the recovery.

While interest rates remain at unusually low levels, yields will eventually reverse their downward trend as the economy gains a better footing. Over time, large annual federal budget deficits may lead to higher interest rates in order to attract demand from domestic and foreign investors. Harold Davidson & Associates, Inc. continues to focus efforts on shorter-term, higher quality municipal and corporate bond purchases. Our municipal bond purchases are concentrated in states exhibiting a high degree of fiscal responsibility, mostly outside of California with underlying financial strength. Corporate bonds, with the exception of financial firms, do not look attractive to us at the moment, given their unusually low yields.

REAL ESTATE: THE REAL ESTATE MARKET APPEARS TO HAVE BOTTOMED. HOWEVER, THERE ARE A LIMITED NUMBER OF COMMERCIAL AND RESIDENTIAL TRANSACTIONS.

The Federal Government has gone to great lengths to stimulate the real estate sector due to its overwhelming significance in the recovery of the economy. Interest rates have been kept at historic lows in order to stimulate demand.

In the commercial sector, albeit interest rates are extremely low, there are few banks lending and those that are lending have become extremely cautious and have created numerous underwriting hurdles. Additionally, there is very little product available as owners are trying to hold on to their properties either because they owe more than the property is worth, or believe values will come back. In the meantime, landlords are collecting cash flow as they wait for property values to improve.

In the residential sector, high unemployment has resulted in less potential purchasers in the market and an abundance of inventory. Until employment growth leads to economic growth, we believe transaction volume will remain low and values will remain fairly constant with a slight upward trend.

SUMMARY & CONCLUSION: VERY MODERATE PROGRESS DEEMED LIKELY FOR THE ECONOMY AND THE STOCK MARKET DURING THE NEXT FEW MONTHS

High unemployment is causing a reduction in general consumer spending and is also limiting the recovery in the housing industry. Additionally, international difficulties such as a potential decline in China’s rate of growth and the possibility of austerity measures being instituted in some European countries may prolong the current global slowdown. Low interest rates and tepid inflation are positive factors; however, economic growth in the United States over the next few quarters is not expected to develop at a rate that will significantly reduce our nation’s unemployment rate. As a result, price/earnings ratios are not expected to advance vigorously and a modest single digit gain is projected for the S&P 500 through the end of this year.

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."