Market Outlook Memorandum

We have expected this year to be a good one for stock investors based on our forecast of continued economic recovery along with jobs and profits growth amplified by rising stock valuations as last year’s deflation fears abate. With the economy continuing to grow and most stock market indexes up by about 5-6% during the recently completed first quarter, we remain comfortable with our forecast. Several first quarter international developments, however, have the potential to threaten the global and domestic economic recoveries and they unsettled investors during the mid-February to mid-March period. These include: (1) the continued rise of inflation in the major fast-growing emerging economies of China, India, and Brazil, with their governments acting to stem the inflation by tightening credit conditions; (2) a new round of European debt problems as attempts to stabilize conditions in Ireland and Portugal failed; (3) political turmoil in North Africa and the Middle East, though hopeful for the oppressed peoples of those regions, pushed oil and gasoline prices up on fears that world oil supplies are threatened in the short-run; and (4) the natural and nuclear tragedies in Japan that will disrupt worldwide manufacturing supply chains on top of the huge toll they are exacting on the Japanese people. The strong domestic and worldwide stock market rebounds in late-March, however, put our own market back on its bull-market track and suggest investors are feeling less threatened by these developments than they were earlier.

Our economy continued to recover during the first quarter, ... An annualized rise of about 9% in personal income fueled a similar increase of roughly 10% in retail sales despite high gasoline prices and disruptive winter weather in the northeast. Very importantly, job growth accelerated and private sector employment rose by 564,000 during the first quarter, bringing private sector employment gains during the past thirteen months to 1.8 million. This year’s jump in private sector job growth to a monthly rate near 200,000 confirms that our economic recovery, which began with immense fiscal and monetary stimulus in 2008-2009 and then progressed to the inventory rebuilding phase in 2009-2010, now has transitioned to the private job creation stage that makes the recovery self-sustaining and enables the fiscal and monetary stimulus to be withdrawn. The pick-up in job growth is a consequence of rising demand, the first increase in bank lending to businesses since the financial crisis, increased confidence on the part of businessmen that demand will continue to grow, and high levels of business profits. In fact, S&P 500 operating profits rebounded by 40% during 2010 and are expected to rise by about 13% this year to a new record-high level. Moreover, during the first quarter of this year an historically high 70% of the S&P 500 companies reported fourth quarter earnings that exceeded analyst forecasts. When we began this year, analyst earnings forecasts suggested the S&P 500 could have earnings of $96 for 2011. Currently, this consensus forecast has risen to $98.15. Thus, we think the domestic economic and corporate earnings portions of our positive 2011 market outlook remain intact.

… and P/Es rose. The second part of our 2011 outlook involved a rise in the valuations of earnings, cash flows, and book values that investors are willing to pay for stocks. Our view has been that the 2008-2009 financial crisis and the 2010 debt-deflation fears depressed valuation measures such as price-to-earnings ratios (P/Es) significantly below levels that otherwise would have existed. In our January Outlook Memorandum we detailed these depressed valuations and our view that as our financial system continues to recover from the financial crisis, and as the economic recovery and, perhaps, progress in cutting the federal government deficit, reduce deflation fears, stock valuation measures would rebound toward more normal levels.

One reliable measure we are watching to judge when investors feel the financial crisis has passed is the extra return investors are demanding to assume the risks of owning corporate bonds rather than US Treasury bonds. For this we use the “spread” of the yield on the Moody’s Baa Corporate Bond Index over the yield on 10-year US Treasury bonds. In normal times, this spread has varied between 100 basis points (i.e. one percentage point) and 250 basis points. An increase above 250 basis points historically has occurred during periods of financial stress, signaling that investors wish to avoid risk. During the 2008 crisis this spread rose above 600 basis points. In the past, when this spread was above 250 basis points and investors feared risk, stock P/Es tended to have been depressed by 2-3 P/E points. With this spread having fallen back to 269 basis points at year end, approaching the zone of normality as the financial crisis eased, we thought this spread was likely to drop back into the normal zone this year, producing a rise in P/Es. With this spread now down to 259 basis points, with banks again willing to lend, and with the trading of sub-prime mortgage bonds even resuming, it is clear that we are close to putting the financial crisis behind us. We continue to believe that this will produce a rise in stock market P/Es this year.

Debt-deflation fears were strong last year as a result of the European debt crisis and the troubling level of US government debt. Consequently, interest rates fell to low levels, with the yield on the 10-year US Treasury bond dropping below 3%, and stock market P/Es were further depressed. Historically, 10-year US Treasury bond yields below 3.35% have been a signal of such deflation fears and have been associated with stock market P/Es being cut by as much as 4-5 P/E points. We began this year expecting that as the deflation fears of 2010 diminished during 2011, the yield on 10-year US Treasury bonds, which had climbed back to 3.30% at year end, would rise above our 3.35% threshold, signaling that the markets had become less concerned with deflation risks. A natural consequence of this would be a rebound in stock market P/Es. During the first quarter, the yield on the 10-year US Treasury bond rose above our 3.35% threshold and finished the quarter at 3.47%. Further confirmation of lessened deflation concerns was the rise in bond market ten-year inflation expectations to close to 2.5% at the end of the first quarter. It also was encouraging that the so-called “adult discussion” on deficit reduction had begun in the Senate using the credible Simpson-Bowles Report as a starting point.

Consequently, we think progress was made during the first quarter both in putting the financial crisis behind us and in reducing fears of a debt-deflation crisis. This progress resulted in a modest rise in the P/E of the S&P 500 from 14.7 at year end to 15.1 on March 31. Though the P/E rise was small, our market forecast for 2011 has been conservatively based on the S&P 500 P/E climbing to only 15.6 by the end of the year, recovering only a small portion of the total valuation discount we think exists. If S&P 500 earnings achieve the $98 level currently being forecast, this P/E would produce a year end S&P 500 of 1529, which would equal a 2011 return of more than 20%. Thus, with one quarter of the year behind us we think we remain on track for a good year.

Inflation is not yet a domestic problem, … Of course, reaching ones investment goals never is easy, and there are plenty of potential stumbling blocks to navigate. A “New York second” has been defined as the time between a New York traffic light turning green and the guy behind you starting to honk his horn. It also might be defined as the time between investors giving up their fear of deflation and their beginning to worry about approaching inflation. Thus, it should not be surprising that with deflation fears now abating the markets already are growing restless about potential inflation. We have expected core consumer inflation to rise this year from last year’s depressed level below 1% that was dangerously close to deflationary to a healthier and more sustainable level near 2% by the end of this year. With gasoline and food prices up sharply, we could see the headline Consumer Price Index exceed this level by year end. But, with our economy still operating well below its non-inflationary potential, we continue to think domestic inflation pressures will remain benign well into 2012.

… though it has become a concern of some emerging economies. Rising food and energy prices have pushed inflation rates above desired levels in many of the major emerging economies, and the Chinese, Indian, and Brazilian monetary authorities have been tightening their credit conditions in an effort to slow their growth rates to more sustainable and less inflationary levels. These steps produced first quarter corrections in these stock markets as investors feared the authorities’ actions might result in recessions. Our view is that these monetary authorities are likely to avoid putting excessive pressure on the economic brakes, and their economies are likely to continue to be world growth leaders. Late-March rebounds in their stock markets increase our confidence that this view will prove correct.

The European debt problem lingers, … The European Union continues to struggle with large budget deficits and excessive debt levels in many of its member states, as well as with a weak overall economy. Recently, the Portuguese government fell when its proposed austerity budget was defeated and Ireland seems headed toward bank nationalization after a new round of stress tests showed its banks in need of even more capital than previously thought. This will increase Irish national debt by about $34 billion. Relative to last year’s crisis, however, European markets remain calm. The difference is that in March the governments of Germany and the other stronger Euro-Union states agreed to increase the size of the European Financial Stability Facility created last spring to deal with the crisis to more than $600 billion. While this does not solve the Euro-debt problem, this level of funding is viewed as sufficient to deal with both the Irish and Portuguese problems.

We remain concerned, however, that European monetary policy is not sufficiently growth oriented to help reduce the debt problem over time. Surely, budget austerity is part of the long-term solution, but achieving adequate levels of nominal GDP growth also is essential. Government tax revenues are a function of nominal GDP, so growing the economy also is needed for deficit reduction. In addition, increasing the size of the overall economy makes any level of debt more sustainable. With so many European Union members struggling to achieve adequate levels of nominal GDP growth, we fear the European Central Bank’s (ECB) recent announcement that it intends soon to begin tightening monetary policy by raising interest rates will prove misguided. We understand that the ECB is concerned about rising inflation and sees a tighter monetary policy as an offset to the expansionary fiscal budget deficits. While some monetary tightening might be appropriate for the stronger European economies such as Germany, it will make it even more difficult for Greece, Italy, Spain, Portugal, and Ireland to solve their problems. Thus, we expect to have to continue worrying about market disruptions stemming from Euro-debt problems in the future.

… while the Mid-east again is in turmoil. The demands for political reform that began in Tunisia and Egypt and have spread across North Africa and the Middle East are both hopeful and potentially disruptive since the region is the source of so much of the world’s oil supply. The hopeful part is that these startling developments in the Arab world hold the potential for beginning a process that could reduce terrorism in the world. Since the September 11, 2001 attacks on the US it has been recognized that our overthrowing the Taliban and destroying the al-Qaeda camps in Afghanistan did nothing to solve the long-term problem of hundreds of millions of Muslims hating western society. In his 2004 classic, The Case For Democracy, Russian refusenik Natan Sharansky argued that the cause of Islamic extremism was as old as human tyranny itself; that the entire Arab people had long been ruled by tyrannical dictators who kept the majority of their peoples impoverished, blaming their poverty on outsiders such as the west. In contrast, Sharansky noted that history has shown open, democratic societies desire to be part of the world community. As predicted by Sharansky, the current wave of demands for democratic reforms confirms that the Arab people have the same desire as others to live in open societies free of fear in which they can build better lives for their families. If their lives improve, they should be less susceptible to arguments that blame the west for their problems.

Of course, history also is full of political revolutions that began with noble objectives, but ended with new tyrants in control. Consequently, even if this movement is sustained, it is likely to follow a long, difficult, and uneven path. And to the extent that leaders in Libya, Bahrain, and Syria already are using their militaries to resist, this movement contains a risk that world oil supplies could be disrupted. This risk has produced a rise of more than 20% in world oil prices this year that reduces household disposable income, increases the cost of doing business, and generally acts as a drag on economic growth. To date, the loss of Libyan oil has been easily made up from increased Saudi production and we believe the overall economic effect has been small. A spread of political turmoil to Saudi Arabia, however, would frighten world markets. We are watching developments closely.

Japanese disasters will slow 2011 growth. Japan is one of the world’s most important economies. Clearly, the earthquake, tsunami, and nuclear plant destruction are costing the Japanese dearly in terms of lives, suffering, and wealth. Though it will take time, we can be confident the Japanese will rebuild and recover. For the broader world economy, however, the issue is that Japan not only is an important end market, it also is a producer of many products that are essential components of other products. This is the “supply chain” issue. For example, Japan is the source of 90% of a BT resin that is used in computer chips. Mitsubishi Chemical, which produces about half the world’s supply, had its plant knocked out by the earthquake and has announced its production will only gradually be restored during April and May. Worldwide inventories of BT will help to absorb the lost supply, but it is that this and similar developments in other products will result in production lines being shut down in the US and elsewhere because one or more components become unavailable. Impacted companies are shifting production out of Japan, seeking other suppliers, or substituting materials and components for those they have lost, but it is difficult at this point to know who will be significantly affected. In the short run, production disruptions seem likely to trim worldwide economic growth, although economists seem to agree that Japan’s rebuilding efforts will begin to boost growth later this year.

2011 still looking promising. So, as we proceed into the spring quarter our domestic economic and market expectations remain intact. We are closely following the potentially disruptive global developments we have discussed, but we think the worldwide stock market rallies of late March indicate investors have concluded these disruptions are unlikely to become major problems. be many Technology stocks that currently are trading far below their respective fair values.