Economic Forecast
Emerging Growth

As of September 30, 2009

In the third quarter that ended September 30th, the S&P 500 Composite Index(1)rose 15.6%(2). Since the S&P 500 reached its low on March 9th, the index has returned an impressive 58.2%(2). We mentioned in our last quarterly report that the run-up in equity prices was not unexpected due to the fact that widespread fear had forced equities into an oversold position. Without digging a little deeper, the continued rise in valuations may lead some to conclude that an "all clear" has been given. While we are encouraged by the positive momentum, the events of last fall will have a lasting impact that will present challenges to future economic growth. This report will review some of these challenges and provide guidance on potential action items.

Looking Back on the Third Quarter:

The third quarter economic data provided further evidence that the recession was subsiding and nascent growth was filling the void. It is expected that third quarter earnings estimates from S&P 500 companies will be $14.47(3) per share. This is up from $13.81(3) per share at the end of the second quarter. After the most severe economic downturn since the Great Depression, the reports of growth were accompanied by exhales along both Wall Street and Main Street. While it was encouraging that economic reports had less red ink, the numbers were somewhat disappointing. The disappointments included:

• The ISM Manufacturer's Index(4) expanded less than anticipated(2), indicating that a recovery might be slow to create jobs
• Housing prices increased for the quarter, but at a pace that was slower than anticipated(2)
• August saw an unexpected drop in durable goods orders(2)

Given the lukewarm economic data, we view the market's 15.6% quarterly climb with guarded optimism. We have to consider the impact that 2008 had on the economy and what changes we should expect over the coming years.

Economic Considerations:

The American Consumer -

Strong economic growth has always been contingent on the American consumer's ability to spend, as 70% of our Gross Domestic Product depends on this consumption. Presently, the American consumer is under a great deal of pressure. Unemployment data continues to suggest a very poor job market, with approximately 7.2 million jobs lost during the recession(2). The average work week has also decreased, which will likely restrain future hiring as employers will increase employment hours before hiring additional staff. There is now little doubt that the unemployment rate will rise above 10% before subsiding. Although unemployment is a lagging indicator of an economic rebound, the magnitude of job losses should not be discounted.

The American consumer has also been forced to raise their savings rate due to the fall of home prices and portfolio values. The U.S. savings rate has risen to its highest level since 1998(2). As the baby boomer generation nears retirement, the savings rate will likely trend higher as the deterioration of wealth has increased the need for additional retirement savings. In the long term this increased savings will create healthier balance sheets, but in the near term will negatively impact spending.

Another concern for consumers is the lack of credit available. In the past, Americans bolstered spending by leveraging their personal balance sheets, the balance sheets of the banks, as well as the U.S. Government's balance sheet. Now Americans face a painful period of de-leveraging. Consumer credit had fallen for seven straight months(2) through the end of August with July recording a record drop of $21.6 billion(2). This reduction was the result of tighter lending standards by banks and credit card companies as well as the aforementioned increase in savings.

It is difficult to imagine a robust recovery with so many factors weighing on the consumer. For these reasons, in order for robust economic growth to take hold, the reduced spending of the U.S. consumer will have to be replaced.

The Global Shift -

In the past, if the American consumer sneezed, the world economy caught a cold. However, over the years the American consumer's massive consumption has raised the living standards of many nations. One of the largest beneficiaries of American consumption was the export-driven emerging economies. As these nations gained wealth, their middle classes expanded. This increase in living standards has also sparked internal consumption. As a result, instead of being exclusively net-export nations, the emerging economies are now contributing more to the growth in global consumption than U.S. consumers(5).

In the coming years it is likely that large emerging economies, such as China's and India's, will continue to be the primary drivers in world economic growth. The International Monetary Fund (IMF) estimates that the U.S. economy will grow by 1.5%(6) in 2010 and that the European developed economies will grow by 0.3%(6). Meanwhile the 2010 IMF estimate is 9.0% growth for China(6) and 6.4% growth for India(6). This would be welcome news for large multi-national American corporations that export to these growing emerging economies. Therefore, as American consumers struggle to regain traction, there is the potential that the emerging economies may reverse earlier trends by helping the U.S. economy achieve higher growth than it could have accomplished on its own.

The Ongoing Stimulus -

The massive government stimulus package was one of the main drivers to jumpstart the American economy. Given the strong returns of equities, we are concerned that the markets are confusing stimulus-driven growth for organic economic growth produced by the private sector. It is estimated that 60%(2) of the stimulus package has not yet been spent. This should provide liquidity for many months to come, but is not a long-range solution. It is essential that there is a transition from government produced consumption to private consumption before the stimulus reserve dries.

The Shaky Dollar -

As panic gripped global investors during the most harrowing days of the economic crisis, assets flooded into safe havens. One of these safe havens was the U.S. Dollar, which increased in value relative to most other currencies. As the fear relents, the underlying fundamentals (the massive U.S. debt and trade deficit as well as low interest rates) are driving the value of the dollar down relative to other currencies. Weston anticipates that without political intervention by the U.S. government or its trading partners, we may experience a long-term decline in the purchasing power of the dollar. A cheapened dollar could have many negative side effects such as inflationary pressures and the potential loss of status as the world's reserve currency; however, it would make American exports cheaper to foreign purchasers and add a tailwind to non-dollar denominated assets such as foreign stocks and bonds.

Weston's Outlook:

We do not believe that the recent run-up in stock prices places equities in dangerously over-valued territory. Equities now trade at a P/E ratio of 17.95(7) (based on ten year trailing earnings). This ratio is slightly ahead of the historical average of 17.35(7). Normally this would be well within our range of acceptable multiples. However, given the uncertainties in the economy one might have expected more of a discount from historical averages. Due to this fact, many prognosticators are suggesting that equity values have come too far, too fast. Some of the most bearish forecasts have suggested that a decline in equities of 20% is likely. While we appreciate these concerns, we believe that a near term decline of this magnitude is unlikely in the absence of another major shock to the markets.

Our outlook is less pessimistic than others' because of the estimated $3.5 trillion(2) in cash currently on the sideline. As of the end of September, $3.5 trillion was equivalent to 73% of the net asset value of the companies representing the S&P 500(2). Due to the extremely low money market yields, many investors sitting on cash are biding their time to re-enter the markets in search of higher returns. The market has had a number of small pullbacks in recent months, but each decline was halted by an influx of new investment. We would prefer to see the market at slightly lower multiples, but this stockpile of cash makes us less concerned about current valuations.

For healthy market conditions to exist moving forward, any future advance in the market should be earnings driven. It is also important that the earnings growth is obtained by an increase in top line revenue growth and not merely due to cost cutting. Because we believe that we are at the beginning of an economic growth cycle, we do expect this growth to occur, albeit at a subdued level. Therefore, we anticipate that the markets will trend upwards over the coming years, but at a decelerating pace.

We remind you that even in bull market rallies, stocks do not advance straight up. While we expect the glut of cash to temper any major pullbacks, we believe smaller declines of 5% to 10% are likely. Depending on the existing valuations at that time, such a pull-back may present an opportunity to invest. On the other hand, the significant stockpile of cash could propel the markets for many months to come. Without a parallel rise in earnings, this could create an overbought position, wherein the underlying fundamentals do not support the prevailing valuations. This would be an opportunity to rebalance into bonds and other less volatile assets.

Potential Action Steps:

At Weston we believe that each client has unique goals and risk tolerances and that a one-size-fits-all strategy does not exist. The following is a list of potential action items that might be considered for your portfolios:

• Clients that are considering a shift to a more conservative portfolio may use the recent increase in stock valuations as an opportunity to reduce volatility.
• Conversely, for clients with longer term horizons, we feel that equities continue to have the best long term growth potential.
• Based on our view of subdued domestic growth, clients may wish to increase their allocation to foreign assets, especially those with ties to emerging economies. This does not come without risk as international investing, especially investments in emerging economies, are generally more volatile.
• Clients may consider alternative risk-reduction strategies that would hedge against a falling dollar and rising inflation.

As always, we urge you to contact your Weston Counselor to discuss your specific needs.

Footnotes:
(1) The S&P 500® Composite Index (the "S&P 500") is a basket of 500 stocks that are considered to be widely held. The S&P 500 is weighted by market value, and its performance is thought to be representative of the stock market as a whole. The S&P 500 is one of the most commonly used benchmarks for the overall U.S. stock market. The S&P 500 cannot be invested into directly.
(2) Data obtained from Bloomberg.
(3) Data obtained from Standard & Poors.
(4) The Institute for Supply Management Index is a monthly composite index, released by the Institute for Supply Management that is based on surveys of 300 purchasing managers throughout the United States in 20 industries in the manufacturing area. The index is released on the first business day of the month and covers the previous month's data, which makes it particularly timely. If the index is above 50, it indicates that the economy is expanding. Values below 50 indicate a contraction.
(5) Data obtained from Morgan Stanley/Smith Barney report Global Investment Committee Monthly.
(6) Data obtained from International Monetary Fund World Economic Update.
(7) Price to Earnings figures obtained from Yale Professor Robert Shiller's data. All numbers are based on the prior ten year earnings. Historical price to earnings for the S&P 500 was from 1926 - 2008.

The contents of this report have been compiled from original and published sources believed to be reliable, but are not guaranteed as to accuracy or completeness. Market opinions contained herein are intended as general observations, are subject to change without notice and are not intended as specific investment advice.

It should not be assumed that any recommendations incorporated herein will be profitable or will equal past performance. The information provided should not be construed as providing a specific recommendation in any particular investment vehicle.

All performance date quoted is as September 30, 2009 unless otherwise indicated and has been obtained from third-party financial reporting sources. Past performance is no guarantee of future results.