STOCKS YIELD SOME GROUND IN THE SECOND QUARTER

Following back-to-back double-digit quarterly gains, US stocks took a breather in the second quarter, with the S&P 500 Index declining 2.8%. It could have been worse. At the quarter’s low point in early June, the Index had declined 10.0% from the first-quarter close. June was a strong month for stock performance, leading to a welcome recovery from the early quarter decline. However, positive returns from the first quarter prevented the Index from becoming negative on a year-to-date basis. For the first half of 2012, the total return was 9.5%, which we believe is impressive given continuing negative macroeconomic headlines. Small cap and mid cap equities underperformed the large cap S&P 500 for the quarter. Still, a total return of 8.5% for the small cap Russell 2000 Index and a gain of 8.0% for the Russell Midcap Index are solid for the six-month time frame.

Considering a longer time frame, the mid-to-upper-teens three-year annualized returns for the US indices are impressive. We now have passed the three-year mark in the equity market recovery from the low in March 2009. While the five-year returns are meager to be sure, this reflects the impact of the 2007 to 2008 global market rout. In an absolute sense, the annualized ten-year returns look better; the S&P 500 has returned over 5.0% annualized, while small cap and mid cap indices performed notably better than their large cap counterparts. In the past decade, equity markets have seen a period of strong earnings-per-share growth, offset by a declining price-to-earnings multiple. In our view, equities have completed the majority of warranted multiple compression, and earnings and dividend growth will likely be the primary driver of equity performance going forward.

Global indices have not performed nearly as well as US equities. While certainly not astounding, the US economy has maintained slow but steady growth, with a gradually improving employment picture. Globally, growth has become quite scarce. Many European nations are in recession or close to it. China’s growth is clearly slowing, creating somewhat reduced demand for energy, materials and other products when compared to the recent past. While global stocks were weak for the quarter, the one-year total return is more informative. Over the past twelve months, the S&P 500 shows a gain of 5.5%, while the MSCI All Country World Index shows a loss of 6.0%. The MSCI Emerging Markets Index has been a very weak performer, showing a loss of nearly 15.7% over the past year.¹

¹The MSCI World Index includes all developed world markets. The MSCI All Country World Index includes emerging markets and all developed world markets.

DEFENSIVE SECTORS OUTPERFORMED

Defensive companies in the S&P 500 led sector performance this quarter, as global growth forecasts continue to be trimmed. The high yielding telecommunications sector posted a mid-teens gain, followed by the income-oriented utility sector with a gain of 6.5%. Consumer staples and healthcare also posted gains. The sharp decline in the ten-year US Treasury rate was a positive factor boosting performance of these traditionally dividend-paying stocks. However, the remaining S&P sectors drifted into negative territory. Economically sensitive sectors, such as financials, technology and industrials, were under pressure as the somewhat higher US dollar coupled with a mark down of growth forecasts in Europe and Asia weighed on performance. Relative sector performance was similar for the Russell 2000 Index and the MSCI All Country World Index; economically sensitive sectors struggled across the board.

EARNINGS GROWTH IS HEALTHY, BUT SLOWING

S&P 500 corporations reported operating profit growth of 15% in 2011. However, earnings growth in the first quarter this year was in the single digits, up about 7.5% year-over-year, reflecting a deceleration of the strong earning-per-share (EPS) leverage achieved from the trough of the last recession. Revenue growth remained moderate, up about 6.5% year-over-year for the first quarter of 2012. We believe both EPS growth and revenue growth are likely to drift lower given the softer tone of incoming economic data. Considering China’s economic deceleration and partial recession in Europe, we expect that earnings growth in 2012 should decelerate to a mid-to-upper single-digit level and full year bottom-up earnings estimates for S&P 500 should continue to edge lower. We think that earnings in the $102 to $105 range could be achievable, representing a gain of around 6% to 9%. This outcome would be within our base case viewpoint. If realized, this would also be the second year in a row of record earnings for the Index.

WE SEE HIGHER PRICES AHEAD, BUT NOT WITHOUT CHALLENGES

Equity-valuation indicators suggest stocks are attractively valued relative to history, and the S&P 500 Index dividend yield currently remains attractive relative to sovereign interest rates. The equity-risk premium has continued to be on the high side, constraining the overall market multiple. The cycle of large, positive earnings revisions for the broad market has essentially played out, so stock picking should become increasingly important in the quarters ahead. We do not see conditions that argue for multiple expansion. An acceleration in economic growth could probably lead to multiple expansion but is currently not a likely scenario. Interest rates are generally expected to stay low and will not likely be a catalyst for higher multiples either.

Dividend growth currently remains the most favorable factor for equities. According to Standard & Poor’s, year-to-date dividend declarations so far in 2012 point to dividend payments of more than $30 per S&P 500 share this year, compared to $26.43 for all of 2011. Many S&P company managements holding high cash positions have become more comfortable with sharing some of this liquidity with shareholders. Since cash on the balance sheet earns almost nothing, paying dividends is becoming a more compelling option than it was a few years ago, when companies were focused on building liquidity during the recession.

Where might the S&P 500 be valued a year or two from now? The range of potential outcomes is wide. However, we know that the long-term average price-to-earnings multiple on trailing operating earnings has been around 15x. Considering earnings estimates in the range of $102 to $105 this year and the potential for further earnings growth in 2013 (assuming no recession), achieving a 15x earnings ratio could mean that stocks may still have meaningful upside. The S&P is currently trading at a little over 13x 2012 earnings estimates, even after the year-to-date rally. While a 15x price-to-earnings ratio is not our forecast, stocks have been trading in a 13x to 14x range recently and stocks could move higher by simply holding valuations constant within the current range as earnings grow.

In terms of risks, there are quite a few. Looking out to year-end, Congress and the White House will be required to act on a long list of expiring tax measures and an approaching debt ceiling. As we saw in 2011, compromise was very difficult to achieve and the elections are likely to introduce another level of uncertainty. Fortunately, the market’s current moderate valuation partially accounts for some of these risks. Beyond our shores, China is slowing, although we continue to expect solid growth just at a slower rate. Further challenges within the euro zone should be anticipated, and, of course, this was an important catalyst for the equity selloff in the second quarter.

Balancing these positive and negative factors, we continue to see equities as an attractive investment for at least the next year or two. In our view, stocks are positioned to outperform conservative fixed income vehicles such as US Treasurys, although equities will continue to be volatile. We recognize that fundamental conditions, particularly in the euro zone and the maturing US recovery, make the 2012 earnings outlook less robust and predictable than it was in 2011. While equity valuation appears supportive and US economic data reflects slow growth, unexpected events can upset the balance making for choppy equity markets. Investors should use periodic selloffs to judiciously add to favored positions, as market volatility will likely present periodic opportunities in the second half of 2012.

Russell 1000 Index measures the performance of the large cap segment of the US equity universe and includes approximately 1,000 of the largest securities based on a combination of their market cap and current index membership. Russell 2000 Index measures the performance of the small cap segment of the US equity universe and includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership. Russell 1000 Growth Index measures the performance of the large cap growth segment of the US equity universe and includes Russell 1000 companies with higher price-to-book ratios and forecasted growth values. Russell 2000 Growth Index measures the performance of the small cap growth segment of the US equity universe and includes those Russell 2000 companies with higher price-to-book ratios and higher forecasted growth values. Russell 1000 Value Index measures the performance of the large cap value segment of the US equity universe and includes those Russell 1000 companies with lower price-to-book ratios and lower forecasted growth values. Russell 2000 Value Index measures the performance of the small cap value segment of the US equity universe and includes those Russell 2000 companies with lower price-to-book ratios and lower forecasted growth values. Russell Midcap Index measures the performance of the mid-cap segment of the US equity universe and is a subset of the Russell 1000 Index that includes approximately 800 of the smallest securities based on a combination of their market cap and current index membership. Russell Midcap Growth & Midcap Value Indexes measures the performance of the mid-cap growth and value segments of the US equity universe, respectively. Standard & Poor’s 500 Index (S&P 500) is an unmanaged market cap-weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent US equity performance. MSCI World Index is an unmanaged index measuring global developed market equity performance. MSCI Emerging Markets Index is a free float-adjusted market cap index measuring equity market performance of emerging markets. MSCI All Country World is a market cap weighted index of stocks from developed and emerging markets providing a broad measure of global equity-market performance.

Indexes are unmanaged and do not incur fees. It is not possible to invest directly in an index.

Past performance is no guarantee of future results.

This commentary is provided for informational purposes only and should not be construed as investment advice. Any opinions or forecasts contained herein reflect the subjective judgments and assumptions of the authors only and do not necessarily reflect the views of Loomis, Sayles & Company, L.P., or any portfolio manager. Investment recommendations may be inconsistent with these opinions. There can be no assurance that developments will transpire as forecasted and actual results will be different. Data and analysis does not represent the actual or expected future performance of any investment product. We believe the information, including that obtained from outside sources, to be correct, but we cannot guarantee its accuracy. The information is subject to change at any time without notice. MALR009370

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