Q3 PlaybookU.S. Economy

Q3 PlaybookU.S. Monetary and Fiscal Policy

Just a few days into the second quarter, the U.S. moved from a significant global market tailwind to a market headwind, remaining in that role for the duration of the quarter. In my third quarter Playbook, the economic condition of the U.S. is priority number one. I am more concerned about the potential for continued deceleration in U.S. growth than about the euro debt crisis or the apparent China slowdown. First and foremost, we need to digest U.S. economic evidence and make decisions from there.

If there is one thing that stands out to me, it is that, despite the abundance of unfavorable second quarter U.S. data, the S&P 500® Index (SPX) was able to maintain its prevailing positive trend for 2012, remaining above the 200-day moving average. Therefore, without evidence of further significant weakness in July data for U.S. labor, ISM Manufacturing, or housing, there is a high probability that the SPX troughed at 1278.18 on June 4. Economic data consistent with 2% GDP growth will not foster enough selling pressure to breach the June 4 low as the market has already, during the second quarter, priced in 2% GDP growth. Furthermore, favorable consideration must be given to the sharp decline in oil prices, historically low private sector borrowing costs, and an uptick in housing data.

Sitting on the fence doesn’t do us any good. On the U.S. economy, I am leaning in a direction, taking a view. The evidence might suggest I leaned the wrong way, but for now my conviction is formulated by my surprise that the SPX has not deteriorated further, even with a significant slowing in the economic data during the second quarter.

The Supreme Court ruling upholding the Affordable Care Act (ACA) of 2010 should have minimal impact on the capital markets. In fact, less than 25% of the $1.5 trillion-plus market cap of the health care industry is considered “services,” which are affected by the ruling. However, the social consequences of ACA will intensify the ideological debate surrounding the November elections and the 2013 “fiscal cliff.”

In my May 3 Virtus blog, “Gridlock Drives the U.S. to the Fiscal Cliff,” I stated that “a failure to act could remove 1% to 1.5% from U.S. GDP.” That would certainly tip the U.S. into recession, given the current 2% GDP track we are on. What is at stake is a first quarter 2013 expiration of tax cuts and emergency benefits, as well as the introduction of automatic spending cuts and potential tax increases for capital gains and dividends.

Given apparent voter apathy towards the upcoming elections, perhaps an intensified debate will motivate the electorate to become more involved. Television ratings across the board are at near-decade lows – rather odd in an election year characterized as “the most important of our lifetime.”

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Q3 2012 PLAYBOOK: “The Trend is Your Friend”Authored by Joe Terranova, Chief Market Strategist

Let’s begin by immediately addressing the rather obvious complaints many investors will have after the second quarter’s performance. Elected officials in the U.S. and Europe continue to provide a headwind to the markets by placing their own self-interests ahead of the good of those that elected them. My analogy is that the student council is in control of the academic institution, with no adult supervision. Additionally, the market itself has been corrupted by the dominance of high-frequency computerized trading.

Sounds ominous, doesn’t it? What rational person would put their hard-earned money into this kind of investment arena? The certain answer: all of us reading this commentary. Our personal sacrifices and hard work do not allow us to accept the alternative – cash. We all know cash’s return and we all know we can do better.

That’s it for the complaints. It’s time to get to work on our third quarter Playbook – what are the investment opportunities, based on the evidence, and what will telegraph to us that our strategy might be flawed.

Q3 PlaybookU.S. Monetary and Fiscal Policycontinued

Q3 PlaybookEurope

Q3 PlaybookChina

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To date, the market appears comfortable that any resolution or compromise will not occur before November 6. The market will digest three more FOMC meetings before November 6, on August 1, September 13, and October 24. At the last FOMC meeting on June 20, an extension of Operation Twist through year-end was announced. If the FOMC announces further quantitative easing measures, it will be a reaction to either significant deterioration in July’s U.S. economic data or a deeper decline by the SPX below its June 4 1278.18 low. The capital markets should perceive no “new” quantitative easing initiatives in the third quarter as a market positive.

In my second quarter commentary, “Third’s Time’s The Charm?” I began my European commentary with “First, let me rule out Europe as the root cause of any slowdown we might see.” Looking back on the second quarter, I firmly believe that to have been true and expect that in the third quarter Europe will not be the root cause of further market deterioration. Looking at the evidence, Spain’s 10-year bond had risen throughout the month of March from below 5% to slightly above 5% by April 1. By the middle of April, the uncomfortable rise reached 6.16%. During that time, the SPX continued to appreciate. In fact, on May 1, the SPX traded at 1415.32, just below its four-year high established on April 2, 2012 at 1422.38. The 9.7% decline in the SPX from May 1 to June 4 was directly attributable to a second consecutive poor U.S. labor report and loss of the financial sector as a market leader resulting from the JP Morgan Chase (JPM) trading loss announcement.

Investors should continue to expect the euro crisis to be present in our markets for months to come. The consequence of Europe’s continued “muddling along” process will be continued heightened volatility. Europe’s solution will come in the form of both monetary and fiscal policies that support the concept of “one for all, all for one.” Only then will the eurozone begin to address the lack of competitiveness present in the majority of its nations, excluding Germany.

The late second quarter Euro Summit proposal to establish a single banking supervisor run by the European Central Bank (ECB) is a positive step. Direct capital injections into eurozone banks from the European Stability Mechanism would be constructive. A favorable consequence of the Summit’s resolutions is that it repositions the ECB back in the driver’s seat to steer EU nations through the crisis. During the second quarter, the governments of Greece, Germany, Spain, France, and Italy all wanted their crack at the wheel, however, each drove in a different direction.

Now that the ECB is back in control, I expect the adoption of further new quantitative easing measures. At the July ECB meeting, I expect at least a 25-basis point cut to the main refinancing rate. Another positive step would be to give Europe’s permanent bailout fund a bank license to tap the ECB, which would, in essence, certify a “buyer of last and unlimited resort.” The response to previous rounds of ECB bond buying has been uniformly successful; another round will likely present similar success.

Finally, continue to use Germany’s economic data as the indicator of whether the euro crisis will continue to slow the rate of appreciation for risk assets. Factory orders, imports, exports, and business confidence all weakened in the second quarter. A third quarter trough in the contraction of German economic data will be mandatory for the SPX to make a run at its April 2, 2012 four-year high.

Regarding China, the conversation continues to center on confirmation of a “hard” or “soft” landing. That debate is a fruitless exercise. China is in the midst of an economic slowdown. On July 12, second quarter GDP will be reported, and there is a risk that there will be a print below 8%. That would be the first sub-8% quarterly GDP since second quarter 2009. However, based on the collective evidence, China is not in the midst of a bursting bubble, also known as a hard landing.

The real China debate should be centered on when the trough in economic activity will occur. Will it be a third quarter, or maybe a fourth quarter, event? I expect, when the trough does occur, you will be able to pencil a contribution from Chinese economic growth firmly in the capital markets’ “tailwind” column.

Q3 PlaybookChina continued

Q3 PlaybookInvestment Opportunities

Q3 PlaybookCorporate Earnings

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During the second quarter, the value of the Chinese yuan currency began to weaken. It is no coincidence that on May 1, the yuan traded to a multi-year high at 6.2769 before reversing lower, as did the SPX. In May, the yuan declined 1.43%, contributing to its worst quarterly performance since 2005. May was a difficult month for multiple Asian currencies. The Indian rupee fell 6.01%, South Korea’s won declined 4.11%, and the Indonesian rupiah was down 3.07%. Capital outflows from Asia and China were evident. In the third quarter, investors should watch the yuan and other Asian currencies closely. Their direction will telegraph the performance of global capital markets.

The evidence continues to confirm further “secular rising consumption” in China. Less than 50% of China’s population is urbanized; consumer fuel usage is below 30%. The world’s second largest economy is in the midst of a well-orchestrated transition that will result in a much larger growth contribution from its own consumer than there is currently.

Chinese President Hu Jintao retires from the Communist Party at year-end and turns over the presidency in the first quarter of 2013. He appears hesitant to enact an aggressive growth strategy in his final days; however, if pushed by the markets, Chinese fiscal and monetary policy makers have the bazooka the U.S., Japan, and Europe so desire. A mini-2008 style stimulus plan ($200 billion USD) could be rolled out quickly. With oil prices declining sharply in the quarter and CPI running at 3.0%, down from last summer’s 6.5%, there is plenty of room for a third quarter interest rate cut and further reductions to the reserve ratio requirement (RRR). It’s just a matter of time before the world’s most efficient and powerful growth engine revs up again.

I concluded last quarter’s commentary with “My expectations for earnings are about the same as they are for Derek Jeter, the Yankees’ Hall of Fame world champion shortstop, now 38 years old. Sooner or later, there will be a slowdown – it’s inevitable.” Expectations for second quarter earnings in the SPX were for flat to potentially negative sales and earnings growth. Once again, corporate earnings, the ultimate tailwind for the markets since 2009, surprised to the upside with sales growth of 5.67% and earnings growth of 5.58%.

Here we are again, awaiting third quarter earnings and anticipating negative sales and earnings growth. Second quarter appreciation in the U.S. dollar will be a headwind for earnings, just as the negative European outlook will bring lower guidance. During the last week of June, Nike (NKE) reported that China futures orders were up only 2%, well below the estimate of at least 15%. Ford (F) warned in an 8-K filing that it may close an assembly plant in Europe if demand weakens further. Texas Instruments (TXN), Procter & Gamble (PG), FedEx (FDX), and Starbucks (SBUX) all lowered guidance at the end of June.

If the economic condition of the U.S. is priority number one for me, the upcoming earnings season is priority number two. P/E multiple expansion is what drives SPX appreciation. A worse-than-expected earnings season will hinder the ability for multiple expansion and raise the possibility the SPX trades toward the lower end of second quarter’s 1278.18 low. At the end of the second quarter, the SPX had earnings of $99 with a P/E of 13.75. Estimates for 2012 SPX earnings are $99 or slightly better, maybe $100 to $102, underscoring the importance of multiple expansion to appreciate the SPX in the second half above its 2012 high of 1422.38.

In late December 2011, Wall Street Journal contributor Greg Zuckerman reached out to me for my thoughts on 2012. I awoke on New Year’s Day to find an email link to his article, “Fasten Your Seatbelts, It’s Going to Be a Bumpy Year.” I was honored to be quoted among the likes of Citibank’s chief U.S. equity strategist Tobias Levkovich and Wells Capital’s Jim Paulsen. For those that read the article, my contribution highlight was “During the second half of the year I expect a historic reallocation trade out of safe-haven Treasuries into risk assets.”

In my second quarter commentary, I wrote that the “Treasury reallocation trade is now on hold.” Based on current evidence, it remains on hold for the third quarter. The impact for risk assets will be an absence of much-needed capital outflows from Treasuries. In fact “money flow,” or the absence thereof, is a major component of my third quarter Playbook strategy.

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Q3 PlaybookInvestment Opportunitiescontinued

Q3 PlaybookHealth & Happiness

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Expectations for a lack of “fresh capital” flowing into risky assets is a major obstacle to the appreciation of assets that have experienced underperformance in 2012. In theory, fundamental improvement in those assets could lift values, but new allocated capital is needed for appreciation. Therefore, I want investors to be attracted to assets that have an overall favorable trend for 2012.

In essence, simplistically thinking, “The Trend is Your Friend.”

1. Utilities will benefit from continued investor capital flows seeking yield. Additionally, my expectation that natural gas prices have bottomed will bolster the earnings potential for utilities.

2. German equities will continue to outperform their regional peers. The decline in the value of the euro currency will become a third quarter tailwind for German exports, in particular to China.

3. Taxable fixed income remains an overweight. High yield corporate bonds provided investors an excellent point of entry in May. For the third quarter, I expect the tailwinds of robust cash, low financing rates, and favorable lending to tighten spreads and neutralize concerns about May’s rise in default rates.

4. Allocations to the U.S. financial sector and its continually improving balance sheets should be made via the debt markets at the investment grade level. Also, within taxable fixed income, the trend is your friend for collateralized mortgage-backeds, mortgage-backed securities, and municipal bonds.

5. Investors seeking to allocate based on an improving U.S. housing market, earnings growth without investment banking exposure, and market share gains should do so through U.S. regional banks.

6. Investors seeking emerging markets exposure beyond the BRICs should look within the borders of Colombia, Chile, Taiwan, Mexico, and South Korea.

7. I downgraded energy on February 1, 2012 and have not upgraded it since. On the spot price of WTI and Brent crude, I offer my expectation that the downside is limited. The spread between WTI and Brent has narrowed significantly, from above $25 to below $15. However, storage conditions in the U.S. remain near capacity. Investors should consider allocations to oil refiners to take advantage of the spread.

8. The domestic surge in the production of shale oil and gas should encourage investments, not in the pricing of the commodity, but rather in the transporters of the commodity. Therefore allocations to master limited partnerships (MLPs) should be considered.

9. I do not foresee conditions that would postpone the late third quarter historical seasonal allocation to technology. The back-to-school season and an end-of-year balance sheet flush for IT enterprise spending is expected once again this year. A late third quarter announcement about the introduction of an Apple (AAPL) iPhone 5 will also contribute to technology outperformance.

10. I expect consumer discretionary to maintain its sector performance lead in the third quarter. In addition to the sector’s exposure to the resilient U.S. consumer and continued low financing costs, this quarter presents the back-to-school season. Investors should also expect the second quarter decline in oil prices to bolster earnings for domestic corporations.

Within this Playbook, I have acknowledged the political, regulatory, and growth obstacles investors continue to be challenged by. I also know of the character, strength, and determination that will not allow us to relent in finding investment opportunities that achieve profitability. Taking calculated risk is something that all of us have successfully executed in our personal and business lives. Therefore, we should not be deterred from doing so with our investments. The capital markets are as deep and liquid as ever. If perceived tailwinds quickly shift to headwinds, there is a workable environment in which to be tactical and quickly neutralize allocated risk.

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Q3 PlaybookHealth & Happinesscontinued

Before assuming the risks, I would like you to please formulate a plan, or at least review your current plan. Work with your team, and remember, whatever the strategy – simple works best.

In last quarter’s commentary, I stated, “Individual investors would be wise to follow the lead of good money managers who know that sometimes it’s best to do nothing instead of something during sideways-trading ranges. I’d be more inclined to ‘sit on my hands’ at such a time.” For the third quarter, let’s elaborate on that and add - if the evidence suggests we should assume more calculated risk, do so remembering I prefer assets “where the trend is your friend!”

I wish all of you an abundance of life’s two greatest assets – Health & Happiness!

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Closing Price 6/29/12 Q2 2012 YTD 2012

S&P 500 Index (SPX) 1,362.16 -3.29% 8.31%

Dow Industrials (INDU) 12,880.09 -2.51% 3.15%

NASDAQ 100 Index (NDX) 2,615.72 -5.06% 14.83%

Russell 2000® Index (RTY) 798.49 -3.83% 4.72%

Closing Price 6/29/12 Q2 2012 YTD 2012

U.S. Dollar Index 81.627 3.32% 1.81%

Euro/U.S. Dollar 1.2667 -5.07% -2.26%

Spot Price 6/29/12 Q2 2012 YTD 2012

WTI Oil $84.96 -17.53% -14.03%

Brent Crude Oil $97.80 -20.41% -8.92%

Gold $1,604.20 -3.90% 2.39%

Copper $349.65 -8.76% 1.57%

Natural Gas $2.824 32.83% -5.52%

6/29/12 3/30/12 12/30/11

U.S. 2-Year Treasury Rate 0.30% 0.33% 0.24%

U.S. 10-Year Treasury Rate 1.65% 2.21% 1.88%

CBOE SPX Volatility Index (VIX) 17.08 15.50 23.40

Closing Price 6/29/12 Q2 2012 YTD 2012

Consumer Discretionary (XLY) 43.78 -2.64% 12.80%

Technology (XLK) 28.73 -4.28% 13.71%

Financials (XLF) 14.64 -6.85% 13.61%

Health Care (XLV) 38.01 1.62% 10.78%

Consumer Staples (XLP) 34.77 2.71% 8.37%

Materials (XLB) 35.29 -4.09% 6.28%

Utilities (XLU) 36.99 6.45% 4.70%

Industrials (XLI) 35.67 -4.29% 6.52%

Energy (XLE) 66.37 -7.23% -3.32%

PERFORMANCE AS OF JUNE 29, 2012

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2011 7-12  © 2012 Virtus Investment Partners, Inc.

This commentary is the opinion of Joe Terranova. Virtus Investment Partners provides this communication as a matter of general information. The opinions stated herein are those of the author and not necessarily the opinions of Virtus, its affiliates, or its subadvisers. Portfolio managers at Virtus make investment decisions in accordance with specific client guidelines and restrictions. As a result, client accounts may differ in strategy and composition from the information presented herein. Any facts and statistics quoted are from sources believed to be reliable, but they may be incomplete or condensed and we do not guarantee their accuracy. This communication is not an offer or solicitation to purchase or sell any security, and it is not a research report. Individuals should consult with a qualified financial professional before making any investment decisions.

There is no guarantee that a diversified portfolio will outperform a non-diversified portfolio, or that diversification among different asset classes will reduce risk. Asset allocation does not guarantee a profit or protect against loss in declining markets.

For more information, visit Virtus.com

JOSEPH M. TERRANOVA, Chief Market Strategist, Virtus Investment Partners

Joe Terranova is Chief Market Strategist for Virtus Investment Partners and a member of its Investment Oversight Committee. Mr. Terranova is a regular contributor to CNBC, appearing as a full-time panelist on the highly-rated daytime program Fast Money and a frequent panelist on Fast Money Halftime Report. He is the author of the book “Buy High, Sell Higher,” published by Business Plus. He is also in demand as a keynote speaker for the investment industry, known for his insightful viewpoint.

Prior to joining Virtus in 2008, Mr. Terranova spent 18 years at MBF Clearing Corp., one of the largest firms on the New York Mercantile Exchange, where his work as Director of Trading was the subject of a June 2004 feature in Futures magazine. Earlier in his career, he held positions at Swiss Banking Corp. and JP Morgan Securities.

Mr. Terranova is perhaps best known for his risk management skills, honed while overseeing MBF’s trading operations during the calamitous U.S. markets of the first Gulf War, 1998 Asian Crisis, 9/11, and 2006 collapse of Amaranth Advisors. In 2003, he was one of the first Wall Street professionals to make an early call for higher energy, natural resources, and commodity prices. In 2008, he cautioned investors to move to the sidelines in commodities, and in 2009, encouraged them to ignore the global “embracement of pessimism” and overweight equities.

Mr. Terranova holds a bachelor’s degree in finance from the Peter J. Tobin College of Business at St. John’s University in New York.