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Weekly Market Commentary of December 1st 2008

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Demystifying The Deflation Dilemma

Last week’s powerful 12% rally in the S&P 500 reminds us that market volatility is not only to the downside. Stocks posted the strongest weekly gain since October of 1974. A combination of catalysts sparked the rally, including greater clarity on the President-elect’s key economic team appointments, the Federal Reserve intervention at Citigroup, and the drop in 30-year mortgage rates to 5.76%, the lowest level since the crisis erupted in mid-September. Key economic data this week on employment and manufacturing are likely to contribute to the volatility.

Inflation as measured by the U.S. Consumer Price Index (CPI) posted a record-breaking one month decline in October. While the main driver of this market impacting economic indicator was energy prices, energy prices are not the only ones that have fallen. The CPI’s core rate, which excludes volatile products such as food and energy, weighed in at -0.1%, the first negative reading in more than 25 years. Contributing to lower prices are moves by the world’s largest retailer to reduce prices on holiday merchandise and efforts by China to prop up exports, even in the face of waning demand.

While high rates of inflation are clearly bad for the economy and investors, deflation, a general decline in the prices of goods and services, can lead to problems as well. When consumers expect ongoing price declines, they tend to hoard their money and defer spending, feeling they will be able to buy at a lower price if they wait a bit. That reduction in demand can result in increasing layoffs and lower consumer confidence—further weighing on spending. The most recent example is Japan’s suffering eight years of deflation beginning in 1999. The classic example is the Great Depression. Both of these periods were negative for the economy and markets, but not all periods of deflation have had negative consequences.

A mild case of deflation following a period of above average inflation may be welcomed by market participants. The United States experienced mild bouts of deflation in the 1920s and 1950s. During these periods, stocks rose at an above average pace.

The pace of inflation has been falling recently. Prices for the past 12 months have risen by 3.7%, down from the recent peak of 5.6% in July. Surveys of consumers do not reflect expectations for a general trend of falling prices. We expect a mild period of deflation in 2009 with the return of inflation as we approach 2010—a result of the global policy response to the financial crisis and recession. During periods of disinflation (a falling pace of inflation) and mild deflation, early cyclical sectors such as Consumer Discretionary and Industrials tend to outperform. During periods of rising inflation, late cyclicals such as Energy and Materials tend to perform the best. A mild case of deflation in 2009 is unlikely to have devastating effects on the market or economy and instead may represent a re-setting of the inflation pressures that have acted as a drag on the economy for much of this decade.

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IMPORTANT DISCLOSURES Investing in international and emerging markets may entail additional risks such as currency fl uctuation and political instability. Investing in small-cap stocks includes specifi c risks such as greater volatility and potentially less liquidity.

Stock investing involves risk including loss of principal Past performance is not a guarantee of future results.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rate rise and are subject to availability and change in price.

The opinions voiced in this material are for general information only and are not intended to provide specifi c advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your fi nancial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.

© LPL Financial

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