Dear Member,

Last week, I said that Wall Street’s focus will be on the economy in the weeks to come. On cue, the economic data stunk badly enough to draw everyone’s attention. Second-quarter GDP growth was modest, and estimated first-quarter growth was revised down to a fraction of a percentage point. The ISM chimed in with a manufacturing survey that suggested that the third quarter is not off to a good start and that the short-term future may not be any better.

Republicans and Democrats agreed to budget cuts and a promise to pursue more deficit reduction actions in exchange for raising the debt ceiling. As you know, the legislation is universally disliked. What it does do, however, is make it harder for Congress and the president to do something about the economy. Additional tax cuts or spending will need to be offset in some manner, especially with the credit rating agencies breathing down Uncle Sam’s neck.

Legislation often has unintended consequences. The debt ceiling law has the potential to throw a wrench in to the presidential cycle for stocks. The third year of a presidential term has historically been good for investors, with the Dow Jones industrial average appreciating every time since 1939. Jeff Hirsch, author of “The Stock Trader’s Almanac,” says that this is because presidents seek to make voters happy ahead of forthcoming elections.

Often, presidents have pushed for some type of economic stimulus. Jeff told me yesterday that the markets have also historically reacted to a cooperative environment in Washington that puts the U.S. in a good place. This has included actions involving both domestic and foreign issues.

Given the conflicting personalities and ideologies in Washington, cooperation among politicians remains in short supply. At the same time, President Obama now has to balance potential future economic initiatives with long-term debt reduction desires. Any proposal, whether it involves spending (e.g., job training, infrastructure, extended unemployment benefits) or tax cuts and expenditures (e.g., extending the 2% payroll tax cut, allowing corporations to repatriate foreign profits) will impact the trajectory of our government’s debt.

This is not to say that the 72-year streak of positive third-year presidential term gains for the Dow will be broken. The economy could recover from its recent slump and/or President Obama and congressional Republicans could find more middle ground. There is also the potential for positive developments in Europe, Japan and the Middle East. (I know some of these are long shots.) Plus, valuations for large-cap stocks are cheap relative to projected earnings.

If part of your investing strategy this year is based on the presidential cycle, you need to acknowledge that things are not going as planned. Streaks last until they don’t. Similarly, if your investing strategy is based on an economic recovery, you will need to acknowledge that growth has slowed. None of this is to say that you should get out of stocks, but rather that you should factor in higher downside risks. Pay attention to valuations and to business trends. Be wary of those companies that are losing market share, as opposed to simply experiencing slower growth because of the economy.

As far as the impact of the debt ceiling legislation on your portfolio, monitor companies that are dependent on government spending. (If you are unsure about the percentage of revenues that come from the federal and state governments, read through the company’s annual 10-K filing with the Securities and Exchange Commission.) Though the cuts will only have a small short-term impact, they could reduce earnings for 2012 and beyond. Be on the watch for downward revisions to earnings estimates.

Do you pay attention to the presidential cycle, or any other calendar-based trends, for stocks? If so, tell us on the AAII.com Discussion Boards.

August AAII Journal Now Online

The August AAII Journal has been posted to AAII.com. (Print copies will be in the mail soon.)

This month’s feature is our 2011 Guide to Exchange-Traded Funds. We expanded this year’s print guide to cover more than 400 funds to accommodate the rapid growth in ETFs. We also expanded our online coverage with information on nearly 1,300 ETFs.

Other articles in this month’s issue include:

• Active Funds and Other Changes in the ETF Industry, an interview with Tom Lydon of ETF Trends
• Model Mutual Fund and ETF Portfolios: Combined Update, Different Strategies by AAII Chairman James Cloonan

The Week Ahead

Approximately 20 S&P 500 companies will report earnings next week as earnings season begins to wind down. Two Dow components are included in this group, Walt Disney (DIS) on Tuesday and Cisco Systems (CSCO) on Wednesday.

The week’s first economic report will be second-quarter productivity, which will be published on Tuesday. Wednesday will feature June wholesale trade data. June international trade numbers will be published on Thursday. Friday will feature July retail sales, the preliminary University of Michigan consumer confidence survey, and June business inventories.

The Federal Open Market Committee will hold a one-day meeting on Tuesday. No Federal Reserve officials are currently scheduled to make public appearances next week.

The Treasury Department will auction $32 billion of three-year notes on Tuesday, $24 billion of 10-year notes on Wednesday and $16 billion of 30-year bonds on Thursday. These will be the first Treasury auctions since the debt ceiling was raised.

AAII Sentiment Survey

Bullish sentiment plunged 10.7 percentage points in the latest AAII Sentiment Survey. The proportion of individual investors who expect stock prices to rise over the next six months fell to 27.2%, an eight-week low. The historical average is 39%.

Neutral sentiment, expectations that stock prices will stay essentially flat over the next six months, dropped 7.8 percentage points to 23.0%. This is the lowest neutral sentiment has been since February 3, 2011. The historical average is 31%.

Bearish sentiment, expectations that stock prices will fall over the next six months, surged 18.4 percentage points to 49.9%. This is the highest level of pessimism since May 27, 2010, and the biggest weekly percentage point increase since July 20, 2006. It is also the 21st time in the 24 weeks that bearish sentiment has been above its historical average of 30%.

There was a large amount of headline risk throughout the survey period. Events contributing to the negative sentiment included the debt ceiling debate, weak economic data such as second-quarter GDP and the July ISM manufacturing survey, and a eight-day losing streak for the Dow Jones industrial average. Many individual investors already had concerns about the pace of economic growth, so it is not surprising to see their nerves rattled by the negative headlines.

At current levels, bearish sentiment is unusually high, but not extraordinarily so. Two standard deviations above the historical average is 50.7%, and levels above that mark are outliers.

This week’s special question asked AAII members what impact, if any, the debt ceiling debate has had on U.S. economic growth. The majority of respondents said that the debate had a negative impact, though many thought it had little or no impact. There was a large variance in the comments, with many expressing frustration at politicians and the political process. Some thought the debate and the lack of a long-term solution has created uncertainty. It should be noted that many AAII members had expressed concerns about the size of the federal deficit before the recent debt ceiling debate occurred.

Here is a sampling of the responses, some of which were given before the debt ceiling debate was resolved:

• “I expect a negative impact because the debt ceiling increase is now and the meager cuts are a future promise at best.”
• “I think the uncertainty of the outcome of the debate (over not only the debt ceiling, but future tax policy, healthcare and federal regulations) has caused businesses—big and small—to move cautiously.”
• “It was another hurdle for an already frail market to overcome. In the short and perhaps long term, it did considerable damage to our economy.”
• “A negative impact. Congress is just delaying problems rather than dealing with them.”
• “Very little impact. It’s market noise and doing nothing more than adding to the short-term volatility.”

Are you bullish, bearish or neutral? Take the AAII Sentiment Survey and tell us.

AAII Asset Allocation Survey

Stock and stock fund allocations rebounded to a three-month high in the July AAII Asset Allocation Survey. AAII members allocated 62.4% of their portfolios to stocks and stock funds last month, an increase of 2.9 percentage points from June. This was the ninth time in the past 10 months that equity allocations have been at or above their historical average of 60%.

Bond and bond fund allocations declined 0.7 percentage points to 18.3%. This was the lowest allocation to fixed-income securities and funds since February 2011. Even with the decline, July marked the 26th consecutive month that bond and bond fund allocations have been above their historical average of 15%.

Cash allocations fell 2.1 percentage points to 19.3%. This was the 20th time in the past 22 months that cash allocations have been below their historical average of 25%.

Low yields remain problematic for many individual investors, particularly those investing in bonds or holding cash. At the same time, uncertainty about the economy kept stock and stock fund allocations from rising significantly at the expense of bonds and bond funds. Stock and stock fund allocations did receive some benefit from improved optimism about the short-term direction of stock prices, however, with individual investors being more bullish in July than they were in June according to our weekly Sentiment Survey.

July’s special question asked AAII members what categories of bond and bond funds they are investing in. In order of popularity, respondents said they owned high-quality corporate, high-yield, international (including emerging market), Treasury (including TIPS) and municipal bonds and bond funds. A small proportion of individual investors said they held diversified bond funds or did not have any exposure to bonds.

Take the survey http://www.aaii.com/assetallocationsurvey

Wishing you prosperity,

Charles Rotblut, CFA
AAII Journal Editor

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