Below please find HBK Sorce Financial LLC’s market commentary.  This commentary is not prepared by me directly but is rather a collaborative effort of my firm prepared by our Asset Management Unit and approved by our firm’s Investment Policy Committee.  I hope you find this information useful.

Domestic Equities – Continued Support for the Rally

The domestic equity markets surged higher in July, continuing the rally that began in early March. Through July 31, the S&P 500 index appreciated by nearly 50% from its intraday low on March 6. The index generated positive returns for five consecutive months after losing ground in January and February.

Markets sustained momentum largely due to support from stronger than expected earnings and improving economic data. In addition, bullish sentiment continued to rise, as evidenced by the lower VIX, improved credit spreads and various economic surveys that indicated improving conditions.

Smaller companies modestly outperformed larger companies during the month, but the year-to-date performance race is neck and neck. For the month, cyclical stocks outperformed defensive stocks, and commodities were up sharply due to increased hopes for a global recovery.

Results have not been close for growth and value stocks year-to-date. Growth dominated so far in 2009 primarily due to strength in the technology sector and low weighting in financials. The small cap value index (Russell 2000 Value) was the weakest year-to-date due to the index’s high exposure to financials, particularly underperforming regional banks and REITs.

On the economic front, second quarter GDP fell 1.0%, which was better than consensus. Housing starts and new home sales far exceeded estimates, indicating that the worst may have passed. The closely watched S&P/Case-Shiller Home Price Index rose in May, the first time in nearly three years. Continuing unemployment claims declined, which is another positive sign that the unemployment picture is improving.

Not all economic news was positive, however. Personal spending fell, demonstrating the reemergence of consumer frugality. Actual wages declined, although transfer payments from the government rose, providing personal income a small boost. And although continuing unemployment claims declined, the long-term unemployment picture remained murky. On August 2, Timothy Geithner said that the U.S. unemployment rate may not peak until the second half of 2010, possibly necessitating another extension in benefits.

Earnings season started off strong with reports from Alcoa, General Electric, Intel and Johnson & Johnson. Later in the month, better than expected results from closely watched financials Bank of America, Citigroup and JPMorgan Chase lifted domestic equity markets further. As of month-end, 79% of companies in the S&P 500 had reported (353 out of 500 companies). Of these, 72% reported at or above expectations. The upside surprises were widespread, with the energy sector as the lone exception. Financials, materials and consumer discretionary provided the largest positive surprises.

The big question remaining to be answered is whether earnings can continue to provide further fuel for this rally. Although many second quarter earnings reports looked good on the surface, the fine print often was worse than reported by the mainstream media. Of the 353 S&P 500 companies that had reported earnings as of month-end, twice as many reported falling earnings as reported rising earnings. In fact, the median company had a 28% decline in earnings. While this is not as bad as some had projected, it is hard to pound to the table in support of strong earnings growth in the near future.

Most economic evidence supports a slow recovery, with uncertainty around a myriad of factors assuring continued volatility. While the markets have traded as if there will be a V-shaped recovery, many unknowns and risks remain.

US consumers must start spending to support the recovery – the government alone cannot provide enough stimulus to keep the economy chugging along. As consumers continue to de-lever, the questions about where and when consumer spending will pick up will get louder and louder. The cost cutting flurry undertaken by companies will eventually end, and revenues may not be adequate to sustain earnings growth. The strongest companies with healthy balance sheets, experienced management teams and niche products stand to benefit the most over the next few years, given the likely difficult economic conditions to come.

Sources: Bloomberg.com; Deutsche Bank; James Investment Research, Inc.; JPMorgan Chase; Morgan Stanley Investment Management.

International Equities Regain Strength

International stocks rallied strongly in July, as the MSCI ACWI ex-US index rose 9.8%. A currency tailwind represented roughly one-fifth of the gains. Risk seeking behavior drove up foreign currencies and weakened the dollar. All countries in the MSCI ACWI index rose with the exception of Finland and Morocco. Emerging markets rose 11.3% in July, now up a whopping 51% YTD (yet still down over 15% in the past 12 months), compared to a rise of only 20.1% in the developed non-US equity markets and 12.3% in the US (Russell 1000). Frontier emerging markets were shunned by comparison, rising only 1.9% in July, as investors directed their interest and inflows toward stocks in the more liquid mainstream emerging markets.

Asian stocks continued to lead in July, up 12.3% (MSCI AC Asia ex-Japan index). Korea, Singapore and Indonesia all returned over 15%. Japan continued to be a laggard in Asia, returning only 4.3% as economic growth remained elusive and the LDP party disarray continued to make the news. On a positive note, in recently released Q2 data, several countries in Asia experienced an uptrend in GDP trends. Although the year-over-year growth was still negative, the quarter-over-quarter growth (Q2 over Q1) was sharply positive. Annualized growth was 20.4% in Singapore, 9.7% in S. Korea, and, per The Economist estimate, roughly 16% in China. In fact, due to its massive stimulus and investor sentiment, China’s local A-share market has now more than doubled YTD, and several of the ten largest global companies by market cap are (again) based in China. Chinese stocks are now flat on a trailing 12-month period, compared to global equity markets that are down 20% over that time.

Europe rose 10.5% in July (led by Spain and the Netherlands) and actually outpaced the BRIC countries, which returned “only” 9.5%. In terms of valuation, European stocks traded at a wide discount to stocks in both the US and Asia as of July 31. The MSCI Europe Index had a 15% forward P/E discount and a 30% P/B discount to the US. It has a 23% P/E and 21% P/B discount to the MSCI AC Asia ex-Japan Index. Overall, European stocks appear inexpensive, but an upturn in earnings growth and GDP growth will likely lag the US by several quarters. Further, investors are paying up for growth in Asian stocks, as risk-aversion has gone out the window.

Within Europe, Germany and France are expected to lead the upturn in 2010, with consensus earnings growth of 45% and 33%, respectively. The southern countries (Spain, Portugal, Italy and Greece) are expected to lag the most in the recovery, with growth below 20%. The UK may still experience a 20% earnings recovery in 2010, but note that the UK index is dominated by many large global multinationals (especially in energy) rather than locally oriented companies.

From a sector standpoint, consumer discretionary and materials led performance in July, both for US and non-US stocks. These two sectors are expected to lead an earnings recovery in Europe in 2010. In addition, investors have high expectations for a large earnings recovery in technology stocks, another highly cyclical sector. Over the past four weeks, the technology sector had the highest earnings revisions of all ten sectors for 2009 and 2010.

Financial stocks still represent the largest sector in non-US equity markets (over 20%), and trade below book value in both Europe and the US. By comparison, financials in Asia ex-Japan trade at over 1.5x book value. The question facing investors is whether financials in “The West” are undervalued or bound to become overregulated, low growth utility-like stocks. In emerging Asia, financial stocks are a favorite of many investment managers, as banks represent a direct play on growth of the middle income consumers. Many of the banks are well capitalized and have high growth rates from “plain vanilla” banking – deposits, credit cards, mortgages, and small business loans.

While global markets might be a bit overbought in the short-term, the Q2 earnings season is not over and momentum remains positive.

Sources: MSCI Barra, Bloomberg, JP Morgan, The Economist.

Fixed Income Continues to Shine

Economics: Improvement in the economy was evident throughout July. The housing market showed signs of bottoming while programs such as ‘cash-for-clunkers’ provided a temporary boost to the broader economy. Second quarter GDP numbers, which were released at the end of July, further enhanced the case of an improving economy. Real GDP fell at a 1.0% annualized rate, but revisions to prior years showed that the current recession was deeper than originally thought. A large portion of the decline was due to a $141 billion drop in business inventories which should set the economy up for a recovery in the second half of the year as businesses work to restock depleted inventory levels.

Tepid improvements were also seen in the housing market. Existing home sales increased for the third consecutive month, new home sales jumped at their fastest rate since 2000, and home prices, as measured by the S&P/Case-Shiller Home Price Index, improved for the first time since 2006 on a non seasonally-adjusted basis. The recession is gradually coming down from its crescendo and continued improvements in housing and the real economy were a welcome development.

Federal Reserve: The minutes from the June Federal Open Market Committee (FOMC) were released in mid-July, and the FOMC’s outlook is cautiously improving in tandem with broader economic optimism. The FOMC’s estimate for real GDP in 2009 is now decline of 1% to 1.5%, before expanding at a 2.1% to 3.3% pace in 2010. Inflation expectations are also subdued with core personal consumption expenditures (PCE) expected to rise 1.3% to 1.6% in 2009 before slowing to 1.0% to 1.5% in 2010. The fear that gripped the economy in the second half of 2008 is subsiding, but any recovery is likely to be modest.

The Fed’s balance sheet continued to evolve in the month of July. There was a rapid increase in the Fed’s balance sheet following the bankruptcy of Lehman Brothers and the ensuing credit crisis. This led the Fed to enter into numerous liquidity programs to effectively backstop many of the toxic and otherwise unfavorable assets in the financial system. Since the beginning of the year, the Fed’s balance sheet has progressively moved away from liquidity guarantees to outright asset purchases (specifically Agency debt, Agency Mortgage-Backed securities and Treasury securities). Approximately $1.75 trillion dollars is currently devoted to this program, with purchases expected to total $300 billion in Treasury securities, $200 billion in Agency debt and $1.25 trillion in Agency MBS. Through July 31, the Fed has purchased 76.4% of its capacity in Treasuries, 53.7% in Agency debt and 56.2% in Agency MBS. These programs are not expected to receive further funding but the Fed still has plenty of room to intervene in the markets.

Treasury Markets: New supply, and the expectations of future supply, drove Treasury yields higher for most of the month. As approximately $235 billion of new Treasury debt reached the market, the bid to cover ratios for most of the auctions fell below historic norms, suggesting investor demand for Treasuries abated to some degree. The resulting sell-off forced 10 year yields to near 3.75%. But, by the end of July, the tides turned as forecasts for 2010 Treasury issuance were pared back by 25%. This re-evaluation, in combination with favorable economic comments from Fed officials and “street” analysts, drove greater optimism. A sharp rally on the last two days of the month resulted in the term structure finishing relatively flat versus the end of June.

An $8 billion 10-year TIPs auction, completed on July 6, weighed briefly on 10-year TIPs, forcing real yields higher and dropping the implied inflation rate to just 1.5%. However, by month’s end, the market normalized with the breakeven rate ending flat month-over-month at approximately 1.8%.

Municipal Market: Just focusing on the headlines, one would think that July was a difficult month for municipal bonds. To recap, California and several other states did not pass budgets by the end of their June 30 fiscal year-end. The Rockefeller Institute reported that state revenues dropped by the largest amount in 47 years, reflecting skyrocketing state and local unemployment rates. Distress in two major metropolitan areas, Jefferson County, Alabama and Detroit, Michigan, made headlines as well.

In reality, investors were not swayed by the headlines. The municipal market was stable, quiet and performed in-line with historical norms for July. The Barclay’s Municipal 1-10 year index and the Barclays broad market index posted solid, above-coupon gains of 1.7%. This healthy performance was mostly the result of a favorable technical environment as investor flows into the market remained positive, while primary supply dropped. In fact, supply fell 40% compared to June and 36% versus July 2008. The drop in supply relative to last year is notable given the low yield environment. Perhaps this is an indication that municipalities are less willing to add to their current debt service requirements.

The municipal curve continued to steepen as investors, unenthused about cash at yields of 0.4%, cautiously invested further along the curve by investing in intermediate bonds. The net result was a month over month drop of 15-20 bps in yield for the 2-15 year portion of the curve. The 20-30 year area of the curve dropped just 8-10 bps. As a result, the curve steepened further; the incremental yield pickup between 2 and 15 years is nearly 3% – historically an advantage to investors.

Corporate Market: Investment Grade and High Yield corporate bonds showed some signs of taking a breather as the option-adjusted spread (OAS) for all ratings, except CCCs, held steady through mid-July. The rally reemerged, however, as a combination of better than expected earnings and optimistic economic forecasts sparked investor interest. Spreads for the Barclays High Yield and Investment Grade indices finished the month 140 basis points and 60 bps lower, respectively. This pushed the OAS for these indices to 803 bps and 243 bps, respectively.

The notable exception to the rally was CCC-rated bonds, which realized a 200 basis point retreat in spreads by mid-July, but rallied back to June levels by month-end. This brief sign of stress for CCC rated bonds is notable. Triple Cs will realize much of the stress inherent in the market as default rates continue to rise (10.1% as reported by Moody’s at the end of the second quarter) and recovery rates fall (down to 22 cents as reported by Fitch at the end of second quarter). New supply from high yield issuers remained strong as a total of $14.5 billion in new deals hit the market during the month.

Sources: Bloomberg; Barclays; Rockefeller Institute; Municipal Market Advisors; Moody’s; Fitch.

Strong Month for Alternatives

It was a strong month for alternative investments, with nearly all strategies ending July in positive territory thanks to continued tailwinds in the credit and equity markets. With the S&P 500 index up 7.6%, MSCI ACWI ex-US index up 9.8%, MSCI EM index up 11.3% and BarCap High Yield index up 6.1%, maintaining a directionally long position was really the only thing managers had to do to make money during July. That being the case, market directional strategies fared well, gaining 3.8% for the month. In the fixed income space, relative value strategies also performed strongly, adding 3.7%. Equity hedge managers, which generally remained cautious through the strong rally in the second quarter, posted relatively muted returns of 1.5% in July alongside event-driven strategies. Macro strategies were essentially flat during the month and continue to struggle for the year.

Convertible arbitrage strategies delivered the strongest returns once again, jumping 6.7% in July to bring year-to-date performance to 28.6%. The BarCap US Convertible index posted a return of 6.9% in July, the second highest since the index was launched in January 2003. Year-to-date, the BarCap Convertible index returned 30%, second only to the high yield index, which was up over 38%. Speculative grade convertibles led returns, gaining nearly 10% in the month, versus the 5.3% gain in investment grade convertibles.

As discussed in the past, the HFRX indices, which are designed to be investable, offer full transparency and daily pricing. These indices are used in the Fortigent Flash Report in order to provide investors with an early month approximation of hedge fund performance in lieu of the HFRI indices. Given liquidity and pricing constraints, many of the HFRI index managers are unable to provide return figures until several weeks following month-end. Why is this important? In certain strategies, such as distressed, there has been a substantial divergence between the HFRI and HFRX index performance. The HFRX Distressed index is down nearly 10% year-to-date, while the HFRI Distressed index was up nearly 10% through June. The reason is that given the need for underlying index managers to be investable, fully transparent, and priced daily, only one manager is included in the HFRX Distressed index. While this is an extreme case, several of the HFRX indices are fairly concentrated, so this fact should be considered when evaluating manager performance versus the appropriate HFRX benchmark.

Despite record hedge fund losses and massive investor redemptions in 2008, many managers are firmly sticking to the “2 and 20” fee structure, according to Bloomberg. While many investors have argued that recent performance does not merit such performance fees, the decrease in assets combined with the recent uptick in performance has made many managers uninterested in amending fee structures, at least for the time being. Given the increase in liquid hedge fund-like strategies offered via mutual funds as well as the

strong performance of credit-oriented mutual funds in general, one wonders how long investors will tolerate such high fees for access to blue chip hedge fund vehicles going forward.

In other news, the SEC announced on July 27 that the temporary rule imposed last fall seeking to reduce the potential for abusive “naked” short selling is now permanent. The temporary rule was originally set to expire on July 31. The new Rule 204 requires broker-dealers to promptly purchase or borrow securities to deliver on a short sale. In addition, the SEC is working in conjunction with several self-regulatory organizations to make short sale volume and transaction data available through the SRO websites in order to increase transparency, an action that could result in a substantial increase in the amount of information presently required. At this point, it is unclear as to how this will ultimately affect long/short equity managers, most of which claim to never knowingly naked short. Public disclosure of short transactions, though, could certainly decrease the effectiveness of strategies that rely on the confidentiality of short positions in order to gain access to company management. There will be more to come regarding this topic as it is discussed with managers in the coming months.

Sources: Eurekahedge; HFRX; FactSet; Bloomberg.

This report is for illustrative purposes only. Past performance is not indicative of future results. The information contained in this report has been gathered from sources we believe to be reliable, but we do not guarantee the accuracy or completeness of such information, and we assume no liability for damages resulting from or arising out of the use of such information. The performance numbers displayed herein may have been adversely or favorably impacted by events and economic conditions that will not prevail in the future. The indices discussed are unmanaged and do not incur management fees, transaction costs or other expenses associated with investable products. It is not possible to directly invest in an index.

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