J.P. Morgan CIO Michael Cembalest market commentary on portfolio strategy and economic outlook

helped cushion portfolio returns when markets declined. We won’t know until the data comes in, but we expect the same to happen this time. [5] The “Eye on the Market” has endlessly chronicled this year the fissures which are now affecting financial markets: European sovereign risk and inadequate bank capitalization; weak labor compensation as an Achilles heel of the US profits recovery, given its negative impact on spending; the political divide in Congress over how to deal with falling government revenue and rising entitlement spending; inflation risks in Asia and Latin America and the resulting need for more policy tightening; and the mixed track record of low interest rates to sustainability solve structural problems. The cover of the 2011 Outlook (a printing press, out of control) expressed our concern regarding a recovery built upon a stimulus machine. I would contrast this with the cover of a competitor’s 2011 publication, which had a picture of George Washington crossing the Delaware, with the caption “America’s structural resilience, fortitude and ingenuity will carry the economy and financial markets in 2011 —- and beyond”. Our job is not to point to where we would like the financial markets to go, but rather to point to where they might end up. It’s like the scene in Oliver Stone’s Nixon, when Nixon looks up at a portrait of JFK and says, “When they look at you, they see what they want to be. When they look at me, they see what they are.” Our job is to see financial markets for what they are. [6] All that said, we have lessons to learn here. Too many of our investment discussions this year focused on the negative real return characteristics of cash, and why to reduce it. In a world of deflation risk on financial assets (rather than of goods and services), cash retains substantial option value at times like these. We could have connected the dots more aggressively on our views on weak growth and easy monetary policy, and owned more gold. While we have had rising price forecasts for gold and owned it in portfolios, we did not have large enough allocations. Given the all-time high of US government transfers to households and negative real interest rates, we should not have interpreted positive economic data earlier this year as being highly representative of the true run-rate of the US economy. The same goes for the global economy, which has been the beneficiary of a lot of stimulus that is now fading, for a variety of economic and political reasons. Great corporate profits are no guarantee against a problem in financial markets. Corporate profits and P/E multiples were fine in June 2007, but rested on top of a systemic problem in private sector credit markets and private sector balance sheets. This year, strong corporate profits and low P/E multiples sit on top of systemic problems in public sector finances. [7] In the wreckage, as usual, there are opportunities, and we will be reviewing them with you in the days ahead. There is a benefit to having held back on our firepower this year. With risk to spend held in reserve, there are oversold assets with considering, particularly among multinationals with strong balance sheets, high dividends and which trade at very low multiples, something we reviewed earlier in the week.” Michael Cembalest Chief Investment Officer The material contained herein is intended as a general market commentary. Opinions expressed herein are those of Michael Cembalest and may differ from those of other J.P. Morgan employees and affiliates. This information in no way constitutes J.P. Morgan research and should not be treated as such. Further, the views expressed herein may differ from that contained in J.P. Morgan research reports. 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