Weekly Update

For the first time in several weeks there was a whiff of turbulence in the air in January.  First the first time since last summer, volatility crept back into the markets, although only slightly.  We expected this could happen as the sort of effortless advance that we have seen in over the past few months typically gives way to a more difficult market environment moving forward - lots of up and downs with limited direction.  What usually happens is we now enter a cross-roads or a turning point for how best to approach the markets and tactically allocate.  Changes of market leadership rarely take place outside of a corrective phase or decline.  A period of weeks in which US markets, as well as international markets were volatile but where downside was limited to 5 to 10%, combined with sharper losses in a number of certain overvalued asset classes, would likely go a long way to encouraging investors to reconsider their current bullish stance and become more defensive.  This type of action is healthy and normal in the context of capital markets - straight up moves, or down moves for that matter, are not.

It is still far from clear whether or not this process has begun in earnest, but as the monetary tightening continues to be heard across emerging market economies, we believe this will eventually impact the US markets.  Just a few weeks ago, there was an increase in interest rates in Brazil, which raised its domestic interest rates by 1/2% to 11.25%, while signaling that further hikes are forthcoming.  Contrary to the US markets, most emerging market countries like Brazil, China, and India have seen their respective markets decline significantly over the past three months due to rising inflation as well as economic growth concerns.  Also, social unrest in several countries like Egypt and Tunisia are adding pressure in overseas markets.

Back here in the United States, with plenty of positive economic data as well as good news coming from US companies in the past month, we believe that while markets could be volatile, there should be a strong level of support below current prices, unless fundamental data changes.  Unlike last April/May, not only earnings have been better than consensus estimates, guidance has also been fairly upbeat as opposed to last summer when most corporate management were still looking over their shoulders fearing a relapse of conditions back to the dark days of 2008.

While there are likely going to be surprises this year (there usually always are), which could derail the markets in the short-term, unless the fundamental data or economic conditions change significantly, the Federal Reserve juiced capital markets should continue to perform well.

Risk versus Reward

This continues to be and will always remain the $64,000 question when it comes to investing as there are plausible arguments for both the bulls and the bears, especially in the current environment. The bears will argue that geopolitical risks in Europe still exist, inflation is starting to accelerate, and bullish sentiment is running high. Bulls will counter that there are more skeptics about the markets and economy, the economy is finally gaining traction, and earnings will likely continue to improve over the year.

The hard part is deciphering which opinion is correct as we can see validity in both arguments. Thus the current market environment creates a double edged sword.

So how does one play this market, given the confusing but equally valid messages being sent by the market? We suggest a more cautious approach as we do believe eventually there is going to be a decrease in price momentum and markets will enter a corrective phase. It is important to be extremely selective and wait for opportunities to arise.

Bottom line is there are always varying degrees of risks and rewards. Sometimes but very rarely the decision is easy. However, most of the time, such as the present, it's not as clear. Right now we believe there is a higher level of risk.

Investing in the "new normal" of markets and government backed economies requires a great deal of patience - knowing when to pounce an an opportunity and when to conserve energy and wait. The time to pounce is when the likelihood of reward is the greatest and stacked in your favor.

However as we all know things change very rapidly in our technology driven society and information moves at the speed of light. It is important to keep an eye on the data (both positive and negative) looking for clues that will help tip the risk/reward scale to favor more reward and less risk.

Sentiment Data Suggests Caution?

The most recent sentiment data from our friend Jason Goepfert at SentimenTrader.com shows that the retail investor is most confident in a market rally while the smart money or institutional investor is least confident.  While markets can continue to move higher, it is typically times like now when the risk/reward setup is least favorable for investors, at least as it relates to past market history.  However, what is really interesting is that the S&P 500 Index is on its longing winning streak without a signficiant pullback (to its 50-day average price) in the 82 year history of the index - over 93 days and counting.

Risk level:  HIGH

The Smart Money is 38% confident in a rally.

The Dumb Money is 75% confident in a rally.

WEF's Global Risks Report

Just recently, the World Economic Forum published its Global Risks Report for 2011.  The World Economic forum is an independent international organization committed to improving the state of the world by engaging business, political, academic and other leaders of society to shape global, regional and industry agendas.

Sometimes it is helpful to obtain information regarding the global economy from people outside of the U.S., who tend to view the world and global economics in a much different way.

The link to the report is below - click on "download PDF" to view the report.

www.weforum.org/reports/global-risks-report-2011

Employment Numbers Still Low

The best news was the decline in the unemployment rate to 9.4% from 9.8% in November. However this was partially because the participation rate declined to 64.3% - a new cycle low, and the lowest level since the early '80s (Note: This is the percentage of the working age population in the labor force).

The 103,000 payroll jobs added was below expectations of 150,000 jobs, however payroll for November was revised up 70,000 and the October payroll was revised up 38,000, both good trends.

The increase in the long term unemployed is an ongoing concern. The average workweek was steady at 34.3 hours, and average hourly earnings ticked up 3 cents.

The following graph shows the employment population ratio, the participation rate, and the unemployment rate.
Click on graph for larger image.

The unemployment rate decreased to 9.4% (red line).

The Labor Force Participation Rate declined to 64.3% in December (blue line). This is the lowest level since the early '80s. (This is the percentage of the working age population in the labor force. The participation rate is well below the 66% to 67% rate that was normal over the last 20 years.)

The Employment-Population ratio increased to 58.3% in December (black line).

Hopefully, the employment pictures begins to improve as we progress through the year.  Employment growth of 250,000 to 300,000 will be needed to really begin to bring the unemployment rate down.