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Economic Update for May 2012

The stock market decline I've been warning of seems to have arrived as the recent weeks declines have all but erased gains for the past 12 months. It is the behavior of the markets that shows why a lower volatility portfolio can be better in this type of environment; while the markets rise, a more conservative portfolio may forego some gains however when the market comes down the more conservative portfolio loses less. In essence if you can arrive at the same point (have the same performance) over a given period with less volatility (smoother returns) your risk adjusted returns are higher. Also less volatility means less potential for emotional errors from panicking as well as capturing higher interest from having more bond exposure. Long-term bond exposure presents greater risks over time if we see rising interest rates which is a topic for future discussion. For now, the lower volatility portfolios seem to be performing as expected given the environment. This recent correction may be minor or something more significant; only time will tell. Meanwhile as The Fed's Operation Twist ends on June 30th, we should expect to see further market declines.

The recent turmoil in Europe seems to be the cause so we'll have to keep an eye on developments abroad. The new French President Hollande has spoken out against Austerity, as have leaders of Greece and Spain. The markets may finally be realizing that there is no easy solution to fix the Euro crisis and that we are likely to see minimal growth in the US for the foreseeable future. A big risk is that the European slowdown causes decreased US exports and increased caution among US consumer thus slowing down our economy. Spain is a critical country to watch in the coming months as their problems seem to be accelerating and the possibility of default increases.

On the real estate front, banks seem to be increasing foreclosures yet the sale of foreclosed properties has not increased. The shadow inventory of real estate then grows and we have to consider what will happen when the banks finally start to sell these foreclosed homes. One option may be to convert the homes into rentals however it seems unlikely that major banks will want to get into the business of property management. Once the banks start relating these properties to the market, we should expect sharp declines. While pending home sales have surged (more inventory released to the market), prices continue to edge down although in recent days there have been reports of modest gains. Until we see a sustained positive trend, I think prices will bounce around this current low level or decline further should rates begin to rise.

First quarter GDP came in at 2.2% and consumer spending was a bit stronger than expected. The Weekly Leading Index published by ECRI (Economic Cycles Research Institute) was improving and just went slightly positive until recently where it has turned back to the 0 level which means neither growth nor contraction. It seems that the effects of QE2 stimulus which are wearing off already had less impact that QE1 which makes the case that even if we do see a QE3, the effects of further stimulus will be even less. If Europe is any guide, the recent efforts of their LTRO (stimulus) program have had minimal effects. This is what I've been warning of which is that eventually the stimulus wears off and additional stimulus has less and less effect just like that 4th or 5th cup of coffee late in the day. Interestingly, one of the goals of the stimulus was to weaken the US Dollar however since other countries around the world have been attempting the same and fear drives investors to the US Dollar, the result is a strengthening US Dollar.

Several technical indicators such as the Smart Money Indicator which has shown a double top in bearish sentiment in recent months similar to the major tops the occurred in October 2007. There has been a major divergence in selling pressure and buying demand that suggests we topped this past April along with a major divergence between Dow Transports and Dow Industrials; there have been no major divergences in the advance/decline line in recent months however. Given the recent turmoil in Europe despite the massive LTRO stimulus along with the above mentioned technical indicators suggests that the market may have put in a major top in April and we may see more significant declines ahead.

I continue to maintain that a conservative investment approach is the safe approach for now given the recent developments. Call me if you have any questions or to discuss strategies to protect your portfolio.

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