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"Education is the movement from darkness to light."
-Allan Bloom
 
Early on in the Obama administration's first 100 days we were clear that the administration needed to "shake hands" with The Client - the Chinese.  Shortly after we said that, on January 22 in a statement to a Senate panel U.S. Treasury Secretary Timothy Geithner said that Obama "believes that China is manipulating its currency."  Yesterday, Mr. Geithner said "while the yuan remains undervalued, no country has met the standards for illegal currency manipulation. "  On the job education is a beautiful thing - moving from darkness to seeing the light on China.
 
The New Reality is that the Chinese need us, and we need them.  
 
We also learned recently that despite their rhetoric, the US Treasuries are still a critical element of China's investment strategy for its foreign-currency reserves and that is not going to change.  The Chinese also need the US to help dive their export driven economy.    Overnight China reported its slowest GDP growth in 10 years; GDP expanded 6.1% in Q1 after 6.8% last quarter.  This was below the 6.2% median estimate...
 
Yes, China is The Client, but we are all in this together!
 
Yesterday, the S&P 500 rallied another +1.2%, and now has rallied +26% from the March 9th low.  There are two sectors with a positive return on a year-to-date basis, Materials (XLB) and Technology (XLK).  Prior to yesterday's move, Consumer Discretionary (XLY) was positive, but is now only down 0.3% on the year. Great Depression?
 
What's driving the move in Technology? Earnings.  As it turns out, relative to every other sector, operating EPS estimates for the XLK have only declined by an incremental 2% to a 24% decline since March 9th- the best performance in the S&P 500. Surprisingly, Consumer discretionary operating EPS estimates have only declined by an incremental 4% to a 14% decline since March 9th - the 4th best performance of the S&P sectors.
 
The Materials (XLB) turned in the second biggest decline at an incremental 10% to a 28% decline in operating EPS estimates.  Helping to REFLATE the XLB is the decline in the US Dollar and Basic Materials is what China needs.   Things are bad, operating earnings are lower this year, but things do not appear to be falling off a cliff.
   
What we are seeing for most consumer centric companies is that there is tremendous flexibility in the middle of the P&L, thanks to slower growth and lower commodity prices.  Yes, demand is lower across the board, but there is flexibility to manage the P&L in a lower demand environment; a theme that should continue to play out this earnings season.     
 
Yesterday, the market was also influenced by the Federal Reserve comments that there are some "faint signs the steep plunge in economic activity that began last fall is starting to level off." Yes, that is true, but we are constantly reminded that it will not be a straight line to economic bliss from here.    
 
The captains of industry that are currently speaking out on Q1 performance are telling us "There's still a lot of stress" or "We're now seeing for the first time the real impact of the economic downturn on healthcare."
 
Also, the last two data points we received on housing are marginally negative, but that has not stopped the home builders from rallying.  The Mortgage Bankers Association reported that its application index fell last week for the first time in over a month.  More importantly, the nation's largest mortgage companies are stepping up foreclosures on delinquent homeowners.  The resulting increase in the supply of foreclosed homes could further depress home prices.  This poses the biggest risk to our housing call that prices will bottom in 2Q.
 
Despite all the potentially bad news, the market does not seem to want to go lower.  As we sit here today, on down days we won't see a major break down unless the S&P 500 closes below 821 and the US Dollar starts to appreciate - a sign the S&P 500 will DEFLATE again.
 
The story that caught my eye on Bloomberg this morning is one on Billy Ackman.  I'll be the first to admit when I make a make mistake and will try to learn from it and be a better person.  Bloomberg reported that Ackman sent a letter to clients telling them he lost 90% of the $2 billion fund set up to invest solely in Target - he remained confident that his bet on the retailer would pay off and asked investors to double down and there was no apology for the colossal miss??
 
The amazing part is the math - Ackman's Target fund needs to produce a 900% return from here just for the original investors to break even!  Billy is still in the dark and can't see the light on this one.
 
Function in disaster; finish in style,
Howard Penney
Managing Director
 

LONG ETFS

EWZ - iShares Brazil- The Bovespa is up 20.1% YTD and continues to look positive on a TREND basis. President Lula da Silva is the most economically effective of the populist Latin American leaders; on his watch policy makers have kept inflation at bay with a high rate policy and serviced debt -leading to an investment grade credit rating. Brazil has managed its interest rate to promote stimulus. The Central Bank cut 150bps to 11.25% on 3/11 and likely will cut another 100bps when it next meets on April 29th. Brazil is a major producer of commodities. We believe the country's profile matches up well with our re-flation theme: as the USD breaks down global equities and commodity prices will inflate.

XLY - SPDR Consumer Discretionary-TRADE and  TREND remain bullish for XLY.  The US economy is showing faint signs the steep plunge in economic activity that began last fall is starting to level off and things are better that toxic.  We've been saying since early January that housing will bottom in 2Q09 and that "free money" for the financial system will marginally improve the US economy in 2H09, allowing early cycle stocks to outperform.  The XLY is a great way to play the early cycle thesis.

EWA - iShares Australia-EWA has a nice dividend yield of 7.54% on the trailing 12-months.  With interest rates at 3.00% (further room to stimulate) and a $26.5BN stimulus package in place, plus a commodity based economy with proximity to China's H1 reacceleration, there are a lot of ways to win being long Australia.

XLK - SPDR Technology - Technology looks positive on a TRADE and TREND basis. Fundamentally, the sector has shown signs of stabilization over the last six+ weeks.   As the world demand environment becomes more predictable, M&A should pick up given cash rich balance sheets in this sector (despite recent doubts about an IBM/JAVA deal being done).  The other big near-term factors to watch will be 1Q09 earnings - which is typically the toughest for tech, along with 2Q09 guide.  There are also preliminary signs that technology spending could be an early beneficiary of the stimulus plan.

TIP - iShares TIPS- The iShares etf, TIP, which is 90% invested in the inflation protected sector of the US Treasury Market currently offers a compelling yield on TTM basis of 5.89%.  We believe that future inflation expectations are currently mispriced and that TIPS are a compelling way to own yield on an inflation protected basis, especially in the context of our re-flation thesis.

XLB - SPDR Materials -It's a bull on both a TREND and TRADE duration. The Materials sector is, obviously, a key beneficiary of our re-flation thesis.  Domestically, materials equities should also benefit as the stimulus plan begins to move into action.

USO - Oil Fund-We bought oil on 3/25 for a TRADE and are positive on the commodity from a TREND perspective. With the uptick of volatility in the contango, we're buying the curve with USO rather than the front month contract.  

EWC - iShares Canada-We bought Canada on 3/20 into the selloff. We want to own what THE client (China) needs, namely commodities, as China builds out its infrastructure. Canada will benefit from commodity reflation, especially as the USD breaks down. We're net positive Harper's leadership, which diverges from Canada's large government recent history, and believe next year's Olympics in resource rich Vancouver should provide a positive catalyst for investors to get long the country.   

DJP - iPath Dow Jones-AIG Commodity -With the USD breaking down we want to be long commodity re-flation. DJP broadens our asset class allocation beyond oil and gold. 

GLD - SPDR Gold-We bought more gold on 4/02. We believe gold will re-assert its bullish TREND as the yellow metal continues to be a hedge against future inflation expectations.

DVY - Dow Jones Select Dividend -We like DVY's high dividend yield of 5.85%.


SHORT ETFS

LQD  - iShares Corporate Bonds- Corporate bonds have had a huge move off their 2008 lows and we expect with the eventual rising of interest rates in the back half of 2009 that bonds will give some of that move back. Moody's estimates US corporate bond default rates to climb to 15.1% in 2009, up from a previous 2009 estimate of 10.4%.

SHY - iShares 1-3 Year Treasury Bonds
- If you pull up a three year chart of 2-Year Treasuries you'll see the massive macro Trend of interest rates starting to move in the opposite direction. We call this chart the "Queen Mary" and its new-found positive slope means that America's cost of capital will start to go up, implying that access to capital will tighten. Yield is inversely correlated to bond price, so the rising yield is bearish for Treasuries.

EWU - iShares UK - We shorted the UK on 4/08. We're bearish on the country because of a number of macro factors. From a monetary standpoint we believe the Central Bank has done "too little too late" to manage the interest rate and now it is running out of room to cut. The benchmark currently stands at 0.50% after a 50bps reduction on 3/5. While the Central Bank is printing money and buying government Treasuries to help capitalize its increasingly nationalized banks, the country has a considerable ways to go to attain its 2% inflation target as inflation has slowed considerably. GDP declined 1.5% in Q1, unemployment  is on the rise, housing prices continue to fall, and the trade deficit continues to steepen month-over-month.

EWL - iShares Switzerland - We shorted Switzerland on 4/07 and believe the country offers a good opportunity to get in on the short side of Western Europe, and in particular European financials.  Switzerland has nearly run out of room to cut its interest rate and due to the country's reliance on the financial sector is in a favorable trading range. Increasingly Swiss banks are being forced by governments to reveal their customers, thereby reducing the incentive of Switzerland as a tax-free haven.

UUP - U.S. Dollar Index
-We believe that the US Dollar is the leading indicator for the US stock market. In the immediate term, what is bad for the US Dollar should be good for the stock market. The Euro is down versus the USD at $1.3157. The USD is down versus the Yen at 98.6610 and up versus the Pound at $1.4894 as of 6am today.

EWJ - iShares Japan -We re-shorted the Japanese equity market rally via EWJ. This is a tactical short; we expect the market there to pull back when reality sinks in over the coming weeks. Japan has experienced major GDP contraction-it dropped 3.2% in Q4 '08 on a quarterly basis, and we see no catalyst for growth to return this year. We believe the BOJ's recent program to provide $10 Billion in loans to repair banks' capital ratios and a plan to combat rising yields by buying treasuries are at best a "band aid".

XLP - SPDR Consumer Staples- Consumer Staples continues to look negative as a TREND and bullish as a TRADE. This group is low beta and won't perform like Tech and Basic Materials do on market up days. There is a lot of currency and demand risk embedded in the P&L's of some of the large consumer staple multi-nationals; particularly in Latin America, Europe, and Japan.