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“The U.S. remains the proverbial elephant in the bathtub”

-John Williams

With S&P now down 11.9% from the peak on April 23rd on the fears of European financial instability, we are shifting our focus to when will the market shift and begin discount the fears of U.S. financial instability. The United States is not immune or separated from the current global crisis; Timmy Geither would be better served focusing on his own job rather than cheering Europe’s “capacity to manage through this”. Geithner said, “we just want to see them follow through”. In the interwoven web of global debt, there are many creditors hoping that their debtors follow through. China is indeed watching.

Yesterday, the S&P 500 index closed right around its worst levels for the day and postedthe biggest one-day decline for 2010. Once again, our “Sovereign Debt Dichotomy” theme is having a growing impact on the trajectory of the global economic recovery. On top of that, the issue is being exasperated by Germany's recent unilateral move to ban naked shorts on certain German banks, Eurozone government bonds and related CDS. Policy-related issues in China and the riots in Thailand also continued to weigh on sentiment.

At home, the economic calendar was a net negative, especially for consumer related names. Our Financials team has been harping on claims for a while now, pointing to the fact that they have been essentially flat for the last five months. Yesterday, they were actually up quite a bit. Initial claims unexpectedly rose 25,000 to 471,000 last week, the highest level in a month. The four-week moving average increased to 454,000 from 451,000. The reality is that without significant improvement in claims, a leading indicator, there will be little improvement in unemployment.

Leading indicators also disappointed, falling 0.1% month-to-month in April with negative contributions from six out of the ten components. The decline marked the end of a 12-month winning streak for leading indicators. The Philadelphia Fed Index rose for a fourth straight month in May, though the headline reading was only slightly better than consensus.

In early trading, the euro bounced big time from our intermediate term line of support of $1.21 and has now moved right to our target of $1.25. The euro is trading up versus all major currencies with the exception of the Swiss Franc. The Hedgeye Risk Management models have the following levels for the EURO – Buy Trade (1.21) and Sell Trade (1.25). Despite this brief reprieve for the euro, the issues in Europe continued to be a drag on sentiment.

Over the short-term, elements of "flight to safety" in the U.S. dollar will help to contain short-term U.S. inflation.  We do, however, suspect that the U.S.'s day of reckoning is coming. The Hedgeye Risk Management models have the following levels for the USD – Buy Trade (85.62) and Sell Trade (89.97).

Currently, equity futures are trading below fair value as markets can’t escape the “Sovereign Debt Dichotomy”. As we look at today’s set up the range for the S&P 500, is 34 points or 0.1% (1,070) downside and 6.0% (1,136) upside. For the first time since early 2009, the Hedgeye Risk management models have moved to 0/9 sectors on TRADE and 0/9 sectors positive on TREND.

Commodities fell to an eight-month low. The CRB Index dropped 1% to 250.07. Intraday, the index was at 247.49, the lowest level since Sept. 8. Energy and precious metals led the decline. The Hedgeye Risk Management models have the following levels for GOLD – Buy Trade (1,182) and Sell Trade (1,255).

Crude oil was poised for a third weekly decline as European leaders struggled to contain the region’s debt crisis and reports cast doubts on the strength of the economic recovery in the U.S. The Hedgeye Risk Management models have the following levels for OIL – Buy Trade (69.01) and Sell Trade (74.16).

Copper is headed for a sixth consecutive weekly loss as investors remains concerned that Europe’s debt crisis will spread and hurt a global economic recovery. The Hedgeye Risk Management Quant models have the following levels for COPPER – Buy Trade (2.85) and Sell Trade (3.09).

In credit markets, the TED spread has widened further to 0.37 and LIBOR has ticked up to 0.49 from 0.48 yesterday. The inverse correlation between the TED spread and the euro tightened further to -0.96.

Howard Penney

Managing Director