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Nolte Notes for the week of January 31 2011

Investors have heard inflation is not a problem in the economy and that Fed Chairman Ben Bernanke believes inflation is not likely to spurt higher anytime soon. However, when looking around the world, while headline inflation may indeed be very calm, food inflation is rising quickly. Cases in point are in Tunisia and Egypt, where rioting in the streets, initially centered on higher food costs, has morphed in Egypt into civil unrest that threatens the current government and President Mubarak’s tenure in office. That development was pointed to as the prime mover behind Friday’s market decline, erasing the slowly cultivated gains from the entire week as well as reversing declining energy and gold prices. The economic and earnings data last week were at least supportive of stock prices, as economic growth has surpassed the prior peak, making this now an expanding economy rather than a recovering economy. The Fed is not impressed; keeping interest rates at their current zero level for the foreseeable future as they lean heavily on their one tool to solve all the economic ills.

Friday’s decline pushed the averages lower for the week, however more stocks actually rose on the week than fell. While good news for last week, reactions to the events in the Middle East are likely to trump any economic or company specific news as trading begins on the last day of the month. It is as though the market was a balloon looking for a pin that has now been found in Cairo. Very bullish investor sentiment figures combined with a begrudgingly steady flow of investment dollars from those wanting to jump on the 20%+ rise from August had to end sometime, the events in the Egypt were merely a catalyst for what had been building over the past 4-6 weeks. It will now be left to the corrective activity to help determine and shape what is to follow. Expectations are for a violent but short correction as investors reassess their global views. Volume will be a key component during the correction, as there have been recent signs of expanding volume during up days and some contraction in volume during market declines. Whether volume trends reverse over the course of the next few weeks will be important in determining whether investors are more interested in selling at any price or willing to take a more wait and see approach to unfolding events in the Middle East. Based upon both Friday’s activity and what is likely to unfold during the early portion of the week may take the starch out of some bullish sentiment to a more neutral position.

Bonds investors have had a rough ride so far this year, with yields all over the map as economic growth in the US continues to unfold countered by still weak housing and employment data and finally with a rush into the “safe haven” treasury securities on Egyptian unrest. The bond model remains mired in negative territory as commodity prices continue to rise and bond yields remain elevated. The only positive member of the five I track is the utility average and that is hanging on by a thread. Bond prices have been mired in a trading range for some time as the 10 year bond has been traveling between 3.25% and 3.50% for the past five months. For now, even with the “safe haven” scare of the Egyptian crisis, rates are not likely to make it back down to the prior lows below 3%.

Next week’s notes will have a bit more detail on the asset class model that looks at using long-term strength in various asset classes to determine how best to invest an equity portfolio. The reversals in the prior strong classes such as commodities and small cap stocks have not yet changed the model significantly, however given the huge runs they both have had, some decline is expected. However to trigger a sell for the small-cap index (as an example) a decline of over 10% would need to be registered from current prices. The last time this occurred was in April ’10, when the small-cap index fell by 16% over four months before reversing and recently surpassing that April high. One of the keys to the model is the use of bonds and cash comparative returns against the equity indices. When bonds (and especially cash) begin to outperform equities, it is a sign that the equity run maybe over. Bonds did perform better but given the quick and strong reversal in late August by equities, the initial expectation for a dominant bond market only lasted for a few months instead of the more usual 10-16 month period. Currently equities are in control and bonds don’t look to be taking the performance lead anytime soon.

Given the tumultuous end to the week, I would prefer standing aside until some of the dust settles, however this week will also end with the unemployment report that may provide some additional insight into just how long the “jobless recovery” may last. Bonds comments are little changed as they remain in a fairly wide trading range and either very strong economic data or crumbling countries are likely to be the only things to break them from their range bound behavior.

The opinions expressed in the Investment Newsletter are those of the author and are based upon information that is believed to be accurate and reliable, but are opinions and do not constitute a guarantee of present or future financial market conditions.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.