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Week In Review - September 9, 2012

The major indices broke-out to a 52 high this week in a definitive fashion. We believe that the move is significant because the break-out was very broad based and it came on increased volume. After a month where volumes were as low as anytime in the past decade, the break-out on an increase in volume has increased significance in our opinion. In a perfect world, the market would do some "backing and filling" - potentially setting up for further upside in the weeks and months ahead. With so many hedge funds and mutual funds lagging the performance of the S&P 500 for the year, it is possible that the market does not pullback much at all. This is likely to frustrate the largest group of investors not positioned properly. In this case it is likely the shorts and the under invested longs.

The above mentioned performance lag will no doubt cause a significant amount of anxiety. With the market at 52 week highs, portfolio managers cannot afford to remain on the defensive with a market that is performing well. Managers are paid to perform when the market is moving higher. This creates an almost self fulfilling prophecy; higher prices forces in more money as shorts cover and the under invested put cash to work.

Taking a step back, we need to ask ourselves what could be driving the performance in the market since June 4? The easy answer is that central banks will not allow equity and bond markets worldwide to react in an adverse way. Perhaps the market is telling us that all the unknowns surrounding the sovereign debt crisis and the resulting economic slowdown are now discounted. To take this a step further, maybe Europe is most of the way through the worst part of the crisis; the austerity, the layoffs and the economic slowdown caused by these policies. With this theory in mind, perhaps the economic trough is occurring or already has occurred with the European economies slowly recovering over the next 12 to 24 months. This would make sense if the equity market is a forward discounting mechanism and a better worldwide economy is coming. In the March of 2009 bottom, no one was predicting the sharp earnings rebound that occurred in the next three years, yet the market was already discounting this rebound. We are not saying that the Euro zone crisis is definitively over. We are trying to figure out what is driving the market performance and, although a long shot, this theory makes some sense.

Of course, investors cannot ignore the fact that the market is being supported by an unprecedented amount of stimulus from central banks and governments. The ECB has now confirmed their plans for unlimited bond buying. The Feds prospects of further quantitative easing increased on Friday after the poor job creation numbers. The interesting thing about the ECB is that they were able to accomplish what they wanted (lower sovereign interest rates in Italy and Spain) without deploying a single dime. The market has now done the dirty work for the ECB at this point. Spain's 10 year bond closed below 6% on Friday signaling less stress in the system.

The economic calendarnull has some important numbers in the week ahead; CPI, PPI, retail sales and industrial production to name a few. Although these numbers could move the market, they will all take a back seat to the all important Fed announcement on Thursday. Expectations are very high for QE3. If we were forced to guess whether they actually deploy more quantitative easing, we would say not now. The Fed can delay this policy as the ECB has provided them with the cover to do so. We believe they would prefer to wait until there is market turmoil prior to using this controversial policy. We will know on Thursday.

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