I read a very interesting discussion about how the equity/credit cycle works:

1. After a washout, valuations are low and momentum is lousy. People/Institutions are scared to death of equities and any instruments with credit exposure. Only rebalancers and deep value players are buying here. There might even be some sales from leveraged players forced by regulators, margin desks, or “risk control” desks. Liquidity is at a premium.

2. But eventually momentum flattens, and yield spreads for the survivors begin to tighten. Equities may have rallied some, but the move is widely disbelieved. This is usually a good time to buy; even if you do get faked out, and momentum takes another leg down, valuation levels are pretty good, so the net isn’t far below you.

3. Slowly, but persistently the equity market rallies. Momentum is strong. The credit markets are quicker, with spreads tightening to normal-ish levels. Bit-by-bit valuations rise until the markets are fairly valued.

4. Momentum remains strong. Credit spreads are tight. Valuations are high, and most value-type players have reduced their exposures. Liquidity is cheap, and only rebalancers are selling. (This is where we are now.)

5. The market continues to rise, but before the peak, momentum flattens, and the market meanders. Credit spreads remain tight, but are edgy, and maybe a little volatile. This is usually a good time to sell. Remember, tops are often a process.

6. Cash flow proves insufficient to cover the debt at some institution or set of institutions, and defaults ensue. Some think that the problem is an isolated one, but search begins for where there is additional weakness. Credit spreads widen, momentum is lousy, and valuations fall to normal-ish levels.

7. The true size of the crisis is revealed, defaults mount, valuations are low, credit spreads are high. A few institutions and investors fail who you wouldn’t have expected. Momentum is lousy. We are back to part 1 of the cycle. Remember, bottoms are often an event (Source: David Merkel).

Interesting………contact me if you have any questions or comments.

“Imagination rules the world.”

– Napoleon Bonaparte

It is easy to be miserable about this weather. But, I have to put my relative discomfort and loss of a couple rounds of golf in perspective. The rain is more than just a trivial inconvenience to many Americans – the farmers, for one. Many will lose a portion or all of their crops. And, it could be even worse – my home could sit in the middle of the Morganza Spillway in Louisiana. I feel very sorry for the thousands of Americans in that category. I suspect that many could not afford flood insurance.

Last week there were more NEGATIVE than POSITIVE developments, and short term investors sold stocks as their reaction to the news.

Below is a succinct list of last week’s events:

Positives:
1) UOM confidence jumps back to average level of the year as one year inflation expectations dip to 4.4% from 4.6%
2) 5 month low in mortgage rates leads to 9% jump in refi’s and 6.7% rise in purchase application
3) Germany and France lead solid Q1 GDP growth for Euro zone but sustainability in question
4) Hong Kong economy grew 11.2% annualized in Q1
5) China again raises reserve requirements after 5.3% CPI report and greater than expected loan growth.

Negatives:
1) CPI, PPI continue to rise with CPI now back above 3% y/o/y
2) Inflation t
akes bite out of April retail sales as sales ex gasoline rise just .2%
3) Initial Jobless Claims above 400k for a 5th straight week and 4 week average now at the highest since Nov
4) Weak US$, energy prices and higher Chinese labor costs lead to 11.1% y/o/y gain in Import Prices
5) NFIB small business optimism index falls to lowest since Sept with most growth categories lower and price index higher
6) Bank of England’s King says UK in stagflationary environment, is it headed here?
7) Political infighting amongst the EU, IMF, ECB and individual country members continue to drag out the fate of the Greek’s

After months spent embracing all risky assets, Wall Street has come to a dividing line: One camp thinks the recent hint of economic slackening is merely a momentary holdup, and yet another chance to buy more stocks. The other isn’t quite as gung-ho and wonders if it should, as the old adage suggests, sell in May and go away.

Stocks flip-flopped for days before ending last week slightly lower, although the flat finish doesn’t camouflage the ongoing retreat from risk. Bond buyers drove the yield on 10-year Treasuries down to 3.187%, near the lowest this year and down from 3.74% in February. The defensive health-care sector has quickly become investors’ favorite hideout, and is up nearly 15% this year. In fact, 19 of 20 health-care stocks have zoomed above their 50-day moving averages, compared with just 69% of the components of the Standard & Poor’s 500.

Some of the apprehension can be traced to erratic commodity prices, which have pulled back from recent records. Inflation in China grew 5.3% in April, slower than the 5.4% pace in March, but still the second-fastest pace in nearly three years. And yet another move by the Chinese government to tighten credit has increased concerns that China’s economy might slow. Bank stocks struggled Friday on recurring fears about euro-zone debt, and weekly jobless claims recently topped 400,000 for a fifth straight week, the longest such spell this year. With gas prices high and job growth slow, some economists are acknowledging that U.S. economic growth this quarter might fall below the 3.2% pace the crowd hopes for, though the pros have yet to cut their forecasts.

Curiously, several Wall Street strategists have continued to raise their profit projections and targets. After all, governments will do anything to prop up the markets, and companies are spending their cash stashes on appeasing shareholders and on deals, like Microsoft’s (MSFT) $8.5 billion bid to buy Skype. Last week, Intel (INTC) raised its dividend, and retailers such as Kohl’s (KSS) and Macy’s (M) saw their shares pop after reporting robust earnings.

All in all, companies are reporting improved first-quarter profits, with sales expanding at a 10% clip that handily outpaces the sluggish economy. After shrinking for much of 2010, the margins by which companies exceeded analysts’ forecasts also ticked higher recently—partly because analysts grew cautious after the earthquake hit Japan. Last week, for example, Deutsche Bank’s chief strategist Binky Chadha nudged his forecast for S&P 500 profits this year to $99 from his previous mark of $96, and also raised his target for 2012 earnings to $106 from $102. He sees the S&P 500 ending this year near 1550.

Douglas Cliggott, Credit Suisse’s U.S. equity strategist, is more circumspect. “Earnings growth is still comfortably positive, but the slope of improvement is tilting lower,” he says. With the profit cycle maturing, tightening credit leading to softer demand in China, Brazil and India, and the U.S. central bank set to end its benevolent asset purchases in June, the market’s tone has turned cautious. Over the past three months, in fact, the top-performing sectors all come with a defensive bent, with total returns including dividends pushing 12.3% for health care, 9.4% for consumer staples, 7.4% for utilities and 7.2% for telecom services.

GMO’s Jeremy Grantham had previously argued that the S&P 500 could top 1400 by October, but now recommends trimming risk exposure. With headwinds including escalating raw-material costs and the end of the Federal Reserve’s second quantitative-easing campaign, he says he doesn’t feel “the same degree of confidence that I did, which was considerable, that the Fed could carry all before it” until October, he writes. “A third round of quantitative easing would very probably keep the speculative game going. But without a QE3, there seem to be too many unexpected special factors weighing against risk-taking in these overpriced times.”

Michael Darda, MKM Partners’ chief economist, had advocated buying cyclical stocks for much of the bull run, but he recently suggested pulling back from industrial, energy and materials and steering toward health-care, consumer and utilities stocks. “As global industrial demand slows and commodity prices come off the boil, the U.S. ISM manufacturing index may fall back to 50 or less, at least temporarily,” he notes. This compression in factory production has historically led to a 10-percentage-point swing in the S&P 500, although cyclical industrial, energy and materials sectors could correct more fiercely.

Moreover, “the commodity boom is long in the tooth,” Darda says. Measured from the 2001 trough to the 2011 peak, the expansion in real commodity prices has endured for 115 months—not counting the eight months or so when prices plunged during the credit crisis, before they climbed anew to fresh highs. That’s almost on par with the 113 months of the housing boom and the 114 months of the tech boom, he notes, constituting “an unprecedented run in both duration and magnitude” (Source: Barrons Online).

Last week, US Stocks and Foreign stocks decreased and Bonds increased. During the last 12 months, U.S. STOCKS outperformed BONDS.

Returns through 5-13-2011	1-week	Y-T-D	1-Year	3-Years	5-Years	10-Years
Bonds- BarCap  Aggregate Index	.1	2.3	5.7	6.2	6.6	5.8
US Stocks-Standard & Poor’s 500	-.6	6.0	12.7	-4.5	-2.0	1.6
Foreign Stocks- MS EAFE Developed Countries	-2.2	3.6	17.3	– 7.2	-2.4	2.4

Source: Morningstar Workstation. Past performance is no guarantee of future results. Indices are unmanaged and cannot be invested into directly. Three, five and ten year returns are annualized excluding dividends.