The catalyst for much of this volatility appears to be increasing fears of sovereign credit risk contagion. Greece is clearly in trouble, with a budget deficit of near 13% of the country's gross domestic product, and total government debt of 113% of GDP. Greece is a very small component of the global economy with an annual GDP of around $350 billion (about 2.7% of Eurozone GDP), but history is loaded with examples of small problems that ultimately caused substantial economic damage (remember how the risk of subprime mortgages was "contained").

However, rather than being simply a cause of the market decline, Greece is just another reason to be wary of lofty stock valuations following the huge rally from the March 2009 lows. In fact, stocks have struggled on several occasions since mid-January following the release of otherwise positive news. Some examples: nearly 80% of companies have exceeded earnings expectations; U.S. GDP expanded by 5.7% in the fourth quarter; and Friday's report of January employment was generally as expected and the unemployment rate actually fell. An old stock market adage seems appropriate today - "the reaction to news is more important than the news itself". Recent reaction to news suggests that good news is already priced into stocks, requiring significantly better news to drive the markets higher.

The one asset that has stood apart during the stock market's troubles has been the U.S. Dollar, which is closing in on a near 10% rally from its 2009 lows. As the dollar appreciates in a flight to quality, risky asset classes are declining, especially the ones that performed the best last year. We continue to remain cautious with a focus on high quality stocks and bonds.

While most pundits are busy overstating the Democrats' loss of a filibuster-proof majority in the Senate, declaring health care reform dead and projecting massive Republican gains in November, the election did give rise to one potential outcome that has important implications for the markets. That is, voters have clearly rejected runaway government spending and huge budget deficits and bailouts, without regard to which political party is responsible. As a result, expectations of additional government stimulus programs and so-called "quantitative easing" by the Federal Reserve should be scaled back. In short, the Fed's printing press is now running a little short of ink.

So let's think of the investment implications. First and foremost, this is positive for the value of the US dollar and bullish longer term for the markets. Our leaders have steadily debased our currency and reduced our standard of living through the Fed's zero interest rate policy and our trillion dollar budget deficits. Any improvement on this front is likely to be met with a rise in the dollar, and in fact the dollar is up about 1.5% over the last two days. The chart below shows that the dollar bottomed on Thanksgiving and recently made a higher low. We think the dollar may move significantly higher.

One other major implication of less government stimulus is that the private sector economy must shoulder more of the burden. This is the handoff of the drivers of economic growth that we have discussed in recent months. After a liquidity-driven rally of near 70% in the equity markets since last March, investors are expecting solid growth in 2010. Perhaps today's market reaction, even in the face of good earnings news from IBM, reflects concern that growth may not be quite as robust in an environment of fading government stimulus.

The December employment report was certainly a disappointment, especially to those who expected the economy to create jobs. Employment fell by 85,000 jobs in December, and revisions to prior months subtracted another 1,000 jobs (we've previously discussed that upward revisions to recent jobs data could be seen as an important turning point). The unemployment rate remained at 10% because the labor force contracted. Why did the labor force contract? Because when those looking for jobs become frustrated by the lack of job openings, they eventually stop actively looking for employment and the government removes them from the labor force for purposes of calculating the unemployment rate. A stark picture of the scale of this problem can be found below, which shows an acceleration in the number of unemployed people filing for emergency unemployment compensation, or those that have been unemployed for so long that they have lost state benefits (typically six months or more). As a result, the unemployment rate will likely remain stubbornly high even after firms begin to hire, as thousands of unemployed re-enter the labor force.

Did the U.S. Dollar bottom on Thanksgiving? Since then, the greenback is up nearly 5% in response to sovereign credit fears, beginning with Dubai and then spreading to Greece. We have been arguing that the "short dollar, long everything else" trade is among the most crowded we've ever seen, and that the near term threat of deflation could cause a bullish reversal in the dollar. Dubai and Greece are proof that the global credit crisis is still unfolding with deflationary impacts as a result. In response to this new dollar strength, risky assets, particularly commodities, have endured swift corrections. Examples: gold is down nearly $130 from its December 3rd high; crude oil is off 10%; emerging markets are down nearly 5%. U.S. equities, surprisingly, continue to show impressive strength, even with today's selloff. However, the S&P 500 has been stuck in a narrow range near the 1100 level for over a month, despite recent economic data that continues to support recovery.

Does Thursday's market action - higher dollar, lower risky assets - signal a major change? Only time will tell, and the fact that the holiday season is upon us, we will likely have to wait until the first of the year to gain confidence in any trend change. In the meantime, we recommend a cautious approach through year-end...and the purchase of more dollar exposure on weakness.

While most observers expect sales this season to be better than 2008's disastrous results, forecasts are rather subdued. For example, the CEO of Target Corp. commented that he expects a highly promotional season to entice reluctant shoppers. With expectations low, stocks are likely to resume the rally if sales are strong this weekend.

However, recent research by financial services analyst Meredith Whitney on credit card capacity suggests that consumer spending will be significantly impacted by reduced purchasing power. As the chart below shows, banks have cut credit card lines by $1.2 trillion, a huge reduction in credit availability. Whitney expects a further $1.5 trillion reduction in credit lines, and the loss of access to credit will accelerate in 2010. The reduction in credit has occurred at a time when consumers are increasing their utilization of credit cards to fund expenses. How can consumer spending continue to drive 70% of the economy when credit availability has been so severely restricted?

On the surface, this is puzzling given the strong growth in third quarter GDP announced on Thursday, which at +3.5% on an annualized basis was better than consensus expectations and marked the end of the recession.  In addition, third quarter corporate earnings have been good - over 80% of companies that have reported so far have beaten earnings expectations, an unusually high number.

So with the generally positive news flow, why is the market showing such weakness?  As we discussed during yesterday's conference call, much of the growth in the third qaurter was artificially supported by government stimulus, such as the cash for clunkers program and the first time homebuyers tax credit.  In fact, automotive sales plummeted following the end of the clunkers program, and home sales appear to be faltering now that the tax credit is near expiration.  Perhaps investors are recognizing that these programs simply pulled demand forward, setting up the next few quarters for disappointment.  If 3.5% GDP growth for one or two quarters is all we get from the massive government stimulus, and business and consumer spending does not take up the slack when the stimulus inevitably fades, then it is time to take profits from the massive rally off the March lows.

Next week is shaping up to be important for near term market direction.  Volatility spiked this week as the VIX index rose 24% today, indicating a sharp rise in investor caution.  Should the U.S. Dollar continue to strengthen, the rally in virtually all risky asset classes (think stocks, commodities, high yield bonds) will be over.

Perhaps today's selling is just a brief pause in the nearly seven month long bull market advance. We have witnessed several shallow pullbacks over the summer that were soon followed by aggressive buying and new market highs. In the bullish camp, we would point to steadily improving economic data as well as "performance anxiety" of fund managers that have missed the rally (those would not include funds in Kanaly's equity portfolio, the average of which are up nearly 30% year-to-date). Bearish investors, including ourselves, insist that the financial and economic crisis has only been temporarily masked by inventory restocking, cash for clunkers, and massive government printing of money. With third quarter earnings reports just around the quarter (Alcoa kicks it off next Tuesday), investors will be looking for significant improvement to justify current lofty valuations.

We have our eye on a handul of recent market developments that could offer clues for the near term direction of stocks:

• First, we are watching the credit markets. A strong rally in corporate credit has lent credibility to the stock market advance. Today, however, high yield debt lost almost 3%, while Treasury bonds enjoyed strong upside to drive yields to the lowest level in months (10-year Treasury at 3.18%, and the 30-year Treasury broke below 4%) . This is an indication that investors are reducing their appetite for risk.
• The U.S. Dollar, despite loud predictions of a coming collapse, has quietly strengthened recently and may be forming a near term bottom. Significant dollar appreciation from here threatens the commodity rally and likely causes a correction in stocks.
• The Volatility Index (VIX) soared 10% today, indicating increased investor fear.
• For the first time in months, it appears the S&P 500 Index may be tracing out a lower high. After closing at a 2009 high of 1071 on September 22, the index touched 1080 the next day but then sharply reversed lower to close at 1060. Subsequent rally attempts have failed to set a new high, suggesting at least a pause in the bull market.

Initial reaction to the jobs report followed the typical script we've seen all summer: with fewer jobs lost, a recovery must be around the corner. True, August's loss of 216,000 jobs is a huge improvement over the 750,000 lost in January, but simply drawing an upward trend line fails to give me confidence that the economy will soon begin creating jobs. Digging into the BLS's release, two important facts, largely overlooked in the press, suggest this report was less robust than the headline suggests.

First, the BLS each month includes a "diffusion index of employment change", which simply measures the percentage of companies that are hiring workers. This is similar to the Institute for Supply Management manufacturing and services sector sentiment gauges, in that a reading of 50.0 represents a balance between those companies that are increasing and decreasing employment. In August, the BLS diffusion index showed that only 35% of employers are hiring workers, an improvement over July's 30%, but a sobering number nonetheless.

The second suspect data point in the BLS release is the infamous "Birth/Death" adjustment. As we've pointed out before, the government attempts to estimate the number of jobs created or destroyed by the birth or death of employers in any one month. According to the BLS report, 118,000 jobs were "created" in August by the Birth/Death adjustment.

Without a doubt, the employment picture in the U.S. is susbtantially improved from several months ago. As a result, one must not be too bearish, because changes at the margin drive financial markets. But we remain cautious on equities in light of our long held view that too much debt on consumer balance sheets will weigh on economic growth, especially with unemployment approaching 10%.

• July Existing Home Sales rose 7.2%, well above expectations of a 2.1% increase;
• The Case/Shiller Home Price Index showed a month-over-month increase in home prices;
• Consumer Confidence rose from 46.6 to 54.1;
• July Durable Goods Orders rose 4.9%, above expectations of +3%;
• New Home Sales soared 9.6% in July;
• Second quarter GDP was -1.0%, better than expectations of -1.5%;
• July Personal Income & Spending matched expectations, and June numbers were revised up;
• Dell beat earnings expectations, and Intel raised its revenue guidance for the third quarter.

The above data points add further evidence that the recession is ending and the economy should grow in the second half of this year. One would expect the market to rally strongly on news like this, yet each day this week the market had trouble holding on to initial gains. By the end of Friday's trading, stocks managed only a small weekly gain and finished about 1% off the week's high.

What does all of this mean for the markets? It could be that stocks are just consolidating the strong gains from July and August, poised to move much higher once traders return from summer vacations. Then again, it is wise to remember that the news is always best at the top, and worst at the bottom. Back in March, very few investors could envision the strong rally to come. Today, investors are tripping over themselves to buy stocks, either convinced the rally will continue or too scared to miss it if it does.

Investors chose to ignore other, rather negative, news last week. First, the Administration announced that the federal deficit over the next 10 years would be $2 trillion higher than originally forecast, to $9 trillion. Isn't it amazing how easily we say the word "trillion"? Next, the FDIC disclosed that 111 banks were added to its "endangered" list in the second quarter. Over 400 banks are now considered by the FDIC to be at high risk of insolvency. Meanwhile, the assets of the FDIC's insurance fund have declined to just over $10 billion. Finally, delinquencies and foreclosure rates continue to rise. Despite these facts, most market pundits say the credit crisis is over. We disagree, and continue to approach the equity markets with caution.