I wanted to provide a quick update on the recent action in global markets, current events, and the associated effects on Smith Capital client portfolios.  Yesterday, on the heels of intensifying unrest across the middle east over the weekend, and with Monday being a market holiday, Tuesday arrived with a bang.  From Monday to Tuesday Asian and European stock markets fell hard while oil prices soared over 7%.  As a result, U.S. stocks fell across the board, declining around 2% on average, while the volatility index (VIX), which tracks the implied volatility of put options on the market, soared higher by over 25%.

The good news – Smith Capital client portfolios had a fairly good day. Accounts that still have a modest exposure to equities only fell by about 0.5% on average, due to our high cash levels, bond positions and hedge positions.  Our more tactical portfolios actually rose for the day, due to high cash levels, hedge positions, strategic bond exposures, and especially due to to our recent positions in crude oil and volatility.  Yes, the two asset classes that were up big yesterday – oil and volatility – we had exposure to within a couple of the Smith Capital model portfolios.

As a reminder, over the last couple months I have been communicating to you my growing concern about the sustainability of the recent market rally.  In commentaries posted on our website since January I have been outlining why I have been maneuvering toward a more defensive allocation across each of the Smith Capital model portfolios.  (Please review those commentaries for a review of my thought process, thesis, and concerns).

Remember, our strategy is quite contrarian, so we look to buy stuff when the masses are selling, fearful and negative, which creates value.  On the flip-side, we look to sell stuff when the masses flip over to exuberance, euphoria, complacency, and over-confidence, which creates over-valuation and a disregard for potential risks.

Over the last few weeks the latter has characterized the U.S. and European markets. Investors had grown overly bullish, overly confident, and highly complacent with regard to risk.  With markets moving higher, pundits, strategists, and analysts tripping over themselves to raise their forecasts and call for a new bull market, and a guaranteed backstop from the Federal Reserve to prop up stocks, the mantra has become full speed ahead with stock exposure.

In the meantime, Rome burns!!!  The equity markets have just brushed off mounting risks from multiple angles, including massive fiscal deficit and debt problems mounting across the globe, massive upheaval around the middle east, and escalating food and commodity inflation that will be disruptive to the global economy.

Hence, I have felt it prudent to move back into the turtle shell a bit, raise cash, and put on some hedges.  I have made this clear in several recent commentaries.

One of the big issues I have been analyzing is the fact that as the U.S. stock market marches higher day by day, the risk was mounting that a significant decline would unfold very quickly, which could wipe out several weeks of gains within a few days.  This tends to be the nature of the market. When you get into a trend like we have been in, and complacency sets in, the market produces gains over a stretched period.  Then, all of a sudden, once everybody is on the same side of the fence, an event occurs to spike up fear and volatility, and everybody heads for the gate at the same time.  This typically produces quick, severe declines that are very hard to time perfectly.  Hence, our desire to get ahead of the herd.

This is also the reason I recently put on a long volatility position.  Over the last few weeks nobody has been concerned about buying “insurance” on their stock exposure, which has driven the cost of that insurance lower, (i.e. the volatility index has been slipping lower and lower).  Therefore, we recently added an ETF to certain client portfolios that gives us exposure to the VIX index so that when the fear button gets pushed by the market we already have the insurance in place.  This manifested yesterday with the VIX going up 25%, and the associated ETF we own rising 12%.  I believe this is just the beginning of these kind of moves, and I will be looking to add to such positions.

As I mentioned, we also recently added a position to crude oil (USO), which I believe will move higher as middle east tensions escalate and the peak oil story starts to spread again.  This benefited us yesterday, and should do fairly well over the intermediate-term.

One last quick comment on geo-political risk.  We seem to be in the midst of the age of protests!  It first began in Europe with the citizenry protesting government austerity measures that have to be imposed to cut back on deficit spending.  Now political protests are breaking out around the middle east, which I don’t believe will lead to the utopia of democracy in the middle east.  I actually believe it will lead more to radical trends taking hold, culminating in an eventual attack on Israel.  This will all be de-stabilizing for the region and the world.

Further, we now have a protest movement taking hold in the U.S.  What began in Wisconsin, driven by government employees protesting Wisconsin’s own version of “austerity” measures, is now spreading to over 27 other states across the country.  All of this comes down to one simple thing – governments have over-promised and are now facing the consequences of out of control spending and deficits.  Regardless of your perspective, the outcome looks daunting.  This all has the potential to be disruptive for the fragile recovering economy.  It definitely represents a risk that must be factored into our portfolio strategies.

In summary, we remain vigilant to manage risk and take advantage of opportunities we identify in the current environment.  As much as our high cash levels may have frustrated some of our clients and even me recently, I sincerely believe it has been the right course of action for each of our clients well-being.
As always, thanks for the opportunity to serve you and your families.

Chad R. Smith
Managing Director

As a follow up to my last published commentary from a couple weeks ago I am excited to announce that our son Samuel Zachary Smith was born on 2/2/11, last Wednesday!!  We are calling him Zachary, and he weighed into the ring at 10 lbs and 22 inches long!!!  My wife Laura and Zachary are doing great!!  We are very thankful and give praise to the Lord for all 6 of our wonderful blessings.

Meanwhile, as I am trying to get back in the saddle I am staring at data, graphs and screens that point to one thing – a continued overbought, over bullish, and overvalued stock market that is now full of speculators with no fear.  While that may sound great and make us feel good to see screens of green, my job as steward of our clients’ capital is to be diligent to manage risk.  It is for this reason that I have been progressively more defensive in recent weeks, as I see risks mounting.

Let me be blunt – the U.S. stock market’s recent advance over the last couple months is being fueled by the Federal Reserve’s QE2 monetary easing policy, with Bernanke leading the charge.  All the while Bernanke steadfastly declares there is no inflation, while commodity and food prices are soaring around the world, driven mainly by the Fed’s policy to devalue the US dollar.  This in-turn drives the prices of stuff priced in those dollars around the world higher.  Riots in third world countries are not just a function of a young, poor, unemployed citizenry being mobilized through Facebook and Twitter to protest corrupt dictatorships.  It is being inflamed by spiralling higher food and energy costs which disproportionately affect the poor.  Yet, Bernanke says there is no inflation, so they will keep pursuing QE2.

In the process, speculators are driving the stock and commodity markets higher and higher, with the green light from the Fed.  This will not be without a price.  The Smith Capital perspective and strategy is to be diligent to get ahead of the “paying the price” moment in the markets.  This is called pro-active risk management, which admittedly hurts a little right now!!

That brings me to a quick follow up point from my last commentary.  On January 21st I wrote the following about making market projections – “.. I am aware that there is a fine line between being early and being wrong, especially in our modern, high frequency markets!  Therefore, I hope for a quick vindication!”  Well, a few days after that comment the markets suffered a fairly significant set-back, and it appeared the big rollover was ready to commence.  Yet, the markets have again continued to speed along and move higher.

So…. it is time for me to swallow my pride and admit I have been wrong over the last couple months.  The stock market has advanced more than I thought it would.  Fortunately, most of our client portfolios are still benefiting from this advance, as we haven’t moved totally out of stocks.  It’s just that with our elevated cash levels and hedge positions our participation has been limited.  Yet, even with this admission, I am not ready to move back into the markets at these elevated, stretched and over exuberant levels.  We don’t engage in stock chasing!

Therefore, I will continue to look for better entry points for the overall market, yet actively seek out specific opportunities in stocks, sectors, and other parts of the market.  My aim is to make up any relative performance deficit, but do so with prudent risk management.  The good news is we have ample fresh powder to deploy in pursuing this endeavor.

Thanks for the continued opportunity to serve you, your families, and your businesses.

Sincerely,

Chad R. Smith
Managing Director

Being a true contrarian investor can be a difficult thing.  First, it typically puts you in  an isolated place, with not much like-minded company.  Second, one of the risks is being early in positioning for market turning points ahead of the herd.

As most of our clients and readers are aware, I not only characterize my analysis and investment management strategy as being contrarian, but I have committed to paper through my periodic commentaries numerous contrarian market calls.  Fortunately, our analysis and forecasts have historically been quite accurate.  Yet, at certain times we have been early in positioning for a significant market or asset class turning point.  However, ultimately we end up being ahead of the curve, and have performed relatively well in capitalizing on opportunity or protecting against risk.

With this said, I am aware that there is a fine line between being early and being wrong, especially in our modern, high frequency markets!  Therefore, I hope for quick vindication!  My market perspective and associated allocations across each of the Smith Capital model portfolios remains the same as what I communicated on December 24th.  I have kept portfolios positioned for a near-term stock market pullback, with elevated cash levels and slight hedge positions.

Within more conservative, income-oriented portfolios I have been making some tactical maneuvers within the bond market, putting some cash back to work in high quality corporate bonds, inflation-protected Treasury bonds, and emerging market bonds.  Each of these areas had suffered fairly large price pullbacks over the last couple months, which we anticipated and avoided.  Now that this has occurred yields are back up to attractive levels that justify increasing our exposures.

Across each of our model portfolios we are holding elevated cash levels.  Yes, in the current environment of near 0% short-term interest rates and an advancing stock market, higher cash levels reduces income for income-oriented portfolios and reduces capital appreciation potential in growth-oriented portfolios.

However, considering the growing risks our analysis foresees from the capital markets, the opportunity cost of sitting on higher cash levels for a short period of time are a small price to pay for prudent protection.  Even though cash isn’t earning anything right now (roughly speaking), it sure is a nice principal protection asset class if markets reverse and head for a 7 – 10% correction in the short-term, which is what I anticipate for the U.S. stock markets.

Let me provide some clarity and context for my views.  First, I am not negative on the prospects for further economic expansion in the U.S. for 2011.  On the contrary, I expect the economy to continue to expand along with corporate earnings continuing to rise further.  This has been my outlook for several quarters now.  My concern relates to investor sentiment having once again overshot to a level of excess optimism.  The point is that markets have now priced in such an economic expansion.  The chart below displays the S&P 500 along with a plot of a contrarian investor sentiment indicator.  (Please note: you can click on the following chart to open an enlarged view of the graphic).

As you can see from the chart above, put buying on the Chicago Board Options Exchange is very low, meaning investors and traders are not concerned about the market going down.  This is a contrary indicator in that when the consensus is optimism and no fear, you should be selling the stock market and actually putting on hedges.  Conversely, when fear is rampant, the consensus is negative and therefore put buying is high, that is the time to be buying stocks and reducing cash.

Remember, back in August and September, as Smith Capital was growing more bullish and beginning to put more cash to work, investor sentiment was broadly negative.  Fear of a double-dip recession was rampant, as was distrust of government and Wall Street.  The broad consensus among market strategists and “gurus” was that stocks were going to struggle, higher cash levels were necessary for fear of the economy slipping back down, and bonds were the place to be.  In contrast, I wrote in early September that stocks looked very attractive, the Fed’s QE2 actions would help drive cash out of safe haven bunkers, the economy would continue to strengthen, stocks were relatively cheap, and bonds looked very expensive.  Hence, around that time we were putting cash to work, selling out of bonds, adding to stock exposure, and going against the grain.

Fast forward to today … the broad consensus is that stocks are the only game in town, the economy is going to expand strongly in 2011, stocks still look cheap, and no one is even considering a market sell-off.  The pendulum has once again swung back to excessive optimism, in typical herd fashion.

Consider the following:

• In the Barron’s Round-table (consisting of 10 strategists form some of the biggest financial institutions in the U.S.), all 10 were bullish on the stock market at the end of December.
• In the annual Bloomberg survey of top strategists around the same time in December (which consisted of 11 different strategists), all 11 were bullish about the U.S. stock market for 2011.

Please note that many of these strategists were negative and feared a double-dip recession back in September.  My point is two-fold.  DON’T LISTEN TO MEDIA OUTLETS’ ROUND-TABLE SURVEYS OF STRATEGISTS, instead listen to Smith Capital!!  Second, while the consensus view of retail investors is always wrong, so is the consensus view of highly overpaid market strategists at big Wall Street firms.  Again, reiterating the wisdom of following Smith Capital’s prudent, contrarian analysis!

While most economic data, especially high frequency, coincident data, points to further economic expansion, below is a list of a few factors I am concerned about.  Each of these factors could individually pose a headwind for the economy, and collectively they could cause some serious problems.

1. European sovereign debt problems remain a major macro problem. The numerous attempts to stem the crises have been pursued by only one main course – the ECB, IMF, EU, and a coalition of the larger European countries extending loans with moderately better financing terms to the likes of Greece, Ireland, Portugal, and soon Spain and Italy, with the hope of buying more time.  All this circus act is doing is delaying the inevitable by piling on greater amounts of debt.  The final outcome is either a major country defaults, which then leads to restructuring, or further pursuits of austerity measures, which will slow the associated economies and cause social unrest.  Note that this is already happening throughout Europe.
2. States and municipal governments within the U.S. are in the same precarious position as that of European countries. After years of fiscal irresponsibility, concessions to major employee unions, and mounting unfunded liabilities due to retirement and health care obligations, nearly every state in the nation is in serious fiscal trouble.  Deficits are everywhere and growing, and debt levels are mounting.  The reality of this situation has come front and center for the capital markets, with the municipal bond market getting seriously clipped over the last two months.  While much of these concerns may already by priced into the muni-bond market, the bigger issue is for the overall economy.  The net outcome of this situation is states will be forced to cut back and impose their own “austerity” measures, like what we are seeing in Europe.  This will cause a headwind for the national economy going forward.
3. The Federal Reserve’s Quantitative Easing 2 (QE2) program, in conjunction with its on-going zero % Fed Funds rate policy, is stoking inflation around the world. While Bernanke continues to say there is no inflation, and the stock market buys the government inflation statistics, base metals and agricultural commodities around the world are soaring.  This is causing real-world inflation that the Fed is seemingly ignoring.  Inside the U.S. the producer price index is now tracking at a 4% year-over-year rate.  Outside of the U.S., commodity and food inflation is a major concern, and is causing many of the higher growing emerging market countries to impose monetary tightening policies to try to curb increasing inflation.  This should become another headwind for global economic growth and, later in the year, could have a negative impact on corporate profitability growth.
4. United States government debt and deficit spending problem has grown to such a precarious level that politicians can’t just “kick the can down the road” any longer. Immediate and substantial action is needed for us to have a hope of not falling off the financial cliff.  While this isn’t a new issue, circumstances are aligning to the point where this issue is soon going to be the front and center topic.  Within the next month political rhetoric will heat up surrounding the need to raise the U.S. statutory debt ceiling.  This, along with clear mandates dictated from the electorate during the November elections, will drive the national and global attention to cutting out of control deficit spending and tackling the burgeoning debt problem.  Regardless of how exactly we pursue dealing with the problem, any course we take will result in a necessary curbing of Federal government spending, which is going to cause another headwind for the economy.  If we don’t begin to pursue our own version of austerity measures, then global bond investors will begin to demand a higher yield for the risk they are taking on, and government bond rates will go higher.  This too will cause a major headwind for our overly leveraged society.

So, as you can see there are a number of factors that could easily pose a resistance or headwind for the U.S. and global economy, just as we are starting to really break out into a new growth cycle.  The bottom line is we are not out of the woods yet, especially with unemployment still stubbornly high and residential real estate still contending with elevated foreclosures and significant negative equity.

The net takeaway for right now is we are keeping a keen eye on emerging risks around the world that could easily rain on the recent market parade.  Given the the level of optimism and expectations embedded in the U.S. stock market currently, I believe many of these risks are not being discounted fully.  Hence, we will continue to keep between 15 – 35% in cash, depending on the model portfolio, and utilize certain equity market hedge positions as well, until we see a more favorable risk / return environment.  Then we will once again commence putting fresh capital to work selectively in undervalued areas.

Since this commentary is getting fairly long, I will provide more detail regarding our various model portfolio returns for 2010 in a follow-up commentary later in the month.  In general, we continued to produce good relative returns, especially on a risk-adjusted and cash balance adjusted basis.

One final personal note – my wife Laura is pregnant with our sixth child (yes, you heard that right!), and is due any day now.  Once the baby comes I will be working from my home office for a couple days, but will be available if needed.

As always, thanks for the privilege of serving you and your families.

Chad Smith

Managing Director

May the joy of the Lord fill your hearts and minds, and may you experience peace this Christmas and holiday season.

Just a quick note about the markets and how I have been positioning our clients’ portfolios.  As you may recall from recent commentaries I have been growing more cautious in the last few weeks about the sustainability of the recent rally in the U.S. stock market.  I was very bullish back in the beginning of September about the prospects for stocks to move much higher over the next six months.  Then, as the September and October rally progressed, I became increasingly concerned about the primary underlying drivers of that rally, namely the Fed’s Quantitative Easing 2 program.  While the age old adage of “don’t fight the Fed” is certainly appropriate in the current environment, as the Fed’s actions are forcing liquidity into the stock market and commodity markets, the ramifications of their actions in regard to underlying inflation is what I am concerned about.

Interestingly, as the U.S. stock market has advanced since the Fed’s announcement of their new easing policy, stock markets in China, India and Brazil have been going down since November, on fears of accelerating inflation choking off growth.  In addition to my concern that inflation is being stoked by the Fed’s policies, from a shorter-term standpoint too much optimism and enthusiasm about stocks is now prevalent in the psyche of the investment community.  As you probably know by now, I tend to be fairly contrarian.  So, as the market has been driven higher recently from Fed policy and hopes of 2011 recovery, investors have grown further optimistic.  This has progressed to the point where so called Wall Street strategists are pervasively bullish.  When a complete consensus develops about what the market will do in the year ahead, that is usually a clear signal to at least hedge against that consensus, if not bet the other way entirely.

Of course, my allocation decisions are ultimately driven by the Smith Capital Allocation Engine.  This is our proprietary econometric model that tracks numerous indicators and data to lead our decision about allocating capital to cash, the stock market, the bond market, and other unique asset classes.  While our model hasn’t moved to a sell signal for stocks as of yet, it has been trending downward over the last few weeks.  At this point, my conviction is that the possible marginal return that could be obtained from stocks is not worth the current risk that prevails.  In our constant effort to balance risk and return, and to anticipate the next substantial cycles in various asset classes, it is imperative for us to act accordingly.

Therefore, depending on the model portfolio, I have been selling equity positions over the last few weeks as the market has advanced.  At this point, again depending on the model, we are sitting on elevated cash levels once again.  This is a tactical risk control maneuver similar to the one I made back in April of this year, which protected us from the significant decline the market experienced from April to August.  I am anticipating another down draft in stocks over the next couple months like what occurred this summer.  I will continue to diligently and pro-actively seek to put capital back to work as market prices hit more attractive levels.  This same tactical approach applies to other parts of the market, like bonds and commodities.  While we have certain exposure to all these asset classes, more recently I have been reducing all exposures and raising cash to hedge against another market pullback.

Thanks again for another wonderful year of serving you and your families.  It is a privilege and an honor to work as stewards of your capital and financial futures.

Merry Christmas and may you prosper and thrive in the new year!

Chad Smith

Managing Director

As a review of our recent market forecasts, at the beginning of September (when the stock market was struggling and investor sentiment was growing more negative), I stated that the markets were setting up for a strong rally over the next six months.  Then, in my last commentary posted on October 13th, after the market posted the strongest September in 70 years, I said I was getting a little concerned about the magnitude of the move higher in such a short period of time.  Therefore, I began moving to a more defensive posture within our client accounts, across each of the Smith Capital model portfolios.

This move to a more cautious allocation beginning in October proved to be either wrong or early, depending on your perspective!  True, each of our clients’ accounts have continued to move higher since that period of time as many of our equity related and fixed income positions have advanced along with the rally.  However, our elevated cash levels along with our small hedge positions have acted as an anchor for the portfolios in the midst of the market rally.

My frustration lies in the fact that I had predicted a sizable rally starting back in September, but our clients’ accounts haven’t fully benefited from the substantial move higher.  Hopefully all of our clients know, we strive to be fully transparent and open as to our market perspective, market forecast, our associated allocation positioning, and our success and failures along the way.  In this light, I am communicating that our move to higher cash levels and a more defensive position was a little early in hindsight.

My decision to sell into strength during October and November has been driven by my growing concern regarding how much of the developing positive news recently was already “baked” into the market.  This perceived “positive” news included the Federal Reserve’s signal back in late August that they were going to pursue another round of monetary stimulus into the economy via what has become known as Quantitative Easing 2 (QE2).  Additionally, the clarity that might emerge regarding regulatory and tax policy once the Republicans won back a majority in the House of Representatives, further indications that corporate earnings were continuing to trend higher, and further economic data pointing to a broader recovery, all were catalysts for driving the market higher during September and into October.

My perspective was that most of these catalysts were factored into the market, and that stocks would take a breather once the November election was over and the Fed officially announced their QE2 plans.  What actually happened was the market’s animal spirits got ignited by the Fed’s indications they were explicitly trying to artificially inflate asset prices in the market.  The Fed’s hope is that this will drive the wealth effect higher and induce consumers and businesses to spend.  With this clear support from the Fed under the markets, traders, speculators, and hot money investors took the cue and poured into stocks and commodities globally since the beginning of November.

In the meantime, as the markets have surged higher, the elevated cash levels and hedge positions within the Smith Capital growth oriented model portfolios has acted as an anchor for our performance. However, while I have been a little frustrated, I am not anxious about the positions or allocation we have pursued.  I am certainly not going to take the Fed’s bait and blindly chase the market higher on the hopes that the Fed is going to backstop the market with a continual flood of liquidity.  My perspective is the Fed’s policies are the wrong move.  They are going to cause collateral damage to the markets and we are going to position our client accounts prudently to protect the downside.

While the Smith Capital Allocation Engine, which consists of our proprietary econometric and valuation models, remain modestly positive toward stocks, many of the individual factors that make up our models are starting to slip downward.  These trends, combined with the concerns I have regarding the Fed’s policies, compel me to raise more cash and put on appropriate hedge positions within the Smith Capital model portfolios that are more growth oriented.  These include the Smith Capital Opportunistic Equity, Tactical ETF and Capital Growth portfolios.

Within the Smith Capital Income and Smith Capital Income & Moderate Growth portfolios, wherein we have maintained greater bond exposure, I have been gradually selling a lot of our fixed income positions and raising more cash.  As you may know, we have ridden this bond wave higher since the beginning of the move in early 2009.  It has been a good ride, but now bond prices are getting too expensive, and inflation appears to be around the corner.  Therefore, in an effort to protect clients’ accounts, we have been reducing our bond exposure and putting on a little bond market hedge position for protection.

My intention is to wait for a mild pullback in the equity markets and be ready to re-deploy cash back into certain parts of the market at more attractive levels.  Meanwhile, rest assured that your accounts have performed very well this year, that I am very carefully analyzing the markets and the economy, and that we are actively pursuing a prudently positioned, and modestly hedged strategy in this very dramatic environment.

As always, thank you for the privilege of serving you, your families, and your business.

Sincerely,

Chad R. Smith

Managing Director

In my commentary from the beginning of September I suggested that the stage was being set for a significant move higher in global stocks over the next six months.  This prediction ended up being quite timely and fortuitous, as global stocks have rallied strongly over the last month, which resulted in the strongest gains for the month of September in over 70 years for the U.S. markets.  Admittedly, I wasn’t expecting that strong of a move in this short of a time period, but we will take it nonetheless!

Smith Capital client accounts also performed well during the month of September and for the third quarter.  Year-to-date through September 30th, the total returns for all of our model portfolios are positive, and each model portfolio is outperforming its respective market benchmark.  Furthermore, we have generated good returns across the board for our clients even with a relatively high level of cash reserves for much of the year.  As you may recall from my commentaries this year, we have been tactically navigating these highly emotional and uncertain global financial markets, seeking to take advantage of shorter-term peaks and valleys in various asset classes.  This of course is within the context of a basically flat overall equity market since the beginning of 2010.

As the calendar rolled over to the month of October, I made some portfolio management maneuvers toward a slightly more defensive posture in most of the Smith Capital models.  These actions were driven by the fact that global stock and commodity markets have very quickly priced in much the positive catalysts I thought could push the market higher through year-end.  While I still believe stocks will move higher over the next several months, and I continue to view stocks as much more attractive than government or even corporate bonds, I do believe we have moved too far too fast once again.

In the SmithCap Income & Moderate Growth and SmithCap Capital Growth model portfolios I have sold a little bit of our large-cap growth exposure, and added between 4% – 7% exposure to S&P 500 inverse and market volatility ETFs.  These positions act as a hedge for the equity exposure within each of our clients’ accounts, which I believe is warranted and prudent in the short-term.

Within the Smith Capital Tactical ETF portfolio I have also reduced the large-cap growth exposure, added to the S&P 500 inverse ETF, added in the long volatility ETF position, sold out of our highly profitable silver ETF position, and took some recent short-term profits on a long crude oil position.  This model portfolio strategy also currently has a fairly high cash reserve position, currently around 30-40% depending on each client account circumstance.

Finally, in our Smith Capital Opportunistic Equity portfolio I have been selling a few of our individual stock positions and raising overall cash reserve levels.  A couple of the stocks we sold hit our short-term price targets so we wanted to lock-in some nice profits, while a couple were sold with slight losses because they were disappointing in their price action.  We have added a slight hedge ETF position within these portfolios as well.

So, let me address why even though I remain positive on the intermediate-term outlook for U.S. and foreign stocks, in the short-term I am concerned and have positioned our client accounts more defensively.

The basic concern I have now relates to the recent excitement by short-term traders over the prospect for significant quantitative easing by the US Federal Reserve.  While other central banks like the European Central Bank and the Bank of Japan have also recently signaled their intentions to pursue further monetary easing measures such as bond and other credit asset purchases, it is the message from Ben Bernanke and the Fed that is really driving equity and commodity markets higher.

Basically, due to signs of further economic sluggishness down the road, combined with a stubbornly weak housing market and a very sticky unemployment picture, the Fed is concerned economic growth will slow again.  Hence, they have announced their willingness and intention to pursue what has been dubbed QE2 (Quantitative Easing round 2), which amounts to the Fed purchasing a host of government and agency related bonds in an effort to keep the financial system flush with liquidity and to keep interest rates low for an extended period.

QE2 is deemed necessary mainly because the Fed is out of bullets, so to speak, with the Fed funds target rate effectively at 0%.  This recent communique by the Fed of their intentions has caused a massive round of selling pressure in the US dollar.  Here is where my concern lies.  Remember that the US dollar is still the world’s reserve currency, so as the dollar falls in value, not only do other currencies rise in value versus the dollar, but other “dollar-priced” assets like U.S. stocks, crude oil, base metals (copper and zinc), precious metals (gold, silver and palladium), etc. are rising in value commensurately.

The following chart depicts the recent strong moves in various asset classes, and their associated inverse correlation to the direction of the US dollar.

???

So, while I was looking for the market to advance higher at the beginning of September, a potent combination of factors drove the markets significantly higher in a condensed time period.  These factors included the following:

• The massive decline in the dollar
• Record low interest rates
• Institutional investors (& hedge funds) who are under-invested in equities, coming around to the theory that bonds are expensive and stocks are cheap, and thus re-allocating into equities before year-end
• Indications that the November elections outcome will be more tax / investor / corporate friendly
• Increased merger & acquisition activity announcements
• Stock buybacks and dividend increase announcements
• Relative valuation of equities rhetoric spreading

At this point, much of the hoped for catalysts for the stock market from the aforementioned factors have been baked into stock prices in the near-term in my opinion.  This is the reason for moving to a more defensive stance.  However, if the current Q3 earnings announcement season comes in strong, and if more of the fear-oriented capital that still sits in perceived safety positions (i.e. cash, money market, CDs, government bonds, and corporate bonds), keeps flowing back into equities, then we could easily see a “melt-up” scenario.  This means a quick, strong advance in global stocks being driven by the anticipation of global economies improving and being pushed by capital re-allocation flows.

I do believe such a bullish scenario could unfold, but I am concerned about its prospects in the short-term.  Hence, I believe the most prudent, risk-control oriented decision at the moment is to be modestly hedged with some dry powder for further stock purchases at slightly cheaper levels.

Within the SmithCap Income portfolios we have kept our relatively high bond exposure at about the same level, but in the third quarter we added a small bond hedge position.  As I have communicated recently, I am concerned about over-valuation within bonds, and I foresee a day of reckoning in the government bond market that will push prices lower and yields higher.  We have begun hedging this potential risk, but will look to further reduce bond holdings as the turning point appears imminent.  For now I have been giving our bond exposure a longer leash so as to ride this momentum wave a little further.  But, vigilance in this exposure is key.

I will be publishing another commentary with a report on the composite returns for each of the Smith Capital model portfolios for the third quarter and 2010 year-to-date very shortly.

Thanks for the privilege of serving you and your families.

Sincerely,

Chad R. Smith, Managing Director

Smith Capital, LLC

While the volatility in global capital markets continued during August, the stage is being set for a significant move higher in global stock markets over the next six months. This is my general conclusion about the direction in which the current intense tug-of-war in the stock and bond markets will get resolved over the intermediate-term. But, before I go onto to provide a quick update on my current outlook for the investment landscape and how I am positioning client portfolios, let me first share some Smith Capital news.

We are in the process of updating and improving our website to better reflect the full extent of the Smith Capital process, methodology and various investment strategies. This redesign will also entail an improved Commentary section that should make it easier for clients to stay updated on my latest views and portfolio updates. We will be going live with the new site sometime during September.

Back to the investment landscape discussion . . . August ended on a sour note, with the net result being another drab month for stock markets, while another strong month for the bond markets. You may recall in my last Quick Update from August 11th that we were positioning client portfolios for such a scenario, but looking for an opportunity to buy back into select areas of the stock market once a pull-back occurred. As the first leg of the August pullback unfolded I began adding a little more equity exposure within various Smith Capital model portfolios. However, we elected to keep higher levels of cash reserves throughout the rest of August to see how the stock market’s technical weakness got resolved. During this recent round of investor fear, which has pushed stocks lower and bond prices higher, the Smith Capital model portfolios continue to perform well versus their associated benchmarks.

With August ending with much weakness in the stock markets and with continued strength in the bond markets, be aware that your account statements for the month of August will reflect these trends to a certain extent. For accounts that are more tied to the stock market, we ended the month on a weak note. However, for client accounts that are more conservatively and / or balanced focused we have benefitted from the strong trends in the bond market. In general, our elevated cash levels and slight hedge positions have been very good portfolio stabilizers for most of the year.

Despite this weakness during August, my outlook for a much improved stock market and fading strength in the bond market has grown stronger. In fact, after the close of the markets on August 31st several key market indicators within the Smith Capital Allocation Engine model were giving strong short-term buy signals. Indeed, September has started off well, as global stocks have rallied strongly the first three days of the month last week. While volatility will likely persist into the fall, I believe we are near the beginning of a sustained rally in global stocks that should last through the end of 2010 and into the beginning of 2011. Ultimately, over the next six months I project the S&P 500 Index could advance back to the 1,200 level, which would produce a gain of nearly 10% from current market levels.

Along with this move in the stock market, I expect the bond market’s strength to wane as capital flows back out of bonds and into stocks. While these capital flows should slow the momentum in the bond market, I don’t expect a massive decline in bond prices to unfold until firm evidence of inflation within the domestic economy clearly appears in the data. At that point, I do expect a significant decline in bond prices to unfold. Therefore, within client accounts where we have maintained more boned exposure I have been gradually selling certain bond positions and slightly adding to positions that act as a hedge against inflation and / or a bond market sell-off.

For much of this year I have been discussing prevailing levels of investor sentiment at various times when I expected short-term market inflection points. While there are multiple factors and indicators I evaluate and analyze that go into the Smith Capital Allocation Engine and our Tactical Allocation Decision Process, market psychology has played a greater role recently. Hence, I have been watching the trends and extreme levels in market psychology more closely this year for keys as to when we should overweight or underweight specific asset classes.

Investor sentiment is particularly influential in our modeling process currently because many of the other factors in our model are giving firmly bullish signals for the stock market. Key leading indicators, relative valuation of stocks versus other asset classes, and monetary policy conditions are all very positive and supportive of a strong stock market. However, investor sentiment has been vacillating a lot over the last year and a half, as the investing public has gyrated from extreme fear to slight exuberance back to extreme fear again.

While much of this psychology volatility is understandable given the times we are in, most of you know by now I am a very contrarian investor. I have discussed with many of our clients through the years, and written extensively about the necessity to have a contrarian view with regard to overall investor sentiment. In other words, when the broad investing public is overly negative and selling reaches a climax, we get bullish and begin buying cheap. In contrast, when the broad investing public is excited and buying with exuberance, we become concerned and begin selling. The key to successful investing is buying low and selling high, but the difficulty is actually doing so when it is un-popular. Indeed, true value investing requires fortitude, patience, and the confidence to take the road less traveled. Today, that road appears to be the one leading to the stock market, but with vigilance!

To conclude, we are still sitting on moderately higher levels of cash reserves across each of the Smith Capital model portfolios, awaiting some clarity on the market’s technical direction. We have been gradually reducing bond exposure in income and moderate portfolios given our concern about overvaluation and excess investor optimism within the bond market. Concurrently, we are gradually putting cash to work in attractive values within stocks, depending on the model portfolio, based on very attractive relative valuations, excess investor negativity within the stock market, and an overall positive outlook for the economic landscape looking forward. Our propensity to buy the dips within the stock market will continue only as long as the Smith Capital Allocation Engine (our proprietary multivariate econometric model) is saying to stay more weighted toward stocks, which remains the case. As always, we will remain diligent in striving to manage risk and keep client accounts prudently allocated. Thanks for the continued privilege of serving you and your families.

Sincerely,
Chad Smith
Managing Director

I wanted to provide a quick update regarding some tactical positioning I have been doing recently across each of the Smith Capital model portfolios. Back in the Quick Update I published near the beginning of July I discussed several reasons why I felt the stock market had gotten oversold and was ready to move higher in the shorter-term. Around that time I was putting more of our clients’ capital to work in a variety of undervalued equities, equity ETFs, and equity related mutual funds, depending on the model portfolio.

Since that time, during the month of July, the global markets did rebound handsomely, which benefitted each of the Smith Capital model portfolios and associated client accounts. However, as August commenced numerous economic data has begun to reflect a slowdown in the rate of economic expansion. Also, with global stock markets advancing at a fairly strong clip during July, I felt the market was getting a little ahead of itself in the short-term.

So, near the end of last week I strategized selling some specific equity positions (select stocks within the Smith Capital Opportunistic Equity portfolio, and select ETF and fund positions within the SC Tactical ETF, SC Growth, and SC Moderate Growth portfolios). With the jobs report that was released on Friday, which came in lighter than what I was looking for, and with overall weakening conditions in equity market technicals, I pulled the trigger to sell several equity related positions and raise cash levels. With these actions we entered this week with elevated cash levels again across each of the Smith Capital model portfolios, but with an eye for re-deploying fresh cash as the market experiences a needed shortterm pullback.

With the Federal Reserve’s FOMC comments from yesterday suggesting the Fed also sees a slowing trend emerging, on top of a few more economic data points confirming this view, global stocks have continued to slide into today (Wednesday). Fortunately, due to our maneuvers last week, we are currently sitting on average cash levels between 20% – 50% depending on the model portfolio. The more aggressive, all equity exposed Opportunistic Equity portfolio is currently positioned with an average of 30% cash, the Tactical ETF portfolio is positioned with an average of 40% cash, and Smith Capital Growth portfolio average cash position is 25%.

Meanwhile, the more conservatively allocated Moderate portfolio, which has equity and bond exposure, is currently positioned with about 20% cash, and the very conservative Smith Capital Income portfolios, which are exposed nearly all to bonds, are sitting on an average of 10% cash. Portfolios that are more conservatively positioned with significant bond positions are performing very well even in this volatile environment due to recent strength in government bonds, and the continued demand for corporate bonds. While this is benefitting performance currently, as I have said this year in previous commentaries, I don’t expect the party to last forever in the bond market. The current deflationary trends and concerns helps drive demand for bonds, along with the great chase for yields higher than cash yields. But bonds are getting expensive! So, I will be watching the inflationary and economic signals closely for when to actively start lightening up on these bond positions in our more conservative, income focused portfolios.

With respect to the stock market, while I started raising cash levels last week in anticipation of another short-term pullback, I don’t expect another full-fledged correction, or even mini-correction to unfold. On days like today our higher cash level is nice, and the importance of our tactical, active portfolio management strategy is further highlighted. However, at this point I do still believe the global stock market will move higher in the intermediate-term, even in the face of softening economic data, provided signs of a double-dip recession don’t emerge (which they haven’t at this point). Interest rates are ridiculously low, corporate profits are strong, balance sheets are solid, dividends are rising, stock buybacks are increasing, and yet corporate publicly-traded stocks are still relatively cheap. So, on any significant market weakness I will be looking to put cash back to work in attractive values within stocks, depending on the model portfolio. Obviously, this “buy the dips” strategy will prolong only if the Smith Capital Allocation Engine (our proprietary multi-variate econometric model) is saying to stay more weighted toward stocks, which is currently still is.

To conclude, we are sitting on elevated cash levels across each of the Smith Capital model portfolios, which we increased the end of last week. This position is helping on a day like today. However, I will be looking to put some of this cash back to work in select areas of the stock market, via stocks, ETFs, and funds, depending on the model portfolio, as the market pulls back. As always, thanks for the privilege of serving you and your families.

Sincerely,

Chad Smith

Managing Director

As June closed out on a very weak note for global stocks, the mood among investors turned even more sour. Going into this week, on the heels of the 4th of July weekend, investor sentiment was approaching almost ubiquitous negativity. While Americans mustered the patriotism to celebrate our country’s birthday, it was almost as if we were acknowledging its demise at the same time! The polls now show that more Americans believe our economy is headed in the wrong direction, and a higher number of Americans disapprove than approve of President Obama’s job thus far. With all the negativity surrounding so many issues recently, the latest fad seems to be discussion about whether we will experience a double-dip recession. In fact, data from Google’s Insight for Search database shows that Google searches for the topic “double-dip recession” have skyrocketed higher since the middle of June (thanks to Barry Ritholz’s blog The Big Picture for this data source). With the general populous so concerned about a double dip recession it is no wonder the stock market is struggling to find its footing.

The pertinent question is how reliable and accurate is the broad crowd of individual investors and the general populous at predicting anything economically? The answer is horrible. When fear is as rampant as it is now, and everybody is pre-occupied with this supposed forthcoming “double-dip recession,” markets tend to have already priced in this potential looming recession in advance. Furthermore, the economic data and indicators that I track, and which are the best prediction metrics, are showing that a soft patch is coming, where economic growth slows a bit from its recent rate, but no double dip recession is on the horizon at this point. So, if the market is already pricing in a double-dip recession, which I believe it is, but we end up not getting one, then prices in the stock market today are very attractive for longer-term investment horizons.

As I discussed in my June 15th Quick Update, the level of fear and anxiety among investors is at extreme levels, which I believe is being influenced by a still lingering “post-crash fear syndrome” that is causing investors to worry that 2008 will be repeated soon. So, rather than evaluate the economic, corporate earnings and valuation data objectively, there remains this short-term trading mentality that is highly emotionally charged right now within the psyche of investors of all types, causing a sell first and evaluate later response to headline news.

Meanwhile, the economic data continues to improve, albeit at a slightly slower pace, and is pointing to a continuation of global economic expansion with low inflation. In fact, I would suggest that moderate growth rather than highly robust growth is preferable, as it is keeping inflation suppressed, thus allowing central banks to keep short-term interest rates low, which in turn is supporting a gradual improvement in the health of the banking sector and housing markets. Case in point, with the 10 year Treasury bond yield falling below 3% for the first time since late 2008, mortgage rates have fallen to record low levels again. This dropping of the long-term yield structure will continue to support economic recovery and expansion. It also makes earnings yields on stocks look that much more attractive when comparing against alternative places for investment. Observe the following charts:

The recent round of fear-induced selling in the stock market has once again created an opportunity to go against the prevailing sentiment, and scoop up high quality stocks at attractive valuations. The chart below depicts a technical indicator that is designed to track advancing and declining shares versus advancing and declining volume on the NYSE. It is highly reliable for use as a contrarian indicator to flag when the market has moved to exhaustion extremes at either bottoms or tops on a shorter-term basis.

As you can see from the chart above, the current selling wave has surpassed that of the 1987 crash, yet the U.S. stock market is only down 15% from its high. Historically, it is very common for the market to experience a mid-cycle correction in the midst of a new economic recovery which is maturing into a new growth cycle. So, while what we have seen since May in terms of a correction in stock prices has actually been routine, because of the already existing negativity, the normal corrective action scared many people into extreme selling and has pushed the ARMS index to flashing buy signals.

Yet, while this fear-driven selling is occurring in global stock markets, the economic data and picture remains fairly strong and robust. The following charts display some compelling evidence that the underlying backdrop for the economy remains healthy:

While economic data continues to support further economic expansion, valuations within the U.S. stock market and really global stocks as well, remain very attractive. With the recent correction from May through the end of June many valuation metrics have declined back to near the spring of 2009 levels. See the valuation charts below:

Conclusion

In summary, I continue to have the same view and outlook as I articulated in the June 15th Quick Update. I believe the market weakness, volatility, and overall negativity that have dominated the capital markets, news headlines, and investor psychology since early May has produced a short-term correction that has run its course. While the broad public and most “market pundits” have become consumed with the idea of a double dip recession, the data and underlying economic backdrop support an on-going expansion that should be sustainable. Leading indicators continue to remain at high levels, the yield curve remains very positively sloping, PMI and ISM manufacturing surveys across the globe remain at expansionary levels, and leading employment data suggest on-going modest improvement in the job market. Furthermore, even with signs of growth, inflation remains very tame, keeping interest rates very low, which in-turn supports economic expansion. Corporate earnings and cash flow continue to exhibit strength, corporate balance sheets are very strong, stock buybacks are rising, and dividends are being increased at a healthy clip. Yet, despite all of these positive factors, stocks remain highly undervalued due to rampant investor fear. This unique situation is creating great opportunity for longer-term focused, value-oriented investors.

Considering my viewpoint and thesis I have discussed herein regarding stocks, you can see that I am favorably inclined toward putting capital to work within global equities. Across each of the Smith Capital model portfolios wherein we have some level of stock exposure, I have been progressively putting money to work in selective stocks, stock ETFs, and stock mutual funds, based on the strategy of each model. As you may recall, we headed into this recent downturn with highly elevated cash levels across each of the Smith Capital model portfolios, driven by our short-term concerns back in April. This positioned us well to take advantage of cheaper valuations that have surfaced over the last month. For Smith Capital models that are more income focused and conservative, I have continued to overweight high quality corporate bonds, but I have recently been adding back in some foreign bond exposure and a small amount of high divided paying equity exposure. I continue to believe that in due time U.S. government bonds, and even corporate bonds, which have performed so well during the last year or more, will begin to underperform other asset classes. This eventually will spark a cycle of interest rates rising, and could further restrict bond performance. Equities should outperform in such an environment as well, so long as inflation is not out of control.

Thank you sincerely for the continued privilege of serving you and your family.

Chad Smith
Managing Director

In our April 1st Quick Update I indicated that we had been scaling back on equity exposure in client accounts across each of the Smith Capital model portfolios due to my concern that global stock markets had gotten stretched in the short- term. At the time I was looking for a mild pullback in global stocks of around 7 to 10% in magnitude, but I communicated my expectation was for a continuation of the global economic recovery and equity market expansion over the intermediate term. As April unfolded foreign stocks did in fact begin to weaken as fear spread concerning the European debt problems. But, U.S. stocks didn’t begin correcting until the beginning of May, when they commenced a significant decline that has continued on into June. In fact, U.S. stocks as measured by the S&P 500 declined 8.2% in the month of May, and with the continuation into June, U.S. stocks were down at one point over 13% from their April high.

Investors across the globe have once again adopted a fearful and anxious attitude regarding the prospect for the global economy, capital markets, and “risk” assets. Just as investors were starting to finally come back into the market, and were actually starting to believe in the economic recovery, a barrage of negative headline news drove them back into their bomb shelters in fear of another market meltdown. My current view is that this renewed wave of fear is overblown and is creating a good opportunity for us to deploy capital at cheaper market levels.

After the “flash crash” that occurred on May 7th, when the U.S. stock market suffered a tremendous one-day selloff, with a near 1,000 point drop on the Dow Jones Industrial Average intra-day, investors have really been scared back into a defense mentality. You may recall that I sent out a very brief update via email at the end of the “flash crash” day, wherein I explained some of the factors that caused the massive sell-off and I communicated our positioning leading up to that day. Fortunately, we have been playing a bit more defense in our asset allocation and capital commitment strategies across each of the Smith Capital model portfolios since April. This has helped our clients weather this current volatile environment relatively well, although we have suffered some mild pullbacks over the last month.

As this recent downturn began we were sitting on significant cash reserves across each of the Smith Capital model portfolios, which varied from 15% up to 50% depending on the model. Within the Smith Capital Income model portfolio our significant bond positions have remained fairly stable during this volatile period, while modest exposure to bonds within the Smith Capital Income & Moderate Growth portfolios has helped off-set equity market volatility. Additionally, within our more growth oriented model portfolios (Capital Growth and Tactical ETF Portfolio) small exposure to equity inverse ETFs and gold and silver ETFs have also been effective in minimizing excess volatility and drawdown. Finally, within the Smith Capital Opportunistic Equity Portfolio, which is exposed exclusively to individual stocks, we had been locking in profits in some stocks that met our price targets and raising more cash back in April. Hence, this portfolio strategy was relatively insulated from the recent market weakness because of greater than 50% cash levels.

Now that the market has experienced a fairly significant pullback, thus causing renewed anxiety among investors and bringing down equity valuations, we have been given an attractive opportunity to put cash to work and invest in asset classes and individual securities that are oversold and moderately undervalued. This is exactly what I have been doing over the last couple weeks in June, putting cash to work in selective stocks, ETFs and stock funds across each of the Smith Capital model portfolios. Obviously taking this course of action is based on my conviction that we are only experiencing a pullback in stocks in the course of a longer-term bull market that is still intact. This is still my thesis as the evidence overwhelmingly points to a continuation of economic recovery around the globe.

Of course I am concerned about the debt crises in Europe, and about the structural issues we have in numerous countries around the globe where government debt and deficits are at unsustainable levels. I do believe these structural issues will pose a headwind to economic recovery and will continue to cause greater market volatility for some time. However, at this juncture the important point of assessment is how much of the prevailing fears are already priced into capital markets. My perspective is that the fear of a double-dip recession in the U.S. and other developed countries, driven by debt-related problems in Europe and a slowdown in China, have been mostly factored into capital markets at this point.

Investment Theory Interlude:

Remember that one of our primary investment theories is to be astutely contrarian. This means prudently assessing when the “herd” is reacting to the markets through a crowd psychology viewpoint, and when this gets to levels of extreme, we lean the other way in our investment allocations. This doesn’t mean always betting against the prevailing investor sentiment, for it can influence important longer-term trends that must be ridden rather than missed. But, what it does mean is evaluating when the prevailing investor sentiment gets to extreme levels in one direction or another, and then positioning against that sentiment. This ultimately should result in selling when “everybody” is buying, and buying when “everybody” is selling. This is how you take advantage of deeply depressed levels and avoid getting caught holding the bag at highly exuberant tops.

With this philosophy in mind, I do believe that investor psychology has once again approached an extreme level of fear and anxiety. Furthermore, what is exacerbating the highly emotional reactions of investors in today’s market is the widespread preoccupation with trading the markets. It is amazing to me how much the content and discussions that dominate cable financial news channels are centered on short-term trading. Market commentators especially are consumed with timing the markets on an intra-day, or possibly three-four day basis, which further confuses investors who are connected in real-time to the deluge of headline news that fills our eyes and minds.

Another characteristic of today’s instantaneous, media-dominated, trading-infatuated culture is that fewer people are really focused on longer-term investing. Especially investing based on fundamentals and valuation. You know, good old Warren Buffet style investing. For most people who are consumed with media consumption it seemingly is impossible to actually invest capital for a longer-term period, and to wait for the return to come over time. This would require digging in, doing hard-core fundamental analysis, ignoring the second by second noises of the news anchors and pundits, and actually THINKING deeply about longer-term trends. Well, I believe this is where Smith Capital shines! This is where I think we have a huge edge on the market because we not only ignore the “noise,” but we think and analyze deeply, and typically go against the noise. This allows us to take advantage of opportunities that emerge when the market is frantically selling or buying driven by emotional reaction to the “noise!!”

Conclusion

In summary, I believe the market weakness, volatility, and overall negativity since April represents a short-term pullback in the midst of a longer-term economic and stock market recovery, which still has further to go. This is true for both the U.S. and for global markets. I believe the market’s extreme exhibition of investor anxiety reflects the overall fear and lack of clarity that investors have toward the state of affairs in the world today. Therefore, much of the reactive jitters that investors are displaying to headline news is understandable in that they don’t know any better. But, this creates opportunity for those of us who do have a greater since of clarity and confidence in the eventual outcome of the current fragile state of the world economy and markets.

I understand that many people are concerned the political strife that is so prevalent around the world today is not going to be resolved positively, and therefore the global economy and markets may roil. But, my contention is that if you truly study history, especially the history of capital markets and economic progress, you will find that political turmoil, threatening wars, and other societal stresses have been par for the course in the midst of markets and economies advancing. What we are facing today isn’t really extremely unique or especially threatening. What is unique is our access to and knowledge about every scary development on the world scene in real-time, with instantaneous coverage, analysis, play-by-play commentary, visuals, etc. This exacerbates reaction, especially in the capital markets when technology allows investors of every shape and size to carry their emotional reactions over into portfolio reactions. The end result is the smallest trader using E-Trade, Schwab, Fidelity, etc. all the way to the biggest global macro hedge fund manager with control over billions of dollars, are both selling and / or buying first, and evaluating later.

This is the reality of our world, which creates greater volatility and greater opportunity. But, it also requires a level head, shrewdness, discernment, knowledge of global macro economics and capital markets, and the ability to evaluate what degree of investor emotion is priced into various securities and markets overall. This is where Smith Capital, and our strategy and process shine. Now that I have gone through this mini dissertation on the current state of the psyche of world capital markets, let’s conclude with some key points to consider regarding the economy and those capital markets.

Key Points to Consider:

• Leading economic indicators have increased substantially in recent months, and remain quite elevated. This typically presages a strong economic recovery and is typically coincident with a strengthening stock market.
• Corporate earnings estimates continue to rise as earnings reports continue to surprise to the upside, with companies generally providing positive outlooks for their businesses. Furthermore, corporations are sitting on near record levels of cash with very lean balance sheets and lowered cost structures.
• Credit market spreads have widened in recent months due to concern about sovereign debt problems in Europe. This in-turn sparked fear of another freezing up of the credit markets like what occurred in 2008. However, spreads remain at SUBSTANTIALLY lower levels than what existed in 2008, reflecting the overall health of the credit markets globally and their funding mechanism efficacy.
• Cash on the sidelines remains at very high levels due to the on-going fear among investors globally, who continue to fear a second act of the drama that played out in 2008. This continued massive reserve of cash, which amounts to nearly $7.5 Trillion in the U.S. alone, remains a huge source for driving markets higher, especially with short- term interest rates remaining at painfully low levels for savers.
• Stock dividend yields and earnings yields remain attractive relative to cash, corporate bond, and government bond yields, each relative to their historical norm. This will fuel a draw of fresh capital into global equity markets over the intermediate-term as fear subsides and economies continue to recover.
• Investor sentiment indicators reflect heightened levels of fear and anxiety, which from a contrarian standpoint, represents wonderful buying opportunities for shrewd, value-seeking investors like us.
• In recent weeks fearful investors have been pouring money back into the U.S. dollar and U.S. Treasury bills, notes, and bonds as a move of safe-haven seeking. However, in the month’s ahead bond investors will come to their senses, once the skies over Europe clear a little, and they will begin to scrutinize the finances of the U.S. government. This should drive money back out of Treasury bonds and eventually drive those government bond yields higher.
• Hence, I believe government bonds, and even corporate bonds, which have performed so well during the last year or more, will begin to underperform other asset classes. This eventually will spark a cycle of interest rates rising, and could further restrict bond performance. Equities should outperform in such an environment as well, so long as inflation is not out of control.

While I am working on a larger commentary with many updated Smith Capital research charts and graphs, this Quick Update summarizes my current views and strategies for our model portfolios and client accounts. Thank you sincerely for the continued privilege of serving you and your family.

Chad Smith
Managing Director