February 2010

L a n e F i n a n c i a l M a n ag e m e n t
Stock Market Commentary .. by Ed Lane
What Moves Markets?
The value of stock and bond markets is essentially the value investors put on the expected returns of dividends/interest and the future value of the underlying investment. easy credit began to show up as consumers bought everything in sight at increasingly higher prices. The S&P rose nearly 14% annualized

Special points of interest:

Since this total return on investment is an unknown quantity, investors anticipate, or have expectations of, what the future values will be. (Short term traders have other motives.) While, at any point in time, the value of a market reflects the expected returns, market movement results from some combination of two factors:
 

The market sold off in January. Is this temporary or a new normal?

Q4 2009 GDP growth was 5.7% but there was less here than meets the eye.

In late 2007, reality set in that asset prices had gotten overextended and credit was made available to many who could not repay. The S&P fell nearly 70% annualized

Market momentum may be shifting to the downside.

A change in those expectations, and/or Fear or greed that a market has moved in one direction or the other too far, too fast.

Last March, investors came to the conclusion that the recession’s impact on the market was too extreme and government stimulus was on the way. A sharp correction ensued as the S&P rose at a 75% annual rate (producing a 6.4% annual return for the entire 15-year period).

Investment focus should be on emerging markets and income.

Looking back to the two most recent major market cycles for the S&P 500 (1995-2003 and 2003-2010), here’s what I observe:

Inside this issue: What Moves Markets 1 At-a-Glance Economic Recap Market Recap Momentum Watch My Bottom Line Disclosures 2 3 4-5 6-8 9 10-11

From 1995 to around the middle of 2000, investors saw an explosion in technology, especially use of the internet, and resulting productivity gains. The S&P rose at an annualized rate of over 26%

So, where does that leave us? Sensing that each of the last 15 years of major market swings in the S&P resulted from an unrealistic view of the underlying real value of the economy, we are now left to discern what that value really is — and put a price on it. However, we are now in a period of great economic uncertainty. As a result, the market is volatile, reacting quickly to news (and advice) that goes one way or the other — and there’s plenty of it. There are many implications for investors, some of which I will try to address in ―My Bottom Line‖ on page 9.

Then, in 2000, investors began to see that many internet-related businesses had no staying power and expectations of never-ending productivity gains collapsed. Along with it, the S&P fell at an annualized rate of 28%

Then, around 2002-2003, the effects of

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L an e F in anc i a l M ana ge me nt
Here is a quick summary of this month’s market commentary: The Economy Despite improved corporate earnings reports during the month, economic signals for January were not encouraging. Employment and credit, my two primary bellwethers, remained weak. The GDP annualized gain of outperformance of the emerging market economies will prove that these areas represent the best investment opportunities for both equities and income-oriented investments. Technology and certain areas of health care along with consistent dividendpaying sectors (like utilities) and preferred stocks will also do well. My Bottom Line The U.S. economy, and that of many, if not most, other developed nations, face a nearly impossible situation with rising domestic deficits and low cost employment competition from emerging market economies (the solution to one exacerbates the other). While those domestic businesses/sectors that are successful selling into or competing with the emerging markets will do relatively well, those that depend on domestic consumption will be severely challenged.

I believe we are on an irreversible trend toward more freedom and democracy - but that could change. — Dan Quayle

5.7% in the last quarter of 2009 turned out to be based on seemingly unsustainable factors. The Market The market took a decidedly negative turn in the middle of January. Momentum indicators are barely hanging on to their preceding upward direction. The Current Opportunities Despite a sharp sell-off in emerging markets and building materials, I believe the eventual

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Economic Recap
The year started off with few sightings of green shoots. Much of the economic news was less than cheerful:

rate in the period 2001-2007), it would take another seven years for the U.S. unemployment rate to return to 5%. (As things have gotten worse since then, you be the judge as to how soon this will be happening.)

Consumer credit in the U.S. dropped a record $17.5 billion in November as unemployment, close to a 26-year high, discouraged borrowing and banks limited access to loans. Fed policy makers have said tighter bank lending standards and reductions in credit lines are hampering the recovery. The series of 10 straight declines in consumer credit was the longest since record-keeping began in 1943.

The so-called ―misery index‖ (the sum of the unemployment rate and the annual change in the CPI calculated by Haver Analytics) increased to its highest level in twenty-five years. The big news was the fourth quarter 5.7% annualized rate of improvement in the GDP. At first, this looked like great news as the rate of increase exceeded most expectations. Then, as the component numbers received scrutiny, it turned out there was less there than met the eye. The largest source of gain (3.7%) was from a rebuilding of inventories as decumulation had occurred in prior quarters. If sales don’t improve — and domestic demand growth slowed in the fourth quarter — that source of GDP gain will soon disappear. While I don’t have the recent impact of government stimulus spending, it was a little less than 2% in the third quarter. I assume it had to account for something like that in the fourth. The net result is that this pace of growth looks unsustainable.

Isn't it strange? The same people who laugh at gypsy fortune tellers take economists seriously. — Anon.

Employers shed 85,000 jobs in December as the unemployment rate rose in 43 out of 50 states. Federal Open Market Committee (FOMC) meeting minutes from December highlighted a concern that hiring activity remains slow, especially in the small business sector (the usual source for employment growth). The unemployment rate stayed at 10% in December but it did so for a very bad reason. It was because the labor force plunged 661,000 in what was the sharpest decline in nearly 15 years. Without that dramatic disengagement from the jobs market on the part of the general public, the unemployment rate would have spiked to 10.4%.

Over 7 million jobs have been lost since late 2007, probably more. According to Rutgers University economist Joseph Seneca in Wall Street Journal article from last October, if the economy returned to the pace of job growth in the 1990’s (about 180,000 jobs/month or twice the

Why oh why as reported by Bloomberg, did Bruce Kasman, chief economist of JPMorgan Chase, say as a result of the GDP announcement: ―We are getting on to something that is pretty sustainable….‖ What am I missing?

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Market Recap
In the chart below, we see the twelvemonth performance of several exchangetraded and closed-end funds representing selected investment sectors. As I have reported in the past, there were signs last June, August and again in October that the market was either overextended or taking a breather. Well, as shown on the perspective, since the current ―bull‖ market began last March, not counting the current decline, the S&P 500 index has gone through three corrections and the emerging markets (EM) index has gone through four, for average declines of 6.1% and 7.2%, respectively. The current decline from the January peak to month-end for the indices was 6.6% and 8.5% for the S&P and EM, respectively. Then again, it might not be over.

The economy depends about as much on economists as the weather does on weather forecasters. – Anon.

chart to the right, it happened again in January. There was a suggestion this was coming in December as momentum indicators were weakening and price advancement was stalling. Yet, that had happened several times before only to see the momentum restored within a few weeks. The second half of January was painful as virtually all equity markets took a simultaneous nosedive. However, putting things in

A prospectus for the above funds can be obtained through this website: http://moneycentral.msn.com/investor/research/etfs.aspx or from your financial advisor.

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Market Recap (cont.)
Looking at selected bellwethers represented by ETFs in the 12 month and January charts below, the pattern is the same as for the regions on the prior page. Basic materials and technology took the hardest hit reflecting, in my opinion, their preceding outperformance and concerns that economic brakes are being applied in the emerging markets. cent beginnings of monetary tightening as the Fed indicated it would not extend its mortgage backed securities purchases beyond its current authorization — unless mortgage rates started to rise.

In economics, the majority is always wrong. — John Kenneth Galbraith

Gold, on the other hand, didn’t suffer quite so much, having already adjusted in December. Interestingly, the not-so-perfect inverse relationship between gold and the 10year Treasury bond yield failed to be perfect in January as both values declined. In the case of the bond yield, the FOMC reiterated its intent to keep interest rates low; in the case of gold, I suspect the decline was due to heightened focus on the deficit and nas-

A prospectus for the above funds can be obtained through this website: http://moneycentral.msn.com/investor/research/etfs.aspx or from your financial advisor.

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Momentum Watch
This section highlights various technical measures of momentum. These measures are not unique and vary depending on the subject and time period. Past performance should not be assumed to continue in the future. That said, I use momentum indicators to inform trading decisions and fundamental economic analysis to inform longer
 

so as the S&P 500. The MACD turned bearish around the beginning of November and took a sharp dip in January similar to the one taken last October. The seemingly decisive break above the resistance line at around 950 failed to hold in January. On the basis of these two charts, the best news remains that the slopes of the EMA’s remain positive. If they were to turn negative, I’d have to say that the momentum had shifted to the downside. On the top of page 8, another chart shows a 14-year weekly value of the S&P 500 index along with a 50-week EMA and the MACD. Notice how well future price direction is ―predicted‖ by crossovers of the price and the EMA line once the slope of the EMA changed. At the bottom of page 8 we see a comparable chart for the MSCI Emerging Markets index. This chart shows the greater volatility of the EM index with otherwise similar results. While it’s true that a substantial portion of the advance since last March would have been missed had one followed the EMA indicator, it is also true the decline from the beginning of 2008 would have been avoided for more than a net positive result. Following the MACD at extremes would have also given a very favorable result, although there was greater potential for false starts.

―Fundamental analysis explains currency movement in terms of macroeconomic variables such as growth, inflation, monetary policy, etc. One of the weaknesses of fundamental analysis is that it says very little about the timing of moves and risk management. Timing is an important part of risk management. Even rudimentary technical analysis can help investors fine-tune their entrance into an investment and help quantify the risk. Monitoring the price action itself will likely reveal a higher probability of successful opportunities….‖ — Journal of Indexes

term or secular views. On the chart of the S&P 500 index on the top of the next page:

Momentum, as measured by 75- and 150-day exponential moving averages (EMA), remains positive. That said, the daily price plunged below the 75-day EMA and was approaching the 150 day average as the month ended, not a good sign.

The MACD (another indicator used to measure direction and strength of momentum) began to change course at the beginning of October and has now taken a sharp dip in January.

The resistance line at 1000 has been handily exceeded and now forms a support to a potential correction. I’ve placed my next resistance line at 1200, near the bottom end of the range of my year-end prediction of 1200-1300.

The second chart shows comparable information for the MSCI Emerging Markets index.

The 75– and 150-day EMAs remain positively sloped, though not as aggressively

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Momentum Watch (cont.)

Human beings are the only creatures that allow their children to come back home. — Bill Cosby

The S&P 500 and the MSCI Emerging Markets indexes are unmanaged indexes which cannot be invested into directly. Past performance is no guarantee of future results.

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Momentum Watch (cont.)

Bureaucracy defends the status quo long past the time when the quo has lost its status. — Laurence J. Peter

The S&P 500 and MSCI EM are unmanaged indexes which cannot be invested into directly. Past performance is no guarantee of future results.

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My Bottom Line
We hardly got out of the gate in 2010 before what I saw as an inevitable correction (admittedly, I’ve been predicting this for some time) sent investors scurrying for safer ground. But is this a temporary adjustment or a more lasting one to establish the ―new normal?‖ While the next few weeks will help answer this question (February has certainly not gotten off to a favorable start), my suspicion is that the answer will depend on which markets we are talking about. For the U.S., the headwinds of continuing unemployment and future deficit reduction that will put further strains on the economy are formidable. For emerging markets and those businesses that serve them, I think the recent correction (brought about by steps taken in those economies to moderate their own explosive growth and concerns about sovereign debt default) will turn into only a temporary adjustment. Here’s my continuing concern (familiar to my regular readers): The U.S. is transitioning to a new reality. In the 1980’s, economic and market expansion came from U.S.-led manufacturing; in the 1990’s, expansion came as a result of growth in productivity and the technology bubble; and in the 2000’s, expansion came as a result of unbridled credit expansion. Where will expansion come from in this decade? For the U.S., the answer is far from clear. As traditional manufacturing continues to move to lower cost emerging economies and the financial sector becomes more tightly regulated, with the financial strains on state and local governments, with the coming explosion of Medicare, Medicaid and Social Security, and with the inevitable winding down of government stimulus, the U.S. needs to establish a new base of employment to absorb the millions who have lost jobs. President Obama’s State of the Union speech gave another clue as to the seriousness of the problem: the reference to expanding exports was a nod, I think, to the understanding that the U.S. consumer will be restrained for many years to come. In my mind, the best opportunity to restore jobs and domestic demand will be for the U.S. to embrace a full-throated approach to energy self-sufficiency and infrastructure revitalization. Given the long lead times, some form of continuing stimulus will be required to achieve any level of decline in unemployment. With the current political climate and concerns over the growing deficit, it is difficult to be very optimistic in the short run. All that said, opportunities for investing remain. Fact is, a global rebalancing of economies is taking place. On account of lower cost of labor, wealth of natural resources, better management of sovereign debt and, it seems so far, generally more effective government in dealing with the financial crisis and economic expansion, I believe the best opportunities for equity and income-oriented investment will be within emerging markets and the businesses that serve those markets, such as building materials. That’s not to say that there won’t be investment opportunities in other sectors. Certain areas of health care (like medical devices) and technology will do relatively well along with consistent dividend-paying equities, like utilities and preferred stocks.

The older I grow the more I distrust the familiar doctrine that age brings wisdom. — H.L. Mencken

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Lane Financial Management is a Registered Investment Adviser with the States of NY, CT and NJ. Advisory services are only offered to clients or prospective clients where Lane Financial Management and its representatives are properly licensed or exempted. No advice may be rendered by Lane Financial Management unless a client service agreement is in place. Stock investing involves risk including loss of principal. Investing in international and Emerging Markets may entail additional risks such as currency fluctuation and political instability. Investing in small-cap stocks includes specific risks such as greater volatility and potentially less liquidity. Small-cap stocks may be subject to higher degree of risk than more established companies’ securities. The illiquidity of the small-cap market may adversely affect the value of these investments. Investors should consider the investment objectives, risks, and charges and expenses of mutual funds and exchange-traded funds carefully for a full background on the possibility that a more suitable securities transaction may exist. The prospectus contains this and other information. A prospectus for all funds is available from Lane Financial Management or your financial advisor and should be read carefully before investing. Note that indexes cannot be invested in directly and their performance may or may not correspond to securities intended to represent these sectors. Investors should carefully review their financial situation, making sure their cash flow needs for the next 3-5 years are secure with a margin for error. Beyond that, the degree of risk taken in a portfolio should be commensurate with one’s overall risk tolerance and financial objectives. Periodically, I will prepare a Commentary focusing on a specific investment issue. Please let me know if there is one of interest to you. As always, I appreciate your feedback and look forward to addressing any questions you may have. You can find me at:: www.LaneFinancialManagement.com Edward.Lane@LaneFinancialManagement.com Edward Lane Lane Financial Management P.O. Box 666 Stone Ridge, NY 12484 917-575-0299 Reprints and quotations are encouraged with attribution.

The human race has one really effective weapon, and that is laughter. —Mark Twain

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The charts and comments are only the author’s view of market activity and aren’t recommendations to buy or sell any security. Market sectors and related exchanged-traded and closed-end funds are selected based on his opinion as to their importance in providing the viewer a comprehensive summary of market conditions for the featured period. Chart annotations aren’t predictive of any future market action rather they only demonstrate the author’s opinion as to a range of possibilities going forward. All material presented herein is believed to be reliable but its accuracy cannot be guaranteed. The information contained herein (including historical prices or values) has been obtained from sources that Lane Financial Management (LFM) considers to be reliable; however, LFM makes no representation as to, or accepts any responsibility or liability for, the accuracy or completeness of the information contained herein or any decision made or action taken by you or any third party in reliance upon the data. Some results are derived using historical estimations from available data. Investment recommendations may change and readers are urged to check with tax advisors before making any investment decisions. Opinions expressed in these reports may change without prior notice. This memorandum is based on information available to the public. No representation is made that it is accurate or complete. This memorandum is not an offer to buy or sell or a solicitation of an offer to buy or sell the securities mentioned. The investments discussed or recommended in this report may be unsuitable for investors depending on their specific investment objectives and financial position. The price or value of the investments to which this report relates, either directly or indirectly, may fall or rise against the interest of investors. All prices and yields contained in this report are subject to change without notice. This information is based on hypothetical assumptions and is intended for illustrative purposes only. PAST PERFORMANCE DOES NOT GUARANTEE FUTURE RESULTS.

Wealth - any income that is at least one hundred dollars more a year than the income of one's wife's sister's husband. —H. L. Mencken

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