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We invite you to read more on our blog The Firecracker Report. Is the S&P 500 in a Top Formation?

As we enter the closing month of 2009, the S&P 500 has rallied 66% off its March 2009 low of 666, and it is now just 200 points shy of its pre-crisis trading level of ~1,300 (AugustSeptember 2008). Heading into 2010, most investors are trying to understand what the future has in store for the equity markets. Is there still plenty of room left to the upside as Cramer from the CNBC bull pen would like us to believe? Is this the beginning of a new bull market where the S&P will clock >20% annual returns over the next few years? We think not, as we explain below. Wall Street’s Best Case Scenario - S&P to Trend Flat in 2010 and Take off Like a Rocket in 2011 As of now Wall Street‟s most bullish scenario bakes in a flattish trend in the S&P 500 for 2010. Consider Chart 1 below, which plots out the annual S&P EPS on a LTM (last twelve months) basis on the left axis, along with the closing year-end value of the S&P on the right axis. As per Wall Street estimates (which are way too optimistic in our opinion) S&P 500 earnings will grow 14% in 2010 to $53 and a whopping 28% in 2011 to $68. In other words Wall Street has pushed the V-shaped recovery further out by a year to 2011. So where would this leave the S&P 500? If we apply a bullish 21x P/E multiple (the average multiple from 2003-2007 was 20x and those were the good years) to these very bullish earnings we arrive at a value of 1,113 for the S&P in 2010 and 1,423 in 2011. In other words the Streets 14% EPS growth for 2010 is already baked into the current trading level of the S&P of ~1100. Beyond 2010 the Street is expecting a sharp recovery in both EPS and the S&P so that they each rally by 28%.

Chart 1: S&P 500 annual EPS (actual and Wall Street Projections) plotted with respective year-end closing S&P values. 1 The Firecracker Report

Looking at the chart above one would be tricked into thinking that the EPS growth projections look pretty promising except for one key fact: Most of the EPS gains in 2009 came not from revenue growth but via massive cost cuts and lay-offs as evidenced by the nearly 10% official unemployment rate. So for the S&P to grow its EPS by 14% next year and 28% thereafter, it would have to show some real revenue growth and profit margin expansion because companies have already cut costs to bare-bone levels. And it would have to achieve all this 1) without the credit gasoline that fired the consumer and corporate engines in the 2001-2007 cycle, 2) with a persistent >10% unemployment rate, 3) Without the housing asset bubble as an ATM and 4) In the face of soon to be the norm capital and trade controls which will have to be imposed as the world‟s central banks race each other to devaluing their currencies (think goodbye export growth to China, India, Europe and Japan). An impossible task. A Bear Market Rally with a Twist In our opinion this continues to be a bear market rally but with a twist. This rally would have fizzled long back had it not been for the enormous amounts of money that the Fed has pumped into the system particularly large financial institutions. In the absence of suitable lending opportunities, all this money has found itself speculating in the stock and the commodity markets. So unlike bear markets in the past, this time the Fed‟s intervention has been so massive (to the tune of trillions of dollars) that it has kept the markets buoyed higher and for longer. So how would this rally fizzle? Not in the way one would normally imagine - i.e. an immediate sharp move lower (it could happen but it would be a low probability event). Instead, as we show in Chart 2 on the next page, it appears that the S&P is in for a prolonged period of forming a top. Justin Mamis captures it best in his newsletter: “The stock market is becoming increasingly familiar. We've seen this before (or lesser variations thereof). This is how an important top forms over a long, very long period of time. It took over a year for the '07-'08 top to evolve -- from spring '07 at about Dow 11,000 to the breakdown in the summer of '08 in the neighborhood of 11,750. And this rise, remember, is to a secondary lower high”. “Market timing has nothing to do with the daily news, because it truly is anticipatory, no matter how much daily news items, such as pennies-better-than-expected earnings reports, are embraced as glorious. "Friday's seesaw 'up' on the so-called employment report, and 'down' when that childlike burst of enthusiasm was exhausted, is but one day in the gradual ebbing of the extensive rally -- 10 months in duration and still incomplete . . . although, of course, 'tis getting later and later.. Not only is the economic news and the financial news calming (and indeed encouraging), but the lack of selling pressure makes the market look benign. "Replete with

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optimism, tops therefore really do take a long time to form, and to form in seemingly 'safe' ways”.

Chart 2: The first chart shows a 5 year performance of the S&P 500 with the red circle highlighting the prolonged the topping out pattern from 2007-2008. We expect something similar to occur now. As highlighted by the green circle in the second chart, the S&P has been trending sideways since its mid October peak of 1,098. Since that peak the S&P has risen a mere 5 points to close at 1,103 yesterday. Thus in conclusion, we expect the market to map out a top formation pattern going into 2010 before trending down (once folks can better ascertain the trend in the EPS for 2010 and 2011). In such a scenario investor portfolios should be defensively positioned in high dividend paying stocks, many of which have not participated in this rally to the same degree as the speculative paper.

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About the Firecracker Report The Firecracker Report is a financial and geopolitical analysis blog started by a team of exWall Streeter‟s with extensive banking and investing experience. We strongly feel that in the current era of corporatized propaganda driven news the „real‟ news often goes unreported. We have therefore chosen to lend our voices and join the growing ranks of independent bloggers that aim to bring insightful commentary and analysis to their readers. We invite you to visit our blog and would love to hear your thoughts and comments. We can be reached at firecracker.report@gmail.com

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The contents and data of The Firecracker Report are published solely for general information purposes only and do not constitute financial recommendation or advice. The content of this report is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments in any jurisdiction. The author(s) of the Firecracker Report are not licensed investment advisors. Thus, the Firecracker Report does not give investment advice and does not advocate the purchase or sale of any security or investment by you or any other individual. It is understood that investment decisions carry risk and are the responsibility of individuals and their professionally licensed investment advisors. Investors should exercise prudence in making their investment decisions. This report should not be regarded by recipients as a substitute for the exercise of their own judgment. The author(s) of The Firecracker Report may or may not have a position in any company, commodity or asset referenced in the report. Any action that you take as a result of information or analysis in this report is ultimately your responsibility. Consult your investment adviser before making any investment decisions. The Firecracker Report does not guarantee the accuracy, completeness, timeliness, suitability, or validity of any published information and will not be liable for any errors, omissions, or delays in this information or any losses, injuries, or damages arising from its display or use. All information is provided on an as-is basis.

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