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Nicholas Colas (Chief Market Strategist): 212 448 6095 or ncolas@convergex.

Christine Clark: 212 448 6085 or
Beth Reed: 212 448 6096 or

Stocks ended higher Friday, continuing a 3-week long September rally. The S&P 500 added 8 bps, Morning Markets Briefing
while the Dow and Nasdaq were up 12 bps and 54 bps, respectively. For the week, the Nasdaq gained
3.26%, as the S&P 500 and Dow were both up over 1 percentage point. In the day’s economic news,
Market Commentary: September 20th, 2010
consumer sentiment unexpectedly fell to 66.6 in September after reaching 68.9 in August, according to
the University of Michigan’s Consumer Sentiment Index. Consumer prices rose 0.3% last month, A snapshot of the markets through the
following an increase of the same amount in July. The core CPI, excluding food and energy, gained lens of ConvergEx.
0.1%. On tap for Monday: the NAHB housing market index, earnings from DFS and LEN, plus the NKE
shareholder meeting.

Top 10 Reasons for Increased Asset Price Correlations

Summary: Increased correlations among financial assets of all shapes and sizes are very much a problem for global capital markets. The benefits of diversification – less
risk for the same return, or greater return for the same risk – diminish when assets behave more and more alike. We think that higher correlations are the confluence of
many market trends rather than the fault of just one or two recent developments like the increased popularity of ETFs or high frequency trading. In this note we list 10
contributing factors, which can be clustered into two groups: those that directly drive correlations higher and those that diminish the investor confidence needed to
encourage contrarian/countertrend investment disciplines.

There is much discussion in the capital markets of late about high price correlations among stocks and other asset classes. The nom de guerre for this
phenomenon is “Risk on, risk off.” The screen is either green or red. This trend is more damaging to capital markets than most reports indicate, however. It isn’t just a
problem for traders looking to make rhyme or reason out of market moves. Rather, it is a deeply corrosive issue that diminishes the value of investing altogether.

Investment assets need low correlations the way a plant needs sunshine – it is what allows both to draw nutrients and grow. Diversification as an investment
doctrine is sometimes called “the only free lunch in capitalism.” But that free lunch goes from a Michelin three star restaurant to dirty water dog on the streets of New
York when correlations increase. This is because asset price correlations and the net benefit of diversification are one and the same. You buy stocks and bonds and
commodities in a portfolio because when one asset class goes down, another will likely rise. But when all move up and down together, you get more risk with no
commensurate payoff in total return. Bad news all around, especially since the last 24 months have made investors especially risk-averse.

Market Commentary – Pages 1-5, Equities/Conferences & Earnings – Page 6, Fixed Income – Page 7, Options – Page 8, Exchange-Traded Funds/Indexes – Page 9, Social
Media & Internet Blogs Top Stories – Page 10
1 1
Nicholas Colas (Chief Market Strategist): 212 448 6095 or
Christine Clark: 212 448 6085 or
Beth Reed: 212 448 6096 or

Changes to the global economy as well as market forces over time have brought us to this unhappy point. In this note we identify 10 such factors, but they fall
broadly into two categories:

• Some are structural changes that draw asset prices closer together. Forces like globalization may generate higher overall worldwide GDP growth in good
times, but tie developed and emerging economies together in difficult periods as well. Also, global banks and capital markets allow flawed assets to reach a
large global market of buyers instead of containing the capital available for shaky products in just one geographic region. Just as health epidemics like AIDS or
swine flu became global problems through the movement of populations through affordable air travel, global capital markets have made financial contagion
much easier to spread.
• Other factors that drive higher correlations relate to existential risks to economic recovery in the U.S. as well as basic market structure. The historically
lower-than-average market valuations often cited by Wall Street strategists are just one sign that investors have little faith in the global economy and hence
doubt the accuracy of earnings estimates for companies large and small. That makes the market “twitchy,” for lack of a more eloquent characterization. As a
result investors are more engaged in asset class selection than stock picking. Sectors that historically move at different points in an economic cycle – consumer
staples and consumer discretionary, for example – now find themselves BOTH beating the S&P 500 year-to-date.

The rest of this note will break up these two categories into 10 drivers of higher asset price correlations.

1) Index-based, rather than active investing. Investing capital by index rather than stock picking is the financial version of “Why buy the cow when you are getting the
milk for free?” After all, IF the stock market regularly returns +10% (which it did from the early 1980s to the late 1990s) AND most active equity managers underperform
their benchmarks, then just putting money into a low-cost product that tracks a broad market index makes all the sense in the world.

What a difference a lost decade for equities should have made, but evidently didn’t. The largest Exchange Traded Fund is the SPY, engineered to mirror the S&P 500.
Other popular ETF products anchor off international stock market indices (EFA, EEM, for example), the spot price for precious metals (GLD, IAU, and SLV among others), and
even unmanaged bond indices (AGG, BND, and SHY, just to name a few). And, of course, many of the largest mutual funds are index-based as well. Index-based
investing has only grown in popularity during the “lost decade” for equities.

The troublesome feature of this trend is that indexing makes no differentiation among companies that merit capital and those that don’t. That’s not an
indictment, per se: it’s what the funds do and investors have every right to make that investment choice. But when capital flows to a company for no other reason than it
is in an arbitrarily created index, the purest function of markets – allocating capital to its best possible use – will by necessity not work as well, and correlations will also
tend to increase. Money that goes into an indexed product will be put to work across the board, not into the sectors and companies that offer the best risk-reward. That
is the recipe for higher sector correlations.

2) Artificially low interest rates/ lack of a rate cycle. The business cycle and its interplay with interest rates is a bedrock driver of stock and other asset prices globally.
During periods of slowing economic growth, central banks lower interest rates. That brings down the cost of capital and spurs investment and hiring. On the upside of a
business cycle, the reverse action takes place as central banks raise rates to lower the chances for inflationary pressures to build. The rate cycle drives historically drove
the out – or – under performance of many equity market sectors, including financials, consumer durables and housing.

Nicholas Colas (Chief Market Strategist): 212 448 6095 or
Christine Clark: 212 448 6085 or
Beth Reed: 212 448 6096 or

Throw all that out the window now. Central banks in developed economies have pinned short-term rates near zero and purchased longer dated sovereign debt in order
to keep rates low across the yield curve. Their economies and banking systems are just too fragile to absorb the shock of “market” rates, especially as the governments
of the U.S., Europe and Japan are issuing incremental debt to fund deficit spending. But without the normal rate cycle, investors are missing cues that have historically
given them reasons to rotate among different industrial sectors. That makes the traditional sector rotation of typical cycles a thing of the past, and it should be no
surprise that correlations rise in the absence of a “normal” investment cycle.

3) Heavier regulatory/taxation overhang. Chief executive officers like certainty. There isn’t much around in the best of times, including the security of their own jobs if
things go awry. The U.S. has seen two large-scale pieces of legislation passed – financial services regulatory reform and health care – since the 2008 financial crisis. No
matter where your political leanings may be, it is easy to see how +4,000 pages of new laws might put a bit of a chill in the C-level office suites of the country’s large
companies and outright fear in the kitchen offices of small businesses. When combined, the two new laws touch both access to capital and labor cost structures in ways
even the most politically connected enterprises on the planet– multinational banks – have trouble quantifying.

Those fears create higher correlations across financial markets because, as with the prior point, they tear up the traditional “playbook” for economic recovery.
Companies are especially reluctant to hire new workers since they worry about what incremental health care expenses may be associated with this hiring. Combine that
with shaky final demand in many sectors and it should come as no surprise that unemployment is so sticky. Financial regulatory reform faces another round of headline-
grabbing uncertainty as the new Consumer Financial Protection Bureau kicks into gear. Can banks fulfill their key role in the U.S. economy when regulatory uncertainty
litters the front page? It seems a tall order.

4) Globalization of economies and financial markets. There is an old saying to the effect that “data is not the plural form of the word anecdote.” Still, the financial
crisis yielded a rich trove of stories about how the meltdown in the U.S. housing market touched everyone from Icelandic herring fisherman to Maine’s lobster business to
Norwegian pensioners to Chinese factory workers. There can be no doubt that the world’s economies are more closely knit together than ever before.

Geographic diversification is one important access point for investors to buy less-correlated assets. Economic co-dependence may yield benefits from trade during
good economic times, but it also increases the correlation of financial assets across the world’s markets.

5) A still fragile U.S. housing market. Most Americans own their primary residence – something over 66% of them at last count. But for +90% of them – maybe even
99%, we suspect – their house is also their largest financial asset. House prices therefore drive a lot of most Americans’ “wealth effect’ – the portion of their spending
that is driven by how well-off they feel rather than how much they make.

Prior to the 2008 financial crisis, house prices had not gone down on a national basis since the 1930s. That rubric was the intellectual anchor for much of the
stupidity in the housing market during its bubble. Even with the pullback in residential real estate prices since 2007 no one can be sure that the troubles are not over for
this market. That is yet another reason why the domestic recovery has been sluggish and choppy. And yet another reason why markets tend to correlate, as the
domestic consumer is responsible for 70% of the economy. When one input – house prices – can swing consumer spending patterns for much of the economy, it is
understandable that many stock market sectors will behave similarly.

6) Worries over deflation as an existential threat in the US. Central banks around the world know how to fight inflation. Raise interest rates, cool the economy, and
watch expectations for inflation fall. If there is an “Easy button” in the central banker’s toolbox, this is it.

Nicholas Colas (Chief Market Strategist): 212 448 6095 or
Christine Clark: 212 448 6085 or
Beth Reed: 212 448 6096 or

In contrast, there is no effective playbook for deflation. Theories, yes. Plenty of those. Drop money from helicopters, to borrow from Fed Chairman Ben Bernanke’s
oft-quoted speech. Japan, which must have more monetary policy helicopters than the world’s armies have real ones, is proof that deflationary expectations are
pernicious and much harder to beat back than inflationary ones. Oh, and don’t tell me that deflation is not a realistic threat just because of the acres of cash hovering
around the banking system. If it were not, why would the Fed be talking up the possibility of another round of quantitative easing?

That lack of a recognized “cure” for deflation causes higher correlations because there are so few investment classes that actually benefit from lower prices.
Sovereign debt is pretty much the only item on that menu, even as the credit-worthiness of most developed economy issuers is the lowest since World War II. All this
contributes to the “twitchiness” we have noted in other points here since deflationary environment is not usually a good one for most risk assets. Just look at Japan.

7) Structurally higher US unemployment. Past U.S. recession – think 1973/4, 1979/80, 1982, 1990, and 2001/2002 – saw quick spikes in unemployment followed by a
gradual but perceptible return to more normal levels. Auto workers are laid off when demand drops, for example, and then called back in 6-12 months as demand

This time the contours of the recovery in labor markets are more difficult to predict. Much of the drag seems to come from the persistently high unemployment
among less-educated workers, where unemployment rates are all higher than national averages. The U.S. has a clear surplus of construction workers and a clear shortage
of affordable software engineers. It seems unlikely that workers can migrate from one vocation to the other, however. Capital markets are all-too-aware of this problem
and cognizant of the fact that this means structurally higher unemployment, a sloppier recovery and greater risks to another economic downturn. And all that means, as
with so many points outlined already, a “twitchier” hair trigger sensibility to investing in risk assets.

8) Memories of recent financial markets turmoil. Clever market watchers have called this the “Jason Bourne” market, because you don’t make an investment without
first planning several exits in case your expectations don’t play out. That’s a hard to quantify observation, but neatly encapsulates the skittish “risk on, risk off” nature of
the markets.

9) High frequency trading. By most widely quoted estimates, high frequency trading is some 60-70% of all daily activity in U.S. equity markets. HFT is a catch-all name
for a range of strategies, from ETF arbitrage and statistical arb to trying to sniff out and front run large orders. But what almost all HFT trading has in common is a studied
ignorance of company and sector fundamentals and an effort to allocate investor capital along those lines. And the few strategies that do still only hold stocks for a
fraction of the time usually required to close the gap between aberrant perception and reality.

HFT doesn’t add correlation as much as it seems to drive money away that has historically put money to work in less correlated methods. Retail investors have
fled actively managed U.S. equity mutual funds since the “Flash Crash” of May 6th. How much of this is due to the volatility of that day is impossible to know. It does not
seem to be performance driven – U.S. stocks are up on the year and essential flat from May 6th.

Those who know far more about HFT than I do say “You cannot turn back the clock on technology.” Fair enough. But when technology becomes the end rather
than the means it should be no surprise that other market participants will pack up and look for greener, less trampled pastures. And when those market participants are
the ones that are better equipped by virtue of fundamental research and investment horizon to set rational prices, equity markets do run the risk of becoming a rodeo
with no riders.

Nicholas Colas (Chief Market Strategist): 212 448 6095 or
Christine Clark: 212 448 6085 or
Beth Reed: 212 448 6096 or

10) Upcoming U.S. elections. We’ll close out this list on a note of optimism. The entire House of Representatives and 37 Senate seats are up for grabs in a few weeks. If
the primaries are any guide, there will be a lot of fireworks on Election Day 2010. No doubt the market is waiting to see the outcome of this event. Gridlock by dint of a
Republican win in the House will almost certainly bring some change to Washington. Markets, like those CEOs we mentioned, like certainty – even if certainty means
“nothing done.” And that could be enough to begin the thawing of corporate confidence and a more “normal” playbook for economic recovery.

Nicholas Colas
C (Chief Market Strrategist): 212 448 60955 or
Christine Clark: 212 448 60855 or
Beeth Reed: 212 448 6096 6 or


Shares off ORCL soared 8.4 4% after the com mpany reported profit that jumpe ed 38%, easily toopping analysts’ estimates. RIMM (+0.5%) was also a up on the
day, as itt posted better-than-expected eaarnings and raise ed its outlook forr the current quaarter. Shares of many financials slid, with JPM (-22.3%) and BCS (--
3.1%) both down more th han 2%, after U.SS. regulators agreed to a proposaal that would req quire companies to disclose more about their debt. Restaurant
stocks alsso faltered as Jeffferies initiated coverage
c on the sector with a “ccautious view” off near-term fund damentals.

Importannt Earnings Today

y (with Estimatess) From…
ƒ DFS: $0
0.35 S&P Futu
ƒ LEN: $0
0.06 One Day (High
( –1132.75; Low – 1117.00):
Source: Blooomberg

nt Conferences/Co
orporate Meeting
gs Today:
UBS Global Life Sciences Confe
erence – New York, NY

Prior Day SPX (High – 1131.74; Low – 1122.43; Close

e – 1126.11): Three Dayy (High – 1127.00; Lo
ow – 1109.00):

Sourcee: Thomson ONE

Nicholas Colas (Chief Market Strategist): 212 448 6095 or
Christine Clark: 212 448 6085 or
Beth Reed: 212 448 6096 or


Last week Treasuries rose for the first time in 4 weeks, as investors speculated the Fed will be more accommodative in its policy statement this week,
after more signs the economic recovery may be in trouble. The benchmark 10-year note yield fell 5 bps on the week to 2.74%, while 2-year yields
dropped the most in 4 months and were within 1 bp of the record low of 0.45% after the central bank purchased shorter-maturity debt.

Source: Bloomberg Source: Bloomberg

Today’s Important Economic Indicators/Events (with Consensus):

ƒ NAHB Housing Market Index

Nicholas Colas (Chief Market Strategist): 212 448 6095 or
Christine Clark: 212 448 6085 or
Beth Reed: 212 448 6096 or


SPX –The underlying Index once again traded in a tight range of +0.6% to -0.2%. The September expiration settled at 1131.15, just below the intraday day’s high of 1131.47.
Implied volatility was also little changed, as reflected in the change of + 1.3% in the VIX. There were two ratio spreads in which the October 1000 puts were bought. The October
1000 puts was bought three times vs. the sale of the November 1,000 puts once, generating a small net credit. The October 1000 puts were also bought five times vs. the sale of
the October 1100 puts once, again for a small net credit. There were also several other more typical spreads such as the purchase of the October 1050 puts over 5,000 times and
the sale of the November/December 1075 put spread about 5,000 times.

ETF- The market spiked in early trading then was bound in a range hovering around neutral throughout the day. Even with Quadruple Witch expiration, Friday’s trading proved to
be lackluster with disappointing news in consumer sentiment negating positive news in the technology space. We saw investors taking advantage of elevated premiums across
much of the ETF space. In EEM (Emerging Markets) for example, investors sold volatility with paper selling 16,000 Jan 40 Puts delta neutral while in another trade 3,100 Oct 43
straddles were sold. Also, XLK (Tech) had investors buying downside through Jan 20 Puts 14,000 times. TBT (UltraShort Lehman 20 plus Year Treasury) had one investor buy
11,818 Sep 33 Puts for .03 closing out a position. Lastly, in XHB (Homebuilder) one investor rolled long calls through buying the Sep / Oct 15 call spread 8,000 times.


Rank 9/13/2010 9/14/2010 9/15/2010 9/16/2010 9/17/2010 30-Day Implied Vol
Top 10 30-Day Implied Vol Bottom 10 30-Day Implied Vol
5 Q AGN AZO PG PG 13.58 PKI 52.72% 28.32 ORCL -31.52% 26.20
6 CEPH FSLR DTV FSLR DTV 22.07 HSY 34.09% 29.82 LSI -21.72% 36.02
8 AGN Q RHT CEPH AZO 24.35 HAR 32.42% 43.45 THC -16.35% 48.07
9 STZ CEPH GIS Q AGN 28.88 CMS 30.11% 23.12 PWR -15.81% 29.79
HNZ 14.83% 17.95 MFE -12.66% 5.07
12 SLM STZ KMB AGN HSP 33.66 HRS 14.38% 28.81 TSN -12.56% 32.94
13 HSP PEP PEP PEP STZ 28.61 CTL 13.70% 16.76 NU -12.19% 16.94
15 YHOO SLM STR WAG WFR 43.40 LO 13.40% 19.10 LEG -11.97% 26.66
16 CLX CLX SLM STR PEP 16.03 Q 12.92% 21.38 LLL -11.91% 22.83
ADSK 11.37% 34.67 BMY -11.48% 17.26
We ranked the S&P 500 companies from the highest to lowest 30 day implied to
24 GIS RHT JEC SLM VRSN 28.93 historical volatility ratio. Above we identify the 10 most positive and negative
25 BBY DVA PX BMY CTL 16.76 movers.
RSH PX MKC NOVL SLM The table to the left represents the 25 highest 30 day implied to historical
CTXS JEC YHOO CLX MKC volatility ratios within the S&P 500 companies. The green represents names
DTE WFR ARG QLGC NKE new to the list while the red represents names that have fallen out.

Nicholas Colas (Chief Market Strategist): 212 448 6095 or
Christine Clark: 212 448 6085 or
Beth Reed: 212 448 6096 or

Exchange-Traded Funds/Indexes
Prior Day Peformance of Largest ETFs by Assets S&P 500 Sector ETFs
Name (Net Assets*) Ticker Category Daily Return Sector Ticker 1-Day Perf YTD Perf Sector Ticker 1-Day Perf YTD Perf
SPDRs SPY Large Blend 0.04% Energy XLE -0.50% -5.47% Telecomm IYZ 0.95% 6.54%
SPDR Gold Shares GLD N/A -0.07% Health XLV -0.02% -3.64% Technology XLK 0.54% -1.74%
iShares MSCI Emerging Markets Index EEM Diversified Emerging Mkts -0.16% Industrials XLI 0.93% 10.46% Consumer Discretionary XLY 0.26% 10.01%
iShares MSCI EAFE Index EFA Foreign Large Blend -0.48% Utilities XLU -0.17% -0.55% Financials XLF -0.48% 1.46%
iShares S&P 500 Index IVV Large Blend 0.36% Consumer Staples XLP -0.26% 4.08% Materials XLB 0.03% -0.78%
Prior Day Top Volume ETFs Currency ETFs
Name Ticker Category Shares Traded Currency Ticker 1-Day Perf YTD Perf Currency Ticker 1-Day Perf YTD Perf
SPDRs SPY Large Blend 195,836,810 Australian Dollar FXA -0.04% 4.16% Mexican Peso FXM 0.24% 2.10%
PowerShares QQQ QQQQ Large Growth 76,372,570 British Pound Sterling FXB -0.03% -3.51% Swedish Krona FXS -0.45% 0.96%
Financial Select SPDR XLF Specialty - Financial 65,745,839 Canadian Dollar FXC -0.44% 1.66% Swiss Franc FXF 0.47% 2.28%
iShares Russell 2000 Index IWM Small Blend 61,780,941 Euro FXE -0.32% -9.12% USD Index Bearish UDN -0.27% -4.79%
iShares MSCI Emerging Markets Index EEM Diversified Emerging Mkts 40,118,044 Japanese Yen FXY 0.03% 8.19% USD Index Bullish UUP 0.21% 2.25%
Prior Day Top Performers VIX ETNs Fixed Income ETFs
Name Ticker Category Daily Return Name Ticker 1-Day Perf YTD Perf Bonds Ticker 1-Day Perf YTD Perf
KEYnotes First Trust Enh 130/30 LgCp ETN JFT N/A 6.00% iPath S&P 500 VIX VXX -1.27% -49.63% Aggregate AGG 0.13% 4.55%
B2B Internet HOLDRs BHH Specialty - Technology 4.30% Short-Term Futures ETN Investment Grade LQD 0.32% 6.91%
PowerShares DB Agriculture Dble Long ETN DAG N/A 4.12% High Yield HYG 0.18% 1.32%
iPath DJ-UBS Cotton TR Sub-Idx ETN BAL N/A 3.35% iPath S&P 500 VIX VXZ 0.13% 10.62% 1-3 Year Treasuries SHY 0.02% 1.59%
FaithShares Baptist Values FZB N/A 3.27% Mid-Term Futures ETN 7-10 Year Treasuries IEF 0.18% 9.79%
20+ Year Treasuries TLT 0.40% 13.10%
ETF Ticker 1-Day Perf YTD Perf ETF Ticker 1-Day Perf YTD Perf
Gold GLD -0.07% 16.06% Crude Oil USO -1.00% -16.88%
Silver SLV -0.29% 22.68% EAFE Index EFA -0.48% -2.98%
Natural Gas UNG -1.02% -33.73% Emerging Markets EEM -0.16% 3.66%
SPDRs SPY 0.04% 0.94%

Major Index Changes:


ETFs in the Headlines and Blogs:

ƒ Diversifying Into Gold ETFs -
ƒ 10 ETFs to Play Deflation -

Nicholas Colas (Chief Market Strategist): 212 448 6095 or
Christine Clark: 212 448 6085 or
Beth Reed: 212 448 6096 or

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Nicholas Colas (Chief Market Strategist): 212 448 6095 or
Christine Clark: 212 448 6085 or
Beth Reed: 212 448 6096 or


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