Mosaic Global Perspectives

Fundamental and Technical Analysis, but Mostly Judgment

Will S&P 500 Profit Margins Get Squeezed in 2011? Week Ending 2/11/2011

Figure 1 S & P 5 0 0 O p e r a tin g M a r g in

12% 95 Story of the Week 1
10% 80 Economic Update 2
8% Global Leading Indicators 3
65
6% Asset Allocation Strategy 4
50
4%
35 Equities 5
2%
20 Fixed Income 10
0%
Source:Standard & Poor’s and Institute for Supply Management Commodities 11
-2 % 5
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Currencies 12

S & P 5 0 0 O p e ra t in g M a rg in (L H S )
I S M M f g . P ric e s P a id , R o llin g 3 -M o n t h A v g . (R H S )

Figure 1, the debate is getting louder about whether profit margins can
expand from 8.5 percent in 2010 to the consensus estimate of 9.0 percent
in 2011. The wake-up call seemed to gain momentum after last week’s
report that the January ISM Manufacturing Prices-Paid component surged Dow Jones Industrial Avg. 12,273 11,824 11,578
to 81.5, the highest level since July 2008. This week’s disappointing S&P 500 1,329 1,276 1,258
earnings report from Kraft followed earlier reports from Proctor and Gamble Russell 2000 822 775 784
as well as Colgate-Palmolive that rising input costs would continue to weighNasdaq 2,809 2,687 2,653
on profits. For 2011, the gap between expected earnings growth of 15
percent and revenue growth of 7 percent implies a sharp rise in operating S&P 500 (TR) 1.5% 2.9% 5.9%
margins. Those who view the current forward P/E of 13.8X as reasonable Russell 2000 (PR) 2.7% 1.8% 4.9%
should be cognizant of this built-in margin forecast. This matters, since a 50EAFE (PR) USD 0.0% 2.1% 4.0%
basis point change in margins is thought to produce a $4 change in EPS. Euro Stoxx 50 (PR) EUR 0.7% 3.6% 8.3%
Let’s review the primary factors that influence margins. FTSE 100 (PR) GBP 1.1% 1.0% 2.8%
Nikkei 225 (PR) JPY 0.6% 1.0% 3.7%
Labor costs are much more significant to the bottom line for most Emerging Markets (PR) USD -3.4% -5.9% -5.2%
companies than changes in commodity prices. Lower payrolls and other Hang Seng (PR) HKD -4.5% -6.0% -0.9%
cost-cutting measures have been a powerful lever for boosting profit
margins. Case in point, the fourth quarter ECI showed that wages and 10-Year Treasury 3.63% 3.64% 3.29%
salaries rose by a very anemic 1.7 percent on a year-on-year basis, while 2-Year Treasury 0.83% 0.74% 0.59%
the 2.6 percent rise in productivity led to a 0.6 percent drop in unit labor 10-Yr. Less 2-Yr. Spread 280 bps 290 bps 270 bps
costs. We believe that companies will incrementally start to increase Moody's Aaa Corporate* 5.31% 5.21% 4.96%
payrolls and wage growth as the economy continues to grow. This would Moody's Baa Corporate* 6.25% 6.19% 6.05%
obviously serve to offset continued gains in productivity and limit margin
expansion. That said, it’s not a bad sign for a company to add employees inOil (WTI) Mar 11 85.58 89.03 91.38
order to meet a sustainable increase in demand for their products. Gold (Comex) Feb 11 1,360 1,348 1,421

EUR/USD 1.36 1.36 1.34

The market is punishing those companies that are most dependent on raw
materials in order to produce their goods. The consumer staples sector is AUD/USD 1.00 1.01 1.02
thought to be the most vulnerable to margin contraction, and comprises 10 USD/JPY 83.43 81.98 81.09
percent of the S&P 500. The consumer cyclical sector is likely to face * Closing levels as of 2/10/11. Source: Federal Reserve

headwinds as well, and makes up 11 percent of the index. However, the

16 percent weighting of the financial sector is expected to be the dominant
driver of the margin expansion story in 2011, as banks reduce their
Please see , Page 6

M o s a i c M a r k e t R e s e a r c h , L L C
K e v i n A . L e n o x , C F A
W e b s i t e : M o s a i c m a r k e t r e s e a r c h . c o m
EKLenox@Mosaicmarketresearch.com
m a i l : K l e n o x @ M o s a i c m a r k e t r Fundamental
e s e a r c and
h . technical
c o m analysis, but mostly judgment 1
 Economic Update
Figure 2 U.S. Weekly Unemployment Claims
4-Week Moving Average, SA
Ÿ Figure 2, nitial unemployment claims declined to a
surprising 383K last week, the lowest in 2-½ years. The four- 700,000
week moving average decreased by 16,000 to 415.5K, but is still 600,000
slightly higher than a month ago. Figure 5, employment is a
lagging indicator, but companies are well positioned to add jobs. 500,000

Ÿ Wednesday’s 10-year 400,000

auction was met with considerable demand. The bid/cover came
300,000
in at 3.23, and P/D’s only took 28 percent of the offering versus
39 percent in January. Thursday’s 30-year auction had a fairly 200,000
Source: Dept. Of Labor
strong bid/cover of 2.51, but the 4.750 percent coupon was the 100,000
highest in over three years. Figure 3, it’s positive to see this 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
week’s higher coupon for the 30-year Treasury along with a
flattening 10s30s curve. This points to a strengthening U.S.
economy without increasing longer-dated inflation expectations.
Figure 4, the broad M2 Figure 3 U.S. Treasury Yield Spread
30-Year Less 10-Year Yield
money supply for January showed growth at a non-worrisome
seasonally adjusted annual rate of 4.3 percent during the past 12 1.75
months. The monetary base has increased in December and 1.50
January due to the QE2 bond purchases. More importantly, the
1.25
slightly more than $1 trillion in excess reserves is still not
circulating. However, inflationary pressures could build quickly if 1.00
banks decided to aggressively expand their loan portfolios.
0.75
Ÿ Factory gate prices increased
0.50
1.0 percent from December, pushing the annual rate to 4.8
percent, according to the Office of National Statistics in London. 0.25
Source: St. Louis Federal Reserve
Prices were expected to have increased by 0.6 percent in 0.00
December, and may lead to a faster-than-expected response 2007 2008 2009 2010 2011
from the BoE. Input prices increased by 1.7 percent in January,
and increased the annual rate to 13.4 percent, the highest since
October 2008. Stagflation and margin compression will be very Figure 4 M2 Money Supply and Excess Reserves, Monthly
ubiquitous subjects in the U.K. this year. 1,400 9,000

1,200 8,800

1,000 8,600
PPI y/y, 6.1%
.
CPI y/y, 5.3%
Retail Sales m/m, 800 8,400
CPI y/y, 4.0% ZEW, 20.1
0.5%
PPI m/m, 0.9% 600 8,200
CPI m/m, 0.3% Source: Federal Reserve
Philly Fed, 20.8 400 8,000
Initial Claims, 401K Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11
Retail Sales m/m,
PPI m/m, 0.6%
0.6%
Excess Reserves of Depository Institutions, Millions (LHS)
M2, Billions (RHS)
The Q4 earnings season is
entering the final stretch as 371, or 74 percent of the S&P 500
reports are in the books. Positive earnings surprises remain strong Figure 5 Corporate Profits After Tax and Total Private Payrolls
at 70 percent, according to Bloomberg. Excluding financials, energy 117,500 1,400
and basic materials have the strongest earnings growth at 52 and 115,000 1,200
45 percent respectively. In contrast, health care and utilities have
the weakest earnings results with 6 percent and 1 percent 112,500 1,000
respectively. Overall, Q4 earnings are projected to grow 28 percent,
110,000 800
15 percent ex-financials on a year-over-year basis. Revenues are
tracking higher by 8.9 percent, 9.4 percent ex-financials on a year- 107,500 600
over-year basis. For 2011, earnings are expected to increase by Source: St. Louis Federal Reserve
105,000 400
approximately 15 percent to $96.18, according to Standard and
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Poor’s.
Total Private Payrolls, Thousands, Monthly, SA (LHS)
Corporate Profits After Tax With IVA & CCAdj., Billions, Quarterly SAAR (RHS)

KLenox@Mosaicmarketresearch.com Fundamental and technical analysis, but mostly judgment 2

 Global Leading Indicators
F i n a n c i a l C o n d i t i o n s A s s e t P r i c e s & E c o n o m i c D a t a

Libor-OIS Spread (3M) Above Average Widening Australian Dollar Elevated Range-Bound
Euribor-OIS Spread (3M) Elevated Range-Bound Copper Extended Strengthening
SHIBOR (1M) Elevated Narrowing
Emerging Mkt. / S&P 500 RS Average Weakening
U.S., 2-Year Swap Spread Low Narrowing Global Small / Large Cap RS Above Average Range-Bound
Europe, 2-Year Swap Spread Elevated Range-Bound Global Cyclicals / Global Defensives RS Above Average Strengthening
Moody's Baa - Aaa Seasoned Corporate Low Narrowing
High Yield - Corporate Low Narrowing Taiwan Export Orders Above Average Strengthening
PMI Mfg., Asia ex-Japan Above Average Strengthening
U.S., Equity Average Lower PMI Mfg., Europe Above Average Strengthening
Europe, Equity Average Lower Belgian Industrial Survey, Mfg. Below Average Strengthening
Currency Average Lower U.S. Initial Unemployment Claims Elevated Improving
U.S. ECRI WLI (level) Average Neutral
XBD / S&P 500 RS Average Neutral U.S. ISM Mfg. New Orders-to-Inventory Average Strengthening
Europe, Sov. and Financial CDS Elevated Narrowing U.S. ISM Mfg. Headline Above Average Strengthening

In aggregate, financial conditions in the U.S. and
Europe portray a very sanguine attitude toward risk oriented
assets. At this point, the decline in emerging market equities
has not resulted in a heightened sense of risk aversion.
Ÿ : The U.S. Libor-OIS spread has been
gradually widening each week since the beginning of the
year. This does not appear to reflect a heightened level of
risk aversion, since the the 3-month forward FRA/OIS levels
have been gradually narrowing over the past 5 weeks. In
Europe, the Euribor-OIS spread widened slightly this week,
and is near the upper end of its four-week range. The 1-
month SHIBOR rate narrowed to 5.11 percent this week
compared to 8.13 percent on January 31, according to
Bloomberg. This level is still elevated, so we’ll continue to
monitor this rate for additional insight regarding liquidity and
credit conditions.
Ÿ The U.S. 2-year swap spread continues to
stay within a narrow range. The European 2-year swap
spread widened for the second consecutive week, and has
moved toward the upper end of the five-week trading range.
In the U.S., the spread between various high yield and
corporate bond yields narrowed slightly this week, as
record-breaking issuance is being met with seemingly
insatiable demand.
Ÿ The VIX declined slightly again this week, but the
Russell 2000 volatility index (RVX), closed at the lowest
level since late December. Volatility also remains surprising
low on the Euro Stoxx 50 index.
Ÿ : European CDS spreads widened slightly this week,
but remain well below the levels seen in early January. The
AMEX B/D index (XBD), strengthened versus the S&P 500
this week, after two consecutive weeks of trailing returns.
The broader financial sector has been very closely mirroring
the S&P 500 since the beginning for the year.
Ÿ Overall, our leading indicators support a
continuation of the recent stronger-than-expected trend in
global growth. The cyclical sectors continue to outperform,
but commodity induced inflationary pressures are
intensifying throughout many of the emerging market
countries. We believe that the economic cycle is in a more
mature phase that will likely be more favorable for the
more developed countries and large cap companies.
Ÿ : The Aussie remains range-bound,
but the pattern is revealing a slight bias to the downside.
The currency struggled again at the 102 area of
resistance, and is now precariously near the 50-day
moving average. Copper seems to be forming a
consolidation pattern so far in February, but the chart is
positive. The demand pattern for early 2011 will become
more visible next week, when reports are expected to
show the amount of copper purchased by China in
advance of the week-long Chinese Lunar New Year.
However, the near-term price pattern will be more heavily
influenced by trends in risk appetite than the ongoing
bullish case about structural supply constraints. Case in
point, stocks of copper in LME warehouses are at a six-
month high, while signs of demand destruction are
becoming more visible.
Ÿ : The S&P 500 has been
consistently stronger than the Emerging Markets index
(EEM) since early November. Persistently high
commodity-induced inflation is increasingly problematic in
many emerging economies as inflation expectations are
becoming more pronounced. The relative strength of
global small caps versus large caps has turned positive
again in February, behind growing investor sentiment.
Globally, the cyclical sectors continue to be consistently
stronger than the defensive sectors.
Ÿ : The ECRI’s U.S. Weekly Leading
Index (WLI), jumped to 130.2 this week, the highest
reading since May, according to the Economic Cycle
Research Institute.

KLenox@Mosaicmarketresearch.com Fundamental and technical analysis, but mostly judgment 3

 Asset Allocation Strategy
Ÿ : Collectively, our series of financial conditions and global
leading indicators are rarely as overwhelmingly positive as they are
again this week. The consistency of performance in many risk oriented
Nov. 19 U.S. Large Cap 3% Europe 3%
asset classes has been impressive, and this has served to further
reinforce the trend. Complacency is perhaps the best word to describe Jan. 7 Cash 3% Long USD 3% (All)
the current attitude among market participants. It’s important to Jan. 14 U.S. Large Cap 6% U.S. Small Cap 6% (All)
recognize when such conditions exist, and remain watchful for a Jan. 28 Cash 5% Asia ex Japan 5% (All)
potential change in the fundamental outlook. Our “Financial
Feb. 11 Long U.S. dollar 5% Cash 5%
Conditions” section on page 3, is a sample of the nearly 20 factors that
we study for early clues about potential changes in risk aversion. Over
the past 12 years, these factors have provided an early signal before
major inflection points in the equity markets. These factors provide the
foundation for the level of risk in our portfolio. Currently, financial
conditions remain favorable for our thesis of global growth and pro-
cyclical tilts within the portfolio.
Ÿ : As the earnings season begins to wind down, we like to look
Large Cap 35 11 46
at revisions being made to earnings at the sector level. Recently,
analysts appear to be raising their estimates for the energy, materials Mid Cap 6 0 6
and technology sectors. In contrast, the defensive sectors have Small Cap 4 -4 0
generally received slightly lower revisions. The consumer staples
sector will likely be the focal point regarding margin contraction. Our EAFE 13 -5 8
tactical tilts toward developed markets and large cap stocks remain in Europe 0 2 2
place. Basic resources and cyclicals are still the preferred sectors.
Japan 0 0 0

Large Cap U.S. Diversified Defensive Equity Income Diversified 2 -2 0

Large Cap - E/W EAFE Asia ex Japan Financial Dividend Growth Asia ex Japan 0 0 0
Mid Cap Europe Latin America Cyclical Total Return Latin America 0 0 0
Small Cap Japan Frontier Resources Capital App.
Treasuries 0 0 0
Core Bond 35 -35 0
Corporate 0 15 15
High Yield 3 0 3
Energy Overweight Positive Above Avg. Refining Coal
TIPS 2 5 7
Materials Overweight Positive Above Avg. Chemicals Metals/Mining
EM 0 0 0

Industrials Overweight Positive Above Avg. Conglomerate Airline

Global REIT's 0 0 0
Technology Overweight Positive Highest Semi. Equip. Comm. Equip.
Volatility 0 0 0
Consumer Cyclicals Neutral Neutral Below Avg. Movies & Ent. Auto Mfg.
0 5
0 5
Consumer Staples Underweight Negative Above Avg. Tobacco Drug Stores
Health Care Overweight Negative Average Equipment Biotech
Telecom Underweight Negative Lowest Wireless Integrated
Utilities Underweight Negative Low Gas Electric
Ÿ No current allocation.
Financials Neutral Neutral Low REIT- Retail Diversified Ÿ The PMI cycle continues to favor
commodities, and we prefer broad-based
Ÿ : Our positioning within fixed income remains unchanged implementation at this level. Our views on
for the fourth straight month. We’re maintaining an underweight specific commodities are typically implemented
position within the asset class along with a high conviction tactical tilt via focused exposure in the equity markets.
toward the A - BBB credit range. We still see an unfavorable Ÿ Initiating a 5 percent allocation to a
asymmetric risk/reward ratio for Treasuries, agencies and muni’s. long U.S. dollar position. See page 11.

Cash Treasury / Agency Non-Callable Nominal U.S. Dollar Global REIT's Industrial Metals USD
Short-Term A-AAA Corp. Callable Floating Rate Non-Dollar - G7 Volatility Precious Metals EUR/USD
Intermediate BBB Corp. Structured Note TIPS Non-U.S. Dollar Energy USD/JPY
Long-Term High Yield Puts / Calls CPI Notes Emerging Mkts Grains AUD/USD

KLenox@Mosaicmarketresearch.com Fundamental and technical analysis, but mostly judgment 4

 S&P 500 Sector & Fundamental Data
S & P 5 0 0 T o t a l R e t u r n ( % ) S & P 5 0 0 E a r n i n g s E s t i m a t e s

1.46% 2.91% 11.37% 5.90%

Energy 12 -0.09% 4.94% 17.83% 8.95% Energy 35.75 41.39 107% 16% 13.35
Materials 4 0.75% 2.83% 13.23% 3.66% Materials 13.07 16.54 84% 27% 15.02

Industrials 11 2.95% 5.84% 17.95% 9.05% Industrials 18.20 20.48 28% 12% 15.83
Technology 19 0.58% 2.97% 11.49% 7.86% Technology 26.28 30.40 50% 16% 14.4
Consumer Cyclicals 11 3.52% 4.29% 10.52% 5.76% Consumer Cyclicals 17.98 20.03 64% 11% 15.33

Consumer Staples 10 0.95% 0.58% 3.50% 0.61% Consumer Staples 19.45 21.18 6% 9% 14.36
Health Care 11 0.07% 0.59% 4.99% 2.76% Health Care 28.87 32.55 9% 13% 11.49
Telecom 3 1.75% 1.93% 6.47% 0.63% Telecom 7.40 7.84 2% 6% 16.08
Utilities 3 0.73% 0.93% 3.43% 2.24% Utilities 12.58 13.18 9% 5% 12.32

Financials 16 2.89% 2.10% 14.75% 7.19% Financials 14.99 18.23 241% 22% 12.53
Source: Standard & Poor’s Source: Standard & Poor’s, data as of 2/8/11

S & P5 0 0 S e c t o r O v e r v i e w
Ÿ We’re maintaining an overweight position
in both energy and basic materials based on favorable
financial conditions, improving global growth trends and
strong fourth quarter earnings. Recently, analysts have
been raising their earnings estimates for both of these
sectors. Energy: The trends within the energy sector remain
favorable, and this sector continues to lead the S&P 500.
The more cyclically sensitive oil/gas equipment and
services industry is our preferred area of concentration
within this sector. Basic Materials: The sector has been
trading in line with the market over the past month. The
rotation into chemicals continues to gain momentum, while
our basket of copper-related stocks is rolling over. Not
surprisingly, the charts of iron ore stocks appear to be
weakening as well. Our bias remains toward the global
growth oriented commodity chemicals and agriculture
companies. However, it’s time to avoid copper and iron ore.
Ÿ The positive backdrop of improving global growth
trends remain a positive catalyst for global cyclicals. It
appears that the market is transitioning toward the “ISM
peak-to-50” stage. The tactically overweight position
remains in place for both the industrial and technology
sectors while we remain neutral on the consumer
discretionary sector. Industrials: After noticeably lagging the
S&P 500 for four weeks, the DJTA surged 3.7 percent
higher while oil prices declined by a similar percentage.
Also, the transports outperform the aerospace & defense
industry for the first time in six weeks. The global growth
oriented conglomerate’s and heavy construction/mining
companies remain well positioned in this environment.
Technology: This sector has traded in line with the market
so far in 2011, and continues to mask the 12 percent year-
to-date return of the Philadelphia Semiconductor index.
Strong fourth quarter earnings (see page 12), and rising
earnings estimates should provide a solid fundamental
underpinning for this sector.
KLenox@Mosaicmarketresearch.com
S & P 5 0 0 S e c t o r O v e r v i e w , C o n t .
Ÿ We continue to favor a focused position in
the higher beta semiconductor stocks, particularly on a
more even-weighted basis. Consumer Cyclicals: Consistent
with our ISM cycle indicator, we’re maintaining a neutral
weighting in this sector despite strong consumer spending
patterns. The sector rose by an impressive 3.5 percent this
week, led mostly by the media industry. Our more thorough
review of the sector did not reveal a pattern that would
indicate the current rally would persist.
The current stage of the ISM cycle along with
lackluster earnings and commodity-induced margin
pressures should present continued headwinds for the
defensive sectors of the market. We remain underweight in
each sector except healthcare. Consumer Staples: Margin
pressures due to higher input costs will likely be a
significant headwind for this sector throughout 2011.
Comparatively lower revenue growth only adds to the
difficulty in maintaining margins. Health Care: This sector
continues to significantly trail the market due primarily to
the poor performance of the pharmaceutical industry.
Pharma accounts for nearly 50 percent of the sector
weighting, and masks the strong outperformance of the
managed care providers and medical equipment
companies. Our tactical tilt toward the managed care
industry continues to benefit from the current environment.
Telecom & Utilities: These two sectors have the lowest
expected growth rate for both revenues and earnings in
2011. In addition, a rising interest rate environment poses
another potential headwind for these rate-sensitive sectors.
This sector has traded in line with the S&P 500
since late December. The large commercial banks are
generally outperforming the sector due to improving credit
conditions and a steep yield curve. Also, increases in M&A,
underwriting and stronger retail flows are contributing to the
relative strength of the broker/dealers versus the sector. GS
has now trailed the sector since late November. The tactical
tilts toward these two industries remain in place.
Fundamental and technical analysis, but mostly judgment 5
 S&P 500, Technicals and Valuation
Figure 6

Ÿ Figure 6, the S&P 500 has Figure 7

increased 5.9 percent so far this year, and closed at the highest
level since June 19, 2008. The MACD line and McClellan
Oscillator both have an upward bias, and the A/D is still
trending higher. The percentage of stocks in the S&P 500
above their 50- day moving average increased from 78 percent
from 82 percent this week. Figure 7 (3rd box from top), The
nearly 4 percent drop in oil prices this week played a large part
in the improving relative strength of the Dow Jones
Transportation average.
Ÿ : Figure 7 (top), the Russell 2000 has
strengthened relative to the S&P 500 in February, and global
small caps remain strong. Our judgment is that the comparative
valuation gap and current stage of the PMI cycle is more
favorable for large caps.

Continued from Page 1

allowances for bad debts. Also, the technology and energy sector
account for 31 percent of the index, and are expected to post
strong earnings growth.
Many companies have reduced their
interest expense by either reducing or refinancing debt. Also,
lower corporate taxes, and additional share count reductions from
share buybacks and M&A can also serve to support margins.
Our assessment is that there will be a margin
squeeze within certain industries, but it will not be pervasive. We
find the current 9.0 percent margin forecast to be overly
optimistic, and think that margins are most likely to settle in the
8.3 to 8.5 percent range. In that case, EPS increases by only 7 or
8 percent , not 15 percent. It also takes the forward P/E from 13.8
to 14.8. Of course, stronger top-line growth would help take some
of the pressure on margins.

KLenox@Mosaicmarketresearch.com Fundamental and technical analysis, but mostly judgment 6

 Core EAFE
Figure 8

Ÿ Figure 8, the EAFE index (EFA as Figure 9

the ETF proxy), the previous level of resistance at $60, has now
become a level of support. The technical trends suggest further
upside in the near-term. Figure 9, the Nikkei 225 and FTSE 100
both displayed positive relative strength compared to the EAFE
index for the second consecutive week. European banks held up
well again this week versus broader European indices, despite
modest widening of several Eurozone credit-related spreads.
Ÿ Eurozone: Last week’s EU summit revealed
several key unresolved issues to be settled before the final
summit on March 24-25 in Brussels. CDS spreads widened
modestly this week due to a lack of progress, according to
Markit. However, the ECB did provide support by buying
Portuguese debt. The persistently high bond yields in Portugal,
Ireland and Greece suggest skepticism that the March summit
will deliver a comprehensive solution for the debt crisis. U.K.:
The BoE left rates unchanged this week, hoping that inflationary
pressures prove temporary while economic growth remains
uneven. Inflation is nearly twice the BoE’s target, but recent tax
increases and spending cuts appeared to slow the economy at
the end of last year. Clearly, the risks of stagflation appear to be
growing. Japan: The Nikkei 225 has gained 3.6 percent so far in
February, as the widening 2-year rate differentials and stronger
appetite for risk has helped weaken the Yen. The Nikkei is also
benefiting from a reallocation trade from emerging market
equities to the developed markets. Implementation: We remain
tactically underweight, but with a focus on broad-based
European exposure with a tilt toward the cyclical sectors of the
market. Although strong in January, Japan’s economic growth
remains comparatively weak to other developed countries. In
addition, any sort of risk-off event could cause the Yen to
strengthen due to its safe-haven status. As such, we remain
underweight Japanese equities.

KLenox@Mosaicmarketresearch.com Fundamental and technical analysis, but mostly judgment 7

 Emerging Markets
Figure 10

Ÿ Figure 10, the Emerging Figure 11

Markets index (EEM as the ETF proxy), declined by nearly 2
percent this week, and fell below the head-and-shoulder support
level of $46. There’s a meaningful support level at $45, which
held this week, but the chart looks heavy. Figure 11, the Hang
Seng index also bounced from a key level of support at 22,500.
Figure 11 (middle), shows the accelerating decline in relative
strength of the MSCI Emerging Markets index versus the MSCI
World index. Asset flows from emerging markets funds fell
dramatically to $3 billion last week, in comparison to the jaw-
dropping $7 billion the prior week, according to data firm EPFR
Global. Heightened geopolitical risk along with intensifying
inflationary pressures have raised the risk premium for this asset
class. From a technical standpoint, this week’s sharp decline of
the bellwether Kospi and TSE indices point toward continued
selling pressure. A sharp bounce from such oversold levels is
very possible, but would not be a buying opportunity.
Ÿ The poor relative performance of China’s
financial sector and elevated SHIBOR levels are indicative of a
more difficult economic environment than the consensus
forecast. Our assessment, is that the PBOC is behind the curve
in addressing inflation, and that the publicized inflation rates are
understated. As such, inflation will prove to be more problematic
than expected. The longer-term economic growth potential, and
the structural dynamics of this region remain compelling. But, this
has been a very crowded trade, so we’re content to wait for a
more opportunistic entry point.
Ÿ Collectively, the global PMI cycle
remains favorable for commodity producing countries, but the
overall environment is looking more late-cycle than the
consensus forecasts. Canada and Australia once again have the
best relative performance of the commodity focused countries
that we follow, while Russia (RSX as the ETF proxy) is the only
emerging country still trading above its 50-day moving average.
KLenox@Mosaicmarketresearch.com Fundamental and technical analysis, but mostly judgment 8
 Fixed Income
Figure 12 U.S. Treasury Yields
4.50
4.00
3.50
3.00
2.50
2.00
Source: St. Louis Federal Reserve
1.50
Jan-10 Apr-10 Jul-10 Oct-10
10-Year U.S. Treasury 2s10s
Ÿ Figure 12, the 2s10s curve narrowed by 10
basis points this week to 280 basis points. The 2-year
Treasury yield increased by 9 basis points while the 10-
year yield fell by 1 basis point. The overall pattern of a
rising 2s10s curve in conjunction with a rising 10-year
yield reflects a strengthening economy. Maintaining
shorter than benchmark levels of duration remains in
place as the bias remains toward higher yields.
Ÿ We view a gradual upward trend in the 10-
year Treasury and 2s10s as bullish for economic growth,
but bearish for government paper. Year-to-date,
Treasuries are lagging sector within the Barclay’s
Aggregate Bond index. We continue to avoid this sector.
Ÿ : MBS are maintaining a bid as a relative value
trade for banks versus Treasuries. Aside from this
constituency, the risk/reward ratio remains unattractive.
Ÿ Intermediate-term corporate bonds at the lower
range of investment grade status remains our highest
conviction sector within the fixed income universe.
Favorable financial conditions, strengthening economic
growth trends and strong net inflows represent a better
investment climate for the credit oriented sectors. The
sweet spot of A- to BBB paper is less rate sensitive than
higher grade paper, and trades at a more attractive risk
premium than high yield. Figure 13, the Moody’s Baa
minus Aaa corporate bond spread continues to narrow,
but remains far above secular levels. The high yield
market continues to be the best performing sector of the
fixed income market, but relative valuations are
increasingly less attractive. The current spread over
investment grade paper remains near secular lows around
300 basis points. Through January, global high yield
issuance has been 61 percent higher than the same
period in 2010, according to the Financial Times. A
corresponding surge of net inflows into the asset class are
already resulting in less restrictive bond covenants. In
addition, we’re seeing more cases of bond proceeds being
used to fund dividends and share repurchases, rather than
strengthening the balance sheet. Our non-consensus
view is that returns in 2011 are likely to be from the
coupon, but not from additional spread compression. The
neutral weighting reflects strong fundamentals, but an
increasingly unfavorable risk/reward ratio.
KLenox@Mosaicmarketresearch.com
Figure 13 Moody's Baa - Aaa Corporate Bond Yield, bps
400
350
300
250
200
150
100
50
Jan-11 Source: St. Louis Federal Reserve
0
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Ÿ Municipals have recovered this month from
very oversold conditions, but the persistent weekly outflows
from mutual funds are likely to limit further gains. That said,
higher income investors can selectively find very attractive
TEY’s as compared to broad-based municipal ETF’s. We
continue to find muni’s unattractive on a fundamental basis,
and envision several bouts of headline risk persisting
throughout 2011.
Ÿ Our basket of emerging market
debt funds continue to be resilient. At this point, outflows
have been at a much more measured pace than their
equity counterpart. To be fair, the constituents and average
credit rating of these funds are different than many expect
However, it’s likely a matter of time before inflation and/or
geopolitical events cause the risk premium to rise. This is a
very crowded trade with massive inflows over the past year
from what we surmise are predominantly weaker hands.
The strong desire to stretch for higher yields have led to an
under-appreciation of risk, and the downside is greater
than many expect. The structural fundamentals remain
compelling, but we’re content to wait for a more
opportunistic entry point.
Ÿ We’re expecting global interest rates to rise in
2011, but the key is whether rates rise in association with
improving economic growth or increasing inflationary
pressures. Commodity-induced price inflation continues to
build around the world, but more acutely in many emerging
market countries. The United Nation’s Food Price Index
reached a record high in January, Brent crude futures
closed slightly over $101 and many PMI reports showed
record growth rates of input costs. Meanwhile, the U.S.
TIPS spread and forward breakeven rates reflect a
sanguine view of inflation. Continued high levels of
unemployment, sub-par wage growth and higher
productivity levels have served to limit the effects of
inflation. This paints the picture of potentially rising rates
due to economic growth rather than inflation. The market
may also sense that the chances of QE3 have lessened
considerably as growth trends have improved. We do
expect next week’s PPI report to show a slightly faster rise
in intermediate goods.
Fundamental and technical analysis, but mostly judgment 9
 Commodities
Figure 14
Ÿ Figure 14, DJ-UBS Grain index continues to be
the leading commodity sector. Strengthening demand
amid long-term structural supply constraints provide a
solid fundamental underpinning for the sector. The broader
CRB index has increased by 1.5 percent, as compared to
the 5.9 percent total return for the S&P 500. The global
economic cycle continues to favor commodities, and our
preferred allocation involves broad-based exposure with a
bias toward the agriculture sector.
Ÿ High Grade Copper was basically unchanged this
week as it consolidated last week’s breakout to record high
levels. Reports are expected to be released next week that
show the level of Chinese demand for copper before the
week-long Chinese Lunar New Year. Strong global growth
trends, expectations of continued supply constraints and
increasing investment demand remain the mantra for the
bullish case. However, our basket of copper mining
companies is reflecting pronounced weakness relative to
the physical commodity. In addition, stocks at LME
warehouses have risen from just under 350,000 to
396,950 tonnes since mid December. It’s our belief that
these two factors point a heightened chance of a
correction. The latest Commodity Futures Trading
Commission COT report showed an increase last week of
4,749 net long contracts by non-commercial net specs to
29,460, while producers increased their net short position
by only 443 contracts to 33,230 contracts.
Ÿ U.S. corn reserves are approaching their lowest
levels in 15 years, raising fears of rising prices for foods
like meat because corn is used to feed cattle and
chickens. The demand for corn is also increasing more
than expected due to a growing livestock industry in many
of the emerging countries, as the growing middle-class are
adding more meat to their diet. Soybeans appear to face
severe supply constraints as well due to strong demand
from China, but not quite as acute as corn. We’re
concerned that the sharp rally in rough rice, a key source
of food in Asia, could lead to lead to a food crisis.
KLenox@Mosaicmarketresearch.com Fundamental and technical analysis, but mostly judgment
Figure 15
Ÿ COMEX gold increased 0.9 percent this week to
close at $1,360 per ounce. The combination of potentially
escalating political tensions and increasing signs of
inflation create a favorable environment for gold. Gold is
recovering from losses in January, as improving trends in
risk appetite saw investors fleeing gold as a safe-haven.
On a technical basis, gold is bumping into resistance at
1,370, but the fluid situation in the Middle East will likely
dictate the near-term trend. The latest CFTC COT report
showed an an increase last week of 15,899 net long
contracts to 167,093 by non-commercial specs, while
producers increased their net short position by 16,714
contracts to 209,911 contracts.
Ÿ ICE Brent for March delivery, rose 1.6 percent to close
closed at $101.43. This marked the highest weekly front-
month close since September 26, 2008. The threat of
spreading civil unrest, declining crude supplies from the
North Sea and China’s dire need for diesel should keep
prices firm in the near-term. Figure 15 (WTI, cash), the
more frequently quoted WTI NYMEX contract for March
delivery, fell 3.9 percent this week, to close at $85.58. U.S.
crude inventories rose by 1.9 billion barrels to 345.1 million
barrels, the fourth consecutive build. Gasoline inventories
increased by 4.7 million barrels, the sixth straight weekly
build. This week’s Brent-WTI spread spiked to a record
$16.24 on Thursday, and closed the week at $15.85,
according to Reuters. This spread has doubled in just
three weeks due to Brent being more susceptible to supply
risks and the supply glut at Cushing. The incremental
demand is coming from the producing countries,
particularly China, due to continued government subsidies.
The latest CFTC COT report showed an increase last
week of 12,799 net long contracts to 165,508 contracts by
non-commercial specs, while producers increased their net
short position by 24,776 contracts to 221,010.
10
 Currencies
Figure 16
Ÿ Speculators increased their short positions
against the dollar again this week to the highest level since
October, according to Commodity Futures Trading
Commission data. We view this as a crowded trade that
could unwind quickly in the wake of any risk-off event that
results in flows to the buck as a safe haven. More
importantly, stronger-than-expected economic growth
trends in the U.S., could lead to a continued rise in yields
that further support the greenback. As such, we’re initiating
a 5 percent allocation in a broad-based long dollar position.
Ÿ Figure 16, the Euro finished the week basically
unchanged versus the greenback to close fractionally
below the key level of support at 1.36. Last Friday’s
announcement of an interim EU summit on March 11,
indicates that the leaders remain far apart on a number of
issues. As an example, the ECB favors allowing the ESFS
to directly buy government bonds or lend money to
countries so that they could directly buy the bonds.
Germany remains opposed to this approach. At this point,
the clouded assessment of EU fundamentals amid
strengthening U.S. economic data leads us to conclude
that the Euro should weaken versus the dollar. This week’s
COT report showed a decline of 5,200 net spec long
positions after three weeks of gains, and the overall net
long spec position remains elevated at 34,734, the highest
level since early November.
The Euro appreciated by 1.6 percent versus the
Swissie this week as complacency and positive sentiment
persist. Trends in risk aversion are the primary driver for
this pair, but this week’s 4 to 5 percent widening of several
EU financial and periphery CDS spreads went unnoticed.
At this juncture, we don’t see a catalyst for continued
strength in the Euro until the March 24-25 summit. In the
meantime, any sort of risk-off event could lead to
meaningful appreciation of CHF as a safe haven.
KLenox@Mosaicmarketresearch.com Fundamental and technical analysis, but mostly judgment
Figure 17
Ÿ Figure 17, the Aussie fell slightly this week to
close at par versus the dollar, and is precariously
positioned at the 50-day moving average. This week’s
employment report showed that 24,000 jobs were created
in January, but that included a reduction of 8,000 full-time
jobs. The unemployment rate remained at 5 percent as
expected. Our assessment is that the economy was
showing signs of a slowdown before the floods, and the
increasing likelihood of slower growth in China should
serve to keep the RBA in a wait-and-see mode. As a
result, lower interest rate expectations may provide
another potential headwind for the pair. However, this
week’s COT report showed spec long positions had
increased to 71,979 contracts, the highest since April. The
market is still being driven by powerful speculative and
carry-related trends, but this pair looks to have a very
unfavorable asymmetric risk/reward ratio.
Ÿ The dollar strengthened by 1.8 percent this
week versus the Yen to close at 83.46. Stronger growth
trends in the U.S. is widening the 2-year rate differential,
and the current spread suggests that the pair should trade
around the 86.0 level. We’ve heard several explanations
for the ongoing dislocation between this cross and the
rate differential, but we’ll avoid a stake until visibility
improves. Also, any unexpected risk off event would likely
result in significant Yen appreciation as a safe haven.
Ÿ The Cable was slightly lower this week versus
the dollar, and is resting at a key support level at 1.60. We
were expecting the pair to strengthen during the past two
weeks in the wake of the surprisingly strong PMI reports
that countered the weather-induced weakness seen in
December. In addition, Friday’s PPI output came in at 1.0
percent for the month of January as compared to the
consensus estimate of 0.5 percent. The combination of
stronger growth and inflation should produce a more
bullish case for the cable as investors raise their interest
rate expectations. This week’s COT report remains bullish
as spec net long positions have increased for the fifth
consecutive week to the highest levels since November.
11
 Q4 Earnings, Cyclical

Exxon Mobil XOM Jan. 31 105,186 89,841 17% 1.85 1.27 46%
Chevron CVX Jan. 28 51,825 47,588 9% 2.64 1.53 73%
ConocoPhillips COP Jan. 26 1,929 1,803 7% 1.32 1.20 10%
Occidental Petroleum OXY Jan. 26 5,063 4,382 16% 1.47 1.35 9%
Apache APA Feb. 17
Anadarko Petroleum APC Jan. 31 2,691 2,417 11% 0.29 0.46 (37%)
Devon Energy DVN Feb. 16
Schlumberger SLB Jan. 21 9.067 5.744 58% 0.76 0.65 17%
Halliburton HAL Jan. 24 5,160 3,686 40% 0.68 0.53 28%
National Oilwell Varco NOV Feb. 3 3,172 3,134 1% 1.05 0.94 12%

Du Pont (E.I.) DD Jan. 25 7,742 6,814 14% 0.5 0.44 14%

Dow Chemical DOW Feb. 3 13,771 12,466 10% 0.47 0.18 161%
PPG Industries PPG Jan. 20 3,379 3,116 8% 1.24 0.85 46%
Praxair PX Jan. 26 2,623 2,407 9% 1.25 1.09 15%
Air Products & Chemical APD Jan. 21 2,392 2,174 10% 1.35 1.16 16%
Monsanto MON Jan. 6 1,830 1,697 8% 0.02 (0.02) "P"
Alcoa AA Jan. 10 5,433 5,652 (4%) 0.24 (0.27) "P"
Freeport-McMoRan FCX Jan. 20 5,603 4,610 22% 3.25 2.15 51%
Nucor NUE Jan. 27 3,854 2,938 31% (0.04) 0.18 "L"
Newmont Mining NEM Feb. 24

General Electric GE Jan. 21 41,377 41,046 1% 0.36 0.27 33%

United Technologies UTX Jan. 26 14,864 13,979 6% 1.31 1.15 14%
3M MMM Jan. 25 6,709 6,122 10% 1.28 1.30 (2%)
Emerson Electric EMR Feb. 1 5,535 4,828 15% 0.63 0.55 15%
Fedex FDX Mar. 17
United Parcel Service UPS Feb. 1 13,421 12,377 8% 1.08 0.75 44%
Union Pacific UNP Jan. 20 4,410 3,754 17% 1.56 1.89 (17%)
Boeing BA Jan. 26 16,550 17,937 (8%) 1.56 1.77 (12%)
Caterpillar CAT Jan. 27 12,807 7898 62% 1.47 0.36 308%
Deere DE Feb. 16

Apple Computer AAPL Jan. 18 26,741 15,683 71% 6.43 3.67 75%
Hewlett-Packard HPQ Feb. 22
Intel INTC Jan. 13 11,457 10,569 8% 0.59 0.40 48%
IBM IBM Jan. 18 29,019 27,230 7% 4.18 3.59 16%
Cisco Systems CSCO Feb. 9 10,407 9,815 6% 0.27 0.32 (16%)
Qualcomm QCOM Jan. 26 3,348 2,668 25% 0.82 0.62 32%
Microsoft MSFT Jan. 27 19,953 19,022 5% 0.77 0.74 4%
Oracle ORCL Mar. 24
Google GOOG Jan. 20 8,440 6,674 26% 7.81 6.13 27%
EMC EMC Jan. 25 4,889 4,100 19% 0.29 0.19 53%

Walt Disney DIS Feb. 8 10,716 9,739 10% 0.68 0.47 45%
Amazon AMZN Jan. 27 12,948 9,519 36% 0.91 0.85 7%
Comcast CMCSA Feb. 16
Time Warner TWX Feb. 2 7,812 7,210 8% 2.41 1.83 32%
Directv DTV Feb. 23
Ford Motor F Jan. 28 32,500 34,800 (7%) 0.30 0.43 (30%)
Home Depot HD Feb. 22
Lowe's LOW Feb. 23
Target TGT Feb. 24
McDonalds MCD Jan. 24 6,214 5,973 4% 1.16 1.11 5%
Coach COH Jan. 25 1,264 1,065 19% 1.00 0.75 33%
Macy's M Feb. 22
lNordstrom JWN Feb. 17
Abercrombie & Fitch ANF Feb. 16
Darden Restaurant DRI Mar. 24
Marriott MAR Feb. 14
Starwood Hotel HOT Feb. 3 1,340 1,246 8% 0.52 0.51 2%
Carnival CCL Dec. 21 3,497 3,282 7% 0.31 0.24 29%
Harley Davidson HOG Jan. 25 917 764 20% (0.18) (0.63) "L"
Tiffany TIF Mar. 21

KLenox@Mosaicmarketresearch.com Fundamental and technical analysis, but mostly judgment 12

 Q4 Earnings, Defensive & Financial
Proctor & Gamble PG Jan. 27 21,347 21,027 2% 1.11 1.01 10%
Colgate-Palmolive CL Jan. 27 3,978 4,081 (3%) 1.24 1.21 2%
Coca-Cola KO Feb. 9 10,494 7,510 40% 0.72 0.66 9%
PepsiCo PEP Feb. 10 18,155 13,297 37% 1.05 0.90 17%
Kraft Foods KFT Feb. 10 13,773 10,597 30% 0.31 0.44 (30%)
Wal-Mart WMT Feb. 22
CVS Caremark CVS Feb. 3 24,771 25,822 (4%) 0.80 0.79 1%
Walgreen WAG Mar. 22
Altria Group MO Jan. 27 5,927 6,014 (1%) 0.44 0.35 26%
Philip Morris PM Feb. 10 17,807 17,008 5% 0.97 0.81 20%

Pfizer PFE Feb. 1 17,561 16,537 6% 0.47 0.49 (4%)

Merck MRK Feb. 3 12,094 10,093 20% 0.88 0.79 11%
Bristol-Myers Squibb BMY Jan. 27 5,111 5,033 2% 0.47 0.47 0%
Eli Lilly LLY Jan. 27 6,187 5,934 4% 1.11 0.91 22%
Amgen AMGN Jan. 24 3,841 3,809 1% 1.17 1.05 11%
Johnson & Johnson JNJ Jan. 25 15,644 16,551 (5%) 0.70 0.79 (11%)
Abbott Labs ABT Jan. 26 9,968 8,790 13% 1.30 1.18 10%
United Health UNH Jan. 20 24,030 21,784 10% 0.94 0.81 16%
Medtronic MDT Feb. 22
Baxter International BAX Jan. 27 3,498 3,470 1% 1.11 1.03 8%

AT&T T Jan. 27 31,361 30,708 2% 0.18 0.46 (61%)

Verizon VZ Jan. 25 26,395 27,091 (3%) 0.93 0.22 323%
Qwest Communications Q Feb. 15
Century Link CTL Feb. 15
American Tower AMT Feb. 23

Southern Co. SO Jan. 26 3,771 3,511 7% 0.18 0.31 (42%)

Exelon EXC Jan. 21 4,500 4,148 8% 0.96 0.92 4%
Dominion Resources D Jan. 28 3,667 3,176 15% 0.63 0.63 0%
Duke Energy DUK Feb. 17
NextEra Energy NEE Jan. 25 3,410 3,660 (7%) 4.30 4.05 6%

JPMorgan Chase JPM Jan. 14 26,722 25,236 6% 1.12 0.74 51%

Bank of America BAC Jan. 21 12,439 11,559 8% -0.37 -0.60 (38%)
Wells Fargo WFC Jan. 19 21,494 22,696 (7%) 0.61 0.08 663%
Citigroup C Jan. 18 18,371 5,405 240% 0.04 -0.33 "P"
US Bancorp USB Jan. 19 4,721 4,376 8% 0.49 0.30 63%
Goldman Sachs GS Jan. 19 8,642 9,615 (10%) 3.79 8.20 (54%)
Morgan Stanley MS Jan. 20 7,807 6,836 14% 0.43 0.18 139%
Berkshire Hathaway BRK.B Feb. 28
Metlife MET Feb. 9 12,838 12,341 4% 1.14 0.96 19%
American Express AXP Jan. 24 4,093 3,645 12% 0.88 0.59 49%
S o u r c e : C o m p a n y W e b s i t e s

KLenox@Mosaicmarketresearch.com Fundamental and technical analysis, but mostly judgment 13

 Disclaimer
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herein. Also, the opinions expressed may be short-term in nature and are subject to change without notice. Past performance is not indicative of future
results.
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KLenox@Mosaicmarketresearch.com Fundamental and technical analysis, but mostly judgment 14