Absolute Return Portfolio Management LLC

This report was written entirely on Wednesday but, unfortunately, my proofing was interrupted by arriving house guests. Given the Dubai induced sell-off it appears a little anti-climatic now. However, the message still holds and the outlook certainly wasn't to warn of a single day sell off.

Overview

I believe the most significant decline since the rally began in March is imminent. Potentially, we are facing the end stages of the rally and the resumption of the secular bear market decline that began in October 2007.

There is an old saw that at the end of a bull market advance we see "the generals leading but the troops going AWAL and retreating". This reflects defensive behavior among institutional investors who must remain fully invested but seek safer havens of blue chip stocks. This is best demonstrated by the most narrow of indexes, the Dow Jones Industrial Average (DJIA) of thirty stocks, as it ekes out new highs while the broader measures of the market struggle to regain their October peaks. Being price-weighted, the DJIA is being driven higher by only a small handful of high priced issues in in the technology and energy sectors.The lower priced stocks of the beaten down financial and housing sectors get little weight and their weakness, as well as that of the general market, is thereby obfuscated. A similar phenomena can be seen amongst the largest capitalization indexes like the NASDAQ 100, S&P 100, S&P 500 as investors, likewise, focus on the bluest of blue chips. Large-cap stocks began out-performing in mid-September coincident with the turning down in the relative performance of Mid-cap and Small-cap sectors reflecting increasing risk aversion.

Following my mid-October warning of a high risk environment, the market had a modest price correction into early November. However, the technical and internal damage done to the market was severe. A considerable amount of distribution of stock occurred during both the decline and the subsequent recent rally. This distribution can be detected using Cumulative Advance/Decline Volume, which measures a running total of the volume going into advancing issues versus declining issues. It had remained the only sign of volume strength since the rally began in March, and is now showing considerable deterioration and negative divergences.

As another case in point regarding the weakening market internals, I note that the peak number of 52 Week New Highs occurred coincident with my October warning at approximately 350 issues(basis www.DecisionPoint.com - Common Stock Only Index). Today, even though some indexes are at new highs, this same measure shows only 66 new highs. In a healthy bull market advance what SHOULD occur is a correspondingly equal or greater number of 52 Week New High accompanying new price highs in the various indexes. What is even MORE remarkable is that today's comparison of 52 Week New Highs is less demanding than the measure made just six weeks ago due to the fact that the market fell approximately 20%-30% (depending on the index) during this same time last year!!! If anything, the number of 52 Week New Highs should have advanced considerably higher on the basis of this easier comparison alone. This divergence is a stark warning that not only are fewer stocks participating in the rally but many are being heavily distributed by smart money ahead of an anticipated decline.

If only market internals were poor I would settle upon the idea of a modest and normal bull market decline of 5-7% that would wash out the overbought condition, put fear back into investors and thereby plant the seeds for a renewed advance. However, what troubles me greatly today is poor market internals coupled with extremes in sentiment. The bullish sentiment on Gold, for example, is at levels that have almost no equal in the 20+ year history of the Daily Sentiment Index (www.trade-futures.com). Though not directly related to stocks, it illustrates a speculative backdrop and tone to the markets.

Similarly for the equity markets, sentiment readings remain quite elevated. The ISEE Options Index (www.ise.com), which show public speculation, has reached levels that have coincided with significant market peaks. The most recent three include; July 2007 (which brought the first warnings of the mortgage crisis and a 10% decline), October 2007 which marked THE peak of the bull market before 2008's huge 55%+ plunge and December 2008 before the 25% plunge into March of this year.

If these were not enough evidence, just now I have seen the report from Investors Intelligence showing that nearly 3 times as many advisers are bullish/optimistic compared to those that are bearish/pessimistic. This is the highest such ratio of bulls-to-bears since the rally began in March and the highest ratio reached since that of THE peak of the bull market in October 2007! In other words, newsletter writers today are more optimistic about the market's future prospects then they were BEFORE the banking crisis and economic collapse. I am having trouble conceiving how this is possible. It's hard to understate the significance of this extreme polarization of bullish sentiment and commensurate lack of concern. Poor market internals + extremely optimistic sentiment = trouble.

All investors should look very hard at their portfolios and take measures to contain losses that would stem from a significant decline. I can hope I am wrong and have grossly overstated the risks but at the very least "forewarned is forearmed". I will speak to each of the asset classes in the sections to follow.

Managed Account clients should expect to see a multimedia report over the holiday weekend giving a fuller explanation with charts and audio commentary. Needless to say, I have taken all measures I believe are necessary for the present circumstances.

International Equity Regions

Many have pointed out the inverse relationship of the US Dollar and risk assets like High Yield Bonds, Equities and Gold since the March 2009 lows. Of course, US Dollar weakness is a boon to overseas investments for US-based investors as it translates into a foreign currency gain which is added to any gain in the underlying investment.

Presently, sentiment towards the US Dollar is at an historic extreme. It's impossible not to be media-beaten by proclamations of a forthcoming "Dollar Collapse", "Loss of Reserve Currency status and "Death of the Dollar" to paraphrase a few... In fact, the Daily Sentiment Index for the US Dollar is, not surprisingly, showing the opposite condition of Gold with some of the lowest readings of bullishness in decades. While this doesn't promise an imminent rally, it shows that far too many people are in one camp and that little critical thought is being applied to any alternative scenarios for the US Dollar.

A rally in the US Dollar would be bearish for all foreign assets as the currency translation loss would detract from the performance of any underlying holdings.

It is interesting to note that even though the US Dollar has NOT yet begun any rally I am seeing a repatriation of capital from foreign investments in the form of weakening price momentum. What this shows is increasing risk aversion. Frequently, before or coincident with market corrections, money flows will begin to favor safer havens like large-cap stocks in the US.

Obviously, the riskiest areas are those like the BRIC regions. However, Japan is no picnic either with its extremely poor relative performance. However, if a significant decline takes hold there is certainly more percentage price risk in the aforementioned area. Investors would be wise to tighten stops, review allocations and overweight conditions in this asset group.

US Equity Markets (Equity Style Model)

The risks here are just as sobering. We are already seeing a flight to safety into the large-cap areas. Small and Mid-cap stocks have already begun to show severe distribution. Value oriented areas are fairing better so far as is typical near/at market peaks. Historically, value-oriented stocks become the safe haven during bear market declines. This is only a relative basis, however, and doesn't insure actual price advances. The point is that their strength speaks to the underlying weakness of the market.

Small-Cap Growth stocks as the riskiest of all style-based sectors saw the peak of their relative strength coincident with the market peak this Summer. Since then, they have under-performed. In a healthy bull market advance, this area typically leads all others, especially during an advance. It's weakness during the rally since July speaks to today's unique, un-chartered and dangerous environment.

Investment Grade Bonds

High Grade Corporate and International Bonds remain on a BUY. We favor International Bonds due to US Dollar weakness which translates into currency gains for non-US holdings.

Our current allocation is:

• 100% International Investment Grade Bonds

As noted at length in the International Equities section, we have to remind mindful of a potentially significant change in the trend of the US Dollar. As much as it's hated, if a global risk asset decline takes hold as I suspect their WILL be a repatriation of capital to the US and US Dollar purchases as a safe-haven. Such an event would require a change to domestic investment grade bonds. For the time being, we will remain with the current International position until an actual trend change develops.

High Yield Bonds

Our High Yield Bond model is on a BUY. Our current allocation is:

• 50% Emerging Market Bonds
• 50% Money Market

I am beginning to see cracks in the High Yield market and given its advance we already have one foot out the door and the other foot at the threshold.

Inflation Hedge / Real Assets

Current allocation:

• 50% Gold Bullion
• 50% Money Market

A mentioned in the Overview section, the sentiment readings on Gold are almost unprecedented. We are seeing back-to-back daily readings in the high 90% area. The question I have is...."if nearly 100% of people are already bullish on Gold, and have presumably bought, who is left to buy now and push prices higher?"

Gold is one of those assets that occasionally goes parabolic and then crashes. The difficult thing to surmise is how long the craziness can continue before the inevitable... Let me say that Gold may continue in a long-term bull market. I couldn't say. However, it doesn't seem a wise time to add to positions and existing positions should be managed with care.

Currencies

We continue to hold a half position in the Australian Dollar after jettisoning the other half at the time of my October 19th warning for risk assets.

As noted previously with respect to the US Dollar, the coming weeks and months could prove quite interesting. Many foreign currencies are tracing out broad topping patterns and appear poised for a decline. This dovetails with the psychology and sentiment studies surrounding the US Dollar and strongly suggests a potential move to a long US Dollar position in the weeks/months ahead.

Absolute Return Portfolio Management LLC provides absolute return oriented portfolio management and institutional research on global macro trends including equity style rotation, global regional equity trends, short-selling and market neutral strategies as well as fixed income strategies. Contact us for information on account minimums and institutional research offerings. These reports express our opinions and suggestions, provided only as a supplement to your own further research and decisions. We take care to assure accuracy of contents but accuracy is not guaranteed. Past performance does not imply future results. The publisher shall have no liability of whatever nature in respect of any claim, damages, loss or expense arising out of or in connection with the reliance by you on the contents of our website, any promotion, published material, alert or update. ALL RIGHTS RESERVED.