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Fourth Quarter 2010

The fourth quarter gave a number of positive economic surprises which boosted the stock market and investor sentiment. Manufacturing grew in December for the 17th consecutive month, expanding faster than any month since last May. Small business optimism is improving, as is consumer sentiment. While unemployment remains high at 9.8%, first-time unemployment claims are dropping sharply, which may soon have a favorable impact on the overall jobless rate. The private sector added a surprising number of new jobs in December, the 11th straight month of expnsion. These improving trends should continue well into 2011, as analysts begin the year by revising upward their GDP forecasts.

The surge in commodity prices continues to gather momentum, and those commodities most important to the global economy (cereals, oil, and iron ore) are hitting two year highs. Copper, gold, and cotton are hitting all-time highs. If commodity prices continue their rise in 2011, some analysts worry that an inflationary surge will ensue, forcing central banks to begin raising interest rates in order to slow consumption. The Chinese central bank did precisely this on December 25th in order to combat higher food and commodity prices. According to the U.N., the global food price index is at its high since the measurement began in 1990. While the debate rages between inflation and deflation, many ordinary expenditures to U.S. consumers are also hitting new highs (ground meat, turkey, college tuition,prescription drugs, domestic package and freight shipping). These are signs of incipient inflation, which will likely drive interest rates higher sometime in late 2011.

Stocks are positioned to benefit from:

  • Investors moving out of bonds and cash instruments seeking higher returns in riskier assets.

  • Corporate cash levels, at an all time high, being used for share repurchases, acquisitions and dividend hikes.

  • Pension funds need to chase higher returns to meet future obligations.

  • The perception of risky assets improving due to better economic conditions.

  • Stock valuations being relatively cheap to history and having a better earnings yield than corporate or government bonds.

It’s useful to consider the difference between the Federal Reserve’s first stimulus package in late 2008 (“Quantitative Easing 1”) versus the recent announcement of further stimulus in October (“QE2”). The first was a response to a huge increase in the demand for money as investors sold risky assets during the financial crisis of 2008 and banks increased reserves against risky loans, and even reserves against plain old deposits. (The deposit-reserve ratio plummetted from 9 to 1, lower even than after the Great Depression.) The Fed’s actions were a necessary response to provide liquidity in the face of this need for money. Now, however, there is no particular increase in the demand for money, but a potentially huge increase in the supply of money. The Fed will be buying some $850 to $900 billion of U.S. treasuries with printed money. To put this in perspective, it amounts to the entirety of China’s U.S. treasury holdings. The potential outcome of this is inflationary, and should continue to drive up prices of real assets. Stocks and commidities are likely to continue benefitting from such a scenario.

As yet, there is still no credible budget deficit reduction plan in the United States. In fact, the Congressional Budget Office is forecasting an important rise in the debt-to-GDP ratio from 61.6% in 2010 to nearly 70% by 2020, despite a forecast rise in GDP. This estimate was made before the extension of the Bush era tax cuts and unemployment benefits, so in reality it may be even worse.

In Europe, fiscal austerity plans are being put into place in Ireland, Greece, Spain, Portugal and the U.K. As one would expect, the peripheral economies are underperforming the manufacturing and export heavy ones such as Germany and Sweden. It is likely that with an improving U.S. economy, the U.S. dollar will further strengthen against the Euro throughout 2011, particularly because Europe is still grappling with its sovereign debt issues. Emerging markets may be due for a pullback and are likely to underperform the U.S. market on a risk adjusted basis, because of inflationary pressures facing these economies for raw materials.

Grant Rogers
Partner

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This report has been prepared by Metis Capital Management LLC. This report is for distribution only under such circumstances as may be permitted by applicable law. It has no regard to the specific investment objectives, financial situation or particular needs of any specific recipient. It is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. No representation or warranty, either express or implied, is provided in relation to the accuracy, completeness or reliability of the information contained herein, nor is it intended to be a complete statement or summary of the securities, markets or developments referred to in the report. The report should not be regarded by recipients as a substitute for the exercise of their own judgment. Any opinions expressed in this report are subject to change without notice. The analysis contained herein is based on numerous assumptions. Different assumptions could result in materially different results. The analyst responsible for the preparation of this report may interact with trading desk personnel, sales personnel, other analysts, journalists, and other constituencies for the purpose of gathering, synthesizing and interpreting market information. Metis Capital Management LLC is under no obligation to update or keep current the information contained herein. The securities described herein may not be eligible for sale in all jurisdictions or to certain categories of investors. Options, derivative products and futures are not suitable for all investors, and trading in these instruments is considered risky. Mortgage and asset-backed securities may involve a high degree of risk and may be highly volatile in response to fluctuations in interest rates and other market conditions. Past performance is not necessarily indicative of future results. Foreign currency rates of exchange may adversely affect the value, price or income of any security or related instrument mentioned in this report. Metis Capital Management LLC accepts no liability for any loss or damage arising out of the use of all or any part of this report.

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