The Navisis Notice

July 9, 2012 Volume 10

Euro Confusion
Most pundits have been led to believe that Angela Merkel was pressured into making earth-shattering concessions at last weeks EU Summit. At least that is what the media and initial market reaction would have you believe. There seems to be a gap, however, between this interpretation and reality. The ESM may indeed be on the precipice of propping up in Italy and Spain, not just the sovereigns but the banks too, but was the 500 billion size of the facility expanded? No. this then means that Germany wont be ponying up any more money (for the moment) and the current limit so far is too small to stabilize Spain, Italy, Portugal, Greece and now Cyprus. Nor was there any new measures or funding provided for reversing the downtrend in economic activity. The recession continues unabated (more on that below). The ECB indeed cut rates to 0.75% today as expected but the problem with the region has little to do with overly tight monetary policy so this is tiny solution to long standing fiscal and structural economic impediments to growth. Lets talk about what we do know with conviction, which is that the global economy is slowing at a rather alarming rate. We now have 80% of the world posting a contraction in industrial activity and the ECRI leading indicator in the U.S. has swung back below the zero-line for the third time in the past three years down now for six weeks running to a four-month low. Recession risks are clearly on the rise and only really being discounted in the fixed-income markets.

Volume Highlights:
Euro Confusion, BWD U.S. Malaise, BWD Stocks versus Oil and Bonds, R. Stine CMO Alternative?, M. Angioletti

Gluskin Sheff + Associates and Breakfast with Dave 7.4&5.12

Economic Forecast
GDP Q1 increased 1.9% Inflation rate 1.70% CCI down to 62.0 from 64.4 Unemployment 374,000 down 14,000
Economic data provided by bea.gov, inflationdata.com and bloomberg

U.S. Malaise
For the fourth month in a row, nonfarm payrolls surprised the consensus to the downside not to mention the ADP survey (which has overstated the official data by an average of 65k over this time frame). The 80k headline was a good 20% shy of street forecasts and dragger the average tally for the second quarter to a mere 75k nearly 70% slower than the 226k average gain in Q1 and the most sluggish performance since the third quarter of 2010 (so dont fret that was the quarter that touched off QE2). This continues to go down as the most tepid recovery on record. In fact, even though the recession technically ended in mid-2009 with the help of the government defibrillator, I wouldnt even hazard to call this a recovery. What is typical for this part of the cycle is for payrolls to be up more than 240k in the 36th month into the expansion. That more or less puts 80k into a proper context. Something else to ponder is that 36 months into an alleged recovery, employment is still 3.6% below the pre-recession peak. Scouring the historical record in the post-WWII ear shows that it generally takes no longer than 25 months to recoup the job losses suffered in the recessionary phase. At the rate we are going so far this year, that fateful day wont happen until March 2015. Gluskin Sheff + Associates and Breakfast with Dave 7.6.12

Stocks Versus Oil and Bonds

The US equity market continues to be resilient despite plunging oil prices and bond yields hovering near record lows. Crude oil is down 22.6% from its February 22nd closing high of 109.77 through its June 30 closing level of 84.96. The 10-year Treasury yield is hovering just above its June 1 record low of 1.44%. Meanwhile, the S&P 500 is down 4.01% from its April 2nd closing high of 1422 to its June 30 closing level of 1362. The first chart highlights the strong correlation between oil prices and stock prices over the past three years (June 2009 through April 2012).

Weekly Trading Ranges

(Closing price Friday to Friday)

DJIA:12220.09-12772.47 S&P 500:13362.16-1354.68 NASDAQ: 2935.05-2937.33 Crude Oil: 84.87-84.12 US Yield Curve as of 7.6.12 6Mo - .15% 1Yr - .20% 2Yr - .27% 3Yr - .37% 5Yr .64% 7Yr 1.01% 10Yr 1.57% 30Yr 2.66%

The second chart highlights the recent correlation breakdown between these two asset classes since May. Oil prices continued to decline in June, while the S&P 500 has spent most recovering from its May slide.

The yield on the 10-year Treasury yield continues to hover near record lows after hitting a high of 2.39% on March 20, 2012. As yields have sharply come down, indicating contraction, the S&P 500 has been volatile but has yet to breakdown.

Locations
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Suite 925 Lombard, IL 60148

Equity markets are clearly not reflecting a contraction in growth or deflationary expectations to the same extent as the energy and bond markets. Its not clear however if this dislocation is sustainable going forward, particularly in the face of weaker than expected economic data. The charts indicate the oil market and bond market are telling a much different story about the global economy then the stock market.

Contact Us
Phone 312.274.0718 Fax 312.274.1578 info@navisisfinancial.com www.navisisfinancial.com

Rob Stine Sr. Investment Executive 630 / 993-9035 Ext. 257 rstine@navisisfinancial.com

CMO Alternative?
Due to the complexity of CMO Products, please contact your representative for information on CMOs and how they react to different market conditions; also additional educational material is available upon request. Two of my previous columns (Vol. 1 & 6) discussed Collateralized Mortgage Obligations (CMOs), a spread product1. I wrote about CMOs issued by Ginnie Mae or FHFAs2 twins Fannie Mae and Freddie Mac. Since Ginnie Mae is part of HUD3; Ginnie Mae CMOs are agency obligations backed by the full faith and credit of the U.S. Government. Fannie and Freddie are former GSEs 4 now operating under the conservatorship of the Federal Housing Finance Agency (FHFA) that backs their CMOs. Importantly, CMOs have a low risk of default and monthly income payments backed by Federal Agencies. CMOs are actually a subset of a larger class of securities known as Mortgage Backed Securities (MBSs)5. MBSs are primarily comprised of what the mortgage industry refers to as unconventional loans i.e. ARMs 6, Jumbos7, Helocs, Sub-prime etc. Since unconventional loans do not conform to FHA standards the loans would not be in the loan pools used as CMOs collateral. Fannie Mae does hold some of these non-conforming loans in their investment account; Fannie backs these loans and started providing increased disclosures on the loans. The increased loan disclosure provides essential information that companies may see as an opportunity to create a new MBS product. Recently some low loan balance and sub-prime loans were acquired at a discount and repackaged into MBS products. In the past Ive pointed out that all CMOs have an embedded call option, implying principal can be paid down at anytime. In a declining interest rate environment, mortgage refinancing typical increases, resulting in faster
1

A fixed income product which is priced to yield (in basis points) greater than the corresponding maturity Treasury security, hence at a spread to the Treasury yield curve. 2 FHFA: Federal Housing Finance Agency, created by the Housing an Economic Recovery Act of 2008. 3 HUD; Housing and Urban Development, an agency of the Federal Government. 4 GSEs; Government Sponsored Enterprises. 5 Mortgage Backed Securities (MBS) are actually a specified subset of securities known as Collateralized Debt Obligations that can be backed by various types of debt i.e. credit card receivables, car loans, student loans etc. 6 ARM; Adjustable Rate Mortgage, useable as collateral if they had 30 year amortization. 7 Jumbo; large size loan typically above $417,000 , later raise to $729,750

repayment of CMO principal. CMO holders receive their principal back but currently will be reinvesting in a declining interest rate environment. Lower yields often are unpalatable to investors; the new MBS products were designed to overcome this perceived problem by combining low loan balance and subprime collateral into a product deemed unlikely to re-finance under todays conditions. Currently, it is uneconomical for the low loan balance mortgages to refinance due to refinancing costs and impossible for sub-prime borrowers to qualify for a loan under todays higher credit requirements, leaving these two types of borrowers locked into their loans. Some important points that may be of concern to potential buyers of this new MBS product are 1) many of the underlying mortgages may be a creation of the mortgage financing boom, hence this MBS product has limited pre-payment experience which may make the products PSA 8 hard to estimate during various changes in interest rates 2) changes in interest rate could create unknown secondary market pricing and future liquidity problems 3) the small increase in yield may not offset the possible extension risk9 caused by first two points Ive stated. The Federal Reserve is currently committed to holding interest rates down but their policy could change and these new MBS products may not be the best security for an investor looking for yield and predictable cash flow in this interest rate environment. To determine if Ginnie, Fannie, Freddie CMOs or alternative fixed income investments are appropriate, investors can contact me, Mark Angioletti, or their Navisis Financial Investment Advisor. Mark J. Angioletti Sr. Investment Executive 312 / 447-2525 mangioletti@navisisfinancial.com

Articles courtesy of Gluskin Sheff + Associates and Breakfast with Dave. Charts courtesy of Dorsey Wright and Associates

DISCLAIMER:
The commentary provided in this

PSA; Prepayment Speed Assumptions, the speed at which a mortgage pool pays back principal faster than the standard 30 year amortization. 9 For MBSs the risk that rising rates slows down PSA speeds and the investors principal is returned at a standard 30 yr. amortization rate, hence preventing investors from reinvesting the principal in a rising interest rate environment.

Navisis Notice is intended to provide our prospects and clients with timely market analysis and should not be considered a research report. This Navisis Notice does not make a financial or investment recommendation or otherwise promotes a product or service of the firm. This Navisis Notice contains only news, facts, and commentary on information previously reported from a news source believed to be accurate and reliable by the author. These news sources include the following: { Breakfast with Dave and Dorsey Wright & Associates} It is possible that at any given point in time, the author, Navisis Financial, or one or more of its employees or registered individuals associated with Navisis Financial, may hold a position, either long, or short, as well as options, bonds, or other instruments in the companies noted in this report. This Navisis Notice is intended strictly for prospects and current Navisis Financial customers only. TO UNSUBSCRIBE- If you wish not to receive further Navisis Notices, please reply for removal. The Dow Jones Industrial Average is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange and the NASDAQ. The DJIA was invented by Charles Dow back in 1896. The Standard & Poor's 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. The NASDAQ is an electronic quotation system that provides price quotations to market participants about the more actively traded common stock issues in the OTC market. About 4000 common stock issues are included in the Nasdaq system The 10-year Treasury Note represents debt owed by the United States Treasury to the public. Since the U.S. Government is seen as a risk-free borrower, investors use the 10-year Treasury Note as a benchmark for the long-term bond market. For purposes of the following guidelines, the term collateralized mortgage obligation (CMO) refers to a multi-class debt instrument backed by a pool of mortgage passthrough securities or mortgage loans, including real estate mortgage investment conduits (REMICs) as defined in the Tax Reform Act of 1986. The yield and average life shown above consider prepayment assumptions that may or may not be met. Changes in payments may significantly affect yield and average life. Please contact your representative for information on CMOs and how they react to different market conditions. Additional educational material is available upon request that includes a discussion of the characteristics and risks of CMOs including credit quality, prepayment rates and average lives, interest rates including their effect on value and prepayments, tax considerations, minimum investments, transactions costs and liquidity. Including the structure of a CMO, including the various types of tranches that may be issued and the rights and risks pertaining to each (including the fact that two CMOs with the same underlying collateral may be prepaid at different rates and may have different price volatility) and the relationship between mortgage loans and mortgage securities. Along with questions an investor should ask before investing and a glossary of terms.

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