Investors digested yet another dose of astounding news from the financial markets last week. Demand for U.S. Treasuries is so strong that yields on T-bills went negative for the first time ever. Imagine that: paying the U.S. government to hold your cash in an era of an exploding budget deficit. Treasury yields further out the curve continue to hover near all-time lows, even though the U.S. may eventually commit nearly $7 trillion to bailout the financial system. Speaking of bailouts, Congress punted legislation intended to avert the bankruptcies of General Motors and Chrysler, as it appears the Bush Administration will use TARP funds to delay the inevitable until after the new administration takes office. In Chicago, federal prosecutors alleged the Illinois governor attempted to sell a U.S. Senate seat, among other charges in an incredible abuse of power. Finally, a reported $50 billion Ponzi scheme was uncovered in what could be the largest investment fraud of all time.

Despite this news, global equities managed to post modest gains for the week. While the Dow Jones Industrial Average was roughly flat, small and mid-cap stocks rose nearly 2%, and foreign markets rose nearly 10%. Last week was yet another example of equities responding well to negative news, suggesting that we have seen the lows, at least for the near term.

In fact, Ned Davis Research, a respected market research firm known for its objective analysis, turned bullish last week, reversing its long-bearish stance. Davis’ logic? The case for a short term market bottom has strengthened since the selling climax in October, evidenced  by diminished trading volume on subsequent retests of the lows, expanding volume on advancing days, and much improved market breadth. This suggests that the selling pressure has been letting up.

We also see potential for “performance anxiety” to emerge among the managers of mutual funds into year-end. The only thing worse than a down year for a mutual fund manager is underperformance relative to a benchmark, because manager compensation is typically tied to performance relative to a benchmark. Should the market continue to improve, managers could be expected to chase the market higher.

All of this evidence, combined with the tremendous monetary and fiscal stimulus being provided, leads us to believe that stocks should trade higher into year-end. However, risks remain elevated, so we do not recommend an aggressive positioning and will continue to watch the markets closely for any deterioration in the indicators.

Finally, a word on diversification. At Kanaly, we believe each investor’s portfolio should be ultra-diversified, meaning allocations not just to multiple securities, but also to many different asset classes and investment managers. It has been reported that many individual investors and investment funds had 50% or more of their assets invested in Bernard Madoff’s alleged Ponzi scheme, exposing them to devastating losses. While investment losses, and even fraud, may be inevitable, investors can protect themselves through proper diversification.

Disclosures

This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the Funds or any stock in particular, nor should it be construed as a recommendation to purchase or sell a security, including futures contracts.

There are risks involved with investing, including loss of principal. Current and future portfolio holdings are subject to risks as well. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Narrowly focused investments and smaller companies typically exhibit higher volatility. Bonds and bond funds will decrease in value as interest rates rise. High-yield bonds involve greater risks of default or downgrade and are more volatile than investment-grade securities, due to the speculative nature of their investments. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume.

Diversification may not protect against market risk. There is no assurance the objectives discussed will be met. Past performance does not guarantee future results Index returns are for illustrative purposes only and do not represent actual portfolio performance. Index returns do not reflect any management fees, transaction costs or expenses. One cannot invest directly in an index.