Morning Review - 080610

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A snapshot of the markets through the lens of ConvergEx.

Market Commentary:

Morning Markets Briefing

Nicholas Colas (Chief Market Strategist): 212 448 6095 or [email protected]

Christine Clark: 212 448 6085 or [email protected] Beth Reed: 212 448 6096 or [email protected]

Market Commentary – Pages 1-4, Equities/Conferences & Earnings – Page 5, Fixed Income – Page 6, Options – Page 7, Exchange-Traded Funds/Indexes – Page 8, Social Media & Internet Blogs Top Stories – Page 9

Following the (ETF and Mutual Fund) Money – Year to Date Capital Flows Summary: Today we review Exchange Traded Fund (ETF) and mutual fund money flows for the year-to-date to get a sense of where investment capital has been moving in 2010. The net outflows from U.S. equity mutual funds has been an important trend this year, and we find that it is NOT moving to the SPY ETF. That mega-ETF is actually down in assets on the year to the tune of roughly $10 billion. That is enough to push the U.S. equity ETF category into the “outflow” camp, even though most other big U.S. stock ETFs have seen modest inflows. The big story is the tsunami of money that has moved into fixed income mutual funds (+$150 billion) and the largest bond ETFs ($14 billion). It’s no mystery why interest rates are at record lows – just follow the money. How U.S. equity market hover so close to the flat line is a bit more of a conundrum. There’s something about a dull market and hot humid weather that forces introspection, whether you want to go down that path or not. Here we are, more than half way through 2010, and the market’s price levels feel like a scene out of Groundhog Day. S&P 500 up 1.0%. The Wilshire Total Market index up 2.1%. The NASDAQ up 1.1%. I would say that stocks are generating money market returns, but even cash doesn’t yield what it used to. Money markets give you nothing, and stocks have been just a little bit better. To get the real juice, you have to look at – gulp – the bond markets. The iShares Barclays 20+ Year Treasury Bond ETF (symbol TLT) is up 10% on the year. Treasuries are supposed to be boring, low return assets for retirees and the risk averse. Instead of playing bridge or canasta with Grandma, however, they have been the “Cinderella story” of the capital markets this year. Govvies have even trounced high yield bonds, the equities-in-bonds’-clothing of the fixed income world. That asset class is essentially flat, just like stocks.

Stocks ended lower Thursday (S&P 500 -0.1%, Dow -0.1%, Nasdaq -0.5%) after weaker-than-expected initial unemployment claims and a disappointing chain store sales report. Jobless claims unexpectedly rose 19K last week to 479K, compared with estimates for 455K and last week’s revised 460K. The 4-week moving average rose just over 5K to 458.5K but was still slightly lower than at the end of June. In other labor market news, the Monster employment index slid 3 points to 138 last month on weakness in demand for construction workers and jobs in leisure and accommodation. Excluding a few exceptions (GPD, LTD and M for example), chain store sales were weak in July, with teen retailers particularly hard hit. After the close KFT reported earnings that beat estimates, but missed on revenue.

August 6th, 2010

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This odd feeling of “What’s in the world is going on here” is as good a reason as any to take a quick lap through the world of money flows to examine where cash is moving within stocks and bonds, both domestic and international. With all this oddball behavior we should be able to spot the underlying trends that cause it. And, in fact, the money flows do dramatically underpin the performance we have noted while raising some questions as well. The attached charts show data from the Investment Company Institute as well as information from our Exchange Traded Fund (ETF) desk and www.xtf.com, our go-to third party source of all things ETF. Starting with mutual fund money flows, the trend to fixed income assets is all too clear. Year to date, U.S. equity mutual funds have seen collective outflows of some $31.5 billion. There has not been a week where investors put money INTO U.S. equities for several months. If you look at the last three-plus year, some 42 months, you will find that investors have only added money to U.S. equity funds in 14 of those months. In contrast, the big winner – to the tune of just over $150 billion – is taxable bond funds. Foreign equities have also posted modest gains in new assets, as have muni bond funds and hybrid equity/debt products. Perhaps the redemptions at U.S. equity mutual funds have simply moved over to ETFs, trading active management and once-a-day liquidity for generally passive management and intraday trading? Nope – ETF money flows mirror the trends in the ICI mutual fund data, rather than providing the other side of the trade. Yes, overall equity ETF assets have risen very modestly thus far in 2010: up 5% to $612 billion. To get a sense of where, within the general category of “U.S. Equity,” “U.S. Fixed Income,” and “International ETFs” assets have shifted, we looked at the shares outstanding for each of the largest funds in these group and compared that to the shares out at the beginning of the year. More shares outstanding equals, everything else equal, incremental demand for the fund. Fewer shares, less demand. We then multiplied that change in shares outstanding by the average price of the fund for the year to get a back-of-the-envelope estimate for money flows. Our findings on ETF money flows based on this calculus are as follows:

• The 10 largest U.S. equity ETFs have collectively lost $6.0 billion in assets in 2010. That may sound like a lot, but it is really one fund: the SPY is down an estimated $10 billion in assets. That money has flowed, in part, into a myriad of other U.S. equity choices – energy stocks, tech stocks, mid cap stocks, etc. But the rest has “left the building,” as they used to say about Elvis.

• The 10 largest fixed income ETFs have all gained assets in 2010. Short duration, long duration, corporate, whatever. If the underlying assets have a coupon

and a return of principal, ETF buyers have lined up to buy. In total, the top fixed income ETFs have added $14 billion in new assets this year.

• International ETF have been more modest winners in big-ETF land this year, with the top 10 funds adding $1.5 billion. The only losers have been a few international bond ETFs.

Those vignettes, based on the largest funds, may not be letter-perfect in terms of total dollar amounts because there are, after all, over 1,000 ETFs in the U.S. markets alone. They are, however, closer than you might think. Remember that the biggest ETFs hold an inordinate share of the total pie. The SPY, QQQQ, and EFA alone represent 14% of all the ETF assets listed in the U.S.

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The upshot to this brief analysis is pretty straightforward. Investors are shifting assets in both mutual funds and ETFs away from U.S. stocks and into fixed income. The moves are dramatic: there is 2-4x more money moving into fixed income than is leaving stocks. Fresh savings, in other words, are going directly into bonds. There is also some modest shift to international investing, mostly in equities, but not on the same order of magnitude as the bond trade. I will close on a point for which we do not have a great answer. Bad form, I know, but the topic is worth the embarrassment of not offering up neat and tidy solutions. We know that both ETF and mutual fund flows have been leaving U.S. stocks for the relative safety of fixed income investments. We also know that the amounts are not small - $32 billion in mutual fund and $6 billion in large ETFs assets. Granted, the S&P 500 alone has a market cap of over $10 trillion, so perhaps these are small amounts in the grand scheme of things. But if retail investors are leaving U.S. stocks in both 401(k)s (read mutual funds) and brokerage IRAs/investment accounts (read ETFs), then who is buying stocks so that the market is still up (modestly) on the year?

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US Equity Mutual Fund Flows and the S&P 500: 2007-Present

US Equity Mutual Fund Flows S&P 500 -50,000

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YTD Mutual Fund Flows by Category

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$14,033,159,736

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U.S. EQUITIES

Teen retailer ARO and department store JCP slid 5.7% and 7.7%, respectively, after falling short of same-store sales projections. Other teen retailers also disappointed (HOTT –5.7%, BKE –4.0%, WTSLA –0.3%), while GPS (+1.8%), LTD (+1.1%) and M (+1.8%) advanced on better-than-expected same-store sales results. Agriculture stocks gained (ADM +5.7%, MON +3.1%, CF +3.5%) following Russia’s announcement of an export ban on grain and grain products from mid-August through the end of the year due to extreme drought. S&P 500 components PCS (+7.5%) and NWSA (+3.6%) surged after reporting earnings that easily topped analysts’ estimates.

Important Conferences/Corporate Meetings Today: BMO Capital Markets Fixed Income Perspectives Conference – Chicago, IL

Important Earnings Today (with Estimates) From…

Source: Thomson ONE

Three Day (High – 1127.75; Low – 1112.25): Prior Day SPX (High – 1126.56; Low – 1118.81; Close – 1125.81):

S&P Futures One Day (High –1127.75; Low – 1115.50): Y: $3.98

COWN: $-0.15 POM: $0.22 PGN: $0.62 PNM: $0.18 WCRX: $0.81 WSC: $1.76

Source: Bloomberg

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FIXED INCOME

Source: Bloomberg

Today’s Important Economic Indicators/Events: Nonfarm payrolls: -70,000 Unemployment rate: 9.6% Average hourly earnings: 0.2% Average workweek: 34.1 hours Consumer credit: $-5.0 B

Source: Bloomberg

Treasuries rallied Thursday, pushing the 2-year note yield back toward an all-time low, as initial jobless claims unexpectedly increased last week. The spread between 10- and 30-year U.S. debt widened to the most in 33 years (1.15 percentage points) on deflation fears. Benchmark yields on the 10-year note dropped 4 basis points to 2.92 percent, while 30-year yields decreased 2 basis points to 4.07 percent. The 30-year mortgage rate dropped to the lowest level (4.49 percent) since Freddie Mac began tracking them in 1971, which is the 6th record low in 7 weeks.

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U.S. EQUITY OPTIONS

We ranked the S&P 500 companies from the highest to lowest 30 day implied to historical volatility ratio. Above we identify the 10 most positive and negative movers. The table to the left represents the 25 highest 30 day implied to historical volatility ratios within the S&P 500 companies. The green represents names new to the list while the red represents names that have fallen out.

SPX – The index traded in a tight range of 0.6% (-0.1% to -0.7%) and the implied volatility measured by the VIX also saw little change. Much like the underlying index, trading in SPX options was largely featureless. There was one large (10,000 contracts) 800/700 Put spread bought in September for $0.45. There was also another net buyer in out of the money puts with a September/ November 1000/850 put spread swap in which the November was bought and the September was sold for a net debit of $10.40 that traded 4,400 times. ETF – Following a sharp decline early on in trading, the market trended higher to close down on the day. Options volume was lower than expected as we saw a continued theme of cautious buying. In the international space, EEM had a buyer of the 10,000 x 20,000 Aug 36 / 41 put spread vs. 42.15 stock, while in FXI paper bought 5,000 Aug 41 puts tied to stock. In Brazil Fund, EWZ, one investor sold 7,800 Aug 74 Calls to buy 7,800 Aug 70 Puts. Financial ETF, XLF, saw a large print with the purchase of 70,000 Sep 16 calls vs. selling 35,000 Sep 14 puts tied to 14.85 stock. Lastly, Agricultural Fund, DBA saw 10.5 times its usual volume as paper sold the Oct 27 / 29 call spread 12,000 times.

Rank 7/30/2010 8/2/2010 8/3/2010 8/4/2010 8/5/2010 30-Day Implied Vol1 MIL MIL FIS MIL Q 19.142 FIS FIS PTV XTO ARG 10.663 DF DF ARG Q PTV 37.634 Q PTV Q PTV NOVL 28.435 PTV ARG NOVL ARG CFN 34.916 ADM NOVL MJN NOVL EL 31.247 FLIR Q CFN BIG KR 21.518 SLE CFN SWN MJN SWN 36.789 AGN CLX EL EL MJN 32.3810 SAI MJN CLX CFN FLIR 24.8811 L SAI SAI SAI AMAT 32.5012 CLX SLE KR FLIR SAI 18.2013 MCK AIG FLIR PCS SJM 21.4514 MJN SWN AIG SWN PLL 30.6315 MRK MCK AMAT KR INTU 25.0516 ARG FRX SLE AMAT AIG 51.4517 HUM PBI ROST SLE MRK 21.8818 CFN EL BIG TSN CLX 15.2319 CAH PCS PCS FRX TGT 25.3920 AMAT FLIR MCK CPB 14.5921 NOVL AMAT FRX AIG FRX 23.1522 SWN ROST PBI ROST NSM 30.1323 FRX ADM TSN SJM MCK 24.4124 PFE CAH CAH MRK SLE 20.9525 PCS SJM PCLN CLX AZO 17.54

GME PFE SJM PCLN CLXAMGN HUM ADM CAH MRK

EL MRK MIL PBI ROSTMFE L DF MCK PPLWFR FIS TSNFSLR BIG

MIL

CURRENT IMPLIED VOLATILITY / CURRENT HISTORICAL VOLATILITY

30-Day Implied Vol 30-Day Implied VolKFT 26.64% 21.28 PCS -30.18% 39.87CPB 18.52% 18.11 TE -21.97% 17.05DRI 17.86% 26.23 CL -20.55% 29.94NKE 16.03% 21.80 IFF -20.31% 21.39K 15.89% 18.94 DTV -17.47% 21.86CF 15.69% 45.41 MKC -16.94% 13.25

NOVL 15.24% 35.33 PPL -15.22% 21.95DELL 15.21% 37.16 AEE -14.33% 19.71ORCL 13.17% 26.34 TDC -14.29% 29.67CAG 12.05% 18.67 BIG -14.07% 40.97

Top 10 Bottom 10BIGGEST MOVERS

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Exchange-Traded Funds/Indexes

ETFs in the Headlines and Blogs: BlackRock Seeks Clearance for Index ETFs That Can Sell Short - http://noir.bloomberg.com/apps/news?pid=newsarchive&sid=aI1v1RrSix90 Dividend ETFs for Deflation and Inflation - http://seekingalpha.com/article/218757-dividend-etfs-for-deflation-and-inflation

Major Index Changes: None

Name (Net Assets*) Ticker Category Daily Return Sector Ticker 1-Day Perf YTD Perf Sector Ticker 1-Day Perf YTD PerfSPDRs SPY Large Blend -0.11% Energy XLE 0.16% -1.39% Telecomm IYZ 0.24% 3.25%SPDR Gold Shares GLD N/A 0.22% Health XLV -0.17% -4.67% Technology XLK -0.45% -2.57%iShares MSCI Emerging Markets Index EEM Diversified Emerging Mkts -0.45% Industrials XLI 0.06% 11.62% Consumer Discretionary XLY 0.31% 8.33%iShares MSCI EAFE Index EFA Foreign Large Blend -0.07% Utilities XLU -0.16% -0.29% Financials XLF -0.40% 3.58%iShares S&P 500 Index IVV Large Blend -0.11% Consumer Staples XLP -0.44% 2.12% Materials XLB 0.21% -1.03%

Name Ticker Category Shares Traded Currency Ticker 1-Day Perf YTD Perf Currency Ticker 1-Day Perf YTD PerfSPDRs SPY Large Blend 139,666,083 Australian Dollar FXA -0.24% 1.65% Mexican Peso FXM -0.08% 3.93%iShares MSCI Emerging Markets Index EEM Diversified Emerging Mkts 43,631,463 British Pound Sterling FXB -0.03% -1.83% Swedish Krona FXS 0.17% 0.31%Financial Select SPDR XLF Specialty - Financial 40,760,759 Canadian Dollar FXC 0.09% 3.11% Swiss Franc FXF 0.66% -1.20%iShares Russell 2000 Index IWM Small Blend 37,979,023 Euro FXE 0.20% -8.03% USD Index Bearish UDN 0.27% -4.32%PowerShares QQQ QQQQ Large Growth 36,519,987 Japanese Yen FXY 0.51% 8.22% USD Index Bullish UUP -0.34% 1.69%

Name Ticker Category Daily Return Name Ticker 1-Day Perf YTD Perf Bonds Ticker 1-Day Perf YTD PerfiShares MSCI Indonesia Invstble Mkt Idx EIDO N/A 4.37% iPath S&P 500 VIX VXX 0.28% -36.69% Aggregate AGG 0.12% 4.10%Market Vectors Double Long Euro ETN URR N/A 4.01% Short-Term Futures ETN Investment Grade LQD 0.18% 5.39%ELEMENTS MLCX Grains Index TR ETN GRU N/A 3.84% High Yield HYG -0.05% 0.63%Direxion Daily Real Estate Bear 3X Shares DRV Bear Market 3.77% iPath S&P 500 VIX VXZ 0.77% 8.80% 1-3 Year Treasuries SHY 0.08% 1.47%Direxion Daily Small Cap Bear 3X Shares TZA Bear Market 3.38% Mid-Term Futures ETN 7-10 Year Treasuries IEF 0.48% 8.61%

20+ Year Treasuries TLT 0.47% 10.13%

ETF Ticker 1-Day Perf YTD Perf ETF Ticker 1-Day Perf YTD PerfGold GLD 0.22% 9.01% Crude Oil USO -0.46% -6.49%Silver SLV 0.17% 8.59% EAFE Index EFA -0.07% -3.06%Natural Gas UNG -2.39% -23.02% Emerging Markets EEM -0.45% 1.54%

SPDRs SPY -0.11% 1.27%

Others

Fixed Income ETFs

Prior Day Peformance of Largest ETFs by Assets

Prior Day Top Volume ETFs

Prior Day Top Performers

S&P 500 Sector ETFs

Currency ETFs

VIX ETNs

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Top Online Social Networking Stories Latest Popular Digg.com Business Stories: Taco bell rolls out street food-inspired menu - http://blogs.westword.com/cafesociety/2010/08/taco_bell_rolls_out_street_foo.php Tax-Friendly States for Retirement - http://personaldividends.com/money/miranda/tax-friendly-states-for-retirement Small Businesses and Hard Facts - http://www.focus.com/images/view/5954/ Market Data firm Spots the Tracks of Bizarre Robot Traders - http://www.theatlantic.com/science/archive/2010/08/market-data-firm-spots-the-tracks-of-bizarre-robot-traders/60829/

Calculated Risk Weekly Initial Unemployment Claims increase to 479,000 - http://www.calculatedriskblog.com/2010/08/weekly-initial-unemployment-claims.html China Stress Tests: 60% Decline in House Prices - http://www.calculatedriskblog.com/2010/08/chinas-stress-tests-60-decline-in-house.html Q2: Office, Mall and Lodging Investment - http://www.calculatedriskblog.com/2010/08/q2-office-mall-and-lodging-investment.html Fed Research Supports Mortgage Cram Downs - http://www.calculatedriskblog.com/2010/08/fed-research-supports-mortgage-cram.html

The Big Picture Tech Gadgets vs Durable Goods - http://www.ritholtz.com/blog/2010/08/tech-gadgets-vs-durable-goods/

The New York Times Consumers Saving More Than Thought - http://www.nytimes.com/2010/08/04/business/economy/04savings.html?_r=1

The Wall Street Journal For Home Builders, Reality Looms in Results - http://online.wsj.com/article/SB10001424052748704499604575407533229497208.html Foreclosed On – By the U.S. - http://online.wsj.com/article/SB10001424052748704499604575407584128526218.html

Bespoke Investment Group Will Google Break Up? - http://www.bespokeinvest.com/thinkbig/2010/8/4/will-google-break-up.html TED Spread Continues to Narrow - http://www.bespokeinvest.com/thinkbig/2010/8/4/ted-spread-continues-to-narrow.html Earnings and Revenue Beat Rates - http://www.bespokeinvest.com/thinkbig/2010/8/4/earnings-and-revenue-beat-rates.html Bearish Sentiment Down Two Weeks in a Row - http://www.bespokeinvest.com/thinkbig/2010/8/4/bearish-sentiment-down-two-weeks-in-a-row.html

Robert Reich’s Blog The Rich and the Rest of Us - http://robertreich.org/post/905177795/the-rich-and-the-rest-of-us

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This presentation discusses general market activity, industry or sector trends, or other broad-based economic, market or political conditions. It is provided for general informational purposes only and should not be relied on for any other purpose. It is not, and is not intended to be, research, a recommendation or investment advice, nor an offer to sell or the solicitation of offers to buy any BNY ConvergEx Execution Solutions LLC (“ConvergEx”) product or service in any jurisdiction. It does not take into account the particular investment objectives, restrictions, tax and financial situations or other needs of any specific client or potential client. Please consult with your financial and other advisors before buying or selling any securities or other assets. This presentation is for qualified investors and NOT for retail investors. Please be advised that options carry a high level of risk and are not suitable for all investors. To receive a copy of the Options Disclosure Document please contact the ConvergEx Compliance Department at (800) 367-8998. The opinions and information herein are current only as of the date appearing on the cover. ConvergEx has no obligation to provide any updates or changes to such opinions or information. The economic and market assumptions and forecasts are subject to high levels of uncertainty that may affect actual performance. Such assumptions and forecasts may prove untrue or inaccurate and should be viewed as merely representative of a broad range of possibilities. They are subject to significant revision and may change materially as market, economic, political and other conditions change. Past performance is not indicative of future results, which may vary significantly. The value of investments and the income derived from investments can go down as well as up. Future returns are not guaranteed, and a loss of principal may occur. The information and statements provided herein do not provide any assurance or guarantee as to returns that may be realized from investments in any securities or other assets. The opinions expressed in this presentation are those of various authors, and do not necessarily represent the opinions of ConvergEx or its affiliates. This material has been prepared by ConvergEx and is not a product, nor does it express the views, of other departments or divisions of BNY ConvergEx Group, LLC and its affiliates.

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