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The statement market action discounts everything forms what is probably the cornerstone of technical analysis. The technician believes that anything that can possibly affect the price-fundamentally, politically, psychologically, or otherwise--is actually reflected in the price of that market." -John Murphy

August 13, 2011 www.alphaprophets.com Issue 1

Alpha Prophets Newsletter Issue 1

The purpose of this newsletter is to provide an alternative look at the financial markets and current economic events that influence the movement of the markets. We take a very different approach to analysis that most people may not have had exposure to in the past. Our take on the markets centers on the art of technical analysis. Technical analysis is defined by Wikipedia as, a security analysis discipline for forecasting the direction of prices through the study of past market data, primarily price and volume. We truly believe this to be the best way to form a view on the future direction of financial securities. It should be understood though that technical analysis must be combined with other forms of investigation to be as fruitful as possible and tru ly give one an edge in making profitable investments. Some of these other types of research include behavioral finance, fundamental analysis, and economic study. Using all of this together can build a truly unique view of the financial world The other main reason for this newsletter is to provide one or more model portfolios as a reference to help traders and investors in their pursuit of above average investment returns. Right now we have started one model portfolio with more likely to come. This portfolio is based on proprietary mechanical models that we have built over the last year to provide us with weekly trading signals. The first portfolio is a long only portfolio. It trades ETFs based upon our sector analysis. Changes will be made to the portfolio on Mondays with the exception of one security that we use to hedge market risk. It is essentially a market-neutral portfolio. This portfolio targets above average returns while reducing downside risk and volatility. Keep in mind; it may take a few months to start producing returns consistent with what can be expected because of the nature of the mechanical models. The portfolio will be updated at the end of the newsletter on a weekly basis. Let it be known that this newsletter is a work in process and changes are likely to be made in the future for the better. We truly believe it will provide a unique perspective to investing and we anticipate you will enjoy it. Feel free to e-mail us any comments and to tell your friends about us. Now, on to the Alpha Prophets Weekly Newsletter Issue I.

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2 Current Perspective
Before we start publishing this newsletter on a weekly basis you must understand our outlook on the big picture. We are essentially macroeconomic traders; we like to catch huge market trends generated by fluctuations in the business cycle. Therefore, it is important for us to explain our current viewpoint on the larger macroeconomic environment. First of all, the S&P 500 and all other major indices have been in a bull market since March 2009. To start our analysis we must determine the strength of the latest bull market and what type of bull market it is. Strong bull markets and economic recoveries are generally led by considerable consumer demand and large capital expenditures from corporations. However, we are not seeing these happen in almost three years since the markets bottomed. Corporations are sitting on the largest cash reserves in history rather than investing in new projects. This can be blamed on great uncertainty about regulations and taxes coming from Washington. Nevertheless, I see it as a demand problem. Corporations are not investing in the future because the demand is not there, not because of Washington. Remember, greater than 50% of the revenues from S&P 500 corporations now comes from overseas. This means that corporations are far more concerned with consumer demand from across the globe than they are with Washington policy. So the point is that the traditional longer term underpinnings of long-term bull markets, corporate capital expenditures and consumer demand, are not in place. Consumer demand has tanked because there has been a drastic decline in disposable household income since the crisis started in 2008. The average American has faced a loss of purchasing power, job stability, portfolio security, and home savings not encountered since the Great Depression. Recognizing this its not hard to understand why consumer confidence nearly at all-time lows, falling dramatically in July to a level not seen since the recession of 1982. Without a sustained rise in consumer confidence we will not see the demand needed to spur corporations into spending mode. The United States needs a way to entice corporations to start investing. Once they start investing theyll have to hire more people, which will raise consumer confidence, which will raise consumer demand, which will cause corporations to invest even more. Its a snowball cycle and neither the stimulus package, nor the Feds rounds of quantitative easing were designed to accomplish this goal.

Source: dshort.com

So where are we now? When the subprime mess started to show cracks back in 2005 we were told by all the regulators, even Ben Bernanke, that any problems stemming from subprime would be contained and the United States would continue to grow at 3.5% for eternity. However, by 2006 it was obvious to anyone who studied the MBS market that banks were about to take losses in the hundreds of billions of dollars. When the crisis erupted in 2008 US authorities, the Fed and Treasury, used every bullet they had in their arsenal. The markets still froze up and the crash of 2008 took place in a matter of weeks once Lehman Brothers fell. The problems should have been dealt with in 2008 and early 2009 when we had a chance. Instead we kicked the can down the road by moving all the toxic

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assets in the banking system onto the balance sheet of the Federal Reserve and the United States Treasury. Now what was once a private sector debt issue is a sovereign debt issue. Right now there is an unquestionable flight to quality happening and the sovereign debt problems are starting to heat up, much like the subprime problems started flaring up in early 2007. My guess is that the S&P downgrade of the US is like that moment when we were told things would be contained in 2005-2006. By downgrading US debt S&P set a precedent. Now they are forced to take a very hard look at France, whose loss of AAA would bring into doubt the whole EFSF (European Financial Stability Facility) mechanism. The EFSF is a special purpose vehicle designed to guide Europe through the crisis and the two main contributors are Germany and France. Therefore, the main result of the downgrade may not be here in the US but in Europe, where there are already issues. A series of downgrades (which are warranted if the US one was) would be devastating. Niels Jensen penned of Absolute Return Partners had this to say: If France is downgraded, a number of French banks will almost certainly be downgraded, following which other European banks will face the same destiny. Such a scenario has the potential to cause calamity across Europe. The 90 European banks which recently went through the (so-called) stress test organized by the European Banking Authority need to roll over a total of 5.4 trillion of debt over the next 24 months. A massive amount even during the best of times. Probably undoable during times of stress..With its downgrade of U.S. sovereign debt, Standard and Poors has started a chain of events which can only make things worse in an already crisis-hit Eurozone. For that reason, the decision to downgrade was not only badly timed but also ill considered; that it was probably justified is of little relevance at the moment. The next crisis is going to start in Europe rather than the US. The concern right now is the failure of Europes banking and financial system and a French downgrade could certainly make this happen because people will lose faith in the EFSF. This is all coming at a time when the US and the rest of the world is clinging on the edge of another recession. What are the markets saying at the moment? They are saying that Niels Jensens observation could be proven correct in short order. These next two charts show how the market is punishing the French government and French banks. Each is a chart of credit default swaps (CDS). A CDS is a type of insurance. In this case it is insurance against the default of France and its largest banks. When a CDS rises it means the cost of insuring that entities debt is going up. Not a good thing.

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As for the United States, we are slowly losing our grip and sliding into another recession. At this point it wont take much to push us over the edge. Just a small shock, like a banking crisis in Europe caused by a French downgrade, will do the trick. We may even already be in a recession. Doing a quick analysis on all the major market sectors says that we are currently in the early contraction phase of the standard 4 year business cycle (displayed below).

Energy stocks and oil topped back in April and inflation concerns have subsided recently, arguing for a top in the business cycle. Since then short term rates have started moving up, stock and commodity prices have fallen, and defensive sectors such as consumer staples and utilities have been outperforming the broader market for months now. Also, GDP growth has been decreasing, it is now at 1.6% annualized and housing prices are in an obvious double dip continuing to fall nationwide. Looking at the chart all of these observations point to one conclusion, we are in the early contraction phase of the business cycle. Next stop..recession. Take a look at the next chart. If you need more evidence for my call of another US recession this should do the trick. Every time year-over-year GDP growth falls below 2%, we end up in a recession. It is now 1.6%. Past performance is not indicative of future recessions, but the trend is not in our favor.

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As you can see, this is a chart of United States year-over-year real GDP growth. Every time in the past, as far as the data goes back, that real GDP growth falls below 2% we have a recession. Looking at the global macro picture I would guess that this chart is going to be correct again. For that reason, I believe were in the midst of a secular bear market. I believe the rally from 2009 to April 2011 was a cyclical bull market in the shadow of a larger bear market. This last bull market was simply the standard four year business cycle. It bottomed in March 2009, but since were in a larger bear market this cycle will be left translated and the top will occur soon. Also, valuations are just too high. P/Es have not got low enough to justify a generational bottom. Housing is still too high, stocks are too high, commercial real estate is too high, debt is too high. Another good indicator pointing to longer term weakness is the dividend yield. The dividend yield must be higher to justify a longer term bottom. So thats currently where our global macro picture stands today. Now lets move on with what our newsletter will look like on a normal week to week basis.

The Past Week

The past week was marked by an extreme surge in volatility. Markets fell early in the week but firmed up by weeks end. The market's focus to begin the week was domestic after Standard & Poor's became the first agency to downgrade the sovereign credit rating of the United States. The downgrade over the weekend from AAA to AA+ caused US equity markets to nosedive Monday. The S&P 500 lost 6.7%. On Tuesday the Federal Reserves Open Market Committee (FOMC) responded by saying that it would keep rates exceptionally low through at least mid2013. The market reacted to the Fed meeting by forming a base and moving higher by weeks end, enticed by more free money. This past week we also received data on M2 money growth. M2 is a standard measure of the money supply. The last time M2 growth reached the levels seen recently was in 1983. Rapid M2 growth back then was driven by a surge of confidence in the US economy, but that is clearly not the case today. The recent growth of M2 surpasses even the explosive safe-haven demand for money that accompanied 9/11 and the financial crisis of late 2008. Something big is going on, and it can only be the financial panic that is sweeping Europe, as money flees a banking system that is loaded with PIIGS debt. In short, it looks like there is a run on the European banks, and the US banking system is the safe haven of choice. This isnt good and even though its not a confirming indicator of my French downgrade theory being the next catalyst for a market panic, it is pretty good evidence. A chart showing M2 is at the top of the next page.

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M2 Money Supply The last time M2 growth approached these levels was in the first quarter of 1983, at a time when inflation was still very high but starting to collapse, the dollar was booming, and the economy was just beginning its first of what would prove to be seven years of exceptionally strong growth. Rapid M2 growth back then was driven by a surge of confidence in the U.S. economy, but that is clearly not the case today. The recent growth of M2 surpasses even the explosive safe-haven demand for money that accompanied 9/11 and the financial crisis of late 2008. Something big is going on, and it can only be the financial panic that is sweeping Europe, as money flees a banking system that is loaded to the gills with PIIGS debt. In short, it looks like there is a run on the European banks, and the U.S. banking system is the safe haven of choice. Well stay on top of this in the coming weeks.

Stock Market Climate

S&P 500 60 Minute Chart

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As predicted on the website in Saturdays weekend update the market moved higher Monday, approaching light resistance in the 1220 area. Again breadth was good and I look for a break of the 1220 resistance and a test of heavy resistance in the 1260-1270 area shortly. Lets take a look at the daily chart.

S&P 500 Daily Chart Looking at the daily chart I see the same story. Watch for a run to the 1220 area and then a retest of the giant head and shoulders topping pattern in the 1260-1270 area. The 200 day moving average also adds to the resistance in this zone. Todays rally was great, the breadth numbers were strong, but I would have loved to see higher volume. Look for the market to trade sideways to higher for the rest of the week. Next we ek, since I wont have to explain my macroeconomic outlook Ill go into deeper detail with my market analysis. Also, instead of only covering the S&P 500 Ill be adding coverage to the Nasdaq, Russell 2000, the CRB Commodity index, gold, oil, and the US d ollar.

Portfolio
For now our model portfolio will be run on the Investopedia stock market simulator. Eventually we will be starting a real portfolio that can be tracked on Covestor.com, but for now this will have to work. Our fund uses ETFs to build a diversified portfolio that can still generate alpha with our proprietary sector analysis system. With this timing system we are trying to benefit by taking advantage of sector rotation and the business cycle. The top 10 sectors/industries will be evaluated at the end of every week and the portfolio with be rebalanced on Monday if need be. Every week we will determine the portfolio beta and the portfolio will be hedged according to a proprietary system using the ultrashort S&P 500 ETF Ticker: SDS. The hedge, if needed, will be updated daily. The goal is to catch upswings in the stock market using the best performing sectors as our vehicle and to hedge against downside risk in the market, limiting our downside deviation. Currently our portfolio looks like this:

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. As you can tell our portfolio is positioned defensively. This could change on a dime, but with our current market and economic forecast I would imagine that we will be positioned this way for some time. This concludes the first issue of Alpha Prophets weekly newsletter. I hope you enjoyed it and will continue reading in the future. Please feel free to email me with any questions or concerns you may have.

Robert Hammer CoFounder http://www.alphaprophets.com West Virginia University College of Business & Economics BSBA & MS in Finance 304-940-6636 brant@alphaprophets.com

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