Chicago, IL – October 23, 2009 – Zacks.com announces the list of stocks featured in the Analyst Blog. Every day the Zacks Equity Research analysts discuss the latest news and events impacting stocks and the financial markets. Stocks recently featured in the blog include: Wal-Mart (WMT), Capital One (COF), Merck (MRK), GlaxoSmithKline (GSK) and Schering Plough (SGP).

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Here are highlights from Thursday’s AnalystBlog:

New Jobless Claims Up

This long-term unemployment is an insidious problem for the economy. People who are out of work for just a few weeks really don't have to cut back on their consumption that much, especially if they feel confident that they will have a new job in a short time.

People who are seeing even their emergency extended benefits expire are not going to be spending an lot of money at Wal-Mart (WMT) or anywhere else for that matter. For a little while they can make due by running up their credit cards, but if a job doesn't come along it just means a much bigger default for the big credit card companies like Capital One (COF).

If the stimulus bill had not passed, there would have been more than 3.8 million people (and their families) who would have been devoid of any income for months now. Next time you hear someone say the stimulus bill is not working, ask them to look one of those people in the eye and say it. Ask them how much lower retail sales would have been if those 3.8 million-plus families were not even able to shop for absolute necessities like food.

Merck Beats, Raises Outlook

Merck’s (MRK) earnings for the third quarter came in at 90 cents per share, which was ahead of the Zacks Consensus Estimate of 82 cents, driven by continued growth of its key products and strict cost management. The company reported revenues of $6 billion, up 2% from the same period in 2008. Revenue would have higher, but for the unfavorable foreign exchange movement, which affected global sales by 3%.

Weaker-than-expected sales of Gardasil were offset by significantly stronger-than-anticipated Singulair revenues. Although the US Food and Drug Administration (FDA) asked for additional precautions regarding the risks associated with the use of Merck’s lead product Singulair (as well as other leukotriene inhibitors), including suicide and depression, the drug recorded an increase of 5% compared to the third quarter of 2008.

Gardasil, Merck’s cervical cancer vaccine, recorded yet another quarter of lower sales. The company recorded $311 million in sales of the vaccine, down 22% from the year-ago period. Recently, the vaccine received FDA approval to be used in boys and young men in the age group of 9-26 years for the prevention of genital warts. However, sales are likely to be hampered as the FDA approval of GlaxoSmithKline’s (GSK) cervical cancer vaccine, Cervarix, will intensify competition further.

Cholesterol franchise sales, consisting of Vytorin and Zetia under Merck’s partnership with Schering Plough (SGP), continued to decline in the reported quarter as well. While sales were down 7% year over year in the third quarter, in the second quarter, they were down 10%. Isentress, the company’s product for HIV infection recorded an increase of 84% to $197 million during the quarter. The drug is expected to record increased sales with the recent FDA and EU approval for the drug’s use in previously untreated patients as well.

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In our view, obesity remains the single largest opportunity for a new pharmaceutical product today. Roughly two-thirds of the U.S. population is overweight. The number is expected to grow to 75% by 2015. There is massive unmet medical need and clear pharmacoeconomic benefits to curtailing the problem.

According to the Journal of Health Affairs, obesity costs Americans $147 billion per year in total medical costs. This is 10% of all healthcare spending, and that number has doubled since 1998. It is likely to continue to surge in the years to come. Obesity is associated with an enormous number of co-morbidities, including high cholesterol, high blood pressure, heart disease, diabetes, joint and muscle pain, as well as depression and fibromyalgia. Studies have shown that reducing body weight by as little as 5% has a meaningful impact on reducing these co-morbidities.

New Products Are Coming...

Several biotechnology companies are working on the next wave of obesity candidates. These include Arena's (ARNA) Lorcaserin, Vivus' (VVUS) Qnexa, Orexigen's (OREX) Contrave and Amylin's (AMLN) pramlintide.

Contrave has completed phase III trials and Orexigen's management is expected to file for approval in early 2010. Qnexa is currently in two phase III programs with an NDA expected around the middle of 2010. Amylin's pramlintide and metreleptin is currently in phase IIb. That gives Arena, with an NDA planned before the end of the year, the first-mover advantage.

Safety Is Key Determinant...

Analysis for Contrave looks similar to lorcaserin in terms of efficacy. Both products offered around 17 - 18 lbs of weight loss after one year of treatment. Vivus' Qnexa, which is a combination of phentermine and topiramate, offered up around 20 lbs of weigh loss after only six months.

We are waiting for the Qnexa 1-year data, but it looks like Qnexa is the most efficacious drug. However, it is important to note that there is clearly more to a weight loss drug than just pure efficacy. If efficacy was the only hurdle, Wyeth's (WYE) Phen-Fen would still be on the market.

Physicians' surveys have clearly showed that safety is the paramount concern. And, with the significant prescriber interest in reducing co-morbidities, tolerability and abuse potential are also high on the list of what makes an overall effective drug for obese patients. Physicians will want to prescribe a drug that they feel has excellent safety and tolerability, with a very good chance in helping the patient lose at least 5% body weight. We are starting to feel more and more like that drug is lorcaserin.

What's Next For Arena?...

The biggest near-term catalyst for Arena is the release of the phase III BLOSSOM data in September 2009. From this program, we will look to confirm the efficacy and safety demonstrated in BLOOM, and finalize the NDA package. Data from the ongoing BLOOM-DM program will be filed as a supplement to the NDA in 2010.

There are several scenarios that could play out in 2010. We expect Arena to file for approval in December 2009, putting the FDA action date in October 2010. Depending on the time of the BLOOM-DM sNDA, the FDA will include the diabetes language in the label in October, approve the drug in October and review the -DM data separately, or delay approval in October while it reviews the full application.

The FDA has not met many PDUFA action dates for NCEs over the past few quarters. Plus, the agency has been very tough on new "neuro-physical" drugs for things like obesity, neuropathic pain and fibromyalgia in the past. So we believe the third scenario is the most likely, meaning a final lorcaserin approval will come in early 2011.

Data from BLOSSOM will most likely provide a small pop to the shares. However, the best chance for a meaningful run in the stock is through the signing of a commercialization partnership. We think this will take place around the middle of 2010 after all three firms -- Arena, Orexigen, and Vivus -- have filed for approval of their respective drugs and potential partners can evenly weight the aspects of each application.

We have said in the past, the best overall drug will secure the best partnership. For the meantime, we are maintaining our Neutral rating on Arena, but we believe there is clearly money to be made on obesity stocks over the next few quarters.

On the same day, the US agency gave its nod of approval to Invega Sustenna -- a once-monthly, injectable version of Invega to treat schizophrenia in adults. It will be marketed in the US by Janssen, a unit of Johnson & Johnson.

Invega Sustenna has been developed using the proprietary technology NanoCrystal Technology, which is a registered trademark of Elan Pharma International Ltd, Ireland, a subsidiary of Elan Corp. plc (ELN). The FDA approved the drug on the basis of two international, randomized, double-blind placebo-controlled studies of schizoaffective disorder patients with acute symptoms.

Approximately, one percent of the world’s population suffers from schizophrenia, which prevents a person from thinking clearly and distinguishing between reality and imagination. While there is no cure for schizophrenia, the symptoms and the risk of relapse can be managed with appropriate treatment that includes continuous, long-term therapy with proper medications.

As a reminder, Invega was initially approved in December 2006 to treat schizophrenia. The drug’s predecessor, Risperdal -- which is used to treat schizophrenia and symptoms of bipolar disorder (manic depression) -- lost its patent in 2008.  Risperdal is available as a generic but Johnson & Johnson has been focusing on transferring patients to Consta (long-acting Risperdal) and the newer Invega product.

Total franchise sales were $3.8 billion in 2008.  Invega sales should continue to ramp in the coming years due to the label expansion, which includes the recent FDA approval.
 
We have a Buy rating on the company’s shares based on its diverse and deep product mix, lack of cyclicality, strong financial position, and consistent record of earnings growth.

THE STOCK TRADER’S CIRCLE OF SUCCESS (AND FAILURE)

1. CAN MISSING A STOCK TRADE BUILD CONFIDENCE?
2. THE SECRET TO TIGER WOODS SUCCESS…AND OURS
3. THOMAS BULKOWSKI AND THE FAILURE OF POPULAR STOCK TRADING PATTERNS

During market declines, stocks in the Consumer Staples sector have traditionally performed better than the stock market, and especially cyclical companies. The fundamental explanation is that food, beverage, household products and cosmetics companies manufacture and market brand-name consumable products, most of which are considered essential to daily life, such as food, drink, toothpaste, deodorants, toilet paper, etc.

Since product demand is relatively stable, the companies should report earnings in line with expectations and, hence, the stocks have outperformed. Generally speaking, food companies generate earnings growth at a mid-to-high single-digit rate. Beverage companies, however, are structurally able to grow faster at the high single-digit to low double-digit rate. But cosmetics companies can grow earnings a percentage point or two above beverage companies.

At year-end 2008, the Consumer Staples sector had outperformed the market on a total return basis for five consecutive years; therefore, the positive performance disparity is long-in-the-tooth. In addition, the relative performance has seasonal attributes, with almost all the relative gain coming in the fourth quarter as investors flee more cyclical investments, which tend to disappoint near the end of the year. In 2009, it is highly probable that Consumer Staples will underperform as stocks begin to discount the recovery out of the current economic abyss.

WEAKNESSES

The outlook for the tobacco industry is negative due to the impact of a 150%+ increase in the federal excise tax, the high probability of additional federal regulation, and the recent losses in product liability lawsuits. In February, President Obama signed the congressional SCHIP (State Children's Health Insurance Program) bill that included a $0.6166 per pack increase in the federal tobacco tax. Hence, the federal excise tax per pack of 20 cigarettes was increased from $0.39 to $1.01 per pack.

When federal excise taxes are increased, it is estimated that industry volume will decline by at least 6%, but the magnitude of the decline could be much greater, especially considering the backdrop of the weak economy. During the first quarter, industry cigarette volume declined 10.4% due to wholesale inventory reductions associated with the federal tax increase. A tobacco tax increase of this magnitude is unprecedented.

Additional regulation of tobacco products by the U.S. Federal Government is now expected. On June 8, 2009, the U.S. Senate again passed legislation, empowering the U.S. Food and Drug Administration (FDA) to regulate cigarettes and other tobacco products. In the last several years, the House had not passed a similar bill, but in April, the House finally passed a comparable measure, indicating a more stringent regulatory framework for all domestic tobacco companies in the future.

The tobacco companies are losing product liability law suits. In late March 2006, the U.S. Supreme Court refused to hear an appeal in the Boeken case; therefore, Altria (MO) paid the $50 million judgment, despite claiming the judgment was excessive. Altria also lost the Bullock case; however, a new trial is scheduled to revise the amount of initial punitive damages of $28 million.

Lastly, in March 2009, Altria lost the Williams case when the U.S Supreme Court dismissed the Altria's appeal of a 1999 punitive damages award of $79.5 million. However, the company is delaying payment by disputing an Oregon state law that requires 60% of any punitive damages should be paid to the state.

As a result of these negative developments, the ratings on both domestic tobacco companies, Altria and Reynolds American (RAI), were lowered to a Sell.Zacks Investment Research

During market declines, stocks in the Consumer Staples sector have traditionally performed better than the stock market, and especially cyclical companies. The fundamental explanation is that food, beverage, household products and cosmetics companies manufacture and market brand-name consumable products, most of which are considered essential to daily life, such as food, drink, toothpaste, deodorants, toilet paper, etc.

Since product demand is relatively stable, the companies should report earnings in line with expectations and, hence, the stocks have outperformed. Generally speaking, food companies generate earnings growth at a mid-to-high single-digit rate. Beverage companies, however, are structurally able to grow faster at the high single-digit to low double-digit rate. But cosmetics companies can grow earnings a percentage point or two above beverage companies.

At year-end 2008, the Consumer Staples sector had outperformed the market on a total return basis for five consecutive years; therefore, the positive performance disparity is long-in-the-tooth. In addition, the relative performance has seasonal attributes, with almost all the relative gain coming in the fourth quarter as investors flee more cyclical investments, which tend to disappoint near the end of the year. In 2009, it is highly probable that Consumer Staples will underperform as stocks begin to discount the recovery out of the current economic abyss.

WEAKNESSES

The outlook for the tobacco industry is negative due to the impact of a 150%+ increase in the federal excise tax, the high probability of additional federal regulation, and the recent losses in product liability lawsuits. In February, President Obama signed the congressional SCHIP (State Children's Health Insurance Program) bill that included a $0.6166 per pack increase in the federal tobacco tax. Hence, the federal excise tax per pack of 20 cigarettes was increased from $0.39 to $1.01 per pack.

When federal excise taxes are increased, it is estimated that industry volume will decline by at least 6%, but the magnitude of the decline could be much greater, especially considering the backdrop of the weak economy. During the first quarter, industry cigarette volume declined 10.4% due to wholesale inventory reductions associated with the federal tax increase. A tobacco tax increase of this magnitude is unprecedented.

Additional regulation of tobacco products by the U.S. Federal Government is now expected. On June 8, 2009, the U.S. Senate again passed legislation, empowering the U.S. Food and Drug Administration (FDA) to regulate cigarettes and other tobacco products. In the last several years, the House had not passed a similar bill, but in April, the House finally passed a comparable measure, indicating a more stringent regulatory framework for all domestic tobacco companies in the future.

The tobacco companies are losing product liability law suits. In late March 2006, the U.S. Supreme Court refused to hear an appeal in the Boeken case; therefore, Altria (MO) paid the $50 million judgment, despite claiming the judgment was excessive. Altria also lost the Bullock case; however, a new trial is scheduled to revise the amount of initial punitive damages of $28 million.

Lastly, in March 2009, Altria lost the Williams case when the U.S Supreme Court dismissed the Altria's appeal of a 1999 punitive damages award of $79.5 million. However, the company is delaying payment by disputing an Oregon state law that requires 60% of any punitive damages should be paid to the state.

As a result of these negative developments, the ratings on both domestic tobacco companies, Altria and Reynolds American (RAI), were lowered to a Sell.Zacks Investment Research

Along with this much anticipated move, which is a natural corollary of the beleaguered firm's entry into bankruptcy court, the benchmark stock index also removed Citigroup Inc. (C) from its lineup to make way for the second-largest U.S. commercial insurer Travelers Co. (TRV). Both GM and Citigroup will be formally taken out from the average at the opening of trade on Jun 8.

While swapping companies on the index usually takes years, the worst financial crisis since the Great Depression has claimed many of its components as victims. The last change came when Kraft Foods Inc. (KFT) replaced the ailing American International Group Inc. (AIG) in September.

Dow Jones Editor in Chief Robert Thomson, who plays a key role in deciding the composition of the index, said, "We were reluctant to remove Citigroup at the height of the financial frenzy, but it is clear that the bank is in the midst of a substantial restructuring which will see the government with a large and ongoing stake."

Citi was added to the index in March 1997 as Travelers Group Inc. The country's biggest financial firm by assets was formed by a merger of Travelers and Citicorp. In 2002, it spun off the Hartford, Connecticut-based Travelers Property Casualty Corp. through an initial public offering. The irony is that the same firm is now replacing Citigroup on the DJIA.

With the addition of Cisco to the index, the technology weighting of the DJIA now goes up to about 17%. Shares of Cisco rose 6% to $19.61 at noon on the NASDAQ, while Travelers gained nearly 4% to $42.20 on the New York Stock Exchange at about the same time. Responding to upbeat economic reports, the DJIA is currently up 2.67% or 227.24 points.

Following the overseas gains, US stock futures suggest Wall Street is headed for a higher open.  Dow Jones industrial average futures rose 1.2% to 8,586. Standard & Poor's 500 index futures jumped 1.4% to 930.50, while Nasdaq 100 index futures gained 1.1% to 1,451.50.       

On Friday, a late-session rally pushed U.S. stocks to their biggest three-month run since 2007, as commodities recorded their highest monthly advance since 2007 and energy stocks rose, helped by a spike in oil prices.  The S&P 500 index, which recorded its steepest weekly loss since March during the prior week, rose 3.6% during the holiday-shortened week.  Sustained expectations that the economy is turning a corner have pushed global benchmarks higher and resulted in increased buying activity.  The Dow Jones Industrial Average jumped 223.01 points, 2.7% to 8500.33, capping an upbeat week for Wall Street.  Since hitting their 12-year lows in early March the indices have jumped nearly 30% on the DJIA, 36% on the S&P, and almost 40% on the NASDAQ.

All ten S&P industry groups recorded gains on Friday.  Since the beginning of the year, basic material shares have recorded the sharpest gains, up 23.8%, followed by a 20.5% jump in technology stocks. The Reuters/Jefferies CRB Index of 19 raw materials increased over 14% in May for its biggest monthly rise in 35 years.  U.S. Steel Corp. (NYSE:X) jumped 16% to $34.08 and Freeport-McMoRan Copper & Gold Inc., (NYSE:FCX) surged 13% to $54.43., leading gains among raw- materials companies.  Oil prices climbed above $66 to a six-month high.  Year-to-date, five sectors remain in negative territory, including: utilities, off 8.4%, telecom, down 6.7%, financials, off 4.1%, and industrials and health care, down 2.1%.

Shares of General Motors (NYSE:GM) plunged 48% to $0.75, the lowest since great depression, as the automaker appeared set to file for Chapter 11 bankruptcy protection. Some media reports suggested the company will sell most of its assets to a new entity. Late Sunday, a federal bankruptcy court cleared Chrysler to come out of bankruptcy and sell most of its assets to Italian car maker Fiat. 

Treasury Secretary Geithner travels to China for two-day talks with Chinese leaders, even as the weakness in US dollar keeps the focus on US economic health relative to its global partners. Traders, nevertheless, are expected to remain glued to developments on that front. Geithner, on his part, has tried to remain optimistic, noting, "The global recession seems to be losing some force; and "The financial system is starting to heal." Last week's OPEC meeting also revealed its members optimistic on the outlook for the economy and crude prices with Saudi oil minister Naimi asserted the world economy can withstand $75-$80 per barrel oil.

However, an increased appetite for risk has sent commodity prices higher, heightening fears of inflation. According to Barclay Capital's (NYSE:BCS) quarterly FX investor sentiment survey only 17.5% of the 605 central bankers, asset managers, hedge funds and international corporate clients interviewed expect the rally to continue, with six out of ten believing the rally is a bear market trap, and 69% describing a recovery as most likely to prove either u-shaped or w-shaped.

Whether it is merely temporary or a sign of something more durable it is hard to escape the fact that as the discourse on green shoots and second derivatives linger we might be entering a new leg of this crisis. Thus, there should be no mistake. We are very much still stuck in the mire and especially so in the context of the so-called developed OECD economies where it is difficult to see where any speedy recovery is going to come from. On the other hand the world is not made up entirely by the OECD edifice and it is exactly the potential for an asymmetric "recovery" and how global monetary policy might serve to transmit such a recovery which is the topic of this entry. In order to frame the discussion, it is worthwhile to go back to before the crisis where, most notably, the low interest rate environment in Japan was driving carry trading activity across the world with Australia, New Zealand, the Eurozone, the US as notable targets in the developed world edifice where also of course emerging markets were in the spotlight. Whether there are similarities with such historical flashbacks can be debated; but what is abundantly clear is that conditional on the return of some variant of an environment conductive to the carry trade something has also changed.

This change is most clearly expressed through the process by which the US Fed's credible commitment to maintain low rates may become the driving force for a search for yield and return (carry trade) in key emerging economies. In that light, my good friend Edward Hugh recently authored two extraordinarily important pieces and although it is hardly news that I plug Edward at this space I highly recommend you to have a look at these two. Nay, it is imperative that you read them.

The main thrust of the story is that after having observed green shoots throughout since February the carry trade wheel appears to be revving up again. Volatility have come down, risky assets have flown, money market rates in the G3 are beginning to behave, and reports have even come in that a seasoned carry trade veteran Miss Watanabe is once again dipping her toe although people close to the data also suggest that a lot of the effect from Miss Watanabe is clouded by Japanese corporates playing with transfer pricing.

[click on graphs for better viewing]

But, as noted, this time there is a twist. Sure, the BOJ is still running an almost open shop with respect to the provision of funding  to play the game but relative to the carry trade of old days, something has changed. Now, it is not the only the BOJ anymore but also the BOE, to a lesser extent the ECB, and most importantly the Fed who are forced to commit to very low levels of nominal interest rates in order to fight off deflation as well as to commit to the support of the restoration of a financial system which has been mortally wounded during the evolving crisis. In a world where uncertainty is high this is a prerequisite to avoid disaster, but in a world where sentiment suddenly shifts to the better it potentially becomes the underpinning factor for what some have dubbed the mother of all carry trades. It is of course this which we have been observing more than passing evidence of in the past weeks.

In a global macroeconomic context, this all goes back to the discussion of re-balancing and decoupling. In the most recent print edition The Economist calls it decoupling 2.0 and although I never liked the idea of decoupling as it was traditionally narrated with Europe or perhaps China taking over as the global supplier of net capacity (demand) it was also always going to be a very true narrative. To put it in other terms; the world decoupled a long time ago and it has long been clear that big emerging economies would rise to the scene to command a much larger relative position.

Besides this common ground, I have mainly had two gripes with the narrative. Firstly, the original idea that Europe and Japan would rise to the occasion to take over from the US was a mirage masked by the simple fact that the Fed reacted more quickly and swiftly to the incoming storm. Secondly, I have also been skeptical about the idea of China (and Russia even) providing demand through a more liberal policy towards the management of its capital account and currency. Essentially, Goldman Sachs' old conceptualization of the BRICs should be allowed to move into the eternal dust bin not only because there is a fundamental difference between China/Russia and Brazil/India, but also  because the emerging market edifice is much more diverse and important to be reduced to the whims of the punch line department at the world's biggest and arguably best investment bank. 

With these points on the table it is of course worthwhile to ask whether investors and other market participants are responding to this new narrative of vibrant growth in emerging markets and subsequent carry trade opportunities.

Even a modest glance over the recent news bulletins suggests almost a feeding frenzy as investors and their advisors scramble to exploit whatever window of opportunity that may have opened to make some easy money in an otherwise extraordinarily difficult environment. One notable example was in the context of the CEE economies where Deutche Bank recently suggested that investors borrow in Euros to buy the Ruble and the Forint. Of course, there are carry trades and then there is; well Russian roulette, and of all the potential punts out there this one would seem, to me, the equivalent of a trip to Las Vegas, playing on horses or another derivative of gambling. Apart from DB, Barclays have also picked up the baton with analyst Andrea Kiguel providing the main points that the Brazilian Real and Turkish Lira be the preferred targets of choice;

Brazil’s real, South Africa’s rand and Turkey’s lira offer the “largest upside” as investors return to the so-called carry trade, Barclays Plc said. A global pickup in investor demand for higher-yielding assets and signs the worst of the global recession is over “bode very well for the comeback of the emerging-market carry trade,” analysts including Andrea Kiguel in New York wrote in a report. The carry trade refers to the practice where investors borrow funds in a country with lower interest rates and then invest the money in nations where returns are higher.

Brazil’s real has gained 18 percent in the past three months against the U.S. dollar while Turkey’s lira has advanced 10 percent. South Africa’s rand is up 22 percent, the best performing emerging-market currency in the past three months. “As the decline of global risk aversion gives way to the re-pricing of U.S. dollar, we see potential for emerging-market foreign exchange to continue rallying,” analysts including Andrea Kiguel in New York wrote in a report.

The American Banks want to play ball too and emphasising the unusual and lingering low interest rate environment in Europe, Japan, and the US; JPMorgan and Goldman Sachs are hailing all systems go.

The carry trade is making a comeback after its longest losing streak in three decades.

Stimulus plans and near-zero interest rates in developed economies are boosting investor confidence in emerging markets and commodity-rich nations with interest rates as much as 12.9 percentage points higher. Using dollars, euros and yen to buy the currencies of Brazil, Hungary, Indonesia, South Africa, New Zealand and Australia earned 8 percent from March 20 to April 10, that trade’s biggest three-week gain since at least 1999, data compiled by Bloomberg show.

Goldman Sachs Group Inc., Insight Investment Management and Fischer Francis Trees & Watts have begun recommending carry trades, which lost favor last year as the worst financial crisis since the Great Depression drove investors to the relative safety of Treasuries. Now efforts to end the first global recession since World War II are sending money into stocks, emerging markets and commodities.

Speaking a language most investors can understand Bloomberg reports that a composite index constructed by ABN Ambro where the Euro, Yen, and USD are used to buy Turkish Lira, Brazilian Real, the Forint etc has so far earned an annualized 196 percent from March 2 to April 10. Such kind of rapid reversal of fundamentals can only be underpinned by a very strong dose of positive sentiment as the one we have been witnessing with all the talk about green shoots and second derivatives. As Macro Man points out the most recent survey on Global Funds Managers from Bank of America and Merril Lynch sported the biggest degree of optimism since 2004 and, naturally, a substantial re-allocation of assets towards emerging markets.

Now, this is of course all well and good but the underlying economic dynamics here are not as straight forward as they may seem. There are particularly two issues worth noting. 

On the one hand there is the simple issue of where all the liquidity provided by the BOJ, the ECB and the Fed is going. Only recently, the vice chairman of the Federal Reserve Donald Kohn pointed out that after getting a one trillion dollar boost from the Fed's purchase of treasuries and asset backed securities (most notably the MBS) the economy appeared to be on the mend. Leaving aside the question of whether the economy is actually on the mend or not the more fundamental question is the extent to which the Fed, the ECB and the BOJ can govern where exactly this "boost" is going and, of course, subject to what leverage multiple. This, I think, was what made Paul Krugman ever so timidly to venture the idea the perhaps some form of buy American/protectionism wasn't as bad as it was meant out to be. In a European context we can ask a similar question about whether all the liquidity provided by the ECB will simply move into the CEE to play the carry there and consequently further exacerbate the imbalances which have not been unwound yet.

On the other hand there is the receiving end where some emerging markets are already reeling under the prospects of sucking up the inflows. The first proverbial shot across the bow was fired by Henrique Meirelles who is in charge of the Brazilian central bank. Recently, he consequently pointed out that the central bank is standing ready to increase the purchases of USD in order to stem the unduly appreciation of the Real on the back of carry trade optimism and a resurgence of the upward trend in commodities which is a core driving force in the Brazilian case. But this runs much deeper than Meirelles recent comments. Going back to the last time, before the crisis, many emerging markets and commodity linked economies also squirmed under the pressure of inflows. Of course and undoubtedly much to the chagrin of many central bankers, raising rates to quell the inevitable inflation which comes on the back of hot money inflows only serves to worsen the problem. Thus, and with a number of central banks stuck at near 0 % in nominal interest rate, raising rates only intensifies the pressure. This was abundantly clear in economies such as Brazil, India, New Zealand, Australia, and most importantly in the CEE where many economies actually depegged with respect to the Euro because it was believed that the carry flows would lead to nominal appreciation which would choke off the inflation. The most ardent example of an attempt to halt the carry pressure was of course Thailand where capital controls on inflows were installed, not in order to to stem an outflow as originally described in the literature, but rather to avoid to much money coming in.

The key to understand this process is the nature of global monetary policy and the so-called credit channel. This is one of the reasons why I demand that you read Edward's posts linked above, but you could also go right to the source in the form of a paper by Danish economist Carsten Valgreen as well as my own account of said paper. The point is simply the extent to which economies can loose control over monetary policy and what this means. There is ample evidence I think that in a world where interest rate differentials of the current magnitude represent an inbuilt part of the edifice, there exist notable externalities from monetary policy. One aspect of this is created by the fact that some central banks basically have committed to a prolonged period of quantitative easing and another aspect is created by the fact that as the crisis ripples through, the world will be saddled with more economies than before dependent on exports to grow. These two facts taken together suggest that the pressure on those brave souls out there willing to stand up and run a deficit will also face what I have come to call a "turret ride" since when times are good the inflows may seem excessive only to retreat if the mood turns sour. As noted, following traditional convention hot money inflows can create investment bubbles and inflationary pressures (if you don't have the capacity) and the answer would be to raise rates, but if the low risk environment persists such policy measures will only intensify the pressure. I think that this aspect of the global economy is very important to take aboard.

Into the Light with Wings of Wax?

This may of course be much ado about nothing since in the current environment wreckers of havoc to the carry trade and any other kind of risk prone activity potentially lies around every corner. In this sense I agree with people closer to the market than myself. However, it is still worth paying attention to the way markets and investors are reacting and then to think about the consequences of the joint commitment by the big central banks to keep rates low. Clearly, such commitments are always subject to withdrawal if and when the respective central banks see it fit to suck back the liquidity, but so far that point is far into the horizon. This means that we are about to see just how much capacity there is to absorb the carry flows and where the money ultimately will flow. Some investors will certainly be flying equipped only with similar wings as Icarus while some again will be sporting a set of more durable wings. Whatever the future days and weeks will bring, I for one think it is fascinating to watch.

We had technological difficulties in Maine, however, and couldn't get the satellite hookup going in time.

Even so, I thought it might be interesting to share the portfolio we were going to discuss. It brings up both an important as well as an interesting topic.

According to Wikipedia, "Reflation is the act of stimulating the economy by increasing the money supply or by reducing taxes. It is the opposite of disinflation. It can refer to an economic policy whereby a government uses fiscal or monetary stimulus in order to expand a country's output."

Reflation is not necessarily good or bad, of course. The response from the Fed, the Treasury and Congress over the past few quarters probably saved us from a more crushing recession/potential depression.

But the challenging part comes next. Can the Federal Reserve and the Treasury drain money out of the system just right so that they don't: 1) stunt the recovery; and 2) create runaway inflation?

Color me skeptical. It seems like the "thread-the-needle" or "goldilocks" scenario is the least likely outcome. Far more likely is that political pressure (and natural optimism) will force the government to leave its foot on the pedal for too long, goosing the economy into an artificially strong recovery ... with a payoff coming through a substantial uptick in inflation down the road.

With that in mind, CNBC asked me to pull together a list of seven or eight ETFs that stand to benefit from reflationary trends. Here's what I came up with:

There are a half dozen other ideas I could have mentioned: the iShares TIP ETF (NYSE Arca: TIP); the Vanguard Materials (NYSE Arca: VAW); the Market Vectors Hard Assets Producers (NYSE Arca: HAP); the Rydex CurrencyShares ... etc.

Tim Middleton, MSN Moneycentral columnist, did appear on the segment. He added a nice idea in the ProShares UltraShort 20+ Year Treasury ETF (NYSE Arca: TBT), which delivers -200% of the daily return of 20-year Treasury futures.

As with any "geared" ETF, you have to monitor long-term performance (as we examined in our recent webinar). But it is an interesting play on the reflation idea.

The general outlines of how a reflation portfolio would look are clear. On the equity end, it would focus exclusively overseas to benefit from a falling dollar, and put a particular concentration in emerging markets, which have been leading the economic recovery. It would also focus on materials and materials-heavy economies, such as Brazil.

Broadening out that view, my own "reflation model portfolio" has a strong allocation to gold. While I think gold faces headwinds in the short term, more traction over time for inflation should be good news to bullion investors.

I debated adding a commodity futures ETF, such as the PowerShares DB Commodity Index Fund (NYSE Arca: DBC). But the truth is that broad-based commodities did not perform particularly well during the inflationary period in the 1970s. Oil did well, gold did well, but ags and even industrial metals barely kept pace with inflation.

Turning to fixed income and currencies, I included allocations to international TIPS (NYSE Arca: WIP) and the new WisdomTree emerging markets currencies fund (NYSE Arca: CEW); the latter provides exposure to 11 different emerging market currencies. Emerging market currencies have rallied strongly since the March 9 lows, and the macro factors support their continued strength.

I don't think this should be 100% (or even 50% or 25%) of someone's portfolio. I don't own all these funds myself; my portfolio, as most people know, is boring, long-term focused and ultra-low-cost.

But it does show how investors can use ETFs to make very specific bets ... choices they could NOT have taken advantage of just a few years ago ... to hedge against various economic worries they may have.

If you had tried to buy foreign inflation-protected bonds a few years ago, for instance, most people would have laughed at you. Now you can do it from an E*Trade account for $9.99 and a 50 basis point (0.50%) annual expense ratio.

And that---if you're worried about inflation and a depreciating dollar—is a good thing.

In a follow-up to his popular JoI article 'Bonds: Why Bother?,' Research Affiliates founder Rob Arnott partnered with the Journal of Indexes for a live webinar examining where investors should be looking for opportunity today.

As a bonus, Arnott has provided written responses to all the questions that were asked by the audience during the webinar. His answers follow below. (In some cases, for efficiency's sake, multiple similar questions on a single topic have been condensed into a single question.)

Audience Question: Given the prospect of heavy or hyper-inflation, how do you find a reasonable return that can keep pace? Do you have any expectations on how this may play itself out in the coming few years?

Rob Arnott: TIPS provide protection against inflation; as bond yields soar in the face of inflation, TIPS yields can potentially go the other way, especially from a high initial real yield. Commodities can protect us from inflation shocks, though not inflation per se-futures prices already embed inflation expectations in the forward prices. Stocks enjoy inflation pass-through, albeit with a lag. Inflation shocks will be bad for stocks, but sustained inflation will eventually be passed through. If stocks are cheap (which is true only of deep value), they can do well even in the face of inflation.

Audience Question: Discuss your view of future interest rates in the coming years and their impact on bond class prices. Which type of bonds are the worst and best to hold in a rising rate environment?

Arnott: Inflation poses a real threat to bonds. It's implausible that the monetary spigot will be "reversed" when the perceived deflation threat is eliminated, in time to avoid meaningful inflation. Bonds and stocks both offer very nearly the widest dispersion in valuations in history. So, the "deep value" side of both categories (junk/convertible bonds and deep value stocks) offer great prospects, barring a real Armageddon scenario. The safe-and-trendy end of both asset classes (Treasuries and quality growth) is richly priced; I find them utterly uninteresting.

Audience Question: How will corporate defaults in late 2009 and early 2010 affect the total returns on these investments? Are they still viable investments?

Arnott: Defaults will be huge. The key issue is not whether we'll see defaults, but whether spreads are rich enough to compensate us for that risk, for the well-diversified investor. With junk bond and convertible bond spreads wider than they were in the Great Depression, we'd have to see worse than that scenario for the investor to forfeit the whole yield spreads.

Audience Question: It is common knowledge that the current fiscal stimulus is tremendously inflationary. What is the expected effect on residential real estate values?

Arnott: It's not common knowledge ... there are two views out there. But I agree with those who think it'll be inflationary, perhaps massively so. Real estate will come back. But real estate is a classic lagging asset class. It can't turn while inventories are rising. Inventories can't turn while foreclosures are rising. Commercial real estate has only begun to tumble. This isn't an asset class that has any hope of turning in 2009. Wait for 2010 or later.

Audience Question: How do you feel about the typical thought that small- and mid-cap stocks tend to lead out of recessions?

Arnott: They probably will again, though large deep-value companies are also likely to lead.

Audience Question: What do you think about the oil market? Are we running out of oil worldwide, and/or what do you expect the energy market to do over the next decade? Also, what do you think of the S&P Commodity Trends Index (that will go long or short different commodities)?

Arnott: Oil is a finite resource. It'll run out. When oil was discovered, folks were fretting about the impending demise of the whale population, the source of whale oil. We'll find alternatives. But not before the economics of finding that alternative become compelling. We have ample coal and natural gas (and don't have to import them!). Nuclear, solar, wind and tides all become economically viable at various energy price levels. But we'll see $25/gallon gas in 10-20 years. At that stage, the shift to alternatives will be in full swing, without any inept, politically opportunistic government intervention.

In commodities, also, we see exceptional dispersion in values. Some are at lows not seen in a decade; others (gold) are near their all-time highs. Playing these spreads should be profitable.

Audience Question: What about munis?

Arnott: Municipal defaults will soar in the coming years. Be very selective.

Audience Question: Perhaps TIPs are priced poorly because they reflect the government's habit of miscalculating the CPI-the source of prospective principal upgrades. Please comment.

Arnott: See http://www.shadowstats.com/. The government does lie about the statistics. People see their homes, their jewelry, their collectables soar, and they think they're making money. No. The purchasing power of the dollar is tumbling. If you own the same home, jewelry or collectables as before, you're obviously no richer just because they command a higher notional price.

That said, TIPS are the cleanest way to hedge inflation risk. The true real yield is perhaps 2% lower than it seems. And, you're taxed on the yield, on the inflation and on the hidden, unacknowledged inflation. But, viewed as insurance against reflation, this yield give-up is the price we pay for that insurance. Also, note that, if real yields on TIPS are lower than they seem, the same holds true for Treasuries and other assets.

Audience Question: What's a reasonable equity risk premium?

Arnott: It varies over time. But the 5% that everyone seems to expect for stocks relative to bonds is no better than an "urban legend." A 5% excess return was achieved while stock market valuation multiples were soaring, and at no other times.

Audience Question: Is asset class correlation a moving target? And what is an efficient way to measure current correlation?

Arnott: Correlations rise with inflation and fall with deflation. By the time you measure it, it's too late to do you any good (witness last Sep/Oct!). It's best to assume that it mean-reverts toward long-term historical averages. And because low correlations generally won't hurt us but high correlations will, it's best to assume that it can be higher than we might expect.

Audience Question: It seems you're simply promoting a diversified approach to investing. How is this different than basic portfolio theory?

Arnott: There's nothing new under the sun. Questions: How many people follow a truly diversified approach? How many think of their stocks as ownership of an enterprise (à la Graham & Dodd), rather than as some assemblage of portfolio characteristics? In the 15^th century, Jacob Fugger ("Fugger the rich") put his money in shares, in loans (bonds), in property and in commodities. And he'd rebalance when the mix drifted away from one-fourth each. The shares and the real estate did well when the economy was strong; the loans and commodities did well when it was weak; the commodities and real estate did well when the government was debasing the currency; and the stocks and bonds did well when the government and the currency were sound. Old ideas have a lot of power, and keep getting rediscovered.

Audience Question: How has a simple allocation strategy that overweights the worst previous 5 years' asset classes and underweights the best ones done? I assume better than equal weighting all the asset classes.

Arnott: It's a powerful idea that few investors have the stomach to pursue. It means selling the best-loved assets and buying the most-loathed assets. It's the essence of successful "global tactical asset allocation.

Audience Question: Do you recommend purchasing individual bonds, or can the opportunities be realized through bond index fund or mutual fund options?

Arnott: I personally strongly prefer funds, as long as fees are reasonable. I don't have time to study individual bonds, and most retail investors won't have the requisite expertise. It's a cheap way to get diversification and (hopefully) someone reasonably smart picking the individual assets.

Audience Question: On a go-forward basis, what are some of the main factors that suggest an asset class is over- or underpriced?

Arnott: The simplest is to compare its yield (or in the case of bonds, the spread relative to Treasuries) with the long-term history. If the yield or spread is near historical lows, you're picking up nickels in front of a steamroller (as many investors learned too late after the skinny yields and spreads of 2006-07). If the yield or spread is near historical highs, there may be larger risks than before, but at least you're getting paid for them.

Audience Question: When do you anticipate Fundamentally Weighted bond ETFs coming to market?

Arnott: I'm not at liberty to comment. Infer what you like from this fact!

Audience Question: Just like alpha has a cost, is the cost of Fundamental Indexing in investment-grade bonds not worth the benefit? It seems that the benefit is smallest in that category. Is that because it is a more efficient market relative to emerging markets?

Arnott: Fundamental Index^® strategies are at their best in any markets where the gap between price and the (invisible) eventual fair value is largest. It's far larger in high-yield bonds and emerging markets debt.

Audience Question: Isn't one of the risks of Fundamental Weighting in indexes that these measures such as price-to-sales are not forward-looking, but backward-looking? Do we really believe GM will generate as much sales in the next 10 years as it has in the last 10 years?

Arnott: Of course. But future expectations are already in the price. The point of Fundamental Index strategies is to take price out of the weighting decision, so that we don't own more of an asset just because it's expensive.

The fundamental weight is perhaps best seen as a sensible anchor for rebalancing, for contra-trading against the market's constantly shifting expectations, fads, bubbles and crashes. It's not the same thing as fair value weighting (which works really well, if only we could know the fair value! Look for my article in the upcoming summer JPM on the subject).

Cap weighting mirrors the composition of the stock market, with all its excesses and errors. Fundamental Indexing mirrors the composition of the economy, by weighting companies on their recent financial footprint in that economy, and so contra-trades against the excesses and errors of the market. It's not that it doesn't have errors ... it's that the errors are not the same ones that are in the price, so they have some chance of cancelling, rather than dragging us into overweighting the overvalued and underweighting the undervalued.

Audience Question: Many financials now have negative earnings and even negative book value. Do you treat them as value or growth?

Arnott: They're value. Deep value. Price relative to historical smoothed sales, profits, dividends and book values are all very low. For a good reason! But, again, RAFI^® makes its money by contra-trading against market excesses.

Audience Question: What is the "real stock price index?"

Arnott: S&P 500 Index level / CPI level

Audience Question: [Are the statistics in the presentation measuring] nominal stock index returns AFTER inflation? Inflation for THAT period? No reinvestment? Stocks don't include dividends at all? Please state or clarify assumptions.

Arnott: Stocks have three components to return: dividends, inflation and real price growth. For the exhibits that compare stock and bond returns, we are looking at total return of both, and taking the ratio of the cumulative wealth of the stock market investor relative to the Treasury Bond investor. For the exhibits that focus on stock price returns, we're focusing only on the last of these. So, we're taking out inflation (which isn't really a "return" on our investments!) and dividends.

I believe I mentioned a number of times that, during these protracted spans where real stock price levels were flat, investors were really only earning their dividends ... with nothing from real growth. This is one reason that dividend yields matter so very much. A yield of 3% (today) is vastly more interesting than a yield of 1% (in 2000) and vastly less interesting than a yield of 6% (in mid-1982).

At a 3% yield for stocks and for 10-year Treasuries, I am not proposing that we should replace "stocks for the long run" with "bonds for the long run"! On the other hand, I do not see a 3% stock market yield as a screaming bargain, either. In my view, there are bargains galore, today, but not in growth stocks or in Treasury bonds.