Last week’s Short-Term Model picks reflected a bet on silver (AGQ), global blue chips (DGT), China (HAO), Real Estate (REM) and Russia (RSX).  They were all down sharply as we bought them, in accordance with our contrarian model.  I said in that issue that it was quite difficult for me to make the selections, but all that effort paid off. Every one of these picks was up handsomely for the week.

Taking prices from the Thursday close, which we always use for tracking the performance of the picks we send out during the day on Thursday, the Model was up over 2% by late morning the very next day, Friday! Because that is a great gain for a one-week hold, we sent out a sell recommendation. But there was a lot more where that came from.  By the close on Tuesday, the next trading day after the holiday, the model was up just over 6% for the week, so if you missed the sell Friday morning, you were one happy pig the next day!

Over the last two weeks we made a tactical decision to step aside and not invest in the Short-Term Model Portfolio. In our view the news-driven environment did not give us much of an 'edge.' We were wrong.

Those subscribers who followed our "unofficial" recommendations did quite well over the past two weeks: first, a 15% gain in the Direxion 3X Financial Bear ETF (FAZ) and then an average gain of 8.15% at Thursday's close in our 5 picks from last week. Apparently, the lesson is "Trust the model, Luke!" 

Last week six of the world's major central banks made a coordinated effort to reassure European bond market investors that in the event of a severe liquidity crisis, the banks are willing and able to provide emergency U.S. dollar loans. Global equities breathed a huge sigh of relief.

The news from the central banks was soon followed by equally good reports from Europe on progress toward greater fiscal unity and better than expected data on the U.S. economy. As a result, last week the Dow Industrials posted its second largest weekly point gain in history.

Our short-term model is designed to identify oversold conditions. Basic materials has been one of the worst performing sectors over the last 8-10 months, but particularly since August. That was when the world began to seriously worry about a recession in Europe and a hard landing in China.

It is the China factor that is the real problem because China consumes 35-50% of the world’s annual production of iron ore, aluminum, lead, zinc and other non-precious metals. Before we look at China, however, there is a bigger picture story to keep in mind. 

According to The Economist’s index of non-oil commodities, commodity prices have almost tripled in the past decade. The interesting point, however, is that the recent surge is unprecedented, having reversed a downward trend that lasted more than a century. Industrial raw material prices fell by approximately 80% in real terms between 1845 and their low point in 2002. The long-term trend has now been reversed.

Move over Greece; it is all about Italy. Italy, the 3rd largest economy in Europe, has a GDP of $2 trillion, more than six times the size of Greece, with $2.6 trillion in debt and about $400 billion that needs to be refinanced next year. Meanwhile, Italy's economy has been stagnant over the past decade, so there is no way Italy can grow itself out of the debt cycle.

After a series of recent missteps, Italian Prime Minister Berlusconi began to lose support from both EU leadership and key members of his own party. Earlier this week he promised to resign, but only after the new austerity budget is passed. The market boost from that news lasted less than 24 hours.

The European bond market immediately sent a glaring vote of no-confidence the day after, which pushed the yield on the benchmark 10-year Italian government bond north of  7%.

Molto Bene? This morning, however, the yield on Italian 10-year bond dropped below 7% due to aggressive buying by the ECB and hope that PM Berlusconi will leave the government by Sunday, paving the way for a new Prime Minister. The chief candidate is Mario Monti, a credible man with broad EU experience.

After a few days of indecision last week, the market decided that Europe was no longer a problem. Despite a lack of detail, the major indices managed to rally almost 4% ahead of last night's EU announcement. Clearly, the market has a tendency to buy the rumor. Will it sell the news? Probably not. 

EU leaders have finally come to an agreement in principle on the three critical issues: bank recapitalization ($150 billion), Greek debt (50% haircut) and expanding the EFSF ($1.4 trillion) in order to make it easier for Italy and Spain to refinance. China is reportedly stepping in as a bond buyer of last resort and the ECB announced that it will also be buying more bonds.

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On Wednesday (October 12) the U.S. equity market posted its sixth advance in seven sessions.

The market mood was boosted by exceptional strength in Emerging Markets, while financials were the strongest sector, up 2.7%. Our Short-Term Model was up 8.1% as of Wednesday's close and our Intermediate-Term Model was up 10.6%.

Contrary to the pessimistic view from the Economic Cycle Research Institute (which says that the U.S. is unavoidably headed for a recession), Philadelphia Fed President Charles Plosser does not believe that growth will contract for two consecutive quarters. "Many of my business contacts suggest that while growth is very sluggish and uneven, they do not see the precipitous declines that many news accounts would suggest."

Plosser is an inflation hawk and voted against both Operation Twist and the Fed's promise to keep rates low through mid-2013. The reason?  Although Plosser expects sub-2% growth this year, he sees nearly 3% growth just around the corner in 2012.

For the past six weeks, the equity market has been bouncing around wildly in a wide trading range driven mostly by news from Europe. As that foreign tail wags our domestic dog, the major U.S. indices can whipsaw 5-10% in a few days in either direction. This is bad enough, but imagine the rollercoaster ride with leveraged ETFs. Thrill rides can be fun, but few find them amusing when one's security is at stake.

That said, our weekly buy candidates are selected based in part on their short-term oversold condition. It is our well-substantiated belief that buying after a pullback provides an entry with the lowest risk and greatest chance of reward. Up to a point, the deeper the pullback, the better the odds of a bounce.

Another way of putting this is that markets constantly fluctuate in a manner that moves from extremes back toward the mean or average price. You might call this Newton's Fourth Law of Motion. It is not a purely mechanical law, however, but rather a statistical law. Our analysis and our trading over the last 18 months have shown that a very oversold instrument is more likely to rebound than to continue on its downward slide. This gives us a powerful statistical edge.

Granted, it is not necessarily a comfortable method for most people. Statistically-based methods never are. It takes "intestinal fortitude" to follow Warren Buffett's advice and buy when others are fearful, but we are convinced that it is one of the best ways to make money in the markets.

The more things change the more they stay the same. Today (9/15) the S&P is trading about where it was last week at this time. Volatility, however, remains elevated. The Volatility Index is oscillating between 30 and 40 as the market is being held hostage to the events (mostly rumors) emanating from Europe. The violent swings, which can be as much as 3% in one day, wreck havoc with short-term trading systems. Ours is no exception.

One can break down the news flow into soundbites for public consumption and more factual reports based on what the professional money is doing. While German Chancellor Angela Merkel and French President Sarkozy confidently reaffirm their position that Greece is too important to fail, European bond investors are pricing in an imminent Greek default and a systemic banking collapse in Europe. The flight to safety is evident in the record low 1.75% yield on the 10-year German bund.

The critical issue in Europe is the amount of Greek bonds held by French and German banks. France is on the hook for about $56 billion, but the total exposure of the global banking system to the PIIGS is around $2 trillion according to the Bank for International Settlements.

Given the ponderously slow and factious political process in Europe, the European Central Bank is the only institution that could act quickly enough in the event of a sudden default scenario. The ECB, however, does not have the same deep pockets as the Federal Reserve. With widespread grassroots opposition in Germany and the German Bundesbank reluctant to support further bond buying from peripheral Eurozone nations, the ECB is likely to run out of funds in the event of a Lehman-like emergency.

Last week we discussed the rather wide discrepancy between the U.S. economy (muddling through) and the highly volatile U.S. equity indices, which have been pricing in a reprise of the 2008-2009 financial collapse. Investors are worried, withdrawing more than $60 billion from equity mutual funds this summer.

Since the market peak in 2007, investors have indeed become more risk averse. Despite one of the strongest market rallies in history, the CBOE Market Volatility Index (VIX) indicates a higher level of baseline fear; almost 2X as much anxiety as previously. The new angst is reflected in the price of gold, which has risen 270% since the 2007 market top.

This “Apocalypse All Over Again” mentality may be overdone, but it does reflects the structural stressors facing the European banking system. If a number of large European banks suddenly became insolvent, the backlash would probably throw the U.S. into another gloomy bout of recession.

Consequently, although the economic data remain fairly benign, a key measure of investor confidence has plunged. U.S. factory orders rose 2.4% in July, the largest increase since March, but the Conference Board's Confidence Index plummeted from 59 to 44.5 in August, the worst reading since April 2009 and the steepest drop since October 2008.

What is different this week from last is that the equity market was finally able to shrug off the bad news. Keep in mind the traditional disconnect between Wall Street and Main Street. Almost 50% of 2010 revenues for the companies in the S&P 500 came from abroad and it accounted for an even larger share of the profits. Last year, S&P companies paid out more taxes to foreign governments ($117 billion) than to Washington ($102 billion).

Additionally, despite the concerns about a banking collapse in Europe, the Dollar Index has not appreciated, as would be expected during a financial crisis with an epicenter in Europe. Similarly, the currencies of smaller foreign countries have remained stable and some are even rising. Clearly, this is not 2008 all over again.

The confidence boost from the Fed's message was short-lived, as expected. We anticipate a few more weeks of highly volatile action before things settle down.

The Dollar Index had another uneventful day, but the bond market continued to rally, albeit more modestly than on Tuesday. The 10- year yield fell to 2.13% from 2.18% yesterday. To put this in perspective, during the height of the financial crisis in late 2008 the 10-year yield hit a multi-year low of 2.03%. We are reasonably close to that level now with no recession and excellent corporate earnings.

Financials now represent the market's mood ring and the sector was a leader to the downside, debiting 7% due to fears of counterparty exposure to Europe. French banks were sold aggressively.

Despite the fact that the Dollar Index is quiet, gold set a new high and silver rallied 6%. Silver has been languishing compared to gold, but we think silver will eventually play catch-up. The move may have started yesterday (See chart here). We like the ProShares Ultra Silver AGQ as a proxy.

As we go to publish, S&P futures have been all over the map (+12 last night to -15 this morning). We expect new lows in the indices today. The Dow closed at 10,719 yesterday. Dow 10,000 and S&P 1000 are possible downside targets.