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!

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.

Many of the most popular ETFs track market capitalization-weighted indexes. The market capitalization of each stock is determined by multiplying the share price by the number of shares outstanding. The companies with the largest market capitalizations will have the highest weights in the index. The statistical effect of this method can be quite significant. For example, the 10 largest companies in the S&P 500 account for about 20% of the Index.

Napoleon Bonaparte once called China the “Sleeping Giant,’ but arguably sometime during the first decade of the 21^st century the country fully woke up, both economically and politically. One cannot say the same for India, although the slumbering giant is definitely stirring.

On Wednesday, the Dow more than reversed Tuesday’s bullish advance, closing down 279 points on relatively high volume. This was the largest one-day decline in the Dow since June 4, 2010 and suggests that another volatile summer is in the cards.

IBB is making new all-time closing highs. Technically, the breakout from the decade-long base makes this ETF particularly attractive. Volume is quite a bit less than during the market heyday in 2005-2007, but it is large enough to provide sufficient liquidity for individual investors and traders.

Like IBB, XBI is making new all-time highs, but interestingly, volume in the last month is increasing nicely. We therefore recommend XBI along with IBB as a paired investment in one of the leading sectors in the market right now.

According to the Investment Company Institute, mom and pop investor threw more than $6.5 billion into domestic and global stock funds during a single week in January, the largest weekly inflow since May 2009. One Wall Street Journal commentator called it ‘dumb money.’