5/25/2011 McNulty

Published on Sunday, May 22nd 2011

Dear Reader,

This past week, the most important market developments w ere the United States taking one step closer to its first default in history, and the
crumbling credit situation in Europe. We'll delve further into the specifics, but the headline summaries for each side of the Atlantic are
essentially:

The United States hit its debt limit on Monday. With no cash, and no ability to borrow further to pay its bills, the US government began
dipping into federal pension funds.

The citizens of Spain are rioting for jobs, Italy was downgraded to a "negative" outlook, and Greece's government bonds w ere sent
further into "junk" status.

The question to those who believe w e are in the midst of economic recovery is as follows:

If this is what economic recovery looks like, then that would mean this is as good as it gets.
If this is as good as it gets, then it can only get worse from here.
What would you imagine worse than this looks like?

EUROPE: In the United Kingdom, monthly inflation spiked from 0.3% to 1.0%. The annual figure jumped from 4.0% to 4.5%, continuing the
relentless pressure on the Bank of England to tighten monetary policy despite their inability to do so (ow ing to the frailty of the UK economy).
Inflation in the UK hasn't been this high since September 2008.

What's interesting about the inflation data is how closely correlated it seems to the UK stock market, represented by the FTSE100. The graphs
below show both the UK CPI (annual rate of change per month) and the FTSE100. CPI data is currently seeing an 83% retracement of the
2008-2009 drop. The stock market has recently seen an 80% retracement of the 2007-2009 drop.

What's worrisome is the timing. The inflation peak (September 2008) lagged behind the stock market peak (October 2007). The inflation
bottom (September 2009) also lagged behind the stock market bottom (March 2009). The recent post-recession stock market peak w as in
February 2011. Last w eek's inflation data show ed that a new peak w as reached in April 2011, lagging the recent stock market peak. Is this as
high as inflation and stocks go before beginning a frightening descent that is far worse than the 2009 bottom (an Elliott Wave 3 impulse)?

Elsew here in Europe, Eurozone monthly inflation dipped from 1.4% to 0.6%, while the annual figure edged upward from 1.3% to 1.6%. These
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5/25/2011 McNulty
Elsew here in Europe, Eurozone monthly inflation dipped from 1.4% to 0.6%, while the annual figure edged upward from 1.3% to 1.6%. These
levels are hardly a problem when compared to the UK, but 1.3% w as enough for the ECB to become the first major central bank to raise rates
in 2011. That inflation continues to creep upward will draw inflation hawks tow ard further tightening. But like the UK, the Eurozone struggles
w ith a weak overall economy.

The w eakness is in the periphery nations, which suffered another bruising week. Spain is in the midst of elections for 17 of 19 regional
governments, and the youth of the country have organized illegal protests to draw attention to the abysmal economy -- Spain has the highest
unemployment rate in Europe, sitting at 21.3%. Italy's ratings outlook was downgraded to "negative" by Standard & Poor's. Greece is
expected to default any day now and on Friday, rating agency Fitch downgraded Greece three notches down to B+ negative, otherwise
known as "highly speculative".

ASIA/PACIFIC: On Thursday, the Bank of Japan decided to hold policy steady, deciding that any further loosening would not be beneficial
beyond short term improvements to sentiment.

The benchmark rate remains at 0-0.1%, and no change was made to the asset buying program w hich was given a massive increase following
the recent tsunami. GDP showed a 0.9% contraction, confirming Japan's 2nd recession in three years, its 7th since the 1989 Tokyo stock
market peak.

NORTH AMERICA: The United States hit its $14.3 trillion dollar limit on Monday.
The 2011 budget deficit is on track to reach $1.4 billion, according to the non-
partisan CBO. That being the case, in order to keep the country running (to
keep from bankruptcy), the USA must borrow over $4 billion a day, each day of
the year. That's over $40,000 per second around the clock for the entire year.

But since the US is not allowed to borrow any more money at the moment,
they've dipped into two federal pension funds: the Civil Service Retirement
fund, and the Disability fund.

As a side note, 3 more US banks went bankrupt last week: Atlantic Southern
Bank, The First Georgia Banking Company, and Summit Bank. The three banks
operated 29 branches, and held over $1.5 billion in depositors' money. $1
billion of that w as covered under FDIC loss-share transactions. That's a billion
dollars of people's hard earned money, gone. Gone -- they don't get it back,
ever. This is a topic w e've covered in previous issues, one that escapes the sort
of media attention it deserves.

In total, that's 43 US bank closures in 2011 so far (banks, not individual branches). 157 US banks w ent bankrupt in 2010, and 140 of them
w ent bust in 2009.

Going back to the impending bankruptcy of the United States in the broader picture, CDS contracts on US debt is reaching for new highs,
having risen 17% in 2011 so far. A Credit Default Swap is essentially an insurance contact against default. If you imagine any other kind of
insurance contract, you know that the higher the risk, the higher the cost (premiums). A rise in that cost is a direct indication of the perceived
risk.

There are many data releases coming out this week, but there are two critical ones that stand out in our research, above all others: the GDP
figures for the US and UK. The UK just narrow ly avoided recession with a 0.5% first reading on Q1 2011 GDP, follow ing a -0.6% contraction in
Q4 2010. This week will be the second reading on Q1 2011 GDP. We'll be studying the release to gauge the severity of the overall weakness
in the UK economy.

Wednesday: UK revised GDP (0.5% previous).

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financial situation is unique, and requires proper assessment, guidance, and care from a licensed and registered professional.

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