Volatility erupted in financial markets last week as mixed economic data and a sharp reversal in commodities grabbed investors’ attention. In the end, several key asset classes reversed course abruptly, leaving many scratching their heads about what to expect next:

Silver plunged 27 percent giving back two months worth of gains in just five trading sessions. Gold also slid about 4 percent lower …

Crude oil prices reversed, declining almost 15 percent and falling back below $100 a barrel …

Meanwhile, the beleaguered buck reversed to the upside with the US dollar gaining almost 3 percent last week — mostly at the expense of the euro.¹

Not surprisingly, global stock markets also pulled back and bonds rallied as the risk-off trade prevailed.

Reflecting a sharp reversal in commodities, the stock market’s worst performing sectors were energy (-6.9 percent) and basic materials (-3.7 percent). These are both areas where we have been trimming our positions recently.²

The best performing groups — the only sectors gaining ground last week, in fact — were health care and utilities, which are classic defensive bets.

So is it time to “Sell in May and go away?” Naturally, we’ve been fielding quite a few questions from clients and investors wondering if what we’re seeing here is a fundamental trend reversal … or just a short-term correction in markets.

This week, I’ll share some insights from the Banyan Partners investment team to give you more perspective about our response to rising volatility.

But first, let’s start with our views about the latest economic data …

Mixed Economic Signals

As we pointed out recently, the US economy appears to be losing some upside momentum, but this downshift should prove only temporary. Last week’s data was a case in point with weaker-than-expected results from the ISM service sector index offset by a better-than-expected employment report last Friday.

The economy added 268,000 private sector jobs in April. That’s three straight months of private payroll growth averaging nearly 250,000 … a big positive.

On the negative side, average hourly earnings in the private sector increased just 3 cents in April. The annual gain in private earnings is just 1.9 percent — not even enough to keep up with the “official” consumer price inflation rate of 2.7 percent in April.³

This is a just one example of the mixed signals we’re getting from the economy, and it may also explain some of the gyrations in financial markets of late.

Remember, it was just a year ago when a sudden slowdown caught investors off guard, leading to a market correction in the first half of 2010. Back then, investors were also worried about the European debt crisis which was just beginning to flare up. Today, a bigger concern is what will happen after QE2 ends in June.

Bernanke: End of Easing as Expected

Investors may have already forgotten the Federal Reserve’s recent meeting a couple weeks ago, but there is perhaps a connection between it and last week’s spike in volatility.

While there were no unexpected revelations, Fed Chairman Ben Bernanke did confirm what we have expected: QE2 will end on schedule in June. The Fed chief also went out of his way to explain that no exit strategy is currently in the cards.

This means that after the Fed’s bond-buying binge comes to an end next month, it’s still not likely the Fed will be hiking interest rates. In fact, it doesn’t appear likely that benchmark rates will move much above zero before 2012 at the earliest.

Predictably, longer-term Treasury bonds began to rally after the Fed’s briefing and continued last week. The dollar first fell out of bed right after the Fed meeting, but then sharply reversed course to the upside. Was it a selling climax for the buck?

The most noticeable result of the Fed’s unconventional monetary policy — including two rounds of quantitative easing — has been to push the value of the dollar relentlessly lower while giving investors the green light to speculate in almost any other asset class … stocks, emerging markets and commodities included.

We believe the future direction of the dollar is a key indicator to watch closely at this juncture. In our view, the US dollar is extremely oversold at this point and is perhaps overdue for a rebound rally at some point. The scheduled end of QE2 in June may provide a timely catalyst.

Here’s a checklist of what we have witnessed so far from the Fed’s two experiments with quantitative easing:

Treasury bond yields rose instead of declining as many expected …

Commodities, stocks and other “riskier” assets tended to rally …

And the US dollar got hammered!

But after QE1 ended early last year and before QE2 was announced — a time when the US economy also appeared to be losing steam — yields moved lower again as bond markets rallied. At the same time, commodities and stocks took a breather.

Could a similar reversal take place after QE2 ends in June? This scenario could already be playing out now, a bit ahead of schedule.

Time for a Trend Reversal?

There are two reasons why we may be in store for a rally in the dollar — perhaps accompanied by a deeper reversal in overheated commodities.

First, the end of QE2 can be considered a form of monetary tightening at the margin … or at least a lack of more “easy” money. In this case, it makes sense that risk appetite could fade somewhat, at least for the time being, as investors gravitate back to bonds and other higher quality, defensive investments.

Just as commodities surged when the Fed opened the QE2 tap last year, we may now see a pullback as Fed liquidity gets turned off. We already see some evidence of this.

Long-term Treasury bond prices have been trending higher — and yields lower — ever since February when tensions began to flare in the Middle East and oil prices began climbing.

A renewed bid in bond prices makes sense amid signs of slowing momentum in the economy, which we see in the mixed data.

Second, we all know the dollar has moved opposite the rally in commodities and stocks. Dollar weakness is closely correlated with strength in commodities among other assets. That’s been the pattern for several years now, but the reverse is also true.

There’s no question that the bull market in commodities is supported by strong fundamentals: Growing commodity demand mainly from developing markets amid dwindling global supply.

The long-term bullish theme for commodities has not changed, but there’s also little doubt this has become a crowded trade.

There’s ample evidence of rampant speculation in some key commodities: Huge asset growth and a spike in volume for the largest silver ETF is a classic example of retail speculation.

Also, net speculative long positions in crude oil futures recently hit an all-time high. This tells me that hedge funds have been piling into an already overheated market.⁴

The consensus view simply grew too one-sided bullish.

That’s very likely why commodities sold off across the board last week on indiscriminant profit taking. And we may see this reversal persist a while longer, which could easily spark an overdue rally in the oversold dollar.

There’s a silver lining to this scenario too. Lower oil, food and other commodity prices could provide some relief to American consumers and businesses that have been squeezed by rising costs. If so, this could feed back into stronger US economic growth ahead, a positive for US stocks.

Watch These 3 Indicators for Guidance

We’re not saying this scenario is carved in stone, but it certainly gives investors something to consider as the second half of 2011, and the end of QE2, approaches. Here are a few indicators to watch for guidance:

1. Bond yields …

2. Renewed strength in US economic data …

3. And the key to it all may be: The direction of the US dollar.

Let’s keep things in perspective. We’re not changing our fundamental view that the economic recovery will continue … we believe it will and expect stocks to move higher as well.

What we are saying is that nothing moves up (or down) in a straight line … including commodities and the dollar.

Market corrections or temporary reversals in the primary trend should be expected from time to time. In our Banyan Partners investment portfolios we have been preparing for this reversal ahead of time by proactively taking some gains off the table in energy and materials stocks. We have also been selectively pruning some industrial holdings since these stocks could be negatively impacted by renewed strength in the dollar.

And for our core stock holdings that we want to hold longer term, we’re using specialized stock options strategies, where appropriate, to help defend our unrealized gains and protect against downside risks.

Keep in mind, these are tactical moves we’re making for our equity portfolios. Once the speculative, fast-money crowd has moved on, we’ll be looking for new buying opportunities in select energy and materials stocks again.

Meanwhile, we’re beginning to position our portfolios in more defensive sectors for the time being, including health care and consumer staples.

Recently, defensive sectors have begun outperforming the market — a bit earlier than usual at this point in the business cycle. This has some investors worried about the potential for a deeper slump in growth, but we don’t see this as a warning sign.

Many defensive stocks are attractively valued right now and offer a higher degree of pricing power that can help maintain high profit margins. It makes sense for money to flow to these sectors considering the mixed signals we’ve seen. But we don’t believe leadership in defensive stocks means a sharp slowdown ahead. Instead, it looks like normal and healthy sector rotation to us.

Bottom line: For the time being, we are gradually shifting our asset allocation in favor of more defensive sectors as market volatility continues to rise.

Good investing,

Mike Burnick
Director of Client Communications
Banyan Partners, LLC

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The opinions expressed in this newsletter are subject to change without notice and do not represent a complete analysis of every material fact with respect to any company, industry or sector mentioned in this report. The strategies mentioned may not be suitable for all investors. This information has been prepared solely for information purposes and is not a solicitation or an offer to buy a security, instrument, or to participate in any trading strategy.

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¹ Bloomberg market data, 5/9/11
² Bloomberg, First Trust, 5/9/11
³ Bureau of Labor Statistics, 5/6/11
⁴ CFTC; Saxo Bank, 4/26/11