Portfolio Update - 10/31/08

By proceeding, I acknowledge that I have read and understood the Disclaimer, Performance Reporting Disclosure and Copyright Statements . Dear Clients, The following is my Performance Update and Outlook for July. All prices and returns are as of 10/31/08.

PART I: INTRODUCTION

This past month will be one for the record books. October was the worst month for the S&P 500 since October of 1987 despite two days where the index rose by more than 10% - The previous biggest one-day advance in the S&P 500 was 9%. Crude Oil saw a drop in excess of 30% - it’s largest one-month drop ever. The government finally passed the largest bailout in history which is looking increasingly likely to fail in generating the desired result – the creation of even more stimulus by the banks. All of this has happened in spite of Fed stimulus of Biblical proportions. Steve Saville writes:

The Fed expanded its balance sheet by $69B during the week ended 29th October, bringing the increase since 10th September to $985B. Putting it another way, the Fed has grown its balance sheet by 111% over just the past 7 weeks. Nothing remotely close to this rate of growth has ever previously happened during the Fed's history. (emphasis author)

But in my opinion, the most significant development this month is a trend that I first wrote about last November, which is, that bonds of all shapes, colors and sizes fell this month in spite of catastrophic losses in the equity markets. Here is a run-down of several of the largest bond funds in the US and how they have faired YTD and this past month.

This development is very significant and is likely to change the landscape of investing and financial planning for years to come. In my Market Update I will delve into this trend in far greater detail.

PART II: ACCOUNT PERFORMANCE

Here is how my performance measured up to the averages October 31st of 2008:

I was not able to immunize your accounts to the further deleveraging that has been taking place in the markets. Despite holding a short-equity bias in your account over the past year and throughout October, the losses in my commodity positions continued to outweigh any protection we owned though inverse equity funds. In an October Bloomberg article, the following was written, “The same credit-market seizure that led to last month’s bankruptcy of New York-based Lehman Brothers and the forced sale of Merrill Lynch & Co is squeezing speculators who drove commodities to record levels.” In my Q2 written update (p. 4), I stated the following…

In my opinion, there are two possible outcomes for the equity markets over the next 6-12 months. One possible scenario is a complete meltdown in the credit markets causing the entire financial system to seize up. I don’t think it is probable but it is not out of the realm of possibility so we should account for it. The second scenario is far more probable which is Stagflation where several factors lead to inflation in consumer prices despite a significant economic slowdown.

I positioned your portfolio for the former and less severe of the two scenarios to play out and thus far the prior scenario has governed market behavior. The credit situation was far worst than even I expected while the Fed and Treasury were far more impotent than I could even imagine. The seizure of the credit markets led to an unprecedented deleveraging of financial assets. There were inexplicable moves throughout October in every part of the capital markets. LIBOR shot up to unimaginable levels. The US$ and YEN rallied as the carry trade become unwound. In less than 12 weeks, the YEN appreciated over 45% against the Euro. On two separate days in October, the S&P 500 appreciated in excess of 10% - TWICE IN ONE MONTH! The previous largest one day gain was 9% on Oct. 21st, 1987 - two days after the market fell over 20%. With the exception of 10/21/87, the next largest daily gain in the S&P 500 was not even 6%. I have run out of superlatives to explain how the market behaved these past few months. The idea of free markets has been tossed out of the window. Some of the government actions have been more overt than others such as the unprecedented ban on short-selling specific shares. Other moves have been more subvert. After the bailout was approved by the Senate and confirmed by the Congress, the stock markets continued to fall until last week. Coincidently, the Treasury waited to cash their blank check until day that the CDS’s for Lehman Brothers were to be settled on Oct. 28th. The settlement of Lehman’s CDS’s may very well have resulted in a market crash had the Treasury not dumped $125B into banking stocks buying them at twice their market value. The whole $700B bailout had nothing to do with freeing up credit markets; rather it was purely a quick fix to cover the investment bank’s worthless derivatives positions. Very little of the money used in the bailout will ever get to Main St. – it is already gone. The excessive volatility in the markets continued to negatively impact the performance of the inverse funds I have used to protect us during a deleveraging event. 10% single day rallies kill the performance of these funds. For example, SKF which is double short IYF is only up 23.7% YTD while IYF is down 41.5% YTD. I switched our short equity exposure to other sectors which were not as volatile and manipulated as the financials have been but our returns still got eaten up when the market rallied last week. Your accounts were up for the month as of last Monday (10/26) but then the rally erased all the gains in our inverse equity plays while the rally in commodities was weaker than equity gains.

PART III: MARKET OUTLOOK There is no more frequent, pressing, or important question these days than that having to do with whether the current crisis will end in a deflation or inflation. The Casey Report, November 2008 Issue

The answer to this question is critical to the success of my strategy. In an inflationary environment, we’ll do well as we did in the first half of the year, but in a Deflationary environment, we will suffer further losses such as we have these past four months. The answer is also important for the rest of the country. If the Fed and Treasury fail in reigniting the economy and reflating the credit markets, the outcome is dire. A 1930’s global depression is not out of the question. It is interesting that only 12 months ago, the argument was whether we would experience a Goldilocks economy or Stagflation. Now, not even the most bullish of all market commentators will utter the term “Goldilocks Scenario”. At the extreme bearish end, analysts are predicting “end of the world” type scenarios. In all seriousness, I’ve read two credible analysts speak of Armageddon in conveying how dire the situation in the credit markets is. Both use the terms metaphorically and neither are actually calling for the end of times. In order to determine the odds of each potential outcome, I’ll examine two sources of information. First, what is the market telling us and second what are the experts telling us. Market Activity The market activity of the past four months can only be explained in one of two ways. First, it is simply the result of a massive deleveraging. Just as all investments (stocks, bonds, real estate and commodities) appreciated from late 2002 through mid-2007 as the world leveraged up, all investment classes fell in unison over the past quarter as the world deleveraged. If this explanation holds true, then we will see inflation pressures pick back up over the coming quarters. In my Market Outlook written in July of 2007, I wrote, “There is unprecedented leverage in the system and when this leverage is unwound, we could see unprecedented moves in the market.” The other explanation if far more ominous which is that the market activity of the past quarter is a precursor to a long-term economic slowdown which vary well may end in global depression. This result will take place if the central banks of the world fail to reinflate economies resulting in a total collapse of the credit and derivatives market. There has never been a depression that has not been the result of a systemic breakdown in the banking sector/credit markets. To me, it seems that the correlations between various asset classes and sectors during October have been far too strong to not be a deleveraging event. From 10/13 through 10/27, the moves in Crude, Financials, the S&P 500, tech stocks, Silver and practically every other asset class were nearly identical. If the market activity foretold a deflationary/depression scenario, the markets should not be moving in unison. Since they did, it suggests that the last several months has been a result of massive amounts of money be pulled from the markets as hedge funds shares were liquidated and other investment vehicles sought safety in US Treasuries. Niels Jenson of Absolute Return Partners writes,

Merrill Lynch did a study recently, showing that the 30 biggest US equity holdings amongst US hedge funds were amongst the poorest performers in the S&P500. In other words, it is likely that much of the recent sell-off in equity markets around the world can be traced back to hedge fund liquidations.

Some Hedge Funds might be leveraged up 10 times which means that when a Hedge Fund redeems $1 worth of shares, $10 of market exposure must be liquidated. Not all Hedge Funds are levered up this far but the worst performing ones, who are most likely to receive redemptions, will likely be the most highly levered. The volatility in both directions along with the high correlations amongst all asset classes certainly suggests that the activity of the past few months was caused by leveraged players liquidating positions and not necessarily a precursor to global deflation. The Experts weigh in: Inflation Camp: Jim Rogers Doug Casey Adrian Ash Dr. Robert McHugh Bob Hoye George Soros (He is calling for the US$ to depreciate which is inflationary) Marc Faber (Long-term suggests an inflationary outcome but could have a deflationary event in the short-term) Deflation Camp: Robert R. Prechter Jr. Nouriel Roubini According to this list, the inflationist have it, however I should qualify this list. None of these men would be foolish enough to make a 100% prediction either way. I put them into various camps as I interpret there stances. Nearly all of these gentlemen would tell you that we will have fits of both inflation and deflation. It is unsettling that so many great minds have seemingly opposite opinions on the economic outcome. Some have argued that we could see both inflation and deflation. It certainly is not out of the question as we saw significant inflation in equity valuations and real estate along side commodity deflation in the 90’s. There is one theme that all of these men agree on which is that the US Fed and Treasury will stop at nothing to stave off deflation. If deflation takes place, it won’t be due to the lack of intervention. For this reason, all of these analysts believe that being long Gold and other Precious Metals along with being short US Treasuries is a fairly safe bet. In past updates, I’ve outlined a whole host of reasons why I think it is prudent to bet on inflation rather than deflation. The most notable reason is that a determined Central Bank managing a FIAT currency like the US$ can always create inflation. I’ll add the following two justifications for siding with inflation over the long-term. • Our Fed and Treasury have provided a massive amount so monetary stimulus and with the current correction in commodity prices, they will feel empowered to continue their printing spree. • If Prechter is correct and bond markets revolt against the massive monetary creation, then the US$ should get slaughtered resulting in commodity price inflation due to currency debasement.

PART IIIb: MARKET OUTLOOK

Equity Markets: Short-term Outlook The technical short-term outlook for the equity market’s is inconclusive. We are either in the middle of a sideways correction that will precede another fall in equity prices or we are building a base for a significant bear market rally. What ever move takes place the next one will be significant (i.e. 15-20%). Regardless of whether Oct. 10th was a bottom or if an even lower bottom occurs in the next month or so, we should see a significant countertrend rally over the next several months. In one month, the Fed and Treasury have created $500B in stimulus, half the cost of the Iraq war, and that money will go somewhere likely pushing capital markets much higher – the starting point may just be from levels lower than today’s. Intermediate-term Outlook (3-9 Months) – Is the Bear Market Over? For the first time since the credit contraction began in July of ’07, I don’t have a definite opinion on whether the bear market will continue. I give it a 50/50 chance that the Oct. 10th bottom was “the bottom” in nominal terms. In real terms (i.e. inflation adjusted terms), the bottom is no where near and we should see Gold, Oil and other commodities continue to appreciate relative to equity prices for quite a while. Why the bear market may be over? I believe the answer to this question largely rests with the inflation/deflation outcome. If we have a severe deflation, than equity prices will be headed lower. Ironically, we might see the inverse of the 1930’s when the systemic collapse in the banking system came at the beginning of the secular bear market starting in 1929 and the inflationary bear market came at the mid-way point in 1937. In the current cycle, 2000 may have been the inflationary bear market while 2007 maybe the systemic banking system collapse. I doubt that this scenario will evolve since interest rates fell in 2000 – 2002 but it would make for an interesting twist. The reason I doubt this scenario plays out is because the government does not have a gold standard to deal with as they did in the 30’s. If we were still on a Gold Standard, we would already be in a severe deflation due to the collapse of the banking sector (of course, you could argue that if we were on a Gold Standard, the banking system never would have been able to get so out of control leading to a systemic failure.) Conversely, if the Fed and Treasury are successful in reflating the economy, the Oct 10th bottom maybe the nominal bottom in equity prices – but not the real, inflation-adjusted bottom. If our Government successfully reinflates the economy, the rise in non-durable prices (i.e. food, clothing, energy and other commodities) will be much more significant than the rise in prices for durable goods (i.e. autos, homes, ect.) and financial assets (stocks, bonds, ect). This will result in a continued contraction of the Dow/Gold and the Dow/CRB index ratio. Even if the Fed is successful, nominal equity prices may fall farther than their Oct. 10th low. I do not have an opinion either way, but we can be certain that Gold and commodity indexes will outperform the equity markets. While it may seem difficult to conceive the equity markets falling more than 50%, it is very reasonable when you view the markets from a fundamental perspective. In 2007, the P/E ratio was 18, but 40% of the earnings were derived from the financial sector. Today, we realize those earnings were not real and will not be replaced easily. So, the earnings for the S&P 500 ex-financials was 30. We could feasibly discount the earnings even more as companies such as GM and Target derived all their profits from “financial activities” even though they were not included in the financial sector. I estimate that this would put the P/E ratio for the S&P 500 ex-financial activities somewhere in the mid-30’s. Assuming a P/E ratio of 35 and an annual earnings growth rate of 6%, it would take an investor in the S&P 500 20 years to recoup his initial investment. According to the Rule of 72, a 20 year payback period is a mere 3.6% expected return. Clearly, this is an unacceptable valuation to support the risk premium of owning equities – especially when the yield on risk-free treasuries is higher. In conclusion, equity prices should fall at least 50% to reach sustainable valuation levels. And given that single digit P/E ratios have been reached in each of the last two secular bull markets, equity prices depreciating more than 50% is a very reasonable expectation. Of course, I have no idea what the market will deem as a sustainable level of valuations going forward. All I can rely on is historical precedence which suggests that we should reach a P/E ratio for the market in the low double to single digits. And I have one more final contrarian indicator which suggests to me that the bear market is not over. On Oct. 27th, a piece on Yahoo!Finance’s Tech Ticker was titled “Time to Abandon Buy and Hold? No – Time to Buy”. These types of stories never have existed at bear market bottoms. Even though formal measures of market sentiment are showing severe bearishness, it seems to me that the general investing public is no where near throwing in the towel. I rarely watch the popular financial media news stations, but when I have, I have noticed a quick recovery of bullishness on each and every rally. I contend that at some point, either at the end of this cyclical bear market next year or at the end of the secular bear market which should take place sometime over the next decade, the investing public will abandon “buy and hold” and the “efficient market hypothesis”. I base this theory on the idea that bear markets always destroy the prevailing paradigm of the previous bull market. Certainly, bearish sentiment reached extreme levels in October which suggests a short-term bottom is in, but I feel that the public sentiment was too eager to jump back on the bandwagon as soon as equities rallied. When this bear market is truly over, I think the majority of people will have abandoned “buy and hold” but this has clearly not taken place yet. Bond Markets

Last week the S&P 500 was down something like 18%. But in the past when the stock market was down, Government bonds in the US rallied. But in the last couple of days this hasn’t happened. The bond market was also weak. Obvioulsy, if the Government bails out the entire system, the credit of the Government diminishes... Marc Faber, Bloomberg Interview – October 2008

Rising interest rates in the face of equity weakness is an inevitable development that I first addressed last November. As with practically every investment theme I’ve ever been convinced of, I was way, way early in making the call. (It has occurred to me to simply put off every investment idea I have for 12 months and my investment strategy would probably fair much better which is why I am painstakingly studying various technical analysis tools to help me time my buy-in points.) I’ve covered this topic in detail in past updates. The following are links to these updates which you can read if you’re so inclined. November 2007 Update February 2008 Update The one definite conclusion that we can make about the recent activity in the bond markets is that the 20+ year secular bond bull market is over. We might see the bond market rally if the equity markets continue to deteriorate over the next month. Furthermore, bonds will rally in the future when equities sell off, but for the long-term investor, bonds are a lousy play. Bonds have been sold to “mom and pop investors” as a safehaven investment since they have historically provided protection against equity corrections. As more and more investors bought into this idea, bond valuations reached unsustainable levels. Spreads on junk bonds reached historical low levels and investment grade ratings were granted to companies with absolutely no merit. The real or inflation adjusted return on Treasury bonds has been negative for some time now. Furthermore, a lot of people own bonds inside of mutual funds which is one of the more foolish investment decisions one can make. Funds that buy bonds are often forced to sell their holdings before the bond matures which results in recognized losses as interest rates rise. If you buy and hold individual bonds to maturity, then the only way you can lose in nominal terms is if the bond defaults. As investors lose money in bond investments in both nominal and in real terms, they will flee this space in a hurry. For the first time since the credit crisis began in July of ’07, bonds lost money right along with stocks. This will serve as a wake-up call for average investors who were told that bonds would provide some level of protection in an equity bear market. I fear that the Municipal bond market will be the next shoe to drop. With retail sales slumping, especially big ticket items like autos, sales tax revenues will be sure to fall. Furthermore, the housing crisis will have a dramatic impact on property tax receipts. Equity and bond market losses will begin to stress state and municipal pension plans. Municipal governments are like all political organizations in that they think they are bullet-proof and they disdain the notion of cost cutting. Revenues will fall faster than expenses which will lead to municipalities heading into bankruptcy. The most tragic element of this development will be the people who were mistakenly convinced that their Muni-bond holdings were insured. The housing crisis essentially wiped out the major Muni-bond insurers so there may not be any reserves left when the Muni-bonds fail. Commodity Markets The commodity markets have been hammered right along with every other segment of the capital markets. Many analysts are expecting a bounce in all assets with the exception of treasury bonds as the government stimulus works its way into the markets. From a technical perspective, commodity markets are strengthening across the board with energy commodities being a possible exception. Ag commodities have seemingly formed a nice base as have Precious metals. However, these securities have shown technical strength on a couple of occasions in the past four months and have failed to follow through. If the equity markets continue to deteriorate, it will likely lead to more deleveraging by hedge funds and other leveraged investors and commodities would likely be vulnerable as well. Oil: In 2006, oil prices came down in an election year. I believe that on top of the deleveraging and the slowing of economic activity, another factor hurting energy prices is the idea that nobody who makes a buck off of oil wants to see somebody get elected in the US on an alternative energy platform. I felt that in 2006 prices were brought down to calm the nerves of American energy consumers before heading to the polls and I think that it is happening again in this election cycle. A mild winter in 2006 contributed to even further deterioration in energy prices which bottomed the following January. After bottoming, crude and related products went on an unprecedented 18 month rally. A contrarian indicator for rising Oil prices came out when Goldman Sachs made a call for $50/barrel oil this past month (source: Reuters). Goldman Sachs made a controversial call in early June saying that Oil could hit $200 over the summer which couldn’t have been more wrong. So if they make a $200 call and the price tanks, then perhaps a $50 call would lead to a price spike. (I am of the opinion that GS knew that the currency markets were about to be fixed by the Teasury causing Oil prices to fall so they made the call to ramp up investment demand for Oil so they could liquidate their long positions.) From a fundamental perspective, Oil inventories have held below their five year average for the first time in several years (I only have data going back to 2000 so my five year average calc starts in 2005). Furthermore, according to an article in the financial times, the IEA says “Without extra investment to raise production, the natural annual rate of output decline is 9.1 per cent.” The previous assumption was a decline rate in the neighborhood of 4-5%. Precious Metals: There are a whole host of reasons why one should be bullish on Gold and Silver right now. The money creation at the government level will have significant unintended consequences most notably on the value of the US$. Marc Faber writes, “[G]old has conserved operation wealth during periods of currency destruction.” Furthermore, we should see inflation reignited as a result of all the government stimulus. According to Marc Faber, “Money supply growth in excess of real economic growth leads to inflation.” In the past two months, our government has created nearly $1T while GDP for Q3 came in negative. You cannot get more inflationary than that. From a technical standpoint, Gold and Silver are very strong. Several indicators have generated new buys in the past week. I have read countless sources which indicate the premium on physical gold and silver over paper gold and silver is at record levels.

PART IV: CONCLUSION

I think I’ve adequately expressed in past updates just how disappointed I am in my performance this year. While I am sure you’re equally if not more disappointed than I am, I am encouraged for a couple of reasons. First, I have taken measures to improve my future performance which includes creating some of my own technical analysis tools coupled with finding several technical analyst’s who should help me navigate the market in the future. Second, it is fairly clear that investors with long track records of success have suffered massive losses in this bear market as well. Buffett’s Berkshire Hathaway is down nearly 19% as of Oct. 31st. According to MFFAIS, Soros’ fund was down a 42.7% as of August 14th of this year. I do not have figures on Jim Rogers’ performance as he only manages his own account, but by his own admission he has been heavily invested in Ag commodities and China this year which have been dealt significant blows. While it may be of little consolation to the majority of my clients whose IRA accounts I manage, all my margin accounts are up double digits this year which at least suggests that I must have something right. All these accounts are invested in the same themes as my Core and Focus strategy it is just that I was able to build actual short positions rather than using inverse funds to profit from the market downturn. I have no idea whether I will able to get your account back into the black this year or not. Many of our long positions are seemingly gaining technical strength which bodes well for the short-term but they have shown fits of strength a couple of times in the past few months and have continued to fall. It is all a matter of when the deleveraging finally ends. With the massive volatility, it is not out of the question but I wouldn’t necessarily count on it. As always, please do not hesitate to call me if you would like to discuss your account. All the best, Matt McCracken