Portfolio Update - 07/31/08

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 07/31/08.

July was a tale of two markets which resulted in the broad equity and bond market indexes ending the month essentially flat; however, the movements in individual sectors was pretty radical. The first half of the month was purely a continuation of the havoc reaped in June but the markets turned a remarkable 180 degrees on July 15th. The back half of the month was defined by increased risk taking as the VIX Volatility Index fell 26% from July 15th through the 30th. All safehaven plays; oil, treasuries, gold, utilities and TIPS, were dealt a healthy blow in the last couple of weeks while risky offerings such as financials, REITS and small-caps mounted unprecedented rallies. The financials had their largest one and two day rallies ever! The six day rally in the financials dwarfed any bear market rally seen in the NASDAQ during the 2000 – ’02 bear market…but more about that later.

Here is how my performance measured up to the averages for the first seven months of 2008:

July was not a good month for us. The two positions in your portfolio that did very well in June, gave back all their June gains and then some in July (or at least in the second half of July). Considering that my strategy is based on continuing monetary and commodity inflation coupled with deleveraging in equity and bond markets, it is not surprising that we suffered a sizable set back this month. And here is where I should inject the obligatory statement about how our YTD returns have been far ahead of just about anyone else. While equity indexes are down over double digits, my focus portfolio is up double digits and my Core strategy is almost in double digit area. Furthermore, I could point out that the performance of the best market neutral fund that I track (TFSMX) is up only a mere 2.8% YTD. However, I am very disappointed with the last several months. Bear markets are amazing opportunities to make money and I feel that I am squandering that opportunity. Wealth is preserved in bull markets but it is created in bear markets. Templeton, JP Morgan, Buffett, Soros and Rogers all made their clients a fortune in bear markets. The legends cemented their legacy by profiting from the foolishness of others which can only be done at market inflection points. While we should be pleased with positive performance in a down market, I am far from satisfied.

The following could be the most important commentary I make throughout this entire bear market cycle. I will cover two ideas that every investor should familiarize themselves with while attempting to navigate any bear market. Furthermore, it should answer the following questions that I have been asked by numerous people over the past few months, which are:

Are we there yet? Has the market bottomed yet? How much further do we have to go?

The first topic relates to bear market leadership and I’m calling it the “Greater Fool Theory” and the second topic relates to the behavior of bear markets when they finally bottom.

The concept of the “Greater Fool” is well known by investors. Basically, the “Greater Fool” is the last person to buy into the market at the peak and the last one to sell at the trough. While the term “Greater Fool” is singular, it actually refers to the masses of foolish investors who pile into an asset class or sector creating a parabolic move up followed by the inevitable crash. The Fool acts in direct contradiction to the number one rule in investing by “Buying High and Selling Low”. But there are some other behaviors demonstrated by the Greater Fool which need to be understood for this commentary. The Greater Fool doesn’t only buy in at the top, but he buys into the sector that has been the best performer in the bull market which coincidently is the worst performer in the subsequent bear market. Furthermore, the Greater Fool has shown a propensity to do imprudent things like “buy the dips” and “average down” throughout a bear market to validate his original purchase – throwing good money after bad. (The term “average down” was used in 2000 while “buy the dips” is the current fool’s mantra, but they refer to essentially the same behavior.) When a bunch of fools do this simultaneously, it results in spectacular bear market rallies such as the ones the market experienced last August and in March and July of this year. (BTW, the 2000 – ’02 Bear saw five of these rallies. The current bear market has experienced three thus far.) It is the nature of these rallies that I want to examine and explain why they provide a solid indicator as to when the bear market is over. We know that the bear market is not over until the Greater Fool throws in the proverbial towel. We also know that the Greater Fool will continue to try and validate himself by buying up his favored sector which is the bear market’s worst performing. Therefore, a sure sign that the bear market is over is when the worst performing sector quits leading the market during rallies because the Greater Fool has finally given up. We are all aware that in the last bear market, tech and/or dot.com stocks was the fool’s paradise losing nearly 78% from peak to trough. It was the highest flying sector in the late nineties and the worst performing in the beginning of the new millennium. For the purpose of this article, I will use the NASDAQ index as a proxy for the tech/dot.com sector. During this bear market, Financials are the fool’s paradise. In each of my last several updates, I have stated that the financials will lead the market which ever way it goes because I knew it would be the worst performing sector (and have positioned my clients accordingly). I have also said that REITs and Utilities would significantly underperform the market as well because foolish investors piled into these sectors with no idea how inflation would wreck income generating assets. I have been right about the REITs thus far but not so with the utilities. (Two out of three ain’t bad.) But for the purpose of this discussion, I’d like to focus on the Financials. For a proxy of the Financials, I am going to examine the performance of the I-shares financial ETF – Ticker symbol: IYF. I expect Financial stocks to behave relative to the market during the current bear as NASDAQ stocks did in 2000. The following is a chart of how the NASDAQ stocks performed relative to the S&P 500 during bear market rallies from 2000 – ‘03 and how Financials are performing relative to the S&P 500 during the last three market rallies. The purpose of the chart is to show “market leadership” so I compared performance in the first 10 days of each bear market rally. (BTW, in both bears, the worst performing sector peaked around 6 months prior to the broad market. So, the first rally in both 2000 and 2007 were prior to the S&P peak but after the NASDAQ and IYF peaked, respectively. The last two rallies in 2000 were the actual market double bottom which you can read about in Part IIc.)

This table clearly shows that as the 2000 bear market wound down, NASDAQ stocks provided less and less leadership when the market went into rally mode. Furthermore, it is evident that IYF has led all the current bear market rallies thus far. If my “Greater Fool Theory” holds true during this cycle, the bear market has further to go and we can expect it not to be over until the financials cease leading market rallies. Of course there are issues that need to be addressed because no two bears are alike. I expect history to rhyme but not repeat itself exactly. The first issue is government intervention. The Federal Reserve and the US government have undertaken extraordinary measures to provide stability to the financial sector. In 2000, they never limited short-selling on tech stocks, they never opened the discount window to dot.com companies, they didn’t create “auction facilities” to lend to the NASDAQ companies and they certainly didn’t provide loans that were collateralized by worthless assets (MER’s sale last week of CDO assets suggest that the market value for these securities is in the range of 11-22% of their book value. The Fed is taking these assets on as collateral at their full book value). These actions certainly account for some of the action in the financials. On the flip side, the capitalization of the S&P 500 today is comprised of nearly 20% financial stocks where as in 2000, tech stocks comprised around 10% of the S&P 500. Therefore, the autocorrelation between IYF and the S&P should be much higher than the NASDAQ and the S&P 500 were in 2000. When you zero out the impact of these two qualifiers, I think my “Greater Fool Theory” is still applicable to the current market; therefore, we should expect financials stocks to quit leading the market once it nears the bottom. However, I always feel that it is prudent to question my theories and ask “what if I’m wrong? - which is by no means out of the question. I’ve been wrong before and I’ll be wrong again. What if leadership in the Financial sector is a sign of the exact opposite of what I expect – the beginning of a new bull market? How can my clients be sure that we won’t miss out on the early stages of a bull market which has been historically a very profitable time to invest? Well, if I am wrong, the following piece of market trivia should provide some reassurances that we won’t miss out on much…

Historically, bear markets have been merciful in providing astute investors with two opportunities to buy back into the market as they have shown the propensity to form a double bottoming pattern. The first bottom represents the best time to buy back in and the second bottom represents the safest time to buy back in. Fortunately for my clients, the second bottom is typically no more than a few points higher than the first bottom. It has always been my intention to buy back in at the second bottom of the bear market just as I did for my brokerage clients in April of ’03. (BTW, for disclosure reasons, I cannot provide any proof what so ever that I actually bought back into the market in April ’03 b/c I was a broker and as a broker by job was simply to recommend and take orders.) So, let’s examine the numbers to validate my theory. I gathered data on every major bear market since the inception of the S&P 500 in 1956 and here are my findings:

The data clearly supports my contention that bear markets have historically formed a double bottom before the bull market begins in earnest. A few observations… • Only once was the second bottom been more than 4% higher than the initial bottom • The two largest differentials between the first and second bottoms were after bear market losses in excess of 48% • In Bear Markets where the market depreciated less than 40% (where we currently stand) the safest time to buy back in was never more than 3% above the best buying opportunity. • Even though ’98 was technically not a bear market, the market still exhibited a similar double bottom before engaging in the strongest period of equity price appreciation in the history of the index • The shortest period between double bottoms was over one month (1998) - The longest period was over six months (2002-’03) The majority of investment advisors often advise clients to stay in the market for fear of missing out on the early stages of a bull market rally. While the early stages of bull markets tend to experience significant gains, bear market bottoms have historically given astute investors two opportunities to buy back into the markets before a sizable rally – the best time to buy back in (first bottom) and the safest time (second bottom). By the second bottom, the market has historically shown strength in various technical indicators such as leadership, breadth and momentum giving a tactical investor greater confidence in assuming equity market risk. In conclusion, I think the odds are that the bear market is not over but there is no way I can be 100% certain. Furthermore, if the market has bottomed, then we should see a secondary bottom in the range of S&P 1220 – 1250 in the next several months buy again there are no guarantees. My job is simply to play the odds and swing them in our favor. I believe it is prudent for us to invest with historical precedence on our side. I firmly believe that I will not be wrong on both counts – which means either the bear market will continue or we will see a double bottom in the market and most likely both will take place. If either holds true, we will be able to buy back into the market at prices cheaper than today and hopefully with confirmation from various technical indicators that equities provide a relatively safe opportunity for us. Therefore, if you are out of equities like we are, there should not be any hurry to buy back into a fool’s rally. For those who are invested in equities, you should be able to liquidate your positions today and buy back in at cheaper prices in the future.

In my Quarterly update, I was fairly certain that Q3 would be a strong quarter for my portfolio but it certainly hasn’t started out that way. We are moving into a strong period for my commodity plays so I’m still confident that they can provide us some nice returns in the coming months. I’ve only made a couple small changes to your portfolio since my last update. I shifted my short equity exposure around a bit and added a little energy exposure in late July after the sizable pullback in the space. My biggest concern is my short equity positions. As I addressed above, the government and Fed are taking unprecedented actions to support the market. I believe some of this has to do with it being an election year, but unfortunately, I think some of it is purely the continuing trend of the US government to interfere with so called free markets. Several analysts have made the point that our government “allowed profits to be privatized yet the losses were socialized” (Nouriel Roubini said this and others have reiterated it). I couldn’t agree more. Government intervention has always led to inflation especially when the currency is not backed by real assets. If the Fed and the US government succeed in bailing out all the banks, our short equity exposure with suffer. However, regardless of whether they succeed or not, they are going to pull out all the stops trying, which will create more monetary inflation which supports the inflation plays in our portfolio. If they succeed, I think we’ll do OK. If they fail, we’ll do unbelievably well – and we should probably expect something in the middle. I believe in maintaining my long/short strategy which should provide positive gains with the potential for explosive gains. Although market participants loaded up on risk this month, nothing fundamentally has changed which would alter my long-term view. When GM posts a loss that is over two and half times their capitalization… When Merrill Lynch sells assets for 22 cents on the dollar and provides the buyer a loan for half the purchase price… When Fannie and Freddie are leveraged 65:1 so that a 2% decline in the value of their assets completely wipes out all their equity… When monthly car sales hit their lowest level since 1992… When unsold home inventories stands at 11 months worth of sales, prices fall 15% YOY and nearly half the homes sold in California in June were the result of foreclosures… When YOY commodity inflation is over 25% and the reported CPI is running at 5%... And when the P/E for the market hits 23… I don’t think it is prudent to start adding long equity positions. In fact, I think the flight to risk this month is an indicator that markets still maintain a heavily bullish bias which is rare at market bottoms. Conversely, election years tend to be good for markets. I don’t think the current administration wants to end on a sour note. From their viewpoint, any market turbulence hurts their chances of holding onto the White House and with the Dems controlling the Congress and Senate, the GOP will do all they can to keep the Presidency. So, I am softening my views on Q3 performance expectations. I am confident in the long-term macro trends but I’m increasing uncertain when the markets will price them in. The inflation half of your portfolio should perform well in Q3 but the short side may or may over the next few months. Short and Intermediate term indicators are inclusive at this point. The next few weeks should be telling.

The ousted top executives of Wall Street firms like Merrill and Citigroup were paid more to leave than 99% of Americans will make in their lifetimes. No one has been indicted. No one has been fined. No one has returned any of their astronomical bonuses. They all got off scott free. The gains were realized by these firms and paid out to their executives but the American taxpayer is absorbing the losses. As quoted earlier, the “gains were privatized but the losses have been socialized” by being shifted to the taxpayer. It is curious that the banks clamored for less government interference while seeking to overturn the Glass-Steagall Acts but now they are demanding to be bailed out by Big Brother. It’s like the kid who complains about his parents discipline yet expects Mom and Dad to bail him out of jail. The US regulators have been asleep at the wheel. The banks have pulled the exact same tricks as Enron, but the situation was worse because Banks have capital requirements which they negated by using off-balance sheet entities. They copied the Enron playbook exactly yet the regulators never even “raised an eyebrow”. And it gets worst. FASB has just announced that they are delaying the enforcement of a rule that would require banks to bring these assets back on their books. Furthermore, Treasury Secretary Paulson is clamoring about giving the Fed greater regulatory powers. That is like charging the fox to watch the hen-house. The idea is absurd because the Fed is owned by the banks which results in the banks regulating themselves. I don’t argue that the Fed and the US Government should not take actions to stabilize the financial markets. But they should do it with the least possible cost to the taxpayer and the highest possible cost to the shareholders and responsible company executives. Unfortunately, the exact opposite is happening as bondholders and now equity holders are being buoyed by the US government and the privately held Federal Reserve. The taxpayer is getting stuck with the bill. Recently, Congress approved over $250B to bail out Fannie and Freddie (now being affectionately referred to as Fhonny and Frauddie). The FDIC will use anywhere between 7.5 – 15% of its funds to bail out IndyMac which wasn’t even on the FDIC’s list of “at-risk” banks one week prior to failing. The Fed helped finance the JP Morgan acquisition of Bear Sterns to the tune of $30B. The Fed extended its auction facilities until Jan of next year and implicitly suggested that they will be available indefinitely. All of these actions create monetary inflation. It takes a while for monetary inflation to work its way through the system, but inevitably it will. Every bank bailout, every Fed action and every piece of government stimulus is bullish for our strategy. But it looks like it will take much longer than I thought for the markets to price the inflationary impact into the market. Yields on treasuries all along the curve are below the official rate of inflation and far below the real rate of inflation. The most popular inflation hedges, Gold and Silver, are still at historical lows relative to all other commodities, with the exception of agriculture. Once the market quits discounting the inflationary threat, these pricing dislocations will correct and our strategy will profit. Fundamentally, the outlook for my strategy is as sound as ever. Technically, the outlook is mixed. Eventually, fundamentals will win out. Maybe this year, maybe next. You have shown incredible patience with me and my strategy and I sincerely appreciate it. It is my goal to reward your patience with sizable gains as the cycle continues to play out. As always, if you have any questions or concerns about your account, please do not hesitate to contact me. All the best, Matt