Portfolio Update - 08/31/08

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 August. All prices and returns are as of 08/29/08.

PART I: INTRODUCTION The currently prevailing paradigm, namely that financial markets tend towards equilibrium, is both false and misleading…I contend that financial markets are always wrong in the sense that they operate with a prevailing bias. (emphasis mine) - George Soros, The New Paradigm for Financial Markets -

As I reported to you in my interim update sent a few weeks ago, I have been reading a couple of George Soros’ books and they have radically changed my perception of how markets work. The lightbulb went off when I read the above quote. Despite the contentions by Wall Street analysts and Ivory Tower economists, markets are never in equilibrium, they are never efficient. Markets are right about as often as the “proverbial broken clock”. They get it right once on the way up and right once on the way down, but that is about it. The rest of the time, capital markets are either overvaluing or undervaluing securities based on the prevailing biases influencing market participants. Here are some more poignant examples… How was the market efficient when it valued the NASDAQ index at over 5000 in March of 2000 when it is still less than half of that level eight years later. How was the market efficient when it valued homebuilding stocks at more than twice their current value as recently as two summers ago. How was the market efficient valuing Bear Sterns at over $170/share in early 2007 before it collapsed this March. Or valuing FNM and FRE at $68 and $65, respectively, within the past 12 months before each fell over 90% - then subsequently rallied well over 50% in just six trading days. How did the market effectively value financial stocks at 4:00 EST on July 15th when they rallied over 10% in the following 24 hours. How did the residential real estate market efficiently value homes whose prices “were never suppose to fall” yet they have depreciated over 16% just in the past year (Source: Case/Shiller Index) Pundits of market efficiency may be quick to point out that even though the market doesn’t always get short term trends correct, it always works in the long-term. And my response would be… How was the Japanese stock market efficient when the Nikkei 225 average was just a shade under 39,000 in December of ’89 and today it stands less than one-third of that value – nearly 20 years later!. How was the market efficient when it priced a barrel of oil below $20 in late 2001 when it rose to over $140/bbl just two months ago – an annual increase in excess of 30%! And how was the market efficient valuing gold at $860 in 1980 when it took over a quarter century for the precious metal to regain the same valuation. How was the market efficient in valuing the S&P 500 Index at 106 in 1980 before it went on a two decade-long winning streak increasing 14 fold throughout the 80’s and 90’s. While I have never been a believer in efficient markets, I would say that I’ve given the market the benefit of the doubt assuming that fundamentals would win out sooner rather than later. After reading Soros, I have concluded that markets are far more inefficient than I originally thought and while fundamentals do eventually win out, sometimes it happens much later than sooner. The emotions of greed and fear play a much larger role in the decision making behavior of investors than rational thought making prevailing biases much stronger than one might expect. Efficient market theory is a silly ideology perpetuated by Wall Street and its various one-offs (Insurance companies, Broker/Dealer’s ect.) used to provide false hope and security to their clients. Studying the history of markets along with their boom and bust cycles, it becomes fairly obvious that markets are far from efficient. The notion that “markets are always right” is asinine.

After reading Soros, I began to reflect on the past year and how despite being right on numerous of the primary economic trends, my strategy has failed to return significant gains. The following are a few articles posted in the last 18 months which illustrate some of the calls I’ve made on macro economic issues: (You can read more by clicking on any of the above links. You’ll need to hit the “back button” on your browser to be returned to this post)

Housing Market Energy Prices Inflation & the Slowing Economy (Stagflation) Market Leadership by the Financials and Real Estate REIT Yields & Prices

So this raises a question. What the hell good is it to be right about economic trends, if the markets are always wrong? My answer is two-fold. The first answer comes in the completion of the quote that I used at the top of the post.

I contend that the financials markets are always wrong in the sense that they operate with a prevailing bias, but in the normal course of events they tend to correct their own excesses. - George Soros, The New Paradigm for Financial Markets -

First, the market will move back to the mean. Eventually, markets will move in the direction of fundamental value. The challenge is when will this take place - when will they begin the process of correcting their own excesses? For example, Alan Greenspan who was practically considered a deity by many on Wall Street warned of “irrational exuberance” in the stock markets in 1996. But the markets didn’t crash for another 3+ years. And if you had listed to the revered Greenspan, you would have missed out on a monumental rise in equity prices and wonderful opportunity to make a lot of money. Second, by avoiding the temptation to get caught up in market excesses and by correctly judging the macro trends, I should be able to protect your account from any catastrophic losses such as those caused by the Tech Bubble and the more recent Credit Bubble. As James Stack likes to say, “It is not how much you make in a bull market that counts, it is how much you keep in the ensuing bear market.”

PART II: ACCOUNT PERFORMANCE

Here is how my performance measured up to the averages for through August:

Obviously, the last two months has resulted in a precipitous pull back in your account value. While we are still ahead of the market averages and my Core portfolio is right at my benchmark, I’ve always said that my goal is to beat the market in up years and deliver flat to positive gains in down years. Now, we are down for the year so I am not living up to my goal for your account. Ironically, my Core portfolio is at the exact same place that it was last year at this time. As you know, we finished out last year well earning just over a 12% annual return so I still have time to get us on the right side of the ledger. This year has been rough on a lot of investors. Even Warren Buffett’s Berkshire Hathaway is down 15% since the beginning of June and down over 21% YTD. Boone Picken’s fund sank 34% in July alone (source: Bloomberg). According to the Economist, several of the best performing hedge funds this year suffered significant losses in July (and probably August) due to the countertrends in Energy and Financials stocks. The sentiment that I’ve received from some of you is that you’d be glad to take a percentage of the upswings if we could limit the pullbacks. I’m in complete agreement with that sentiment and I am taking corrective measures to accomplish this objective. First, I’d like to examine three critical mistakes I’ve made this year which has led to a negative YTD return in your accounts.… Point 1: Assuming the market would account for inflation in a timely manner (i.e. assuming that markets were self-correcting/efficient.) In my Market Outlook last year, I clearly made the case for Stagflation and the inevitable “Inflationary Bear Market”. At the time, this was a gusty call as the majority of Wall Street pundits were calling for a Goldilocks scenario. But despite nailing the prevailing economic trends correctly, the market did see fit to agree with me on half of my argument. While the market reacted to the credit crisis and the slowing economy, the market never took the inflation scare seriously. We made money on the “Stag” part of portfolio but lost money on the “inflation” plays. As discussed in Section I, the market can ignore inconvenient economic trends for long periods of time. If the market were concerned about inflation, the following would have taken place…

• Interest rates would be higher. For the first time since 1979, the CPI exceeded the yield on ten-year treasuries by almost 2%. A market that was concerned about inflation would bid treasuries down in order to receive a higher yield to be compensated for inflation. The disconnect between the bond market and CPI is the most obvious sign that the market is not concerned about future inflation.
• Leverage Gold (Silver and PM mining shares) would be outperforming Gold. Historically, Leveraged Gold has significantly outperformed Gold when there were negative real rates (See 1974 & 1979). While Gold has appreciated some in the last year, Leveraged Gold (Silver and Gold mining companies) has significantly underperformed Gold. Since I posted my Market Outlook last July, GLD has outperformed SLV by more than a 4:1 ratio. The speculators (Wall Street Analysts, Hedge Funds, ect) drive market trends and they would be most likely to use Leveraged Gold to play the PM market. The underperformance by Leveraged Gold suggests that these players are not in the PM market and are therefore not taking inflation seriously. I’ve used Leveraged Gold with the idea that since Gold was going up, Leveraged Gold would go up more. I was right about Gold but wrong about Leveraged Gold which has negatively impacted my strategy.
• Equity Valuation Contraction: In an inflationary environment, the future cash flows of a company are discounted which results in valuation contraction, most commonly measured by the P/E ratio. In the last IBM (’73-’74), the P/E ratio for the Dow Jones Industrial Average was cut in half (source: Valueline). Over the past year, the P/E ratio for the S&P 500 actually expanded from 18 to 25 rather than contracted (source: Investech).

As I stated in Section I, the market is often governed by a prevailing bias and the current bias has ignored inflation in our economy. This may last for some time. The market didn’t care about valuations or cash flows throughout the late 90’s. The market didn’t care about financial accounting standards for the banks over the last couple of years. The market didn’t care that homebuilders threw up nearly twice as many homes as they were selling for several quarters which resulted in far more homes than willing buyers. But eventually, all of these trends corrected themselves and those who came late to the party were cleaned out while early adopters betting against the prior trends did remarkably well. Over the past year, the tightening credit markets and falling earnings became impossible for the stock market to ignore; however, the markets have been able to look past inflation pressures because inflation is inconvenient to the current investment themes dominating Wall Street firms. In the July 5th Issue of the Economist, it says, “But the remarkable thing about the inflation scare is that it has left [bonds] virtually unscathed.” And since the article was written, bond prices have risen even further pushing yields even lower. Our inflation plays haven’t been a total loss. We have made money on assets that cause inflation such as commodity indexes, be we lost more on “inflation hedges” mainly precious metals. Point 2: Assuming the market correction would be quick like other Inflationary Bear Markets (IBMs): I have long argued that this correction would be violent and quick as the last three inflationary bears were in 1907, 1937 and 1974. None of these bears lasted more than 21 months while slicing the market indexes practically in half. While this bear market is not in the books yet, this prediction will likely be proven wrong. I made several aggressive decisions using inverse equity funds based on the idea that the correction would be swift and fairly linear. While most of my inverse equity funds have made us money, due to the nature of these funds our gains experienced significant deterioration in the past two months. In hindsight, I should have paid more attention to the most recent bear market which began in 2000 and factored that into my theory. The 2000 bear market lasted nearly 50% longer than any other bear market since the Crash of ’29. The Federal Reserve and the Government have tools to prolong bear markets and they have been increasingly willing to use them over the past couple of decades. It was foolish of me to think that the current bear market would play out like 1973-’74, even though the economic conditions were eerily similar. In every bear market prior to ’73, the Fed had to contend with a currency linked to Gold (and Silver way, way back) which severely limited their ability to deal with falling asset prices. In ’73, the Gold peg had been lifted, but there were two key differences between then and now. First, the inflation threat was a shock, not a decade long event. Because the inflation threat was quicker, it stands to reason that the equity contraction would be quicker as well. Second, we were a creditor nation at the time so the Fed was unable to create massive amounts of debt that foreigners would be willing to buy. We were the buyers, not the sellers. Foreign central banks were unwilling to finance our inflation during the 70’s so the Fed was not able to pull all the tricks that they have during this cycle. In addition, the Fed was just handed the keys to their new printing press so they were less inclined to do anything extreme such as the current Fed is doing. Point 3: Execution: In the past 12 months, I have had several successful ideas for ways to play the market and while I’ve executed some well, others I’ve executed very poorly. The best example of my poor execution was how I used energy stocks to hedge our PM exposure. Late in the spring shoulder season for Oil, I became apprehensive about how a pullback in Oil might effect the our PM exposure. In order to hedge this impact, I shorted energy stocks to mitigate any impact that falling oil prices would have on our PM exposure. The idea was perfect since energy prices began to fall in early July along with energy stocks and gold prices. However, I executed this play pitifully, buying into and selling out of a short energy stock fund far too early which resulted in a 9+% loss in the position. If I would have held the position, I would have made money on it or I could have liquidated some or our PM exposure. Either option would have been better than what I actually did. While I’ve had some successes and some failures this year, I don’t plan on just sitting around complacent. I’ve inventoried my strengths and weaknesses and have taken actions to capitalize on my strengths (macro analysis) while minimizing my weaknesses (short-term market movements and trade execution). There are two corrective measures I’m taking in order to accomplish my objective of limiting the severity of the pullbacks in my strategy while trying to recognize the majority of its upside potential. First, I’ve adjusted my outlook on market behavior in line with Soros’ philosophy of Reflexivity. Previously, I believed that if I nailed the long-term Macro trends in the economy, the market would come around quickly. I made the mistake of assuming that the inevitable was imminent, which history suggests is not necessarily the case. From this point forward, it will be my duty to not only determine long-term macro trends, but also to judge which of these trends the market is or is not favoring by using technical analysis. I will build my portfolio around a larger number of themes and invest according to the ones that are exhibiting the greatest technical strength. Second, as I wrote to you in the middle of the month, I have been working diligently on a system that should minimize my mistakes in future execution. From this point forward, my trading decisions will be far more objective which I am confident will allow me to time my execution with far greater accuracy. My system is still a work in progress but by the time I send you my Q3 update, I should have most of the kinks worked out and be able to report on how I am fairing with it. My ability to judge long-term trends has been proven to be fairly solid. Properly deconstructing the big picture should help us avoid any catastrophic events. But at some point, it’s time to capitalize on these events and make some money. While your accounts have faired far better than the average investor over the last year or so, there is a lot of room for improvement on my part. I’ve left a lot of money on the table but the measures I’ve taken over the past several months should allow me to generate stronger returns in the future.

Part III: Market Outlook

The current market has taken no prisoners. When Buffet is down double digits, the majority of market neutral funds in negative territory and news of Hedge Funds liquidating, even safehavens aren’t proving to be safe. The investment themes during the first nine months of this bear market were pretty consistent – long commodities and short the US$ and financials/economic sensitive securities. But the last two months has turned everything on its head. Commodities have been slammed, the US$ has rallied over 10% and Financial stocks have rebounded in larger fashion than any sector in any bear market ever. There are a whole host of explanations, none of which seem to explain everything that is going on. One possible explanation, and the best that I can come up with, is that the Yen Carry-Trade is finally unwinding. For the first time that I can recall, the Yen has rallied counter to the US$ strengthening against the Euro. While the Euro/US$ move has been substantial, the Euro/Yen move has been nothing short of remarkable. The Yen has appreciated 10% versus the Euro in just one month and 5% in the last five days. (I am writing this section on 9/4, so I’m using data as of 9/4). Part IIIa: Is the Bear Market Over? I would contend that the odds of the bear market being over are slim to nil. I think it is wise to assume that the bear market is currently on hold but set to resume soon. The best case I can make for the continuation of the current bear market is “My Greater Fool Theory” which I wrote about in Part IIIb of last month’s update. This theory says that the bear market will not be over until the Financials quit leading the market higher. The financials have led each of the last three rallies including the current one. Here are few other points that support the continuation of the bear market… Market Valuation: The P/E ratio for the S&P 500 now stands at 25. Bull markets typically do not find their footing when valuations are so rich. The historical average for the S&P 500 is approximately 15. Its current level is in the neighborhood of the early 2000’s at the onset of the longest and most severe bear market since 1929. But the earnings picture gets worst when you consider the stocks that comprise the Dow Jones Industrial Index (Dow). According to Barron’s, the earnings for the companies that make up the Dow turned negative in Q2 for the first time in the indexes existence – an index whose history predates the Great Depression! This means that when you total all the earnings and losses for the 30 of the largest companies in the US, they have no P/E ratio (technically its negative but that doesn’t sound as cool). The Herculean losses suffered by GM in Q2 certainly skew this figure and it should rebound somewhat in the next quarter. But I think the odds are against an emerging bull market when the 30 largest companies in our country are hovering around the break-even point. Continued Deterioration in the Housing Market: Builders are still building more homes than they are selling and inventories of new and existing homes are at all time highs. The correction in the housing market will not be over until inventory levels come down, regardless of the number of homes being sold. Home sales picked up in the last couple of months but prices have fallen precipitously which suggests that sellers are starting to throw in the towel which is a necessary step prior to the market bottoming but also a strong signal that the bottom has not been reached yet. 300 Point Rallies in the Dow: In an interview with CNBC, Merrill Lynch Analysis David Rosenberg commented that “there aren’t 300 point rallies in the Dow during bull markets.” So I thought I’d do a little homework and I discovered that he was right. From the bear market’s second bottom in March of ’03 until the beginning of the credit crisis in July of ’07, the Dow did not experience a single one day advance in excess of 300 points. . In July, the Dow experienced two 300+ point daily rallies. Since July 19, 2007 when the Dow hit 14,000, it has experienced eight one day rallies in excess of 300 points. Bear market rallies are far more volatile than cyclical bull market advances so we should expect rallies to be more violent in a bear market than in a bull. ^VIX Index: The VIX index, which is a commonly used measure of perceived market risk, closed out August at 20.65. Earlier in the month, it closed as low as 18.81. These figures are much lower than at the end of the last bear market. While the market was forming its base in Q4 of ’02 through the spring of ’03, the lowest reading on the VIX was 23.16 and it average close was in the neighborhood of 30. The end of bear markets are defined by risk aversion, not risk taking. If market participants were risk adverse, the VIX would be much higher. Part IIIb: Inflation or Deflation Last year, analysts debated between the possibility of Goldilocks vs. Stagflation. Currently the debate has turned between Deflation vs. Inflation. In past updates, I’ve focused on the Inflation outcome while giving lip service to the possibility of deflation as a result of a complete seizing up of the credit markets. First, we need to understand that both deflation and inflation can happen at the same time. In the 30’s, we had widespread deflation and in the 70’s we had widespread inflation, but it is entirely possible to have some assets go up in price while others go down. This has been the case in the past 12 months as oil, food, gold and bonds have gone up in price while real estate, base metals and equities have fallen in price. In a recent interview, Marc Faber said, “You always have a combination of some prices going up and some prices going down.” Given the monumental fall in commodity prices in the past two months, I think it is time to carefully examine the situation and decipher the odds of each outcome. First, let’s examine the causes of each. Inflation is simply an increase in the supply of money in excess to the increase in the supply of goods available for consumption. When there is more money than goods the price of goods goes up. While the government and most analysts measure inflation through changes in consumer prices, technically, it starts with the excessive creation of money. Deflation is exactly the opposite. The money supply is restricted resulting in fewer dollars chasing more goods. There are more goods than money so the price of goods falls. The danger with deflation is that once prices begin to fall, they tend to continue to spiral down because people will just wait another day and be able to buy stuff cheaper. The supply of money comes from two sources – the government and banks. It is supposedly the job of our US Treasury and Federal Reserve to balance the excesses or shortfalls in the issuing of credit/money by private banks. We are now discovering that these two organizations did a pitiful job of balancing banking excesses over the past decade which led to an explosion in the money supply and inflation. Now the banks are seizing up and are not effectively creating new credit therefore the money supply is being constricted. In a Bloomberg interview on 8/19/08, titled The Market’s Closed, Thomas Richlovsky, National City’s treasurer said, ``I've been at National City for 30 years and a month and for 29 of those we've seen nothing like it. In past cycles certainly lending, or credit, has gotten more difficult. The cost of credit would go up. In this particular phenomenon of the last year it's not like you can borrow money and the price went up. No, the market's closed.'' (emphasis mine) These events, like all events are cyclical. Without proper regulation, banks will eventually get out of control and when they try to regain control, it requires restricting credit which naturally results in deflation. There are two reasons why the US didn’t suffer a major banking crisis for over seven decades. The first reason was that in the mid 30’s, the Glass-Steagall acts were passed which severely limited the activities of banks preventing them from getting too out of control. These acts were repealed in 1998 by another act sponsored by Ex-Senator Phil Gramm. (It’s ironic that Senator Gramm is griping about a nation of whiners when it was his act that did in the banks to cause a lot of the current mess.) Secondly, the Fed was given enormous powers to support the banks when the Gold Standard was nixed in ’71 coupled with the fact that the US maintained the world’s reserve currency. These two factors combined to give the Fed seemingly unlimited powers to support our banking system. Given the events in the banking sector coupled with the severe correction in commodities, a lot of very intelligent analysis that I follow are making the case for deflation. Most point to the example of Japan throughout the 1990’s. There is no doubt that there are very scary parallels between how our government is currently handling the banking system and the way Japan did in the 90’s. While I am not prepared to make an absolute prediction one way or the other, I believe the odds lie on the side of inflation for the following reasons. 1. Creditor Nation vs. Debtor Nation: It is valid to compare the actions of Japan’s government in the 90’s with the US’s today but there one significant difference that should be addressed. Japan has been and continues to be a creditor nation making more stuff than they consume where as the US is the largest debtor nation in history of the earth. Japan was buying debt, we are selling it. When you consider the monstrous deficits and future obligations of our country, I stand by the notion that our government has no choice but to inflate the money supply which will result in an effective discounting of our current obligations. If the banks won’t create money, then the government will find a way to do it. Mr. Gerald O’Driscoll, a senior fellow at the Cato Institute and an economic advisor to the Federal Reserve Bank in Dallas, writes the following in an article titled Washington is Quietly Repudiating its Debts

.

…Congress, with the complicity of the White House and the Fed, has arguably embarked on a stealth repudiation…the bond markets are certainly not protecting creditors from the risk of what [Adam] Smith called “pretended payment” through inflation.

Mr. O’Driscoll is referring to our nation’s ability and willingness to inflate its way out of deficits. It is necessary for our federal government to inflate our money supply because it will be the least painful way to correct our country’s massive imbalances. 2. Ben Bernanke – Deflation fighter Our Fed chairman earned the nickname “Helicopter” Ben for a speech where he claimed that we could defeat any sort of deflationary threat by figuratively dropping money from a Helicopter to increase spending. Bernanke did his Ph. D. dissertation on The Great Depression and how it could have been prevented through various means of stimulus. Bernanke and friends have showed their true stripes ever since the credit crisis began by dropping rates to well below the level of inflation, bailing out Bear Sterns and providing an implicit guarantee that they will prop up whatever bank is in jeopardy of failing. The US treasury has actually gained approval to use tax payers’ money to sure up FNM and FRE. The only Fed chairman with any inflation-fighting credibility, Paul Volcker, has suggested that the current Fed is taking steps that are possibly illegal. The next in line at the Fed bailout window is the FDIC. Also in line are the PBGC, FHA and the Big Three Auto manufactures from Detriot. The Fed and Treasury have provided an implicit guarantee that they will do everything in their power to keep credit markets afloat and bailout all those in need of it. All of these actions have inflationary consequences. 3. The Next President: I know I’m breaking Rule #1 here, but I have to comment on how either of the next two presidents will impact the inflation picture. One has promised to keep us at War and Wars are always inflationary. WWII pulled us out of the only fit of deflation our country has ever known. The fallout from WWI led to hyperinflation in Germany. The other candidate has promised entitlement programs to every living, breathing American whose net worth doesn’t qualify him for the Forbes 400 list. Both of these candidates are promoting inflationary agendas and unfortunately, I think they’ll succeed – at creating inflation anyhow. The stimulus package passed in March is a fine example of inflationary policies at work and why I think deflation is unlikely. The US government just handed every American $600+ out of thin air. This is just one of many pieces of government spending that is leading to the largest annual deficit in our country’s history. The budget deficit alone next year is expected to top $500B – and this estimate is from an administration that thought the War in Iraq would only cost $200B. All the government stimulus programs, entitlement promises, bank bailouts and trade deficits lead to inflation. They always have and they always will. Deflation is certainly an option given the mess that banks are currently in, but given the lack of a gold standard and the current mentality in Washington, inflation seems to be the much more likely outcome. (There is one caveat: If the market for US Treasuries dries up, then the odds of deflation grow exponentially. Currently, the market for US treasuries is still strong, much to my own surprise. Before the market dries up, interest rates will go much higher. I’ll be looking to see if this is happening and will attempt to adjust your exposure accordingly.) Part IV: Conclusion Over the past 18 months, a lot of convenient myths have come and gone while the inconvenient truth regarding the state of our economy, the credit markets and inflation refuses to back down. Here are just a few of the bigger myths used to tickle the ears of investment community… …home prices will never fall …the earnings and balance sheets for the banks are legitimate …the subprime crisis will be contained …the market is cheap in light of forward earnings …REIT yields are safe and secure …foreign equity markets would decouple from the US. Currently, the Wall Street sales machine are spinning more myths that will be proven false as well, such as… …the bottom in housing is in …the worst for the financials is behind us and the stocks bottomed in July …relative to bonds, equities are cheap …slowing economic demand will result in lower commodity prices resulting in lower inflation. The current rally may continue for a bit, providing credibility to these myths, but they will be busted like all the ones before them. The Bear Market has a ways to go as things will get worst before they get better. It is not possible to unwind simultaneous bubbles in real estate and credit market without some fallout. There is no way the government can bail out all the banks, GSE’s and government organizations while keeping interest rates suppressed, the US$ strong and inflation under control. Something has to give and in my opinion, I believe it will the US$ and inflation. When the bear market continues, my strategy should provide similar returns as we experienced earlier in the year. In the interim, I’ve backed off a lot of my more aggressive positions which I’ll look to rebuild when the technical outlook is in our favor. I should be able to generate some significant gains by year end for you. As always, please do not hesitate to call or e-mail with any questions or concerns you have about your account. All the best, Matt