By proceeding, I acknowledge that I have read and understood the Disclaimer, Performance Reporting Disclosure and Copyright Statements .

PART I: INTRODUCTION

If the bear market has begun, expect gut-wrenching volatility from the market over the next few months. Two percent intraday corrections for the market will become commonplace.
- April Market Outlook -

When I suggested we would see “gut-wrenching volatility”, I didn’t even expect this. I expected 1-2% daily movements, not 2-3%. Market tops and bottoms are characterized by extreme volatility as the “C” words, contagion at the top and capitulation at the bottom, take hold of the market whipsawing it up and down. Market participants become very emotional changing their outlooks minute by minute.

Over the past quarter, most mutual fund investors were lucky to do better than break even while many hedge fund investors “took it on the chin”. Our portfolios did very well this quarter suggesting that if the market turmoil continues, I should be able to generate profits in your account. With that being said, I would not be surprised to see a short-term pullback in some of our positions as they have done very well and are probably overbought. But after recoiling, they could renew their advancement and I wouldn’t be surprised to see further strength, especially in our commodity positions.

Here is how my performance measured up to the averages for the first quarter of 2007:

PORTFOLIO	Q3 RETURN	YTD RETURN
Core Portfolio	8.0%	4.5%
Focus Portfolio	7.9%	(0.4%)
S&P 500 (VFINX)	1.6%	9.1%
NASDAQ 100 (QQQQ)	8.06%	19.4%
Benchmark	3.1%	7.7%

PART II: CURRENT MARKET CONDITIONS

What is truly intriguing is the internals of the market…The last three months have not been kind to equity investors as the typical stock declined over 3.9%. Normally a declining market favors value stocks which are trading at cheaper valuation levels. This has not been the case in this decline. In fact the best “value” stocks dipped almost 11.8%. Meanwhile, the best growth stocks completed the investment surprise by advancing 4.1%.
Barry James, James Investment Research – 9/30/07

The substantial increase in market volatility is a sign that the bull market is either over or close to it. In this section, I’ll explain how the “market internals” are providing a mixed picture and what it means to your portfolio. The question I’d really like to answer is, “has the bear market started or not?” Unfortunately, my answer is that while I’m inclined to say that it has, I have no real assurances from technical gauges.

Leadership: Investech’s “Leadership Indicator” fell from neutral to fully bearish in 9 days. There have only been two instances when leadership fell so precipitously – 1973 and 1987. This suggests that if we are the doorstep of a bear market, it will be one of the swiftest in our market’s history – which reinforces my macro outlook of the market. However, Leadership has improved slightly over the past few weeks and come off its worst levels. It is still bearish but has improved.

Market Breadth: While market breadth has definitely deteriorated over the past couple of months, it is still not in bear market territory and has even notched up a couple of points in the last week of the quarter. In past updates, I’ve stated that I am not confident in breadth’s ability to identify the market top for a host of reasons. They are:

• Market Breadth measures weakness at the margin and the margin is in real estate and credit/bonds which only account for a small percentage of the equity market’s capitalization. In other words, weakness in these sectors will only have a small direct impact on the technical strength of the market even though they will have a strong impact on the economy. Weakness in the tech sector in 2000 had a sizable impact on equity markets and breadth.
• The proliferation of indexing, both actual and closet indexing, has led to all asset classes becoming overly correlated making breadth mute. For example, REITs have historically had around a 50% correlation to equities but in 2005 and 2006, that correlation reached 90%. Furthermore, there was only two indexes to invest in during the 90’s, which were the Large Cap S&P 500 and the NASDAQ 100, but now index investors can buy funds and ETFs that invest in every sector and market cap.
• The increasing popularity of “quant funds” counterbalances any weakness in breadth as their computer algorithms automatically place “buys” on any equities that underperform the market.
• Globalization has lead to all equity markets becoming correlated and their may be weakness in breadth in foreign markets that is not being measured by the analysts I follow.

The problem with my theory is that weakness in market breadth is a self-fulfilling prophecy. Lots of people watch breadth and as it weakens they start liquidating their positions which in turn leads to more selling and further weakness in breadth. While many of the analysts that I track have reduced their equity exposure, they haven’t sold everything.

Sector Leadership: Two sectors always lead the market up or down. One of the sectors is always the same while the other sector varies from inflection point to inflection point. The sector that consistently leads the market is Small Caps. So while Wall Street focuses on the Dow and the S&P, successful money managers watch the Russell 2000. In Q3, the Dow and S&P were up 4% and 2%, respectively, but the Russell 2000 was down 2%. Small Caps led the market down in 2000 and led the market up in 2002/2003.

The other sector that will lead the market is whatever sector that will see the biggest move during the next market cycle. Tech stocks led the market down in 2000 and were by far the biggest loser in the bear market that started in 2000. Financials and REITs will be the biggest loser in the next bear market and therefore will lead the market down this time around. While the broad indexes are up for the year, both Financials and REITs are down over 5%, underperforming the market by a double digit margin.

I have been watching the behavior of REITs, Financials and Small Caps relative to the rest of the market. Each of these has significantly unperformed the market – until the last week of the quarter. If these sectors continue to underperform, the probability that we are in a bear market is high but if these sectors outperform the market, as they have the past week, the market may rally to new highs.

Conclusion: Market internals are mixed and providing ambiguous signals. One of the reasons I waited to send out this update is that I wanted to see how the market behaved this week as we are at a critical juncture. I wasn’t certain the action in the last week of the quarter was a reversal of trend or an attempt at “window-dressing” by hedge funds and private equity. If the broad market (not the Dow, but the Wilshire 5000) breaches its previous high, we could see a significant rally. If not, and Small Caps and Financials continue to flounder, we could see a steep sell-off. I’m not sure which way the market is headed but I do think that which ever way it goes, the movement will be steep.

PART III: MARKET OUTLOOK – STAGFLATION IS HERE!

Currently, Wall Street is divided into two camps: Those who feel the Fed should fight recession, and those who feel it should fight inflation…As usual on Wall Street, both camps have it wrong. Both camps incorrectly assume that inflation (rising prices) and recession are somehow mutually exclusive. By concentrating on the demand side of the price equation, Wall Street ignores the impact of supply…Similar to the 1970s, we are experiencing what economists call “stagflation,” a period when economic growth contraction occurs simultaneously with high inflation.”
Stagflation Revisited by Peter Schiff, Euro Pacific Capital – 9/28/2007

Sound familiar? Market cycles are interesting. It was over a year ago when I first read Ed Easterling’s book Unexpected Returns. After studying secular market cycles, I noticed that the second correction of a secular bear market had historically been inflationary. After following the analysis of Jim Rogers, it further reinforced the idea that we are in a commodity bull market cycle that would eventually lead to higher consumer prices.

But it wasn’t until the Fed pulled their 50 bps cut of the Fed Funds and Overnight Target rate on September 18th that I became absolutely convinced that the inevitable outcome for our economy was Stagflation. Wall Street is still struggling with this conclusion as they have for some time, pointing to softening government inflation figures and hit-and-miss strength in consumer spending. It won’t be long before the data is too obvious to ignore.

I’d like to provide a quick primer on what drives inflation. This comes from Doug Casey, editor of the well-known International Speculator:

The word “inflation” covers two different concepts, and it’s important to keep them separate. One concept is monetary inflation, which is an increase in the supply of money that outruns growth in the supply of goods and services. Papering over problems with yet more money is now the default solution for governments around the world. Case in point, when faced with the growing problems associated with the subprime mortgage sector, the European Central Bank announced that it would make “unlimited” funds available to the banking sector. The Fed will, predictably, react in the same way, running the printing presses overtime.

The other concept is price inflation, which is an increase in the overall level of prices for goods and services.

The relationship between the two is the relationship of cause and effect. Monetary inflation causes price inflation. But while almost everyone sees price inflation when it happens, few people notice the monetary inflation that is causing it. And so they tend to blame the producers of goods and services for higher prices — rather than the money-creating government that is the true culprit.

We’re now experiencing a lot of monetary inflation, which eventually will be reflected in price inflation. What’s really going to tip this over the edge, however, is the rest of the world deciding to get out of dollars. A lot of those $6 trillion abroad are going to come back to the U.S., and real goods are going to be packed up and shipped abroad. Inflation will explode.

I have included my Stagflation Alert as a separate post on this site which you can visit by simply clicking anywhere along this sentence. In the remainder of this section, I’m going to focus on the inflation side of the equation as I’ve covered the issues with the economy in past updates. Furthermore, the recessionary pressures are getting all the headlines in our nation’s media, so I think it is prudent to cover “the rest of the story”. In this section, I’ll cover the four primary reasons why inflation will continue regardless of economic activity:

1. The Federal Reserve
2. The US$
3. Commodity Inflation
4. Inflation Data

The Federal Reserve: I will begin with the Federal Reserve because that is where inflationary forces began. The US Federal Reserve along with Central Bankers worldwide has provided an irresponsible amount of stimulus in the form of low borrowing rates and increasing the supply of money.

Fortunately for our portfolios, but unfortunately for millions of American retirees and investors, the Fed is playing precisely into my macro market and economic outlook. It is clear that we are headed directly towards Stagflation. It is no longer probable, now it is inevitable.

By their actions on September 18th, the Fed proved three things:

1. They don’t care about the US$. On three separate occasions in the past month, the Fed had the opportunity to strengthen the US$ and they took deliberate action which led to depreciation in the US$. I don’t think they are conscientiously devaluing the US$, it’s just that strengthening the US$ is at the bottom of their priority list.
2. They care more about Wall Street than Main Street. By constantly inflating the economy, the fed is eroding the purchasing power of retiree’s savings. Meanwhile, nominal gains on investment products have generated loads of fees for investment banking firms. (It also creates additional tax revenue as inflated investments lead to capital gains that are taxed when realized.)
3. They have a very short memory . As late as their August meeting, they were hawkish on inflation and adamant about not bailing out irresponsible lenders and investors. In September, they clearly acted to bailout the banks and Wall Street at the cost of the US$ and inflation.

Since Bernanke took over as Fed chief in the spring of ‘06, money supply has grown at a 14% annualized rate. This is the fastest rate in 35-years. John Mauldin raises the question, “Given that the Fed has two mandates, stable prices and full employment, is the Fed abandoning its inflation mandate?” Considering their actions this past month, I can say that the answer is unequivocally “yes”. They stood strong on inflation when it was easy because the economy was strong but when they had to choose between the economy and inflation, they sided with saving the economy. Unfortunately, they may fail on both counts.

The US$: The precipitous fall in the US$ has been monumental. A falling currency is inflationary. Not only do goods purchased from foreigners become more expensive buy our goods become cheaper to foreigners which increase the demand for our goods driving up the price in our currency. The US$ has fallen 7.5% already this year. Therefore, on average, everything we buy from countries with floating currencies (Canada, Japan, Europe, Australia, ect) is 7.5% more expensive than it was on January 1st. And conversely, everything they buy from us is 7.5% cheaper.
Three developments in the US$ have taken place over the last several months that will negatively impact our economy and increase inflationary pressures:

• Owners of our debt are requiring higher rates to offset inflation and the devaluing of the US currency. If you are a foreign bank holding a 10-year US treasury with an effective yield of 4.5%, you have lost over 3% on your investment this year alone. When the Fed lowered rates in September, the yield on the 10-year treasury jumped 20 bps. The last three times the Fed started to ease, the yield dropped 20 bps. Higher long-term rates will harm the economy by making long-term borrowing (i.e. mortgages and corporate debt) more expensive.
• US Trading partners are rapidly diversifying their central bank holdings away from US$’s and into Gold, Euros and other currencies. The Fed’s action in September accelerated this activity.
• Countries that have pegged their currency to the US$ are moving away from the peg to either a floating currency or a peg to a basket of currencies. China moved to a basket of currencies last year. Be ready for China to move to a floating currency, adjust their currency up dramatically (which our government has been pleading with them to do) or move to a peg to the Euro/Yen (They will likely just opt to increase the weighting of the Euro and Yen in their current basket). When this happens, we’ll see a considerable rise in inflation as the price of goods from China spike.

Commodity Inflation: The CRB Commodity index jumped 8.2% in September, with most of the increase coming after Sept. 18th. This is the biggest one month jump in commodity prices since July of 1975! Here’s a rundown of the key commodity indexes for the month, quarter, YTD and YOY (Year over Year).

Commodity Index	Month	QTR	YTD	YOY
CRB Index	8.2%	9.1%	13.3%	20.9%
Energy Sub-Index	9.7%	8.5%	25.9%	17.7%
Foodstuffs Index	3.1%	3.2%	19.2%	22.8%

I’ve said all year that energy prices are going higher. (click here to read). We are entering a “shoulder season” where we will likely see a pullback in prices, but then they will continue to go up. I base this on inventories and imports – both of which are declining at a significant rate. Over the last year, inventories of Crude, Gasoline and Distillate have been drawn down by 46M barrels. Since the beginning of July, there has been a draw of 31M barrels, more than twice the average during this same period over the last 6 years.

Energy imports have declined 3% YOY. It doesn’t sound like much, but it is the first decline in 4 years and only the second YOY decline in 12 years. During the last decade, the average annual increase in energy imports has been in the range of 5-6%. A weak currency, a strengthening global economy and declining production have all played a significant role in these trends.

The scariest part of this trend is that there haven’t been any acute events, either weather or geo-political in nature, that have contributed to declining inventories (Despite my warnings of a heavy hurricane season). What if this winter is colder than normal? What if there is an uprising in Africa? And I shutter to think of what might happen to prices if tensions in Iran become escalated.

The outlook for agriculture/food inflation isn’t much brighter – unless you’re betting on prices to go up as we are. I’ll address the prospect for agricultural commodities in the next section.

Inflation Data: Before examining the inflation data, we need to consider the “flow” of inflationary pressures. First, there is excessive money creation. Then, money creation stimulates the economy creating additional demand for goods. As the production of goods increases, the prices for inputs to go up. The most common way to measure input price inflation is to look at the commodity indexes. The final step is when producers have their margins squeezed and they have to raise the price of finished goods. The CPI (Consumer Price Index) is used to measure inflation in finished goods.

Wall Street has perpetually pointed to relatively tame CPI figures (and CPE figures which is just another way for government to measure the government inflation data) that shows inflation pressures as being contained. Here’s a run down of commodity and government reported CPI numbers:

Timeframe	CRB Index	CPI	Core CPI
Since 12/31/2001	134.8%	17.7%	12.4%
YOY	20.9%	2.0%	2.1%
YTD	13.3%	3.0%	1.9%

There are two significant takeaways from these figures.

1. The incredible disparity between commodity inflation and finished goods inflation.
2. The increasing pressure in the pipeline on CPI.

Personally, I believe that the means by which the BLS “adjusts” the CPI figures results in these figures being consistently understated. The gross disparity between input or commodity inflation and output or finished goods inflation certainly gives credence to my theory. Mike Hewitt wrote a brief yet effective synopsis outlining the six ways that the BLS “adjusts” the CPI. Click here to read and feel free to make your own judgment.

But back to the second issue. As you can see, YTD inflation numbers are higher across the board than YOY numbers. You may recall energy prices declining precipitously about this time last year – conveniently right before the elections. This decline in energy prices resulted in a softening of all inflation gauges in September through November of ‘06. Therefore, as soft inflation data from this period last year is removed from the YOY figures in the coming months, there will be an inevitable increase in all inflation gauges barring a significant reversal of the current pricing trend.

As of August, the YTD change in the CPI is 3%, which is a 4.5% Annualized Rate. Therefore, if CPI is flat which is highly unlikely given the considerable move in commodities this year, the CPI for the year will be 3% at a minimum, considerably higher than the Fed’s “comfortable level” between 1-2%. In all likelihood, YOY CPI could approach 4% or higher as there is bound to be monthly increases associated with higher commodity prices coupled with the elimination of negative monthly data from Q4 ’06.

Part III: Conclusion: Just as happened in the 1970’s and early 1900’s, inflation will persist regardless of what happens in the economy because inflation is a monetary phenomenon. Whenever the increase in money happens faster than the increase in goods, you’ll have inflation on some level. While lots of assets will depreciate (i.e. houses, real estate, bonds and equities), the stuff we buy every day will continue to get more expensive.

PART IV: FORWARD STRATEGY

As you know, my strategy is designed to profit from an economy in Stagflation. During the past quarter, we got a little taste of how my strategy will profit during the months ahead. Wall Street has been slow to except the reality of Stagflation but in the coming months, the case for it will become so compelling, it will be impossible to ignore.

Historically, the most effective means of taking advantage of Stagflation has been an investment in non-cyclical commodities. Therefore, I’ve chosen to focus on both positions tied to precious metals (gold and silver) and agricultural goods. While I’m still bullish on energy, I believe the recent climb in crude is a bit overdone. I think there are safer ways to play this trend.

I feel like I’ve beat the Precious Metal issue to death and hopefully you are comfortable with my positions as they make up the majority of your portfolio. The one item worth mentioning is that the positive correlation between equities and precious metals has seemingly ended. This relationship had been a source of frustration for me over the past year and I think it is finally over. As recently as August, the metals moved in virtual lockstep with equities. As equities sold off, precious metal positions were used to meet margin calls and liquidation orders.

Precious metals and companies that mine them were very good performers in September. It is not unreasonable to expect these metals to make a parabolic rise where the metals will move up 50 – 100%. Although you can never say that any investment is completely safe or without risk, I feel much better about our Precious Metal positions today than I did three or four months ago. Even in a Credit crunch, I now think they could hold up and even appreciate. We might see a few decent size pullbacks in this space, but eventually you should be very satisfied with your position.

In a recent newsletter, Doug Casey of International Speculator outlined four reasons why you need to be invested in Gold and Gold mining shares. Three of the four reasons I’ve covered but the fourth is worth sharing:

The public is still out of the gold market. I promise you that every market top I’ve witnessed in my life was accompanied by cocktail party chatter about the asset class in question. I have yet to have any indication the public has a clue that gold and other resources even exist. If this is a market top, it’s unique.

I am very bullish on the agricultural space. The Chinese aren’t going to be satisfied eating rice the rest of their lives. I’ve been to China. I’ve seen the lines at Kentucky Fried Chicken. (I went in 1991 so it was before McDonalds, Starbucks and the others.) The types and quantity of food that will be consumed throughout Southeast Asia will change dramatically over the next several years. It will take time for the farming industry to adapt. This is good news for the US economy. We are very proficient farmers and agricultural goods are one of our biggest exports. More expensive ag products will do a lot to correct our trade deficits.

In addition to commodity plays, I am maintaining our position in foreign bonds. These positions should continue to benefit from a falling US$.

PART V: CONCLUSION

When the market is fluctuating near its highs, it can be easy to forget that markets move in cycles rather than lines over time. It’s similarly easy to forget how effective corrections and bear markets are in eliminating most or all of late-stage bull market gains.
John Hussman, Ph. D. – 6/18/2007

I’m not being lazy by copying the featured quote from my July Outlook, but I felt compelled to reinforce the importance of understanding the nature of market cycles. I’m not looking forward to a stock market correction, an economic slowdown or ramped up inflation, but these events are all part of the economic and stock market cycles. And when these events happen simultaneously, the market has historically experienced a quick and significant sell-off.

If the bear market started in July and the stock market doesn’t reach new highs, I can say with a very strong level of certainly, the ensuing bear market will be one of the fastest on record. It will be up there with 1907, 1937 and 1987. I don’t think equity losses will be as severe as ’07 or ’37 but we could see a substantial retracement. An above average bear market would result in 30+% losses in equities.

During these market events, commodities, especially non-cyclical commodities, can experience parabolic price increases. So, while the events that are unfolding will be inconvenient for many and possibly devastating for a few, the next market cycle does provide an incredible profit opportunity if it is played right. It was during the last period of stagflation that Jim Rogers and George Sores generated a 4,000% return in 10 years. I don’t expect returns anywhere near that magnitude as their Quantum fund was highly leveraged and they are two of the legends in the investing business, but I am confident that we will see appreciable gains that will provide you a much more secure retirement.

I’m not sure if the Market has one last rally or not, but the Fed cut in September increased the probability by a significant margin that our economy will wind up in Stagflation. There will be some bumps along the way, some of which we’ve already endured. But in the long run, we will do very well.

As always, do not hesitate to call me if you have any questions or concerns regarding your account.

All the best,

Matt McCracken

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