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

Part I: Introduction
Historically, a significant increase in market volatility accompanies a market inflection point. Using history as our guide, it certainly feels like we are at inflection point. While we are entering a seasonally strong period for equities, the winter months do not guarantee positive gains. In fact, the two bear markets that I’ve consistently compared the next bear market to, 1937 and 1973, both started during this seasonally strong period for equities. The ‘37 Bear started in early March while the ’73 Bear started in January.

In the Market Outlook portion of this update, I’m going to briefly cover two very disturbing developments in the capital markets that merit our full attention. But first, I need to get the administrative part of my update out of the way, so here is my account performance on a YTD basis.

Part II: Account Performance

Here is how my performance measured up to the averages on a YTD basis through November:

PORTFOLIO	YTD RETURN
The MAC’s Core Portfolio	5.8%
The MAC’s Focus Portfolio	2.2%
S&P 500 (VFINX)	6.1%
NASDAQ 100 (QQQQ)	19.2%
Benchmark	8.95%

While all the major market indices lost over 4% in November, my core strategy only lost 1.4%. Our losses primarily stemmed from a rather significant pullback in the precious metals and PM mining stocks. Otherwise, the rest of the portfolio was flat to up.

I’m encouraged by the overall trend in my strategy the last several months. While the market has been in a sideways to down trend since July, my core portfolio is up 9.4% since 6/30/07. Besides a set-back in August and in November, your accounts have done exceptionally well in the second half of this year given all the market volatility and turmoil. The most encouraging development is how my Focus Portfolio has outperformed my Core Portfolio. This relationship suggests that the recent gains in your account can be attributed to a solid fundamental strategy rather than simply because one or two positions have done really well.

Part III: Market Outlook

As I stated early, there have been two disturbing trends in the market which are worth paying close attention to, which are:

• The extreme disconnect between bond yields and gold prices over the last six months.
• The lack of responsiveness on the part of equities to the aggressive behavior of our Federal Reserve.

Treasury Bond and Gold Prices:
Treasury Bond prices and Gold prices have historically held a strong negative correlation as they are fundamentally opposed to one another. Rising bond prices/falling bond yields are a result of a deflationary economy where as rising gold prices are a result of inflation.

However, since July, Gold and Treasury Bond prices have made remarkable runs simultaneously. Since the beginning of July, the price of the Gold ETF, GLD, is up 18.8% while yield on the 10-year treasury has fallen nearly 20%. By my rough calculations, 10 year treasuries have appreciated nearly 25% since 6/30.

Historical precedence suggests that they these two trends cannot co-exist for any length of time – eventually Gold and Treasury Bonds will need to move in opposite directions. So which market has it wrong? Is inflation going to persist as the world’s central banks continue to flood the capital markets with liquidity or is the credit crunch going to stall out the economy causing prices to come down? My clients know that I’m on the side of inflation and therefore I’m betting that the Gold market is right. I believe our government has no choice but to inflate the economy. (See my
Market Outlook for further discussion.)

Before we look at the data, let’s keep in mind that it was just a few months ago that the mantra on Wall Street was “Goldilocks” as they portended that neither inflation nor deflation would grip the market. Today, the possibility of a Goldilocks scenario is laughable and the market is holding out hope that neither inflation in consumer goods will be all that high nor will a collapse in the credit markets cause widespread deflation. The equity markets are still holding out for the best case scenario – its just that the current best case scenario isn’t nearly as good as it was six months ago.

From this disconnect we can draw three conclusions:

1. There is a significant flight to quality.
2. There are massive amounts of liquidity being injected into the marketplace pushing treasury bond and gold prices up while trying to sure up the equity and credit markets.
3. The market is undecided about whether inflation will persist or if an economic slowdown/recession will cause system wide deflation.

Let’s take a look at the data for some clarification. Since April of this year, I have been keeping a
Stagflation Watch on my Market Research page. My Stagflation Watch is tracking data on a YTD basis but I’d like to look at the data since the bond and gold price disconnect started in July.

In attempt to not sound overly bearish, I’ve spent a lot of time trying to find some piece of positive economic news from the last several months – unfortunately, I failed. Since the market peeked in July (on a US$ weighted index basis), it is striking the number of economic data reports that have come in “below the economists/analyst’s expectations”. Furthermore, inflation pressures throughout the entire pipeline have increased substantially.

The following is a run-down of leading economic and inflation indicators since the end of June when the equity markets were peaking.

Economic Data:
• Since June, the ISM Manufacturing index is down from 56 to 50.9 – 5.1 points. Any reading below 50 means that manufacturing is contracting.
• Construction Spending is down 1%.
• Durable Goods Orders (big ticket items like planes and tractors) is down over a whopping 7%.
• New and Existing Home sales are down 16% and 13.5%, respectively – in 4 months!

The sole bright spot for the economy has been the consumer whose spending is up 1.5% since June. However, the consumer is starting to show signs of weakness as the increase in spending over the last two months has come in at a paltry 0.2%. Furthermore, consumer optimism from the last several years has been replaced by general pessimism as consumer confidence and sentiment are down 16.6 and 14 points, respectively, since June – the largest 5 month drop since 2000 Bear Market.

INFLATION DATA	Change since 6/30
CRB Index	10.0%
CRB Energy Sub-Index	13.6%
CRB Foodstuffs Index	4.2%

Since the market peeked in July, their has not been any material good news on the economic or inflation front. Stagflation is becoming increasingly more evident. Given the fundamental deterioration in our economy, the monumental decline in the US$ and the precipitous increase in commodity prices, I’m astounded that equity prices are still at their current levels.

The only thing keeping stocks up is the “Greenspan/Bernanke Put” which according to Wikipedia is the “perceived attempt of [Fed]-chairman Alan Greenspan/Ben Bernanke, of ensuring liquidity in capital markets by lowering interest rates if necessary.” While Wall Street has put its full faith in the Federal Reserve, the “Greenspan/Bernanke Put” has caused our currency to be significantly devalued (50% vs. the Euro since 2002 and over 10% this year alone) which is inflationary. Unfortunately for equity markets, the assurances provided by the “Greenspan/Bernanke Put” are in jeopardy. In next section, I’ll provide anecdotal evidence that the Federal Reserve may be incapable of bailing out the equity markets…

The lack of responsiveness of equity markets to the Fed:
Now for the frightening news! Prior to November, only twice had equity markets fallen more than 10% in the six months after the third rate cut. After the Fed’s third cut on 10/31, the S&P 500 fell just over 10% in less than four weeks. The other two times this occurred were in 1930 & 2001 – in the heat of the two worst bear markets in our country’s history. (Source: Investech Research)

So why is this significant? Why can’t we just chalk this little bit of market trivia up to some kind of anomaly? Because this development signifies that the Fed has “lost control”. The most appropriate analogy I can think of is that the Fed is “driving on an ice” and they have just begun to spin. It will take an amazing feat to regain control of the economy and avoid a recession..

If the Fed has lost control, then the assurance that Wall Street has been “banking” on will be rendered worthless. If the Fed has lost control, all bets are off. It will be crucial to see how the market reacts after the Fed’s next meeting on December 11th.

Part IV: Forward Strategy
If the bond market is right and we have a deflationary event, two things will take place. First the Fed will continue to lower rates which will further erode the value of the US$. Second, there will be a more sincere flight to safety of which, Gold is the ultimate safe-haven. Both a weaker US$ and a flight to safety will benefit the PMs and our foreign treasury debt exposure. Treasuries have served as the world’s primary flight to safety, but with yields below 4%, they will turn to alternatives – and Gold is the most viable alternative.

The rest of your portfolio is positioned in predominantly non-cyclical assets that should hold up well during an economic slow-down. If the bond market is right, I’d expect that my strategy will at least break even while I protect you from losses in equity markets. At some point, we’ll buy up equities at much cheaper prices than today’s current levels.

If the Gold market is right (i.e. than I would be right as well) and inflation persists, then the PMs will appreciate substantially. Furthermore, a lot of your portfolio is invested in “inflation drivers” meaning they will certainly profit from any further inflation pressures. (Gold and Silver are technically beneficiaries of inflation but they don’t contribute to inflation directly.) If the Gold market is right, you should experience substantial appreciation in your account.

The final option, and the one that I shudder to think about, is if both Gold and Bonds are right. This could only play out if credit markets seize up entirely choking off the economy and destroying the US$. Earlier in the year, I was afraid that Gold would suffer right along with equities in this type of environment but that fear has been largely alleviated given the behavior of Gold and the US$ over the past couple of months. I want to be clear that I do not think this scenario is probable – only possible and therefore worth keeping an eye on. I’m bearish, but not ultra-bearish.

As always, please do hesitate to call or e-mail me if you have any questions or concerns regarding your account.

All the best,

Matt

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