Portfolio Update - 11/30/08

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

November was another tragic month for the capital markets. The most significant event of the month was the S&P 500 breaking below its previous lows set in 2002. This virtually guarantees that the equity markets are embedded in a secular bear market which will likely last another decade. I’ll delve into this subject deeper in Part III. Another tragic element of this past month has been the behavior of asset classes that have been sold to investors as safehaven’s. REITs, Investment Grade bonds and Muni’s have all taken significant hits over the past several months and continued their losses in Nov. IYR which tracks the Dow Jones REIT index is down 48% YTD while bond funds such as American Funds Bond Fund of America and Fidelity’s Intermediate Bond Fund are both down double digits YTD.

PART II: ACCOUNT PERFORMANCE

Here is how my performance measured up to the averages as of November 30th of 2008:

PORTFOLIO	2007	2008 YTD
MAC’s Core Portfolio	12.5%	(12.3%)
MAC’s Focus Portfolio	11.0%	(9.9%)
S&P 500 (VFINX)	5.4%	(37.7%)
NASDAQ 100 (QQQQ)	19.0%	(43.0%)
Benchmark	8.5%	(22.9%)

Despite continuing losses in practically all sectors, I was able to “stop the bleeding” this past month by generating double digit gains in your accounts. The turnaround can be largely pinned on a couple of factors. Most notably, I changed my approach to using inverse funds to hedge continuing deleveraging in the market. Rather than buying and holding them throughout the bear market cycle, I simply moved in and out of them generating some nice and quick short-term gains. Of the four inverse funds I used in November, I liquidated them at prices significantly higher than where they closed out the month and generated substantial gains on three of the four. Had I held on them, I would have lost money on three of the four.

I also benefited from the application of several new sources of research that I have identified over the past several months. MLI has been especially beneficial in gauging short term market movements allowing me to adjust my long/short bias. Only time will tell if the adjustments I have made over the past few months will continue to be profitable. I am hopeful that the hard lessons learned over the past quarter will pay dividends going forward. Although, I am still deeply disappointed in my performance over the past five months, I am confident that I will be more effective at protecting your account in the future. On a positive note, your account is essentially flat over the past two years – a feat that few can claim. Over that period, your accounts have faired substantially better than a portfolio of equities and even a balanced portfolio. Since 12/31/06, Scott Burns Couch Potato Portfolio is down over 17%.

PART III: MARKET OUTLOOK

All equity and commodity markets have been defined by force liquidation as a result of massive leverage applied to every corner of the capital markets. In four months, the market essentially wiped out 10+ years of leverage. The behavior of the currencies and the high correlation between historically non-correlated asset classes clearly makes the case that market behavior is primarily a result of deleveraging. The market pundits keep proclaiming that this is a “once in a hundred year” event that no one could have predicted. However, lots of folks did predict it because it is not a once in a hundred year event, it is a once in a generation event. Every 30 -40 years, the market suffers from a massive deleveraging. It happened in 1907, 1929, 1974 and now in 2007. I addressed this issue in detail in my Market Outlookposted in July of ’07 (if you click on the link, you’ll need to bit the “back” button on your browser to be returned to this post). In each of these deleveraging events, the market fell nearly 50% or greater in a relative short period of time. Long-term Outlook for Equities As I mentioned in the introduction, the piercing of Oct ‘02’s lows by the S&P 500 virtually assures that the equity markets are in a long-term secular bear market. Several events have historically taken place in secular bear markets which are worth pointing out. Market Valuation P/E ratios for equities hit single digits in each of the last three secular bear markets. In 1980, the P/E ratio for the DJI was 7.3. It hit 7.0 in 1950. (source: Valueline). Crestmont research calculated the P/E ratio for the S&P Index at 5.3 in 1920. My take: I am not sure if the P/E for the DJI or S&P 500 will eventually fall below 10 or not but we should not be surprised to see it fall to low double digits (10 -12). Another noteworthy point is that these extremely low valuation levels appeared towards the end of the Secular Bear Market. Currently, we are in the middle of this secular cycle so we may not necessarily see P/E’s fall to low double digits for many years. Dow/Gold Ratio The Dow/Gold ratio has hit 1:1 in each of the last two secular bear markets. This means that you could buy one unit of the DJI for one oz of Gold. In 1932 and in 1980, this ratio hit 1. Currently, the ratio stands at 10.8. My take: Again, I am not so sure that we will see such an extreme in the Dow/Gold ratio during this secular bear market as we did in the last two. However, we should expect to see this ratio fall substantially over the next decade. I think a 5:1 or lower ratio is likely. A 5:1 ratio would require the DJI being cut in half or the price of Gold doubling. Given the massive monetary creation by our Fed, betting on the price of Gold to double seems like a winning trade. Secular Bear Market duration It’s nearly impossible to decipher the exact length of a secular cycle. I’ve seen various analysts measure long-term cycles in various convincing ways such as in real terms, nominal terms, from when the market hits new highs or from when it finally breaks out of its trading range (which in the 40’s was far below the high of ’29). What most agree on is that a secular bear market will last in excess of 12 years. The S&P 500 did not exceed its 1968 highs in nominal terms until 1980 and didn’t best its ’68 highs on an inflation adjusted basis until 1991. The DJI didn’t pierce its 1929 highs until 1955. Then there is the issue of when the Secular Bear Market started. Did it start in 2000 with the popping of the Tech bubble or did it start last October? I contend that it started in 2000 but there is a legitimate argument that the secular bear didn’t start until last October. Regardless of when the secular bear started and how long it will last, it is safe to assume that equity markets will be mired in sideways to down trading for at least another 7 – 10 years. For this reason there is no hurry to build significant broad based equity exposure at this time or at any time over the next several quarters. The only way to generate significant gains of the next decade or so will be through tactical allocation (market timing) and individual stock and sector picking. Investing in a diversified portfolio which worked well for the past two decades will not work over the next decade. Intermediate Term Outlook for Equities: Despite already falling halfway to zero, it appears that equity markets are still headed lower over the next year. Several indicators suggest that the bear market is not close to being over. There are four specific indicators that I am watching to provide any hint of the bear market resolving itself:

1. Market leadership: Despite massive support from the Fed, Treasury and the SEC, Financials are still leading the market both up and down. Financials should cease leading the market before it finally bottoms. Investors are having a difficult time grasping the concept of why one should own equities. The reason why you own equities is because it is a claim on future positive cash flow or profits. Even though the banks have had their balance sheets nationalized by the Fed and Treasury, these companies will not be allowed to turn a profit until every dime is repaid to the taxpayer. Due to the enormous amounts of capital injected into the banks, it will likely be a decade or more before the industry is able to turn a profit. Since bankers aren’t in the business of not making money, they will likely find a way to unwind current companies and start over with new equity, making existing equity worthless. Once investors realize this, equity shares will plunge no matter how much support the PPT gives them. If you want exposure to this sector, buy the bonds but stay the heck out of the equities. In 2000, the major excesses were in the dot.coms and lots of dot.coms went to zero. So far, LEH has been the only major bank to go to zero – many others will before the bear’s appetite is satisfied. (A lot of REITs will go to zero as well as they were another area of excess from 2000 through 2007.)
2. Directional Velocity: I’ve always believed and many technical indicators are based on the notion that the slower trend is the more dominant trend. If the larger trend is down, then rallies will be fast and sell-offs will be slow. As the bear market bottoms, the speed of a sell-off will exceed the speed of a rally. This notion is supported throughout all previous bear markets. While the forced liquidation event in October certainly increased the velocity to the downside, rallies were still quicker and more violent than the sell-offs. From 10/10 through 11/21, there were three 10% intraday rallies in the S&P 500 but we have yet to have a 10% down day. It is true that markets rally hard at bear market bottoms, but the velocity of the rally should not exceed the velocity of the prior sell-off. Once the market falls faster than it rises, it should indicate internal strength as sellers finally outnumber buyers and we’ll see the market capitulate.
3. Bear Market Waves: Bear markets come into two varieties – two legs and three legs. 1987 and ’98 were of the two legged variety. Two-legged bears appear in secular bull markets. ’29, ’37, ’74 and 2000 were all three legged bears. I believe that the current bear market is of the three legged variety for two reasons. First, we are inbedded in a secular bear market and cyclical bear’s inside of secular bears tend to be three legged events. Second, never has there been a two-legged bear market that fell over 40% and since this one has, historical precedence suggests it will consist of three down legs. There is precedent that the third leg down could truncate leg #2 in which case the market would not hit new lows. While this is a possibility, truncated third waves are rare so I would not bet on it.
4. Contrarian Sentiment – Actions vs. Emotions: Everyone seems pretty worked up about the market yet few have taken action. For equity prices to be cut in half in less than 13 months is a significant, once in a generation event. In addition to equities of every sort getting whacked, bonds and other safehavens, except treasuries, have taken a healthy blow. Despite all the carnage, few individuals are selling. Most folks I talk to are just sticking it out – taking their advisor’s word that you have to “buy and hold”. As I’ve expressed in past updates, bear markets destroy the prevailing paradigm that exists at the beginning of the bear market. The prevailing paradigm in the most recent bull market was Modern Portfolio Theory - of which “Buy and Hold” is a derivative. I theorize that by the time this bear market is over, the term Modern Portfolio Theory will be nothing more than a punchline, just like New Economy was after the 2000 Bear Market. No bear market has ever been completely played out until the little guy throws in the towel. As far as I can tell, the majority of “little guys” are still heavily invested. Maybe it is different this time but betting on the “it’s different this time” rationalization is not a long-term strategy for success. So far, the market pullback has been a forced liquidation of hedge funds and other highly leveraged investment portfolios. Before it is over, individuals will be liquidating their mutual fund shares and their ETF holdings.

Short term outlook for Equity Markets: Despite still having a bearish bias on equities for the next 12 months, I think we are due for a consolidation phase which could be either up or sideways. In a three legged bear market, there are two consolidation phases. The first phase which lasted from March through May was an upwards biased consolidation. I am not sure how this consolidation phase will play out but I am leaning towards a sideways correction. I am basing my assumption that this consolidation will be sideways by comparing this market to previous major bear markets. The second consolidation in ’29, ’37 and ’73 were all sideways corrections. The second consolidation during the 2000 bear market is somewhat ambiguous. This consolidation took place directly after 9/11 so there was a ton of exterior forces at work. Once the market popped from the post 9/11 lows, it traded in a sideways range for a few months before the third down leg began. Either way, if the correction is sideways or up, the market is not presenting us with a good opportunity to hold short positions. I have liquidated all your short equity exposure for the first time since early 2006. The volatility may present us with opportunities to build short positions for small increments of time but I will not be holding short exposure until there is evidence that the third leg of this bear market is being initiated probably sometime early next year. At that time, I’ll attempt to rebuild short exposure and liquidate some long exposure that I have built in the past few weeks. Short Term Outlook for Commodities

The period we are in now is one of forced liquidation. We have only had 8 or 9 periods like this in the last 100 – 150 years…In a period of forced liquidation, everybody has to sell everything with no regard to fundamentals, whenever this has happened before, you find the things where the fundamentals are unimpaired and you buy those because they will lead the market if and when the market comes out…the only thing I know where the fundamentals are unimpaired and have even improved is in commodities…and that is where you put your money. Jim Rogers - http://www.youtube.com/watch?v=4KxWAfr4KWI&feature=related /"> Bloomberg Interview with Mike Schneider, 11 | 25 | 08

I’m still a long-term bull on commodities but I’m having my doubts. The excessive money creation by central banks worldwide should cause inflation simply because the relative value of each unit of currency is sure to fall. However, if this year has taught me anything is that my long-term outlook which has been fairly accurate has little to do with short-term market movements. So, I think is worthwhile to discuss the short-term outlook for commodities to set some expectations for the year-end. I’ll split my commentary into two sections, the first covering the prospects for the Precious Metals (PMs) and the second covering the outlook for Energy and Ag. (We don’t have any exposure to Base Metals so I won’t take the time to cover them.) Precious Metals Short Term Outlook From a technical perspective, the short-term outlook for the PM’s is very strong however the ultra short-term technical indicators do provide for a quick pullback. Both Gold and Silver have built a nice base and are showing intermediate and long-term technical strength so I would be surprised to see them fall to new lows. MLI states that technical indicators for Silver are “suggesting an explosion higher is approaching.” But there is one element regarding the precious metals market that has me very concerned short-term. For quite a while a rumor has been circling that a very large owner of Gold and Silver futures contracts on the COMEX is going to request physical delivery of the metals when the December contract comes due. If people are buying the metals in anticipation of this event, then we could see a significant sell-off if it does not materialize. I have no idea if the rumor is true or not but if I had to take a guess, I would say that it is a fabrication by a group of gold bugs. The truth is that if owners of futures contracts were to demand physical delivery of Gold and Silver, the price could literally shoot to the moon. The reason is that there is far more paper gold and silver than there is physical metal available for delivery. It would be impossible for the shorts (i.e. the sellers of contracts) to deliver the metal as there is relatively no metal to deliver. The paper market is simply too big and now dwarfs the physical market. I think the reinflation efforts by the Fed and Treasury would offset any selling done by disappointed gold bugs if the rumor is proven unfounded. Energy and Ag Short Term Outlook The technical outlook for Energy suggests that prices are bottoming and should begin to rally. With equities markets in rally mode or at least in a sideways trading range, the impact that deleveraging has had on energy commodities and stocks should be muted. All sectors of the capital markets reached deeply oversold levels so bounces should be dramatic – some of which we have already seen in late November. If a low for energy prices is not already in, it should be in soon. The same applies for Ag commodities. These securities have formed a nice base over the past couple of months and seem poised for at least an intermediate-term rally. Ag commodities also commonly referred to as Foodstuffs are the ultimate counter cyclical play. No matter what happens to the economy, people will have to eat. They may not eat out or eat as well, but they will no doubt eat. When food is scare - people riot. Governments do not like rioting so everything will be done to support food supplies. With inventories at multiple decade lows and prices near inflation adjusted all-time lows, foodstuffs maybe the biggest beneficiary of the highly inflationary tactics employed by the world’s central banks. While I cringe at the thought of hyperinflationary food prices and the impact it will have on the already disadvantaged people of our world, cycles are undeniable and when governments go on hyperinflationary binges, food prices tend to go up. While profiting off of higher food prices will be the least pleasurable way I can think of making money, ignoring the trend would be foolish. Part III: Conclusion The recent period of forced liquidation has destroyed the prices of all assets but it has not changed the fundamental outlook for commodities. Commodities prices will rise simply because the value of our units of currency will fall. Some commodities, especially, non-cyclical ones such as Foodstuffs and Precious metals stand to gain more than economically sensitive commodities such as base metals and energy. The “baby has been thrown out with the bath water” but once the deleveraging process ends, fundamentally strong securities will lead the markets higher.

PART IV: CONCLUSION The definition of insanitity is doing the same thing over and over again and expecting different results. - Albert Einstein -

Unfortunately for the long-term prospects of the US, our government is making the exact same mistakes that governments have made in every single financial disaster in history. Our Fed and Treasury are making the same mistakes that they made in the 30’s, 70’s, and as recently as the early part of this Millennium. Many of our Government’s reactions to the current crisis are the exact same mistakes made in Japan during the 90’s which has resulted in their stock market being valued at only 20% of its all-time high achieved nearly two decades ago. Our government is essentially rewriting the textbook on everything you could do wrong in a financial crisis. (The one mistake from the 70’s that the government has yet to make is implementing price controls but we’ll likely see them sometime next year if I’m right about commodity inflation.) So far, the government has spent $8T on the crisis and its not nearly over. Municipalities, State Pension plans, the PBGC and many others still need bailed out. The price tag to bail everyone and everything out will be cost prohibitive as eventually US Treasury holders will revolt. The long-term ramification will be significant inflation and higher rates. Congressman Ron Paul says, “One key attribute that gives money value is scarcity. If something that is used as money becomes too plentiful, it loses value. That is how inflation and hyperinflation happens.” In 2003, the Fed used the threat of deflation to justify inflating the economy which directly led to elevated prices over the next half decade. Today, they are using the threat of severe deflation to justify hyperinflating which will likely lead to even higher prices of the next half decade. The opposing argument is that deflation will prevail as the “money multiplier” effect is non-existent as banks are not relending the funds being given to them by the Fed – in other words, the banks are hoarding all the cash and none of it is reaching the end consumer as promised by the Treasury and Fed. If the money multiplier continues to not function, deflation leading to depression is not out of the question, but the Government still has other tricks they can pull to fight deflation. I am still leaning towards an inflationary outcome for the same reasons I’ve explained in previous updates but I am diligently studying the situation and seeking ways to hedge the deflation risk. As always, please do not hesitate to call me if you have any questions or concerns about your account. I wish each of you the very best during the Holiday season. May you enjoy family and friends and may we all remember the blessings bestowed upon us even in difficult times. Matt McCracken