Investment Letter December 7, 2009

To Our Friends,

The Dollar and Asset Inflation

Before we review the markets, a couple observations to share:

1) While lunching a couple weeks ago with one of the smartest value
investors we know, a person who has literally made a fortune as a public market investor over the past 30 years, we asked what he was doing in
the markets, and his response was: “I’m just trying to get out of dollars.”

This reminds us that excessive monetary stimulation and currency creation
lead directly to inflation of other assets. Investors do not want to get caught
holding a depreciating asset, so they try to diversify out of it. In the case of the
dollar, one is holding Treasury Bills that pays little or nothing in a currency
that is depreciating. To do nothing is to sit idly by while one’s purchasing
power continuously erodes. The process by which our friend and the rest of
the world “get out of dollars” is a secular trend that we call a “bear market on
the US Dollar”, and this is a continuing theme that is not going away soon.
We have been bearish on the dollar for some time and expect to be so for
sometime into the future.

That said, there is currently a rally underway in the dollar, which is in our
opinion, primarily due to technical factors, but cannot be ignored. Since this
rally has been different in character from other recent dollar rallies we must
consider the possibility that it will carry on for longer. This dollar rally has
played a major role in creating a short-term top in the gold and commodities
market. We will be monitoring this vigilantly as any protracted rally in the
dollar will tend to be negative for gold and other commodities where we are
bullish. On the other hand, in 2005 the dollar and gold both rallied
significantly so we will need to monitor this relationship carefully.

Pending resolution of this dollar rally and related gold correction, we have
reduced our gold position to the smallest level since the inception of the fund.
With less bullishness at the top, the last gold high at 1030+ in 2007 was
followed by a 30% correction. While we believe this correction will be much
shallower and that gold will make new highs by a considerable margin, at this
time we think caution is warranted. We will vigilantly watch for an opportunity
to rebuild our position in this market.

To keep the big picture in perspective, the current correction in the gold
market is setting up for a major up leg that will carry gold far higher than
Saddle Point Capital Partners, LP
9601 Wilshire Boulevard, Suite 736, Beverly Hills, CA 90210
people imagine. In a world of rapid currency creation, gold creation is
constrained (by Mother Nature as well as mining challenges) and so it
becomes an accepted form of money and store of wealth that cannot be
debased by incompetent politicians and central bankers. In a world in which
financial assets total hundreds of trillions, few investors understand that the
entire value of all the gold ever mined in the world is less than $10 trillion. The
upside potential of gold is breathtaking. We believe the bull market in gold will
not be over until gold is over $3000/oz and the Dow:Gold ratio (which is
currently about 9:1) will be close to 1:1.

2) Some very smart strategists have suggested that the Fed is not only
buying hundreds of billions of mortgage debt and Treasuries, as they have
made known publicly, but that they are also coordinating the purchase of
public market equity -- to improve consumer balance sheets, confidence and
spending. You read that right; the Fed is more or less “buying” the stock
market either directly or by coordinating the purchase of the equities by other
central banks and key financial institutions.

The notion that the Fed is operating in equity markets or influencing the market is
not that farfetched. The existence of an emergency “team” of Fed and Treasury
and other key market participants, the Plunge Protection Team, has been well
known for some time. But given that Bernanke has admitted that they don’t want
banks to make bad loans, and given that everybody knows the economy is not
strong enough to support a lot of loan demand and banks are upping credit
standards, the Fed chief has precious little tools left to assist the real economy.
The famous Bernanke reference to dropping money from helicopters is easier
said than done it turns out. So Helicopter Ben, unable to actually drop money
onto Main street from choppers, and unable get banks to use excess reserves,
may have turned to the financial markets to help improve the economy. This
hypothesis would make sense for an administration willing to spend trillions to get
the economy turned around, and for Bernanke given the situation with the banks.
It also tends to explain the decoupling between equity market valuations and
activity in the real economy.

The question becomes how high do financial assets and the stock market have
to go before some of the gains begin to bleed over into the real economy, and
how does the Fed deal with the obvious unevenness of a recovery where only
Wall Street and big banks make money in the market but the rest of the economy
goes nowhere? Bernanke testified a week ago that US stock prices were not
overvalued depending on your assumptions for the recovery, which was a
backhanded way of saying there is no asset bubble in US stock prices. I am not
sure that the market believes this -- and the numerous statements by US
government officials that there is “no asset bubble” in US stock prices reminds
me of the famous quote that is attributed to Bismarck: “Nothing is true until
officially denied.”

Saddle Point Capital Partners, LP
9601 Wilshire Boulevard, Suite 736, Beverly Hills, CA 90210
Whether the Fed is assisting the equity market more or less, directly or indirectly
or not at all, is really only a way of making sense of some of the behavior of the
markets. Regardless of why, the fact is that this most hated bull market of all time
continued to crawl higher during most of November and early December, and did
so again on mostly light volume with low volatility. The market seems to shrug off
everything, including the failure of the Dubai city state to make interest payments
on its $100 billion of debt, an event which would have surely cratered the market
a year ago. Scary thing is most people we talked to concluded that “It was only
$100 billion.” Hmmm... talk about complacency. That is a red flag for us, and
suggests that perhaps the thus far toothless Dubai incident may yet prove to be a
milestone of some kind that will take time to be fully reflected in the markets.

We continue to believe the equity market is distributing and trying to top, though
the action of the market has prevented us from building any kind of significant net
short position.

Summary Overview:

We continue to believe that the primary trends we have identified in the past
remain intact:

1) Global wealth has bounced back with the rally in financial assets but
overall it is way down from 2007 as are incomes and employment. Global
income is barely budging the needle.
2) Balance Sheet de-leveraging is continuing.
3) Central bank reflation is still going at top speed, and any discussion of
tightening and exit strategies is self indulgent on the part of the financial
media and premature given the income and employment backdrop.
4) The US Fed and Treasury continue to pursue a three pronged strategy to
stimulate the economy: a) they are keeping short term rates as low as
possible, b) they are allowing the dollar to weaken and thus far have
managed this in an orderly manner, c) they are trying to support key asset
prices – bonds, housing, equities?
5) In this type of money creating environment we believe that paper
currencies and financial assets in general will lose value against hard
assets, and that the dollar specifically is in the process of losing value
against other currencies and that within five or ten years will no longer be
the reserve currency of the world. This has dramatic implications for your
dollar based wealth and purchasing power.
6) Given the weak economy and the massive efforts of the government to
support every aspect of our society with other people’s money, the federal
deficit will continue to swell and this will continue to weigh on the dollar,
and eventually on interest rates. The only way that interest rates will
remain low would be in a total meltdown of the global economy which
Bernanke/Geithner and friends will clearly not allow.
Saddle Point Capital Partners, LP
9601 Wilshire Boulevard, Suite 736, Beverly Hills, CA 90210
7) The dollar has continued to generally move inversely to US stock prices.
We have continued to expect the falling dollar to eventually correlate with
falling bond and equity prices, but this has yet to occur. Logically, we are
simply expecting that a protracted decline in the value of a national
currency will be associated with falling financial asset prices that are
denominated in that falling currency. Recently, there was an interesting
development in this regard, as the dollar experienced a rally which did not
coincide with an equity decline, though commodities declined across the
board including gold. It is possible that the dollar is beginning to shift its
correlation to equity/growth, which would be very bearish for the US
financial assets, given our expectation of a continuing downtrend in the
greenback. It is too early to say at this time if this shifting correlation will
be sustainable, but we are watching it on a daily basis.
8) We believe the best ways to protect wealth in this environment is to be
short the US dollar, long gold and commodities, short equity and short
bonds. We are following these guidelines in our portfolio.

Performance Review:

Both our macro and stock specific positions have worked very well for us lately,
and combined to generate a turnaround in the portfolio from a month ending low
of about -12.5% at the end of August, to a +12.5% year to date at the end of
November. This performance is even more impressive when you consider that
the portfolio has never been leveraged more than 2:1 and is normally less than
1.5:1, and that it is hedged as to net long or net short exposure. Our portfolio is
also characterized by some position concentration, which means we have
several larger positions in excess of 10% of the portfolio, including a long stock
(VRMLQ) and a short stock (AMED) both in the health care area, as well as gold
(which has been our biggest position). Strong movements in these key positions
at the same time contributed to the gains through November, but these positions
do not go straight in our favor and tend to ebb and flow. In early December we
have thus far seen some correction in these positions. We are not in the
business of trying to trade in and out of our key positions frenetically, expecting
that our underlying thesis will continue to work over time, so some drawdown or
correction in performance must be tolerated to allow the positions to mature and
fulfill their potential. Therefore we are expecting our performance to consolidate a
bit in the next month or so, though we are highly confident that our position book
has significant upside potential over time relative to the capital risk. For example,
while we would be very surprised to see our portfolio finish the first year down
10% we would not be surprised to see it up 30% or more.

As always, please feel free to call us if you have any specific questions or
comments. We believe in transparency and communication with our investors,
and we thank you for your continuing support.