Investment Letter: July 23, 2009

In our May 12th, 2009 investor update we said:

“...we do not believe this is a new bull market; we think it is a
countertrend rally in a primary bear market. The rally could go
further, but is likely closer to the end than the beginning. Sharp
rallies of this character in bear markets are... the rule rather than
the exception. The sentiment and valuations have been all wrong
for a bottom. There has never been an ultimate market bottom
when you have so much optimism and constant attempts to make
every new low into “the bottom”, volatility is way too high
historically, and multiples are too high. Prior bear market bottoms
have been characterized by a loss of interest in equity and very low
multiples...”

Nothing has happened in the past 70 days to change that fundamental longer-
term overview; however, the near term market rally is proving to be much
stronger than we anticipated. We have clearly underestimated the potential of
the cyclical bull market to rally within what we still think is a secular bear market.

Consistent with our very bearish view of the economy and market, we
significantly increased our short positions in early July, just in time to have the
market commence a 10+% rally beginning early on the morning of July 13th. We
took the brunt of a couple big rally days early in the move and realized that the
market was not behaving as we expected. As a result, we covered our excess
short position, returning the fund to a market neutral position and leaving the
partnership down roughly 6.5% year-to-date, according to our internal
calculations (based on assets under management). This is not a happy
circumstance, but neither is it fatal, as losers are part of the business, and we
anticipate losing 5-10% on our bad trades, expecting our good trades to yield
substantially higher gains than our losses.

While we believe that the market will trade lower at some point, given the recent
uptrend, we were not prepared to suffer any more losses and so we stepped to
the sidelines. In particular, the market’s ability to shake off bad news of some
magnitude (such as California going bankrupt or CIT Group failing) underscored
the robustness of the current rally. The reigning in of our excess short proved a
wise decision as the market has continued to rally every day since, and is up
strongly again today.

BULL VS BEAR

The Bull Case is championed by the financial industry, including the financial
media, which functions as an arm of the Wall Street distribution system. The bull
case is based on the following factors:

1) The Fed is easing aggressively as are other central banks. How many
times have we heard them say: “don’t fight the Fed”
2) This is just another recession, not something fundamentally different.
3) The positively sloped yield curve (lower short term rates, higher long term
rates) is good for banking and business
4) Sooner or later, all of the Fed and Government activity in the market “has
to” produce a recovery.
5) Things are getting better by some definitions, including “not as bad”
6) There is almost no return in risk free assets (0% T Bill and 3+% 10
Treasury Note rates)
7) There was and continues to be a lot of “cash on the sidelines” getting no
return, and as the market moves up these participants (mutual funds, pensions,
brokered public) must put money to work. This becomes a more important factor
as the market rallies more.
8) Valuations are “reasonable by long term standards”. SP500 trading at 18X
forward earnings, which is only slightly above the long-term trend.

These are the primary elements of a cyclical bull market. They’re cyclical
because they’re based on the cycle of business slowdown, inventory liquidation,
Fed accommodation as a response to the downturn, subsequent inventory
rebuild and expected employment recovery, against a backdrop of lower equity
prices following a bear market. The financial industry is absolutely expert at
generating optimism and systematically building it by beating earning estimates
to nurture more positive news flow, which then pulls more cash into the market.
The recent rally has been on light volume and acts more like a short squeeze
than a breakout. In a short squeeze, the desperate buyers push prices up a little
bit each day. This is what buying the market has become for a lot of investors on
the sidelines who are now suddenly underperforming their benchmark and must
put money to work.

Overall, we must admit that given the market action, it is hard to argue with the
bull case in the short term.

The Bear Case is very lonely and out of favor at the moment, but we believe it
still has merit. It is more secular in nature, and based on the following factors:

1) The 2007-2008 credit crisis and subsequent economic downturn is
fundamentally different from prior post war recessions. It is the result of an
exhaustion of a long-term credit cycle and not simply a normal business cycle
downturn. It is structurally the same phenomenon that precipitated the Great
Depression. This limits the expected benefits of central bank easing.
2) The amount of global wealth that was destroyed has fundamentally
changed the robustness and output potential of the economy, especially
considering that 70% of the world’s largest market (USA) is dependent upon its
consumer.
3) The amount of debt remaining from the pre crisis economy is much too
high for the reduced level of incomes. Global de-leveraging will be a continuing
theme.
4) The banking system is in very weak shape, and not willing to loan
aggressively because their balance sheets are weak and there is also a dearth of
credit worthy borrowers and viable projects.
5) Consumer demand is likely to remain muted compared to prior cycles,
primarily due to the devastating effects of high and rising unemployment
combined with still depressed housing and stock prices. People are saving more.
6) The consumer is structurally weakened in a way that will not repair itself
easily or quickly.
7) The financial industry is overly optimistic about the strength of the
recovery.
8) Sentiment is much too bullish, with the vast majority of market participants
believing that “the bottom” is in and the worst is over.
9) The disconnect between market optimism and the weak consumer/real
economy create an opportunity to wait for lower equity prices. Valuations are
relatively high with stocks trading at close to 20X forward earnings, thus making
the risk reward for shorting the market more compelling. At some point anyway.

What makes the bear case secular is that there are trends at work which are
beyond the scope of the cycle, which are not accounted for by the cycle, such as
the de-leveraging of global balance sheets.

The lynchpin of the bear case is that “this time things are different”; that the
consumer is irreparably damaged; and, output/income/earnings are going to be
disappointing going forward. The government will have to spend much more
money to generate economic activity, and this will make real growth difficult and
come at the expense of the currency and inflation rate.

From our perspective, stock prices are discounting a big recovery. With all of the
money creation by central banks, any serious recovery would come with inflation,
which is not good for stock prices, and if the economy doesn’t snap back
earnings will likely be very disappointing. Either way, we see stock prices having
trouble going forward.

The recent earnings season has been celebrated as companies have beaten
their estimates; however, most companies reported lower top line, and only
bettered the Wall Street earnings estimate because of cost cutting. Cost cutting
is not going to generate enough earnings growth to support this rally much
longer. The question is how much longer, and how much higher.

GOLD

Gold has been one of the best performing assets in the past ten years. We
believe that it will continue to be a top-performing asset. In an environment like
we have today, where central banks are creating massive liquidity, any upside
momentum generated by the global economy is likely to bring inflation, or at least
the fear of it. So, on the upside, we believe that gold will perform well if the
economy rebounds sufficiently to maintain or increase stock prices.

In addition, we believe that the US will need to systematically weaken the dollar
in order to improve the economy, and since gold is denominated in dollars, any
sustained dollar weakness will result in higher gold prices.

On the downside, we believe that any further weakness in the economy will see
other assets fall more than gold; hence, it is the safest store of value on the
downside.

Therefore, we maintain a substantial core position in gold, against which we can
short more or less equity depending on market conditions. We believe that gold
should be at the core of any investment portfolio in the near future.

US DOLLAR

We continue to believe that the dollar is key to any resolution of the deflation v
inflation debate. We continue to believe that in spite of all the “strong dollar”
rhetoric, the true US policy is to systematically weaken the currency, but to do so
in an orderly manner. This makes sense for several key reasons: 1) improved
export competitiveness which translates into JOBS, 2) put the wind behind
consumer/business balance sheets, 3) making it easier for us to repay our
national debt, 4) making our assets more attractive to foreign buyers/investors.

In addition, we believe that President Obama’s pursuit of a populist agenda of
change is extremely negative for the dollar, as government spending soars in the
face of falling revenues, and our nation takes on the feel of a chicken with its
head cut off. There has never been a shift to the left of this nature that did not
result in a sharply lower native currency.

We believe that there is a large amount of capital in the market being allocated
with a strategy of looking through the inflation trough towards the expected peak
that will result from what is perceived to be an inevitable decline in the US Dollar.
These pools of capital are betting that sooner or later the current global reflation
effort will work, and that it is best to get positioned now. While we have been and
continue to be in the deflationist camp, we certainly see the merit of this
approach, and are considering how best to position ourselves. At the moment,
our substantial gold position will provide us some protection if this inflation trade
proves to be the correct approach.

We expect to see a decoupling at some point between the dollar and the growth
trade, as continued declines in the currency eventually diminish the global
appetite for dollar denominated assets. This is a long process that is slowly
unfolding. We wonder about a future world in which the falling dollar moves hand
in hand with a falling equity market and low growth. This would be the stagflation
scenario, and we think it is coming. Again, our position in gold as the “anti dollar”
covers us against this eventuality, which is one of the main reasons we hold a
large gold position as a core in our portfolio.

ASSET ALLOCATION

As we make this final edit the morning of Thursday, July 23rd, here is our asset
allocation:

75% invested, 25% cash in US Dollars

Of the funds invested, the allocation is as follows:

55% Long Gold and related securities
46% Short Equity