Investment Letter: November 6, 2009

Inflation v Deflation – The Binary Dilemma

In our last investor letter, we made the observations, some of which are
reiterated below for further discussion:

1) Considering the amount of money that the government has provided it is
remarkable how little benefit the real economy has experienced, in terms
of income or employment, financial market rallies notwithstanding.
2) The basic bull/bear debate is now focused on whether the financial market
rallies are forecasting a better economy or are simply a liquidity bubble
fostered by an extremely low interest rate environment. We suspect that it
is more the latter than the former, and we are structuring our portfolio
accordingly.
3) We suspect that there is some kind of tail event lurking, and that the
markets have become complacent and are vulnerable to any kind of tail
event shock.
4) We believe that there are going to be some paradigm and correlation
shifts in the near future, and that these will mainly be focused around the
dollar, as the continued bear market in the greenback begins to bleed over
into equity and fixed income markets in addition to the commodity markets
(where it is already being felt as investors worldwide seek to diversify out
of dollars into other assets like gold, copper and crude oil).

Regarding the correlation shifts, it is noteworthy that in the past week we have
had some brief bouts of equity market declines in which gold actually firmed up
and rallied. This is a harbinger of our future.

The market as defined by the Dow Industrials has not quite hit our 50%
retracement target of 10330, having put in a high so far of 10,119. We will note
that our experience is that the markets usually don’t reach the targets when you
are right and when you are wrong they blow right through them, but that said, the
fact remains that we appear to be in a dynamic binary situation in the global
macro market environment.

The binary options we face are basically inflationary growth vs deflationary
contraction. At this stage the equity market is the battleground since it is the
floppy tail of still overleveraged global balance sheets. It is critical to note that the
hyperinflation scenario while almost inconceivable becomes more possible as a
chapter following a deflationary contraction due to the inevitable response of the
current US political leadership.

Saddle Point Capital Partners, LP
9601 Wilshire Boulevard, Suite 736, Beverly Hills, CA 90210
The Dow is a good benchmark (or the SP 500) and right now, this market is
consolidating and will likely break out to the upside or reverse and test the
downside. The likelihood of going sideways for an extended period at these
levels is fairly remote. We believe that a recent pick up in volatility is a harbinger
of even more volatility; increasing volatility is not healthy for markets as we have
discussed before. We believe that this period since the March lows will
historically be viewed as the eye of the hurricane, where there was a calm that
engendered a false sense of security.

It is really impossible to know what will happen because it is impossible to predict
money velocity, however, the two alternatives and scenarios seem fairly clear: a)
the asset markets continue to rally off of the central bank accommodation and
this will eventually lead to higher growth and higher inflation, or b) the asset
markets will roll over and do so sharply because they are complacently bullish
and very long, and this rolling over will lead inevitably to more desperate
government attempts to revive it, which will increase the chances of even higher
(ie. hyper) inflation.

What is knowable is that given the level of money creation, and the fact that any
weakness in the economy and/or markets is going to be met by more money
creation, we do know that equity prices must decline relative to the price of gold
and hard assets.

Our portfolio is structured to benefit from a decline in the price of equity relative
to gold, and we believe this narrowing will occur regardless of whether we have
an inflationary or deflationary resolution to the current situation. We are also
structured to benefit from increased volatility, whether it comes from an up equity
market or a down equity market.

Our opinion is that it is hard to keep focused on the big picture but we are
reminded of the old French saying: “Plus c’est change, plus c’est meme chose”...
which translates into “ the more things change the more they stay the same.”
This seems like a modern version of the early 1930’s and the resolution is not
going to be tame. We believe it is still possible that this rally since March will
prove to be just a great bear market rally, just like what followed the stock market
crash of 1929.

We discussed “tail events” last month, and so in keeping with that theme we will
postulate that the market is absurdly complacent and that the resolution will find
itself in the tail of expectations rather than in the belly of the curve. What does
this mean, obviously it is impossible to know, but expect the unexpected. That is
how our portfolio is structured, to expect the unexpected. We think there is a
chance the market is set up for a vicious downside reversal that will take it much
lower than imaginable as the financial world sits complacently in the eye of the
hurricane, but at the same time, if we are wrong and the resolution is to the
Saddle Point Capital Partners, LP
upside it will come with much higher inflation, possibly hyperinflation, sharply
higher interest rates and a set of problems not seen since the late 1970’s.

Building on our initial small position from last month we have added to our short
in US government bonds, as we believe over the next four to six months there
will be upward pressure on the long end of the global yield curve, especially with
regards to 30 year US Treasuries. This pressure will be greatest if the resolution
of things is to the upside, due to inflation expectations rising, however, even if the
economy doesn’t take off as the bulls hope, there will still be upward pressure on
rates as the US issues more and more bonds with the Fed running out of money
designated to support this market. If the markets resolve strongly to the
downside, this would likely create conditions for a final attempted bond market
rally, and so our short bond position is in the form of put options that allow us to
quantify our risk as a small fraction of our potential upside.

In a world where we anticipate increased volatility and potential binary outcomes,
we have structure our portfolio accordingly.