Investment Letter: October 5, 2009

WHEN IS “ENOUGH” LIQUIDITY NOT REALLY ENOUGH?

In our last investor letter, we postulated that the deflationary cycle was broken by
the massive liquidity efforts of the central banks. We had shifted from bearish to
market neutral in June 2009 when the Dow Jones Industrial Average was about
8400. The question is now whether or not the liquidity provided to stabilize the
system was enough to generate growth, and more importantly, enough growth to
satisfy the expectations of the market. We think not. However caution is still
warranted as it will likely take some time for bullish momentum to dissipate. So while liquidity is king, at this point we believe that not enough was done, and
that the economy is going to sink from its own weight; the weight of debt, the
weight of persistently low velocity, the weight of a bailout that preserved large
zombie institutions at the expense of the small business entrepreneurial
backbone of job creation in the US and the weight of a president whose frenetic
policy mix has (on top of all the other problems) served to confuse and paralyze
business investment.

As the disconnect between the stock market and the real economy widens, we
are again becoming bearish. Very bearish. As for how we might play this, we are
looking for a test of the 10300 level of the Dow Jones Industrial Average. How do
we get to that number? The 10300 level represents the 50% retracement of the
entire bear move from 14000+ to 6600. Very often major moves are followed by
large retracements. At this point, heading into the third quarter earnings season
we find as of last week that there were an inordinate number of parties in the
short or correction camp for the market, and the bearishness was building as it
often does as the market falls. However, we suspect that this bearishness will be
wiped out by another upsurge in the market, taking it toward the 50% retrace
level mentioned above. We have started to deploy some short positions, but our
short is relatively modest at this stage. We will short more if/when the market
rallies and we see sentiment turn more bullish. Speaking of bullish sentiment we find the bond market sentiment to be extremely
conducive to shorting. The government has been buying more and more
Treasury and related debt securities in an attempt to keep rates down, and this
has created a bull market that is now sucking in the public into bond mutual funds
at a rate almost equivalent to tech buying in the late 1990’s. No doubt this bond
market bubble will end badly for the public, as they are typically last in and end
up holding way too long. The only question about shorting bonds is when and
how much?

Regarding gold, we find the market action to be extremely bullish, as the
gradually but inexorably falling dollar is driving gold higher. Interestingly, gold is making new highs in almost all currencies which shows that paper money creation is eroding purchasing power around the world, not just in the US, though
we are the worst culprits.

By the time you read this you should have received your September
performance. You will see that we have recovered all of our losses and that our
fund is now positive. Part of this performance is due to the rise of gold and
precious metals stocks in which we have a core investment, but a good portion of
the performance is also due to two special situations we have invested in:
Vermillion (VRMLQ) and Design Within Reach (DWRI). Vermillion is a small medical diagnostics company that was sitting in bankruptcy expecting a protracting approval process for their Ovarian cancer blood test,
when they unexpectedly received FDA approval. We were fortunate enough to
learn of the situation relatively early after the approval through our network of
health care contacts, and we accumulated a decent sized position at an initial
price under $5. At this time we have in excess of 10% of the portfolio in this
security, and it is trading in excess of $15. We believe that the potential news
flow and earnings potential for this company is dramatic and that the stock has
limited downside and significantly more upside. We continue to hold this position,
but are not adding because we do not want too much concentration in any one
name.

Design Within Reach is a promising furniture retail brand that suffered a
deterioration in their business as a result of the recession. Through a combination of circumstances we were able to purchase a significant position in
the company at a price that we believe to be 50% below the liquidating value of
the business. We believe that the downside is limited from these levels (our cost
is $0.20/share) but that there are numerous positive scenarios that would cause
the stock to move higher in both the short and intermediate term. This position
has appreciated about 20% for us so far, and currently constitutes a little more
than 10% of our portfolio.

At present we maintain a slight short on the equity market (that we plan to
increase) and a sizable long position in gold.

We continue to look for
disappointing growth and greater money creation by the government.

We believe that stocks are overpriced and gold is underpriced and have structured
our portfolio accordingly. We are short the dollar by virtue of our gold position.

We believe that bonds are in the later stages of a generational bubble and we
are bearish over time, but we do not have a short position at this time.