Investment Letter: September 2, 2009

WHAT HAPPENED TO THE DEFLATIONARY SPIRAL?

In the late 1970’s, leading up to the market bottom in 1980-81, there was a
period of time where in order to choke off inflation, the Federal Reserve drove
short term interest rates up to levels that exceeded long dated Treasuries. This is
called an inverted yield curve, and it was our first experience with this
phenomenon. What it does is basically eliminate the ability for anybody to get
any kind of short term financing in the credit markets and wipes out anybody in
the business of borrowing short to lend long. We will never forget an article that
we read about it entitled: “Inverted Yield Curve, A Warning to the Money
Markets”.

Regardless of the relative level of interest rates, an inverted yield curve is also
very bad for equity prices, since the high risk-free Treasury bill rate tends to pull
money out of riskier asset classes. The inverted yield curve represents an
extreme stage of tightening by the central bank, and is the opposite of the
extreme accommodation we have now.

Regarding our current ongoing and evolving “crisis”, the timeline is more or less
that the western banking system imploded and created a credit crisis where
nobody trusted anybody else’s balance sheet. This caused the entire system to
panic; inter-bank rates soared and credit markets “froze up”, leading the financial
system to desperately attempt to de-leverage as fast as possible. This initiated
and then fueled a downward spiral in asset prices that resulted in the massive
liquidation pressures that drove the markets to their early-2009 lows.

Step in the central banks of the world with unprecedented liquidity and support –
essentially backstopping the entire banking system. It took the market some time
to accept that this government support of the counter party system would work to
slow or stop the liquidation, but once the market realized that the central banks
were more or less guaranteeing the other side of any trade involving a significant
financial institution, the credit tightness eased. As the credit tightness eased, the
market began to take a deflationary death spiral off the table and began to
assess the future.

The bottom line is with the central banks providing virtually unlimited liquidity they
have succeeded in slowing the normal asset liquidation process. There is no
pressure to liquidate bad loans, and short-term financing is being made available
by the Fed through all kinds of credit facilities. This process is assisted by what
has amounted to a changing of the rules to accommodate bank balance sheets,
and a generally well coordinated effort by official parties and the financial media to paper the crisis over with liquidity and positive news flow. Many companies
that are highly leveraged and dependent on short term financing have been
rescued from the clutches of their own balance sheet indiscretions by the
accommodative central bank policy. However, this government rescue can only
work while the central banks are able to produce unlimited amounts of money
without any negative consequences.

Logically, if the central banks are on a coordinated reflation mission, sooner or
later they are going to succeed (who wants to be against the printing press),
which means eventually we will have growth but in order to overcome the
structural weaknesses in the economy, the growth will be slow and will cost a lot
of money relative to prior recoveries. Eventually, the logical conclusion of this
process is that we will get a lot of nominal growth, but it will come with inflation,
and regardless of the chatter about an exit strategy, we find it extremely unlikely
that the central banks will exit the reflation mission before there is an actual
inflation problem.

Once that occurs, and once the central banks shift from an accommodative to
restrictive policy, then they will be unable to protect the market from deflating
asset prices. So, during this period of government created buoyancy in the
markets, we expect to see huge amounts of equity offerings and debt/equity
conversions as overleveraged balance sheets attempt to take advantage of what
is essentially a government sponsored second chance to bring themselves in
line. The smart balance sheets will try to de-leverage in this extended “eye of the
hurricane” period.

Our view is that a continued central bank reflation effort will eventually work, and
that we are at the beginning of the next wave of inflation, with each bout of less-
than-robust real economic growth (read “jobs”) met with greater central bank
stimulation efforts. This will lead to growth, along with a weaker dollar and higher
inflation, which is how the market is handicapping the future as it moves cash out
of low yielding Treasury securities. Eventually we see the central banks
withdrawing the liquidity, but only after inflation rears its head, and then we will
be on our way towards an inverted yield curve. This will create the final leg down
in the bear market, as the inverted yield curve needed to cure inflation will
decimate leveraged balance sheets and finish the deflationary liquidation that
was interrupted in 2008-2009 by massive government intervention and
accommodation. Once inflation returns, this level of accommodation will simply
not be possible, as each effort to stimulate will be met by rising rates (bond
vigilante phenomenon) and essentially be self defeating.

The real question is how long will it take to reflate the economy, and how far will
it go until the situation reverses. We think it may take some time because the
real economy has a very long way to go, and until there is another crisis, we
don’t see any end to the liquidity and stimulus frenzy of central bank super
accommodation. Right now the central banks are in a sweet spot as the deflationary pressures on prices have created low levels of inflation which allow
for almost unlimited injections of money. At this stage the dollar decline is well
managed and we expect government support in the form of liquidity to continue
unabated. After all, we know that a slow economy and high unemployment rate
are politically untenable in the United States, especially when we are using a well
oiled printing press without any repercussions and everybody agrees inflation is
not a problem. That, my friends, is a recipe for a lot of inflation.

Our take on what is happening is essentially that the market, being a discounting
mechanism more than anything else, has determined that sooner or later the
central banks will create enough money to reflate the global economy. Therefore
it doesn’t make sense to hold capital in zero percent or low yielding Treasury
securities when there is probable future inflation in addition to a depreciating
currency. Periodic market corrections notwithstanding, this money is going to
work rather than sit and deteriorate, and the rally from the March lows reflects
relatively positive news flow regarding GDP and corporate earnings, and the
market’s belief that the central bank will get it right. This is, of course, overlapping
with the apparent fiscal irresponsibility of our left leaning administration, and you
get the recipe for a market that believes growth is coming, and with it a probably
weaker currency and some inflation. In addition, with the market caught short in
March, there was (after the initial short covering rally) a kind of low volume
tyranny of the most bullish as they drove prices up and started a cycle of
performance chasing by the rest of the benchmarking underinvested world. This
explains the cyclical bull and its enormous strength. Remember, there is no
liquidation pressure and now the underperformance situation is becoming
catastrophic for all the money benchmarked to the S&P 500.

But the big macro cycle has not changed. This is the eye of the hurricane. We
are reminded of the 1973-1981 period when the market suffered from a severe
bear market in 1973-74, bottoming at about 550 before it rallied to over 1000 in
1976 on the back of significant government support before falling back under 750
twice in the 1980-81 bear market before finally breaking out over the 1000 level
in 1982. The point is that when the government throws everything at the market it
can impact it and the duration can be years rather than months.

In this cycle, government intervention has clearly obscured and slowed the de-
leveraging process, but not eradicated it. Money velocity remains low because of
depressed incomes and housing prices. Global balance sheets are still highly
leveraged. We are still in a longer term global de-leveraging cycle in which
current and future incomes are not likely to be able to both service existing debt
requirements and generate any significant growth. The central banks and
government leadership had a chance to wipe the slate clean and guide the global
economy through a de-leveraging that would have set the foundations for
sustainable longer term growth, but they opted to try and reflate instead. And
since the patient is sicker than before there is going to be a lot more government
accommodation needed, and eventually the money created will find its way into asset prices. Once the inflation comes it will bring with it higher rates and
eventually central bank tightening, and it will be at this point that global leverage
cannot be eased by central bank accommodation, and only then will we see the
completion of the global de-leveraging process.

Summary and Conclusions:

Based on the global central bank reflation mission, we have changed our stance
to neutral from bearish on equity and asset prices as we anticipate the beginning
of a new inflationary wave. We remain bearish on the dollar, bullish on gold, and
continue to believe that interest rates will tend to move much higher over time,
though they may have room to decline in the short term. We would be inclined to
become bullish if the market corrected and made a higher low, but at these levels
we are neutral.

Our investment thesis is best represented by our commitment to owning gold as
a core holding. In addition, we like exposure to commodities as a play on the
falling dollar, and we will selectively invest in individual equity names, particularly in the health care area where we have substantial knowledge capital.

To date our portfolio performance has suffered from our too bearish outlook up to
and into mid-July, but we covered most of our net short position and turned
neutral on the market in mid-July when the Dow Jones Industrial Average was
roughly 8600. The unwinding of these positions in July and August has resulted
in some additional small losses in our portfolio. At this time we are maintaining
our market neutral position on equity, as we believe the chances of a further rally
are equally balanced by the chances of a 10% correction (more or less). We are
selectively adding long exposure but hedging it to stay market neutral, and will
consider getting net long into any significant weakness. We are taking
substantially less risk with our positions at the moment, as we seek to gradually
recover our losses and carefully work our way back to profitability for our
investors.