Dunamis 2008 4th Quarter Letter

4th Quarter 2008 “So unaccountable are the prejudices of men on the subject of currency that it is not

well to leave anything to discretionary management.” – English Economist William Stanley Jevons, 1875 Stanley Jevons uttered these words in defense of the gold standard reinforcing the monetary religion of the era. Mr. Jevons of course failed to realize that the gold standard was in itself discretionary, relying in part on technological advances in gold discovery and mining and on the whims of the earth in giving up its gold hoard thus impacting the amount of currency in circulation. The gold master would crucify it’s victims on it’s own cross as the high priests pushed forward with their creed and faith that all must be sacrificed to restore this dogma if events such as war derailed the gold standard. This thinking caused great human suffering in 1821 following the Napolenic wars and 1925 following World War I. Though Mr. Jevons may have been wrong within the context of the gold standard, there is a certain level of deep wisdom in his utterance. Mr. Jevons must have known of the thousands of years of great empires falling at least partly as a result of debasement. It is the drug, the wandering whore that is so tantalizing that weak “discretionary management” is unable to refuse its allure. It is the path followed by Dionysius of Syracuse, the Roman emperors Nero and Galleinus, Constantine IX Monomachus of the Byzantine Empire, and Sultan Mahmud II of the Ottoman Empire that either greatly weakened or destroyed great nations. The allure is that it can be an effective monetary instrument in the short term to alleviate pain, but the long term consequences are often a breach of trust in the currency and hence the sovereignty of the nation itself. The United States went into its own “discretionary management” system 38 years ago after the complete break from the gold standard by President Nixon. The nation finds itself at the whims of a new priesthood with its own prejudices heartily embracing the idea of debasement. This is the same priesthood that got us here in the first place managing with complete incompetence. The short term impact of such policy may indeed lessen the short term pain, but the fear in the minds of observers should be that the bear market in trust continues and spreads to government currencies themselves.

Jason Kaspar Managing Partner [email protected]

PO Box 331 Shiner TX 77984 361-594-3327 ext 390 http://marketseer.blogspot.com 1

Performance Last quarter I wrote that “the third quarter was brutal for almost all market participants.” This ended up being just a prelude for the 4th quarter. Essentially everything went down except government treasuries. Many portfolio managers found themselves no longer in charge of their own portfolios but rather at the mercy of margin clerks and fund redemptions. There were no hiding places, no bomb shelters, no shields of defense except cold hard cash. Due to the dramatic action taken in the fund on September 18th referenced in the previous letter, the fund entered the 3rd quarter with a very large cash position. This allowed the fund not only to perform well on a relative basis but also on an absolute basis. We remained on the sidelines on the long side into mid November before finally initiating new “core” positions in a few companies. In the fourth quarter, the S&P 500 declined 22.45% pushing the index down 38.49% before dividends year-to-date and 41.70% since the funds initial launch on November 1st 2007. For the year, the partnership has been able to generate positive returns of 19.31% net of fees, creating 5,700 points of alpha. We were fortunate though this is almost mathematically impossible to repeat. The fund was able to generate positive returns in a couple of longs that were more trades off the October lows in energy and insurance. We also made money in selling options, taking advantage of extreme volatility in October, and of course on the fund’s short book. In the quarter, we lost money in a timber related company and in technology on the long side but these positions were partly hedged.

Dunamis Capital LLC Kaspar Investments LP Returns Since Inception (11/1/07)

Kaspar Investments LP - Net S&P 500

Q4 2008

YTD

9.70% -22.45%

19.31% -38.49%

Total Return Since Since Inception 20.94% -41.70%

Fund's Net Performance Since Inception

An Initial $100,000 investment

$130,000 $120,000 $110,000 $100,000 $90,000 $80,000 $70,000 $60,000 $50,000 Nov 1st 2007

Nov 30th 2007

Dec 31st 2007

Jan 31st 2008

Feb 29th 2008

Mar 31st 2008

April 30th 2008

S&P 500

2

May 30th 2008

June 30th 2008

July 31st 2008

Aug 31st 2008

Kaspar Investments LP

Sep 30th 2008

Oct 31st 2008

Nov 29th 2008

Dec 31st 2008

Portfolio Dynamics - 2008 Mistakes and Success The annual version of the letters will contain this new section examining some of my bright and not so bright moves in the previous year (the bright moves could probably be limited to a sentence or two). Starting with the mistakes, the biggest loss in the fund for the year was being long Weyerhaeuser (one of the largest companies in the world whose focus is on growing, harvesting, and selling timber products). This cost the fund 1.5% in performance for the year though .25% was gained back through option hedges for a net loss around 1.25%. I was simply wrong (happens a lot) and even when the fundamental story changed, my thesis of why the fund owned the stock changed. This is one of the biggest mistakes for any investor. Originally it appeared the stock was undervalued on a sum of the parts basis, and it appeared there may be some catalyst to realize this value. The thesis changed that the investing public would value their earnings higher because of a likely Obama win as a result of some restructuring the company could undergo to transfer itself into a very efficient tax structure. The bright spot was Weyerhaeuser was never a large position in the fund, originally about 4%, and it was sold in October (even a dimwit can be convinced he is wrong) limiting the overall loss (the stock is now down another 34% since the sell date). A dumber mistake was losing around .90% net (after all hedges) in Zions Banc Corp. How did yours truly manage to lose money in a bank stock in 2008? What a great question. It can be summed up as ridiculous. The timing of the trades was horrendous, and listening to other voices who were long the stock proved to be detrimental. The short trading ban and the TARP all caused massive volatility in the name. The stock has now destroyed its lows of 2008 after rebounding over 200%, falling 50%, rebounding 67%, before finally falling 70% all in six months. In the end it looks like my original thesis will indeed be correct, and not making money off it may be even a bigger mistake than if my thesis was incorrect. The final mistake mentioned for the purpose of brevity (this letter could be composed entirely of mistakes) is not capitalizing to the fullest on my overall bearishness. If you took the absolute notional value of long positions, short positions, and options, the fund probably averaged 60% to 80% invested for the year. If you take out direct hedges it was probably less than 50% (this does show investors do not need mountains of leverage for successful performance results). What would have happened if the portfolio was positioned much more aggressively for the year? I cannot help but feel some money was left on the table, but at the same time my reactions to various counter violent short term moves may have been detrimental if the added exposure caused poor decision making. Though this tepidness is more of a mistake than success, it is more in the gray area than the other two mentioned. There are two broad general successes that are worth covering. I am very pleased personally with my emotional reactions to market news and price action in various companies both long and short (except ZION which as mentioned above was ridiculous). Shorts such as MBIA, Washington Mutual, Bon-Ton Stores moved against me 100% or more at some point while shorting them (in certain cases more than once). A whole host of other names moved against me 50% to 100%. Understanding the psychological stresses and for the most part handling them correctly in the most volatile market going back to the 1930s was pertinent to overall success in 2008. Others will also chalk up my actions on September 18th in being a key to 2008. As the news was flashed on CNBC on September 18th that England was banning short selling, it took me 30 seconds to connect the dots that it would occur in the U.S. within several days and this was going to cause massive disruption driving up stocks initially before facilitating a crash on the back end. I have never reacted to news like that before, but it seemed so clear to me what was going to happen that after a sanity check I proceeded in drastically changing up the portfolio. This added large amounts of Alpha in the 4th quarter. 3

Market View The inflation, deflation question mentioned in the previous letter continues to rage. Unfortunately, it has also become probably the single most important question in investing as whichever occurs will most likely be a several standard deviation event impacting every single investment down to the microcap company. In my mind, it has become when, not if, inflation will occur. By the end of 2009 or maybe not until 2012 to 2015? The deflationary forces will continue to be massive with option ARM and consumer credit blowing up in 2009 into 2010 and the wave of corporate defaults starting in 2010 into 2012. This will spread to sovereign nation debt and emerging markets. Will the government be able to create “dollar currency inflation” while this is occurring? Basically, when inflation rears its ugly head will the result be true inflation or a “currency inflation” where real economic activity continues to decline but trust in government currencies also plummet creating a scenario of “depression currency inflation?” This type of economic environment is something that does not exist in working memory outside of maybe the very elderly in Germany. The rest of this letter will be focused on money, value, and monetary history. Some of the following thoughts will be much more theoretical and philosophical which many readers may find boring and even useless. It has been what has consumed my mind over the past few months as we enter into a new era of economics with the government saying the United States may spiral to its death but it will not be because of dollar deflation. A Mother’s Babysitting Club

The first question that must be answered is what is money? Webster’s defines it as “something generally accepted as a medium of exchange, a measure of value, or a means of payment.” While this definition may suffice, it seems to miss hitting the essential element, trust. Money is a commodity with supply demand characteristics that relies solely on trust. Whether it is gold, U.S. dollars, or paper clips, an individual must be able to trust that if it is taken in payment for something useful, it be can be exchanged to someone else for an item of value. I received my first understanding of this at a very young age. My mother was part of a group of mothers who took turns babysitting each others kids. Each time a mother dropped off her kids with another mother, she paid with babysitter club paper currency. This “money” would get exchanged from mother to mother. Though maybe 7, I remember being very puzzled over it. Here was something that was not money, but it was. It had zero value outside of this club, but inside the club it was worth a great deal because it meant a free afternoon for a mother who possessed this ultimate standard of babysitting club wealth. Looking back, I realize it was in every sense of the word money, but like all great currencies of times old, it lost value because it lost trust. The ultimate inflation occurred. As children got older, fewer and fewer exchanges took place and the trust that the piece of paper really meant anything disappeared. Those holding the paper eventually stuffed it in a drawer, threw it away, or simply forgot about it because the trust in its value completely disappeared. It used to have more value than gold; it meant a free afternoon, a mental break from kids who asked why, but now it was clutter. Even gold has this trust characteristic. Why is gold worth anything outside its industrial use? Humans cannot survive off of it by eating or drinking it. Simply because people trust it can be exchanged for something useful. When a society or dynasty fails, the new one with a new currency will carry some value 4

in relation to gold. Said differently, gold has always been able to eventually buy a standard of living in a new empire. For example, if the U.S. dollar collapsed and all mayhem broke loose for 30 years until eventually a new world power came forth with a currency called the brok, there is an inherent trust that those who had gold could easily buy broks capable of starting businesses, buying houses, and functioning on a daily basis. This is ultimately my inherent concern with the course that the current government is taken, the idea that all else must be sacrificed to prevent deflation, even trust in its own currency (though it would not be phrased in this manner). Throughout history countries and empires have survived serious deflationary bouts, very few have survived massive debasement, resulting in massive currency inflation, and hence a failure in trust in the currency itself. Depression does not keep me awake at night. The U.S. has gone through several in our history. “Currency inflation” has destroyed multiples empires. History of Money The belief is that Egyptians around 4000 B.C. were the first to cast gold bars while setting a standard ratio between gold and silver. This amounted to the start of monetary history. The Lydian’s were the first to use coins around 700 B.C. Approximately a century later, it was Croesus who developed a sophisticated bimetallic silver and gold currency system that would exist in the majority of history following this innovation. Croesus was defeated by the Persian King Cyrus the Great who then conquered Babylon. Around 540 B.C. King Cyrus may have made the greatest contribution of all with how coinage would be viewed in the hands of man as the Persian Empire was the first to collect taxes not in kind but in coin. This was revolutionary as it solidified money in place of society. As a side note, it is fun to speculate that Daniel of the Old Testament may have had something to do with this innovation as he was one of three presidents who “was distinguished above the presidents and the satraps, because an excellent spirit was in him; and the king thought to set him over the whole realm” Daniel 6:3. It is not a stretch to think he was tied deeply into monetary affairs with much success if King Cyrus looked to put him over his kingdom. (For those of you who are confused that the book of Daniel refers to “Darius the Mede,” the King Darius as known in modern history followed King Cyrus and did not conquer Babylon. Biblical theologians believe Cyrus, whose mother was a Mede as was his wife, may have also gone by the name Darius or that variant early texts reveal some early mistaken swaps in the names Darius and Cyrus). Following these events, various coins and governments came and went. Darius and the golden Daric, Alexander, Greek, Roman, Byzantine (the list goes on) currencies came and disappeared. This backdrop is given to make this point - that the U.S. dollar presence in monetary history is simply a speck on the timeline. The U.S. dollar has no more divine right to be at the top of the world stage than all currencies before it (and there have been many). The U.S. dollar also is making its passage in history, and government officials should be careful assuming it can be trashed because it is somehow divinely appointed as the world currency and so things will work out. If you consider 4000 BC to be the start of monetary history and assign 10 yards to every thousand years you have 60 yards of history, over half a football field. The U.S. dollar makes it to the 2.3 yard line. The longest running currency in history was the Bezant Gold Coin introduced by Constantine around 325 A.D. It was called the dollar of the Middle Ages. It fell away as a result of debasement after Constantinople fell. It also did not make a first down, traveling only 7 yards or 700 years.

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“Currency Inflation” Defined References keep being made to “currency inflation.” To some degree a game in semantics is being played since all inflation takes affect in currency terms, but a distinction is trying to be made. Inflation is typically thought of when supply of a product is constrained (i.e. oil during the Arab Oil Embargo in the 1970s) or demand jumps (oil earlier this decade to fuel the growing emerging markets) to drive up prices in dollar (currency) terms. In my musings over the last few months the realization hit me that inflation can really be broken down into three parts. Essentially, I = ∆Ea + ∆Ms + -∆‌‌T‌ where I = inflation, Ea = Economic Activity, Ms = Money Supply, and T = Trust (this is something I completely made up and not in any economic textbook, so take it with a grain of salt). This creates another set of questions and could probably be broken down further and argued with for various reasons, but the point trying to be made is that inflation can occur for three basic reasons. If economic activity booms while money supply and trust are held constant, inflation will occur. Conversely, if economic activity tanks while either money supply explodes or trust craters, inflation can also occur. This second scenario is what is being referenced to as “currency inflation”. In fact, throughout history this is when hyperinflation has occurred. This is what occurred to Iceland’s Krona after the collapse of the nation’s banking system earlier in 2008. Often times it starts with a change in Ms augmented later by a drop in T. Right now the U.S. government is drastically increasing Ms. The economic problems are so large (larger than anyone in government seems to realize) that to be successful it will be the largest increase in Ms in absolute and relative terms in United States history. This government action risks decreasing trust (T) by foreign governments and ultimately U.S. citizens in the U.S. dollar. While not an immediate concern, this ultimately could create “depression currency inflation” where Ea continues to decline or collapses while “currency inflation” spirals higher. For all the problems with the gold standard, this scenario of depression currency inflation was not one of them. Trust Busters For months, I have been telling anyone who would listen that the British pound is at risk of collapsing in 2009. There are also growing concerns with the Euro as Italy, Spain, and Ireland face massive debt problems putting strain on the European block. Switzerland has the same structural problems as Britain though the country does not appear in immediate danger as belief that the country is a place of refuge continues. How this could play out is vitally important. My number one fear for 2009 into 2010 is that the bear market in trust will spread into government currencies and the sovereignty of nations. It was the British Pound collapse on September 21st, 1931 that initiated a run on gold pushing the U.S. to raise interest rates, causing hundreds of additional bank failures, and manufacturing to tumble another 25% over the following nine months. History seems destined to repeat (the same way Lehman failure rhymed with the Bank of New York failure in 1930) though this time around government officials will not raise interest rates. However, the international response to a Great Britian failure may have the same impact as trust in government debt collapses (including the U.S.) driving up market interest rates causing an additional collapse in lending and borrowing driving down international economic activity. The Eurozone could create a fast track into the EU for Britain to prevent a collapse but that may not alleviate the damage done. It would be possible to see gold move strongly higher as currency inflation depression sets in. The dollar could also move higher initially though most likely it would also crash in relation to precious metal. What is described is not inevitable, but this type of scenario has played through my mind over and over the last few months. The amazing thing is that a year ago it would have been considered loony, unfortunately not anymore. (To understand the dynamics for Britain, the Centre for Economic Policy Research, 6

Policy Insight No. 26 is a must read. It gives a great explanation of what happened to Iceland. Britain is simply a bigger island.)

Looking at a Depression – a Contrarian Thought Most Americans seem to believe the world started around 1929 and it is defined by the 50 U.S. states. They can remember stories from their parents and grandparents about the Great Depression. Sadly, 1929 to 2009 seem to define all of world history - political, financial, and social. This seems to filter up to the country’s political elite and embarrassingly the financial titans. During “history” the worst thing most Americans can think of economically is the Great Depression. This limited view of history creates a mindset that pushes all effort, sweat, brain power, to be directed at preventing a depression. As a result, we are embarking upon what a few have described as “The Great Experiment” in monetary policy. In actuality there is no experiment in our efforts to print enough money to inflate out of the problem as it has been tried by multiple government bodies over all of history all ending in ultimate failure. (There are a few exceptions such as King Henry VIII of England who was known as the “Great Debaser” but who conveniently split from the Catholic church allowing him to ransack the Catholic Cathedrals of their gold hoard largely avoiding the consequences of his earlier debasing actions) Looking at a depression, is it possible that there is a worse outcome that Americans do not have in working memory or the ability to see in history since in our view, we are history? Is it possible that the cost of avoiding a depression is actually far greater - crippling our nation for decades to come? Do people realize that an individual born in the United States in 1925, dying in 2000, had one of the highest standard of living in all of history and did the unthinkable – survived a depression? Could it be that the mindset today, inflation at all costs, is equally if not more wrong as the religious dogma of the gold standard that drove the U.S. government to raise interest rates in 1931? Could it be that the transfer of private debt to government hands that all of Wall St. seems to be clamoring for will be mismanaged just as badly as most other government programs, assets, and liabilities? How did the masses get here in their thinking? I am blown away by people who I respect in finance running down this road embracing the idea of debasement and inflation not even slowing down to look at the other side of the coin. It is like a high school football cheerleader who jumps up and down yelling with the crowd while really having no idea what is going on behind her or even really understanding the game. My suspicion is that most have gotten here in there thinking by embracing the idea that market economics failed and former President Bush laissez-faire regulation policy created the problem, both ideas which I believe are deeply flawed (though there is no doubt there was massive failure under the Bush administration with enforcing the regulatory laws on the books). As Charlie Munger says “invert, always invert.” Okay, lets invert and ask if there were moments of government intervention that helped create the situation we are in today; moments where the free market was not allowed to work. One could look back to January 7th, 1980 when Jimmy Carter signed the Chrysler bailout. Yes, the government made $350 million on this deal but would the failure of Chrysler prevented union power from crippling the automakers today allowing a forklift driver to make $85,000 with massive over capacity in the industry and the government likely to lose far more than $350 million bailing out the industry again? Natural Darwinian market economics would have allowed Chrysler to fail and capacity to be taken off line. Or what about the moment in September 1998 when the Federal Reserve stepped in with a consortium of banks to bailout Long Term Capital Management? Natural market forces would have caused a massive failure of LTCM, likely bringing down a large Wall St. bank with it, stopping the equity bubble, initiating a recession, and avoiding even the beginnings of a debt bubble that we have currently. Or maybe look at 2001 and 2002 when 7

Federal Reserve Alan Greenspan intervened in market forces. After one of the biggest stock bubbles in world history, he engineered the shallowest recession in U.S. history when something much deeper was needed to purge the system. As a result of low interest rates, this helped spark the housing and debt bubbles that peaked over the last few years. The market was not allowed to work over the last thirty years as a direct result of government intervention to alleviate unwanted and political undesirable consequences. It is as if the Piper came to collect his payment for abuse and government leaders (with financial titan encouragement) convinced the Piper again and again to take an IOU with interest accumulation and to come back in a few years to receive payment. The Piper has come back and the U.S. seems to be begging for the Piper to take one more IOU to push off consequences of our actions yet one more time. Maybe the Piper will accept this IOU and we take a smaller dose of pain than would be natural in a market system over the next couple of years, but the amount owed to the Piper will only grow. The end result is always a full payment to the Piper. A Proposal – Or the Debasement Route I am not suggesting that America should roll over and accept a depression, but the mindset should not be anything else but a depression. If you look at the Great Depression, according to Milton Friedman in his book Monetary History of the United States, the velocity of money (the turnover) decreased by 21% and the money supply fell by a staggering 31%!! Why did the money supply decrease? The financial priests believed that the gold standard and gold hoard must be defended at all costs. In October 1931 the U.S. lost 17% of their gold holdings as nations around the world rushed to redeem dollars for gold (this was mentioned above in the Trust Buster section). The reaction was typical, raise the interest rate (discount rate went from 1.5% to 3.5%) and deflate. This was flawed thinking. Equally flawed thinking is pursuing debasement today. History is full of debasement stories. It is the window that allows many dictators to come to power – Napoleon after the debasement of the Assignats by the National Constituent Assembly in France in 1792, Adolf Hitler after Germany debasement after World War 1. It is more the norm for a currency failure than the exception. It is the path world governments appear to be pursuing. M2 U.S. Dollar money stock has increased at an 18.2% annualized rate over the last three months which will likely only continue to increases. This is dangerous!! The reason this is working in the short term is because the velocity of money is slowing by an equal amount. The idea is when the time is right, the government will pull down the money supply soaking up excess liquidity preventing the depreciation of the dollar and ultimate inflation. (If any readers truly believe this, there is a great piece of Louisiana swamp land for sell by my good friend Andrew Robertson that is full of gold once you drain the swamp.) The U.S. government should not allow the money supply to decrease as it did during the Great Depression, but we should not let the “prejudices of man” dictate the right path to avoid depression at all costs. A simple proposal would be to agree that the money supply should increase by some set amount, maybe 3% to 5%. (There are many individuals more qualified than me to come up with the right number) This would avoid the mistake of letting the money supply decrease as it did during the Great Depression while letting the chips fall where they fall. If that means a depression, so be it. Investment Ramifications The question for investors becomes what to do as one watches this horror show unfold. The answer is unfortunately unclear and partly based on time horizon. All those investors rushing to hard assets, mining companies, and inflation protection may be painfully early. The correct comparison may be that it is the summer of 2004 and the housing bubble is obvious, but there are two more years for the bubble to build. The beginning of this Market View section began 8

mentioning some of the massive deflationary forces that continue to rage and that are coming. The consensus seems to be we do not need to worry about inflation in 2009 but will in 2010. My view tends to lean toward the fact that we may not need to worry about U.S. dollar currency inflation until maybe 2011 or even a couple of years later. It depends partly on how the world would respond to a Great Britain failure or bailout if it were to occur. What is clear to me is that the systemic risk is as great as it has have ever been and those investors running around talking about $.50 or even $.20 dollars saying one can ignore the macro picture at this point is asking for potential continued investment disaster. The system is teetering and the systemic risk premium demanded by investors should be at its highest level in decades. A vocal cry of I know nothing should be the starting place for all investment decisions. An appreciation for the history of wealth preservation and understanding there are few heroes that ever survive should be the next step. Market View Conclusion A plain vanilla depression will cause massive amounts of human suffering and is tragic, but it is survivable. A debasement that helps alleviate pain for a few months or years only to cause a currency deflation depression would be far worse. History is full of such stories. From my perch in a little town in Texas, it appears political titans and financial titans remember no such history. They are blind to the fallacy of their actions and want to take the easiest road for the betterment of tomorrow, not next decade. The story will not unfold over days or months but rather years. It is not even unthinkable the markets could finish positive for the year though my bet is against it. The focus should be on American dominance fifty years from now, not squeezing 1% more out of GDP in Q2 2009. Personally, I do not believe (maybe naively), we have past the tipping point, but the road being traveled and cheered on by many is laced with the carcasses of those past. All you have to do is open your nose and eyes to realize their presence. We have national leaders who are either are unable or refuse to do so.

Political Embarrassment America should be ashamed of our political leaders. The exit of the Bush administration could not have come quick enough. Unfortunately, any initial optimism I may have had for the Obama administration is now about gone also. How could Tim Geithner be nominated as Treasury Secretary? Part of the same crony crowd who cheered both Alan Greenspan and Ben Bernanke. It’s a travesty. Mary Schapiro as SEC chairmen is a bad joke that is not funny. We heard a lot about Paul Volcker leading up the election? Where is his name? He is probably being stuffed in the corner because he is actually recommending the strong painful medicine that America needs to swallow. Our country should be ashamed. Maybe this is the humility dose the country needs.

Closing Thank you for all your support. I appreciate your trust in giving me a portion of your hard earned capital. If I can be of service in anyway, please do not hesitate to contact me. The idea of panicking before you need to has been the correct investment action over the last year. Whether my currency concerns are warranted is yet known, but this is the area where my panic is focused currently. It would be nice to be wrong. Sincerely, Jason Kaspar Managing Partner 9