Mkc Global Nov 09 Newsletter

THE MKC GLOBAL REPORT MANAGER’S COMMENTARY November 2009 _________________________ “By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.... The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.” – John Maynard Keynes _________________________ Trading is a funny business; sometimes the best signals come not from economic indicators or in depth research, but chance encounters far from Wall Street or a trading desk. At times it can be tempting to call a top or bottom in a market, such as the March 2009 lows, but doing so is dangerous sport. The several days prior to that low, I witnessed an interesting tell for a possible market turn. In the final days of February ‘09 and the climax of the stock market decline, I drove north in my move from San Francisco to Seattle. In the pitch black of Southern Oregon and low on fuel, I pulled off the highway and found a tiny gas station in the middle of nowhere. Aside from the lady at the front counter, I was the only person in sight. The middle-aged cashier seemed nice enough, simply a product of her isolated environment and the midnight shift. She was easily the last person on earth I thought would speak to me about the markets. As she took my payment she noticed the “Citi” logo on my credit card, she proceeded to tell me about the latest news developments from Citi Corp. and the Treasury that I hadn’t even heard yet. She also referred to Citi’s CEO by name and continued to express her opinions on the stock market and how people were losing all their money and “folks should just get out”. At the time I thought the whole situation was bizarre. Later that day I emailed a fellow fund manager that if I were a swing trader (a trader that finds turning points) I would start buying right now. That was Feb. 26th and the ultimate low occurred the following week. I absolutely did not buy the low in March since buying a rapidly falling market would be an egregious violation of every rule I adhere to when managing money. In hindsight, the social signals were quite loud at that time and I had many people asking me what they should do. One person mentioned to me they had lost 75% of their savings from energy investments and many others feared for their retirement savings. _________________________ After showing double and triple digit returns in the chaotic markets of 2008, many trend-following CTAs and CPOs find their funds flat or in small draw-downs. Strongly trending markets tend to be followed by flat or trendless periods, and vice versa. This is the nature of price action. Although there have been a couple strong trends this year, such as copper, most funds like MKC Global didn’t participate due to the market’s volatility. Compared to its history, the recent volatility in the copper market skewed it risk/reward characteristics making it an undesirable and ineligible for trading in terms of the fund’s models. Every action we take exists to either increase the fund’s overall return or dampen its volatility. One price trend that has everyone’s attention is Gold, as it rose above $1150/oz last week. As gold continues to advance, palladium and silver seem to have higher risk/reward ratios, but owning any of them serves the purpose. Generally the most talked about markets fail to perform the best; rather the markets out of the media’s eye tend to impress the most and for the longest periods. For example, nobody in the media speaks about the rubber market where prices are up 95% from March

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lows. Other off-the-radar markets include Cocoa which ran up almost 35% from July and the sugar market which rose 66% between May and August of this year. One last quick thought about precious metals, I recently found some interesting content on a financial website I frequent titled “Jesse’s Café Americain”. In defense of gold against the theory that it’s in “bubble territory” he showed the table below of six gold stocks and there corresponding appreciation during the last gold bull market that ended in 1980. The tremendous move in these gold mining shares is nothing like what we currently see. I also doubt that gold is in the latter stages of a “bubble”. Company Name Lion Mines Bankeno Wharf Resources Steep Rock Mineral Resources Azure Resources

1975 Stock Price $0.07 $1.25 $0.40 $0.93 $0.60 $0.50

1980 Stock Price $380 $430 $560 $440 $415 $109

In the world of CTAs and CPOs the larger and more established funds become so large that they are unable to participate in some of the smaller markets like Palladium, lumber or rubber. Initiating a reasonable position for a $100 million fund can be a challenge in these markets, liquidity becomes a factor and single handedly moving a market becomes a reality. By choosing a smaller fund with an ability to navigate the smaller (but still established) markets, one can take advantage of markets typically passed over by the industry behemoths. For example, if both a large and small fund decides that a position should be initiated in the grain sector they each have a different set of markets to choose from. The large fund will mainly be confined to Corn, Wheat, the Soy Complex and maybe Palm Oil, whereas the smaller fund can choose among those listed in addition to Canola (Rapeseed), Rough Rice, and Japanese Adzuki Beans. Often, the most profitable opportunities occur in these smaller markets. This concept parallels a massive mutual fund that can easily initiate positions in Wal-Mart or Microsoft stock but would struggle to quickly build a meaningful position in a high-flying stock like Crocs back in 2006. Bottom line: fund size can be an inhibiting factor of performance.

Market Commentary I don’t particularly care for short term trading. Unless the manager has an exceedingly good “edge”, the transaction costs continue to rise with the frequency of trading and become a larger percentage of profits. Instead, I prefer the longer and larger moves in price. That strategy typically requires the analysis of larger macro fundamentals; analyzing government policies and large scale economic developments. In that light, this commentary may be a bit redundant. In my mind, not a lot has changed over the last few months. Right now, as I see it, everything is one trade. Either you own risky assets (like stocks, commodities and currencies) or cash and bonds. The correlations are quite high and most assets continue to move in lock step. Due to the coordinated worldwide government stimulus, the investing theme has shifted back to risky assets. Worldwide governments have made it brutally clear that they will stimulate to high hell, period. They repeat again and again that stimulus efforts will continue until the global economy emerges from the recession. Politically, the current administration can’t cope with a large reversal now. They have one option on the table, to continue supplying liquidity and to fight the threat of deflation. With near zero short term interest rates and the U.S. Dollar declining, sitting in cash actually costs you money, therefore the move into riskier assets for any positive return makes sense. In fact, a declining dollar paired with low interest rates makes for a very powerful stimulant. Back in July the Riksbank, Sweden’s central bank, cut interest rates to negative .25%, thereby penalizing those sitting in cash. The government knows from history these actions move liquidity into the asset markets. Bank reserves continue to soar as the banks refuse to lend. Banks currently have a massive amount of cash that they aren’t lending out. Those in the inflation camp are correct about the fact that the Fed has printed a large amount of money.

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Unfortunately for their theory, the money just sits there instead of making it out into the economy. Their much needed variable, the velocity of money, remains quite low. Banks aren’t lending reserves for a number of reasons. The rise in loan qualification standards make it quite difficult for even credit worthy individuals to be approved. In addition, those creditworthy individuals don’t want to borrow and non-credit worthy borrowers can’t borrow since they are underwater in their home mortgages and credit card debt. Lastly, one can only imagine the banks are sitting on these reserves as insurance against future write-downs. In regard to stock market direction, I recently I had the pleasure of reading a letter from Bill Gross, Pimco’s manager of the world’s largest bond fund. He wrote a very nice article stating that late October/Early November marked the end of the current rise in stocks. I have no interest in being a wise-guy or second guessing a man who is probably much smarter than I. Unfortunately, his conclusion makes little sense. God knows I agree with his opinions of the underlying fundamentals. I’ll be the first to agree that nothing has changed fundamentally for our economy or to stimulate corporate profits. I would LOVE to short the stock market right now, but I just don’t think the time is right. The time will come without question if we stay the course with the current economic policies. At the current time, it seems that the governments and central banks simply won’t allow Mr. Gross to be correct. In that same vein, Paul Tudor Jones released a letter to his investors explaining that their fund had missed most of the rise in stocks this year and that after a “probable correction sometime in the fall” they would initiate a position. Also, Meredith Whitney, an excellent analyst who called the housing crisis several years ago told CNBC today that she hadn’t been this bearish in over a year. With so many professionals and amateurs alike insisting on a top or at least a correction, maybe we simply won’t get one for a while. We are in historic times; can we see a historic run in stocks fueled by federal liquidity? Could this rally be one where nobody wants to buy in, instead waiting for a reaction that never comes, investors must capitulate much later and at much higher prices?

Wealth Preservation Wealth preservation is difficult enough in boom times. Between investment mistakes, over spending and especially taxation, families and individuals have a full time job in front of them. In the significantly more difficult periods, like what we currently face or such as those of the 1970s, the 1930s or in Japan since 1989 the job of preserving wealth becomes increasingly

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difficult. Although each of these periods was very much different, each similarly destroyed large amounts of wealth or at the very best stinted the growth rates of most portfolios. Japan’s Nikkei 225 Index (1989-2009) NIKKEI 225 INDEX (9,784.14, 9,802.53, 9,725.81, 9,791.18, +20.8701)

45000

40000

35000

30000

25000

20000

15000

10000

1989

1991

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The individuals that really profited from the liquidity boom of the 1980s and the 1990s were those that successfully preserved wealth in the late ‘60s and 1970s. Similarly, those individuals that were able to take full advantage of the post WWII secular bull witnessed during the ‘40s and ‘50s required what seemed like untraditional asset allocations during the 1930s. During the massive bear market from 1929 to 1932 savvy investors like Jesse Livermore and Joseph P. Kennedy (the father of the future president) shorted stocks heavily and made fortunes. Some of the wealthiest people today were able to take full advantage of the inflationary environment of the 1970s and invest with CTAs or at the very least commodity related stocks. Being a true investor involves more than simply buy and hold. That strategy works magically during a secular bull market and it can work decently in nominal terms during periods like the 1970s. But, for even that to be the case, one needs a high tolerance for pain and the unblinking nerve to add to one’s investment after large declines. In my opinion, being a true investor requires some alternative thinking and the ability to recognize the very long-term trends. With this, one must embrace alternative investments. They will be the only way to preserve wealth in prolonged recessions, depressions, inflationary periods, deflationary periods or a period of deleveraging like we see have seen. People may believe their portfolio is at the same level seen back when the Dow first crossed 10,000 in 1999. Unfortunately when adjusted for the Dollar’s decline, we now stand at the equivalent of just under 7,700 on the Dow. Ouch.

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