Q3 Newsletter

THE MKC GLOBAL REPORT MANAGER’S COMMENTARY Q3 2009 Current Fund Environment: Performance for many CTAs and CPOs have been flat over the last few months as the commodity markets remain divided and stocks continue to rally. Stock indexes contributed nice returns to those who had long positions as did the sugar and copper markets. The meats and energy markets likely eroded some of those profits as they oscillated back and forth, largely directionless. Most managed futures funds that posted strong returns in 2008 have had a quiet 2009. These funds are either flat or down slightly for the year, while still maintaining the desired near zero correlation with typical investments. For those of you interested in MKC Global Fund’s performance (or browsing the performance of other managers), it will be documented in a number of different fund databases. Among them, the two with the better websites are IASG.com and BarclayHedge.com. Equities: Even compared to the NASDAQ in the late 1990s, the current rally in stocks has proved remarkable. Although bear market rallies (like we saw in 1929 and the 1970s) can be vigorous, 2009 will still go down in the record books for sheer performance. The U.S. stock market rose 50% as of Sept. 14th and some Asian indexes more than 100% from their lows. Many fundamental factors have worked in unison to move the global markets higher. First, the global stimulus driven by the EU, U.S. and China have been reflected in asset prices. In the U.S. the government’s influx of cash has been reflected on financial company’s balance sheets and the bank’s quarterly earnings showed the improvements investors wanted to see. The “toxic” assets have been assumed by the U.S. government and replaced with cash. Also, fund managers are feeling pressure to put up numbers this year after 2008’s walloping and subsequently moved a large amount of cash back into stocks. As the rally continues the desire not to “get left out” grows stronger until all the individual investors have bought in. Lastly, the government stimulus has given lift to the automobile and housing sectors specifically, giving the public an illusion of a recovery. Cash For Clunkers and the $8,000 tax refund for first time home buyers did their jobs, temporarily. I am an owner of stocks and will be (at least off and on) for a while longer. With that said, I don’t have a particularly strong opinion for them over the next 9-12 months. I will offer a guess that they can be higher while the interim becomes increasingly volatile. Historically, markets have a tendency to become choppier as a move progresses. In the past, September and October have proven to be poor months for stocks. Calendar coincidences aside, this year shouldn’t be an exception. At some point this rally in stocks will need to take a meaningful breather and that break could come shortly. (Projections are always fun…how about first half of October?) Although I will remain involved in stocks, I wait patiently for the next top. Like I stated in my last newsletter, I don’t see a way in real terms for this to be the beginning of a secular bull market, one that will take us to all time highs and beyond, marking March 2009 a generational low. I just don’t see it. President Obama, Timothy Geithner and Ben Bernanke could engineer us into a situation where we can witness what I just described, but it would be in nominal terms.

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When the top in equities arrives, I believe that one’s aggressive capital (if appropriate) needs to be allocated to shorting the weakest stocks or stock indexes. If the performance of the various global stock markets remains consistent, this means shorting England’s FTSE and France’s CAC 40 indices. They are by far the weakest, underperforming their Asian piers by some 50%. P/E Ratios are a favorite tool of many value oriented investors. I appreciate their uses on a very long-term scale. Going back over the last century, stocks have averaged a P/E ratio of about 16 (+/-). Generally, when P/E ratios get out of line one way or the other, either stock prices or corporate earnings adjust to bring that ratio closer to its historical average. For example, in 2000 the average P/E was 30 (twice the historical mean and overvalued). In early 2009 the average P/E was 12, undervalued but not to an extreme degree. Unfortunately, it is only the extremes than can give me the confidence from a fundamental viewpoint that a final real generational low occurred. Every meaningful, final, end-of-the-bear-market, everyone is swearing off stocks, genuine bottom has ended with stocks trading at single digit P/E ratios. Chances are, this time around will not be different. Commodities and Housing: The great debate between inflation and deflation continues and the evidence for both remains strong. Maybe we will see each as commodities move sideways before high inflation finally sets in? I certainly don’t have the answer. Until I do, I will simply follow the price trend. Since the last newsletter, sugar and copper have been the two strongest commodities worldwide. The price of sugar advanced in a parabolic manner from 14 cents to 23 cents. The street perceives copper as a global recovery/China story and has bid up its price accordingly. The advance in global stock markets coupled with China securing relationships with many natural resource producing companies and countries (particularly in Africa) have helped copper. China remains exceedingly aggressive about securing its raw material supply chain. The Chinese are very shrewd, and have aggressively pursued development and infrastructure within Africa. Chinese trade with Africa has increased by a factor of ten and at the end of 2008 China passed the US as Africa’s top global trading partner. Watching Africa over the next 10-20 years should be very interesting.

Occasionally, analysts and economist refer to copper as “Dr. Copper” since its price can precede movements in the direction of the general economy, giving the illusion of a predictive ability. In that same light, lumber prices may give us some sense of the direction of home prices and residential real estate. Lumber hit a major

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low last January and has consolidated since. Several weeks ago, it began to move lower and dropped below the prices in January. If speculators and hedgers anticipated the potential for home values to rise in a meaningful way, they usually would expect a demand increase in lumber and prices would rise accordingly. People seemed excited about the fact that in July, home prices rose for the first time in 3 years. In any major bear market, prices rise periodically before moving lower again. I don’t believe home values are an exception. Even though supposed affordability is at a 30 year high, there are several reasons why prices probably haven’t bottomed in real terms. First, the inventory of homes remains very high. This requires time to work off the oversupply. Next, an ample (and accelerating) supply of foreclosures and short sales come on to the market each month, driving the value of homes down since these types of transactions typically sell well below current market rates. Also, high unemployment (and rising) will dampen the demand. Lenders typically need to see a consistent job and salary for at least two years before processing a mortgage; this is aside from the fact that people obviously need jobs to afford the deposit and mortgage payments on the home in question. Most of the previous criteria could worsen when the economy turns down again. Lastly, another mountain of growing resets remains for various types of adjustable rate mortgages (ARMs) peaking in Feb. of 2012 and remaining elevated through 2014. See the chart above. Prices probably won’t collapse in value from here, but further declines shouldn’t be surprising. The following chart shows a 60 year price history of U.S. average home values. In virtually any market that witnesses extreme prices, those prices correct to and past the long term mean.

Maybe I have spoken too soon though… If President Obama rolls out a Cash for Condos program then all bets are off. Gold I didn’t originally plan on saying much about the yellow metal, but after last night I couldn’t resist. While watching TV, there were four advertisements for gold companies within a thirty minute window, two of which were back to back. This has been occurring to some extent for several months, remember when the company Cash For Gold paid for a Super Bowl ad in Jan. 2009? Typically, big advances in a market simply don’t occur when everybody is expecting them. Think about it, if everybody has bought, who remains to buy and propel the market higher? Epic bull markets begin when nobody wants anything to do with them. This bothers me about gold and silver over the next year or two. In regard to the current situation in precious metals, I think there may be enough anticipation and excitement about an advance in their prices that they could indeed move higher, for a while, but Its sustainability may be

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in question. Back in the 1970s before gold rose by seven times (and silver by a factor of twelve) it declined by 50% while silver moved sideways for three years. That type of price action kills any and all enthusiasm for a market and consequently sets up an ideal scenario for the genuine bull market. Politics and the Economy This topic alone could span many pages, but I will keep it short and use a very broad brush. Currently President Obama’s push for universal healthcare dominates the headlines. This coupled with the Cap and Trade Bill will make our economic future interesting. These two items are obviously historic since neither has been seen in any form on a national level before. Each will be historic due to their financial implications as well. The Wall Street Journal called Cap and Trade “the biggest tax in American history”. Businesses and individuals will be taxed heavily to combat Global Warming. This obviously comes at an inopportune time for them do to the recessionary environment and challenging economic situation. Implementing and enforcing it will cost money this country does not have and the government will take a larger percentage of people’s already finite income. Universal healthcare exists in several countries, including England. In England, their government healthcare system (their only form of healthcare) is by far their largest government expenditure. Running their system employs 1.4 million people, which makes it the 3rd largest organization on the planet. There are more administrators than healthcare professionals. Aside from that, the quality may be in question with many surgeries maintaining a multi-month waiting list. From the data I have reviewed, the U.S. currently spends (without Obama’s proposals) more per capita on healthcare than any other country in the world. Since the U.S. is so inefficient with its spending, the current spending gap will balloon with any new healthcare program. Before this begins to look like a political piece, I will tie it back into economics. The simple fact remains; this country has no money to run a federal healthcare system. President Obama states that no government funding will be used to operate it. Unfortunately, that only leaves one other option for financing it: higher taxes. Either funding healthcare through higher taxes or increasing our government debt will have similar long-term effects; both will prolong a genuine recovery in our economy. ___________________________ Finally, as John Mauldin recently left his readers in his newsletter “Thoughts from the Frontline”, so shall I; with a quote from The Privateer: “In 1909, the US federal government had an annual budget of $US 0.8 Billion. With this it governed a population of just over 90 million people. The cost of government was about $9 per capita. In 2009, the US federal government has an annual budget of $US 3,550 Billion. With this it governs a population of just over 300 million people. That’s a cost of about $11,675 per capita. Are we 1200 times better off?”

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