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Where Have We Been and Where Are We Going

When the market is acting contrary to our investment strategy, I like to review our core investment themes to see if we need to make a strategic shift or whether we are simply in a counter-cyclical trend within the core investment theme. The markets do not move in a straight line, so there will always be advances and retreats. The key is to determine if a retreat is just a correction within a long-term bull market theme or if it is an end of the theme and a change of direction. Below is a discussion on four of our key investment themes and the implications for each.

(sorry about the underlining below – I’m not sure what caused it and short of re-typing it I can’t get rid of it)

Core Investment Themes

§ Theme #1: Inflation Protection

o Basis: High energy costs and food costs, when present at the same time, have historically led to significant increases in inflation. Inflation has historically destroyed significant value in investment portfolios, devastating both equity and fixed income holdings. This is a significant risk for which a portfolio needs protection.

o Portfolio Implications: The portfolio is structured to prevent capital loss from the growing inflationary pressures in the world economy:

§ Very short term fixed income exposure

§ Heavy cash position

§ Gold and commodity exposure

o Is this theme working now?

§ It worked perfectly until July 13th when the Treasury announced that it would not let Fannie Mae or Freddie Mac fail

· The big hedge funds were highly leveraged to the gold and commodity theme, and were short financial stocks – they have been selling their gold and commodity stocks to pay back their leverage and/or cover their financial shorts

· This is a short-term issue- once the hedge funds are re-positioned or have their leverage paid back, the selling in commodity names will abate

· Part of the nationalization of Fannie Mae and Freddie Mac was a world-wide effort to prop up the failing dollar. Japan’s Nikkei business newspaper reported that a plan has been put into action for the Federal Reserve, Bank of Japan and European Central Bank to buy dollars and sell Yen and Euros. Gold and commodity stocks, to some extent, trade inversely to the dollar – a stronger dollar means weaker gold and commodity stocks.

· These currency interventions never last long – eventually fundamentals of the country’s finances will dictate the value of its currency vis-à-vis its trading partners. With the recent nationalization of Fannie Mae and Freddie Mac, the US has doubled its national debt and weakened its balance sheet significantly, which will lead to a weaker dollar.

o What is the outlook for this theme?

§ Intermediate and long-term, inflation will be a significant problem, albeit not at 70’s and early 80’s levels. Current CPI and PPI projections show that we are at a 17 year high for inflation. Television pundits have taken the position that given the sell-off in Energy and Ag prices, this is just an aberration and that we will return to low inflation again. This is specious thinking, in my opinion. The reality is that we have likely just raised the trading range for oil, corn, beans, natural gas, etc., and that the next bull market move will be a higher high and a higher low price for the trading range. This is how markets and inflation work.

§ Short-term, we are likely to see continued softness in the inflation hedges until the market sees that inflation is not going away – it will likely take a couple of quarters before this will happen.

§ It is important to note that after I wrote this China has announced its first interest rate cut in six years and Europe and the US have announced massive liquidity infusion into their financial systems in order to firm up th
ings after the Lehman Brothers bankruptcy and Merrill Lynch purchase. These things are inflationary in the long-term.

o What is the Strategy now?

§ In the near-term, we are waiting for an oversold rally in the gold and commodity names to lessen exposure to the inflation hedges until we see the buy-in by the broader market that inflation is not going away. We will likely increase our exposure to cash equivalents during this time. We will continue our positions in short-duration fixed income and cash equivalents as opposed to increasing durations.

§ The nationalization of Fannie Mae and Freddie Mac is the single biggest inflationary event ever to happen to our country, in my opinion. Using history as a guide, countries that build up debt in significant amounts can only pay it off by debasing their currency, flooding their economy with liquidity, and generating inflation. This is the most likely course that I see happening in our economy and it will mean that gold and commodity stocks will be worth significantly more in the future than they are today.

§ Theme #2: Changing Demographics

o Basis: There have been monumental shifts in demographics around the world as formerly poverty stricken citizens of the third world are moving into the middle class. Demographic shifts are generational in nature and provide strong investment themes that last several years. Demand has increased for energy, base metals, and agricultural products so that the new middle class can cars, homes, appliances, meat and dairy.

o Portfolio Implications: The portfolio is structured to capitalize upon the higher growth rates for the economies in the developing world:

§ Foreign Stocks, including Emerging Markets

§ Commodity Stocks, particularly energy stocks, base metals and ag

o Is this theme working now?

§ It was until Spring, when there was speculation that China would slow down its economy after the Olympics.

· China began to comply with US pressure to let its currency increase in value against the dollar as a way to improve the trade deficit between the two countries. The Yuan increased in value by 1% per month while their economy slowed to 9.1% growth from 10.7%.

· This led to fears that there will be a world-wide slowdown in demand for energy and base metals, and a world-wide recession…again, there is some teleological thinking happen as a 9.1% GDP is far from recessionary

o What is the outlook for this theme?

§ The China Post reported yesterday that China has instituted a $54 billion economic stimulus plan to increase growth back above 10%

§ China has also intervened in the currency markets to stop the Yuan from rising in value

§ China has announced several new infrastructure projects, including a tripling of their railroad system and hundreds of new coal fired power plants – as well as an interest rate cut. September 18th is a big day in China – it is the day after the Paralympics ends and all of the factories that were told to shut down for polution reasons can re-open and begin to be consumers of oil and metals.

§ September 18th is a big day in China – it is the day after the Paralympics ends and all of the factories that were told to shut down for polution reasons can re-open and begin to be consumers of oil and metals. That is just 3 days from today.

o What is the Strategy now< /u>?

§ Maintain exposure to this theme at current levels.

§ Theme #3: Dollar Bear Market

o Basis: The United States is the world’s largest debtor nation and we require a constant inflow of funding from the rest of the world in order to meet our spending needs. The countries that supplied over 90% of our funding in the past two years are: China, Russia, Brazil and the Middle East. We have no strategic friends in this group as our traditional funders, Japan, Great Brittan, and the UK, decreased their purchases of our debt during this time period.

o Portfolio Implications: The portfolio is structured to capitalize upon the continued fall in the value of the dollar:

§ Emphasis on Foreign Stocks, and earlier Foreign Bonds (none currently held due to our inflation theme)

o Is this theme working now?

§ The foreign markets are in a bear market along with the US market

o What is the outlook for this theme?

§ The current currency intervention will make US investments preferable for foreign investors. This, however, is a short-term situation

o What is the Strategy now?

§ Maintain current exposure to Emerging Markets Stocks. China’s stimulus plan will help turn emerging markets positive as other Asian countries begin to follow their lead. The crowd expects the US stock market to turn positive first, but given our financial market problems which are shared by the European economies, I do not believe that will happen. I believe that the contrary position is more likely to prevail: emerging markets will recover before developed markets.

§ When the emerging markets begin to outperform, incrementally increase exposure.

§ Watch the technical support level of 1,215 on the S&P 500. If it is violated, then we will likely reduce exposure to both large cap US Stocks and developed market Foreign Stocks. A violation of 1,215 would indicate that we will likely have further downside and a protracted bear market.

§ Theme #4: Mid- and Small-Cap Stock Outperformance

o Basis: Mid- and Small-Cap stocks outperform Large Cap stocks over the long-term due to generally higher earnings growth. A long-term oriented portfolio will have an above average allocation to Mid- and Small-Cap stocks.

o Portfolio Implications: The portfolio is structured to capitalize upon the historic outperformance of Mid- and Small-Cap stocks:

§ Overweight Mid- and Small-Cap stocks compared to traditional benchmarks

o Is this theme working now?

§ The Russell 2000 was outperforming the broader market YTD by 900 basis points

o What is the outlook for this theme?

§ The historical relationship should continue

o What is the Strategy now?

§ Coming out of a recession or bear market, Mid- and Small-Cap stocks generally lead the way due to their ability to increase their earnings faster than larger competitors

In examining these core themes, I am confident that we are simply in a counter-trend within each of these major trends. Counter-trends are painful, but they are a natural part of the market’s actions. We always look for investment themes that have at least five-years duration on a forward-looking basis. Within the five-year period, you will have advances and retreats as a natural part of the theme’s progress. We are simply in the retreat phase that will run its course: dollar intervention will not last, it never has, its always a short-term action; China has already begun to stimulate its economy; inflation is not whipped but will be an issue for the next several years; and the move from poverty into the middle class in the third world will continue (remember, they have no subprime mortgage problems in the third world – other then their governments’ ownership of Fannie Mae and Freddie Mac bonds, which our government has now guaranteed their repayment).

In terms of these major themes, they will return to dominance – it will just take some time (and we are already seeing signs of some of them turning around with stimulus in China). Corrections are never fun – they cause me to lose sleep and eat Tums like candy – but the absolute wrong thing to do is panic and follow the herd into doing something stupid. The time to take action was in June and July, which we did.

In June and July when commodities were at their top, and Normal 0 as oil approached $150, we sold a lot of our energy/metals/gold/ag exposure, selling partial positions to lock in gains. The sales were based upon the surveys showing that public sentiment was fairly negative; the high oil price would likely have an incremental slowing in demand, leading to lower prices. With oil at historically high levels, it was prudent to book some profits and wait for a market price correction, then reinvest the proceeds in companies with strong fundamentals and catalysts for earnings growth.

Our core thesis on energy/metals/gold/ag has not changed – we still see that we are in a long-term bull market for these commodity names – but risk management practices sometimes dictate changes should be made. That was the strategy we employed going into the third quarter for our clients that owned individual equity securities.

Here is the list of what we sold along with the percentage of each holding we sold among the accounts that we manage:

Anandarko Petroleum: 15% of position Apache: 20% of position

BHP Biliton: 10% of position Canadian Natural Resources: 10%

Compania Siderurgica: 50% of position Core Labs: 15% of position

Diamond Offshore: 15% of position FMC Technologies: 15% of position

Frontier Oil: entire position Halliburton: 20% of position

Imperial Oil: entire position Lundin Mining: entire position

Marathon Oil: 20% of position National Oilwell: 20% of position

Oceaneering Int’l: 20% of position Southern Copper: 10% of posi

Tenaris: 10% of position Ultra Petroleum: 10% of position

Valero: entire position XTO Energy: 15% of position

After energy/metals/gold/ag companies had fallen 15% to 20%, we started buying again – some beaten down energy/metals/gold/ag names, some beaten down global industrial names with significant international sales, and some biotech names: Cabot Oil & Gas, Cleveland Cliffs, Mosaic, Eaton, EOG Resources, El Paso, Covance, Genentech, Imclone, Goodrich, Nucor, Gilead, Occidental Petroleum, Parker Hannifin, Petro Bras, Sandridge, Southwestern Energy, Syngenta, Xenoport.

Assessing this strategy decision, the sales were all good moves – we booked profits and diversified away from energy to a big degree with those profits.

The purchases of biotech names were extremely good moves – two of the companies have already been acquired and we booked 20%+ profits on those investments in a few weeks.

The purchases of the industrial names and the other commodity names were clearly early since these markets have continue to sell off – but we are using technical indicators to build these positions at lower prices so that when the recovery comes we will have holdings in areas with strong/growing earnings. Companies with growing earnings have historically led the market coming out of a recession/bear market.

The biggest reason for the selloff in these areas is that the hedge funds, ETF’s, and mutual funds are being liquidated by investors in a significant way. Several hedge funds that opened near the top of the commodity bull phase are collapsing, and there is a need to dump the assets to pay off investors. This sort of selling presents an artfical downdraft not supported by fundamentals, and the absolute wrong thing to do from an investment perspective is to sell into the downdraft.

A similar thing happened in 2006 when oil went from $75 per barrell to $50 per barrell, and once the artifical downdraft was removed, both oil and oil stocks continued their moves upward. Things are a bit different right now as oil demand is down due to a slowing world economy. But, as noted above, economic stimulus is being implemented and demand will return to previous levels.

As we proceed through the third quarter and into the fourth quarter, we will continue to make changes to client portfolios as we see opportunites present themselves.