Volume 1.14 Risk & Uncertainty in 2010 Dec 21 2009

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OLUME

1.14

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ECEMBER

21,

2009

There have been five overriding themes forour investment letters during the past year.Below we list and review them.1) Expanding liquidity drives financialmarkets, particularly when it occurs in theface of a sub-par but recovering economyand weak price inflation. This is the sweetspot in the cycle we so often talk about, andit is the best of all times for stock andcorporate bond prices when perception of risk abates.2) The Great Reflation underway sincelate 2008 has done its first job - abortedwhat surely would have been a full scaledepression at least on the scale of the 1930s.That was Act I.3) No one should believe that the hugereflation underway will make the economyand financial system whole again. Theprivate sector debt excesses were far greaterby 2008 than they were in 1929. A good partof the reflation effort is to transform privatedebt into public debt, and this will surelycreate another, different debt monster. Asthe year draws to a close, credit ratingagencies are starting to downgradesovereign debt and credit default swaps(CDSs) and are showing increased concernthat some major developed countries aregoing to have problems servicing their debt(e.g. Japan, U.S., etc.).The markets are starting to tell us thatGovernments with brittle, over-extendedfiscal positions will soon have to put inplace credible fiscal consolidation -- taxincreases, expenditure cuts, decline inservices, etc. This means more deflation,more uncertainty.

RISK & UNCERTAINTY IN 2010:

Hopefully Some Return Too

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4) Zero interest rates in the U.S. togetherwith Federal Reserve asset purchases, much of it low quality, has done its job of inflating assetprices which improves balance sheets. Betterfinancial markets greatly help capital raisingability, further strengthening balance sheets.As a result, they are much improved. Thequestion is over sustainability. Fears of renewed asset bubbles have surfaced,complicating Fed and other central bank decision making. Do they risk tightening toosoon or too late? Does a middle ground exist?Zero interest rates are an extreme anomaly andcannot last unless the U.S. economy remainspermanently depressed and in deflation likeJapan has been for 20 years. This seemsunlikely but cannot be ruled out.5) The great flaw in the internationalmonetary system has allowed the U.S. - thekey reserve currency country in the world - torun up a $4 trillion tab with foreign centralbanks and has created excess liquidity andasset bubbles in countries buying those dollars.It has also contributed mightily to thedestruction of savings and investment in theU.S., and has created massive disequilibria inthe global economy and financial system.Economics 101 tells us clearly that alldisequilibria eventually get corrected. Theinteresting questions are how and when? Thatwill be the story for Act II of the drama and ithasn’t been written yet.As the year 2009 draws to a close, thereis clearly an aura of unreality. We barelysurvived a near-death experience nine monthsago. However, the pain and the fear for mostpeople were brief. It was not like the 10-yeardepression in the 1930s that changed attitudesfor two generations. The recent experienceprobably won't change many peoples' attitudesat all, and may even have a perverse, moralhazard effect. If the U.S. and othergovernments are always going to bail out thebanks and other over-indebted, overleveraged,reckless players, and stick the costs onto thesober and prudent, why not join the former? AsMark Whitehouse put it in a recent article,

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"Let's default and go to Disneyland - theAmerican dream - default and then rent."The music is playing again, people areup on the dance floor and the bankers(somewhat diminished in numbers) are gettingrich once more and raising tens of billions of dollars in equity on the much-improved stock market to pay off their TARP loans so they canpay out mega bonuses. Meanwhile, the banksare sitting on hundreds of billions of dollars of bad loans with more to come (default lags canbe long).The question for investors is - do youget up on the dance floor like everyone elseand pretend that the crash was a bad dream?Or, do you pay attention to the unresolvedproblems, do a little dancing, but be ready tograb a chair when the music stops?A key point we have been making allyear and will continue to do, is that the stock market in March 2009 met most of the criteriafor a durable bottom. These were: goodvaluations, massive fear, very expansionarymonetary policy and government throughintervention, bailouts, and stimulus etc. to do“whatever it takes” to put air back in the burstballoon. Simply put, the government took thedownside out of the economy and risk assets.The odds were very high that themarket environment would be good for sometime and it has stayed that way. However, theso-called fundamentals are very artificial - thestimulus, the subsidies (first-time home buyers,cash for clunkers, moratorium on foreclosures,etc.), the zero interest rates - none of that canlast.A second key point we have beenemphasizing is that no one knows what theunderlying economic conditions are really like,and more important, what they will look like in6-12 months. No one knows how sensitive thestill over leveraged economy is to a rise ininterest rates. No one knows how long nervousforeign central banks will keep buying dollars.No one knows whether the recovery in assetprices might morph into a full-blown assetbubble. Or the reverse. No one knows when

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