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ANNUAL REPORT COMMENTARY

2014 & 2015: Closing, Reflection, and Five Bad Trades To Avoid Next Year
December 2014

To our Clients and Investors,


The Investment Fund has returned an estimated +15% year-to-date, net of fees, as of the publication of this report.
As the year closes out, we once again reflect on the past 12 months, evaluate the current surroundings, and
continue to study and prepare for what may come ahead. Looking back to last December:

As we surmised a year ago, 2014 was about as good for mean-reversion thinking as one could expect. Well
expand on this later in the note. Having been given up for dead, some trend-followers also did well. However
trend performance wasnt consistent during the year. Some trends increased but so did volatility, in many
cases far more. Overall doing the homework and patient, disciplined portfolio construction paid off.

We were surprised by the outcome for global inflation throughout 2014. Against all odds, and despite the
wishes of monetary academia, the air continued to leak out of the balloon. We entered 2014 overweight U.S.
duration and tempered our view somewhat in late Q3 / early Q4. Overall this was a lesson in trading the
market you have, not the market you want. Meanwhile the cloud of deflation has darkened almost
everywhere we look. As if on cue policymakers are once again oblivious.

We are less convinced about what this means for Rates than Equities (well have more to say on this later). As
for inflation expectations, never say never. Hard to imagine something more mean-reverting than inflation
expectations in the long run, except perhaps market volatility. We think the picture below holds the key to
next years narrative. Markets have come to believe central banks can do anything. Unfortunately, late cycle is
when even the most well-intentioned theories and beliefs finally intersect with reality.

Citigroup G4 Inflation Surprise Index vs. US CPI YoY %

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Commodities had their moment in the sun in the first half of the year as envisioned, with the CRB up fifteen
percent. In a classic tale of two halves, that now seems like a distant memory. For trend-followers these were
ideal moves. For longer time frame investors like us, this was mean-reversion at its finest. The net result:
Commodities down seven percent from the January lows, but the round trip was almost six times that.

Whatever ones investment strategy, the year provided ample opportunity and time to study, prepare, and
avoid big mistakes. For example at one point in September, with just a month until the Fed closed the
faucet, short-term volatility in the Silver market fell below ten percent for the first time in fifteen years.
Regardless of ones view for the Silver price at that point, why was volatility plunging so close to the end of the
party, and who was selling? Yet many are still surprised by the sudden crisis in Commodities markets. Well
revisit volatility later in this note.

Last but not least, blind faith in policymakers remains a bad trade thats still widely held. Pressure builds
everywhere we look. Not as a consequence of the Feds ineptitude (which is a constant in the equation, not a
variable), but through the blind faith markets continue to place on the very low probability outcome that
everything will turn out well this time around. And so the pressure keeps rising. Managers are under pressure
to perform and missing more targets, levering up on hope. As we wrote last year, bad companies were
allowed to push their debt up in order to pay generous shareholder dividends and director packages that are
now (in an uninspiring turn of events) higher than their free cash flow. Buybacks are all-in at cycle-highs,
funded with shareholder money while insiders continue to cash out their own. Individual investors pressured
to pick up yield became their debt or equity holders lured by higher returns, easy-to-use ETFs, and asking no
questions. And so, just as Moodys suggested a year ago would happen (and we presented in last years
report), high yield spreads have widened all year in stark contrast to the gains in stocks and one of the most
supportive government Bond rallies in history. The default cycle doesnt appear to be that far off anymore,
and not just in U.S. markets. Credit markets have embarked on a new fundamental narrative bills still need
to be paid, and not everyone deserves to sell new paper at the same price. Markets are illiquid, fractured, and
in many cases unable to sustain any real test of selling. Meanwhile its business as usual at the Fed, where
credibility remains intact and market participants blindly expect another magic trick for Equities in the coming
year.

We think 2015 could mark a turning point in the narrative and for the first time in eight years weve begun
deploying capital, albeit still conservatively, in areas with the largest potential for significant dislocationswithout
risking much if we are wrong.
Without further delay we present our slightly unconventional annual list. Instead of the usual what you should do,
we prefer the more helpful (for us at least) what we probably wouldnt do. Five fresh new contenders for what
could become some very bad trades in the coming year. As usual this is not intended as an exhaustive list. In fact
we had to leave out some rather compelling candidates on this go-around. To further complicate things, some bad
trades from last year happen to be sneakily carrying over as we mentioned before. Well discuss these and others
in the next section.

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Five Bad Trades To Avoid Next Year 2015 Edition

BAD TRADE #1 For 2015: Leaked Research.


In March of this year one of the biggest Emerging Markets-focused macro funds in the world leaked a 100+ page
slideshow for why EM, and specifically Brazil and China, were going to implode (and bring down the world with
them). Around the same time the head of macro research for a major fund published an article in a top newspaper
warning of an imminent systemic calamity in Emerging Markets, and specifically China. We spoke with some
managers at the time and they said: Our team went to [insert country name here] with a bearish view, and came
back even more bearish. This statement probably deserves a whole section/discussion for itself. What followed is
now history.
Long ago, there was a time when professional money managers on average possessed an informational advantage
over the average market participant as well as the ability to translate this advantage into superior performance.
Some may attribute that edge to a combination of better data, research departments, experience, portfolio
construction, and risk control. We dont necessarily disagree. But a sixth factor may have been the most important
of all patience to let high-conviction, asymmetric bets pay off. Whatever the weights one assigns to each factor
or edge, most have been in irreversible decline for over a decade. Data is free. Research departments are
increasingly rigid. Average experience keeps falling as the industry contracts. Six years and a rising market have
forced portfolios to ignore probabilistic outcomes and focus only on the past trend. Risk control is modeled so it
doesnt have to be understood. Patience has been cut to zero.
The result of this October 2014 a prime example, is that major developed equity markets can now easily decline
nearly 10% in a period of only 3-4 days, without any new or significant information released from news or
government sources at the margin. And some individual stocks (which appeared liquid not even a day before) can
now effectively stop trading as if the market were closed.
Valuable and timely research doesnt come in a polished easy-to-flip format. It is planted and cultivated over time
and with great care. It doesnt copy-and-paste what is happening, but drives an ever-changing discussion of what
may happen in the future. It is exchanged with clients as part of a broad conversation on future investments, goals,
and strategy. Sometimes it may not even aim to recommend a specific course of action. It may simply conclude
that different information is needed, and outline the paths to get there. Good research should include alternate
scenarios. It should guide towards the most likely outcomes, not shut the door on everything else. Keeping an eye
on the vault labeled wont open can sometimes be much more rewarding. Next year should be no different.

BAD TRADE #2 For 2015: Its A Bull Market, If Markets Rise Then Volatility Will Fall.
Well save the bit about Its A Bull Market for Bad Trade #3. In this section well discuss Volatility Will Fall.
Volatility used to be regarded as a highly-specialized tool for risk management. Hedgers used it to hedge, and
every few years or so a levered speculator (read: seller) blew up. Today, six years of rising markets have turned
every yield-starved investor and performance-chasing fund manager into a volatility seller.
Selling volatility has become a casino floor bleeping with offerings of ETFs, leveraged structures, swaps and
futures. Every table offers its own brand of excitement and adventure. Yet unlike a real casino where some patrons
know theyll lose money and consciously play small to enjoy a free drink on a getaway with friends no one
selling volatility today thinks they can lose at this game.
Lets step back for a moment. The biggest monetary experiment in history has just (possibly) ended. From 2008 to
2014, the Fed was the largest synthetic seller of volatility in financial history. Following smartly along, countless
asset managers and even the worlds largest Bond fund came out as proponents of selling volatility. That is, until
the founder of said fund left to manage a smaller fund he could actually trade without the whole market knowing

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about it. Two weeks after his departure, the market collapsed and volatility briefly doubled. So the two biggest
volatility sellers in history have just left the casino floor and are sitting down to eat at the complimentary buffet,
while everyone else is doubling down on a new deck.
But lets ignore all of that. Its a bull market, you know, Mr. Partridge. So stocks will rise and volatility will fall. Well
it turns out not really. Six years into this bull market, calling this environment Mid Cycle would be very, very
generous. More likely, we just ended the first year of a two-year Late Cycle phase.
Take a look at the picture below. In over a century, U.S. Equities on a year-on-year basis have made gains with
falling volatility about one-third of the time, and made gains with rising volatility about a quarter of the time. In
total, U.S. Equities have made gains roughly 60% (one third plus one quarter) of the time on a year-on-year basis.

Percent of Time Stocks and Volatility Rose Together in the Prior Year

As it turns out, the long-term averages are trumped by the specifics of the stage in the cycle. Very strong trending
returns with rising volatility, both of which are firmly observed today, are the hallmark of late cycle bull markets
with very few exceptions. In late stage bulls, the market and volatility rise together well over double the long-term
average. Not very good odds. This is one of those cases where one doesnt have to be right about the underlying
trend in stocks to make a thoughtful, truly hedged bet. We wish the brave few hedgers luck.

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BAD TRADE #3 For 2015: It Didnt Work The First Two Times, So Lets Go All-In On The Third.
We could spend all day on the previous comment Its A Bull Market. But the fundamental truth, at least for us,
is that it doesnt really matter what animal this is. Market participants devote too much time to this discussion and
usually with little benefit other than satisfying their need for confirmation bias. We believe in watching risk instead
and letting the returns take care of themselves.
One way we define risk is price acceleration in any direction. Two of the ways we estimate this are by monitoring
market conditions and assessing the equity cycle. What has become increasingly clear is that more parts of the
market now behave as if we are in Late Cycle, while others have transitioned to a new Bear Market. These
conditions have been developing all year.
To our surprise this late cycle pricing (and risk) had not yet started to show up in our Core Risk guidelines. So in our
view, throughout most of the year we were dealing with a normal extension of prior conditions, with brief periods
of elevated risk.
Then over the last 2 weeks something truly remarkable happened.
We track a number of late cycle fundamental data series that we call our Core Risk framework. Our primary
concern in running these long-term price series is risk-management. The bigger the dislocation in our long-term
data, the larger the risk. Further, in our experience risk is also non-linear. Historically, above certain levels of risk
the probability and magnitude of severe drawdowns follow patterns similar to a power law.
The chart below offers an example. In almost thirty years, the highest value (risk) ever achieved in our Late Cycle
Equity Pricing Model was during May 2008. It also led to the largest drawdown. The occasional failure such as 2005
produced a flat market, but in the process gave us valuable information that High Risk dynamics were not yet in
play. Even then, caution and patience were highly rewarded.

Archaea Late Cycle Equity Pricing Model

As can be seen above, the last few weeks have finally produced what we call an All-In Late Cycle risk dynamic.
Historically this has transitioned to very high volatility and very large drawdowns for U.S. equity markets. We cant
control how the market will respond to this. All we can do is recognize the problem and manage the risk
accordingly.

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Also Going All-In, another one of our Core Risk monitors:

Archaea Core Risk Monitor

We hope this drives the point that debating a Bull or Bear case is particularly irrelevant here. Yes, it could be either
one. But the risk of ones bias being wrong has almost never been higher. And going All In this third time around
doesnt look right either.

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BAD TRADE #4 For 2015: Ill Worry About It Tomorrow.


We live in a world where long-term thinking has been thrown out the window. Stock traders have decried this on a
daily basis for over a century and yet it still rings true. Nowhere is this clearer than in the below chart. It starts at
the inception of the SPY ETF in January 1993. We break out the markets cumulative price return into overnight
(which well call investors) and cash-session (which well label day traders) components.

During its first few years of existence, the Cumulative Return of holding the SPY overnight vs. the cash session was
roughly equal. The market advance was being driven by both. Then in 1997 something changed. Day trader returns
peaked and became a headwind. Overnight returns started to accelerate and overtook the Market return. Even
more fascinating, this outperformance was maintained with lower volatility and lower drawdowns. None of this
factors in transaction costs or taxes. Regardless, its an extremely powerful visualization of what we think is a key
structural change in stock investing.
Recent years have been even more fascinating. Zooming in since 2009, the SPY has gained +195%, with the
investor component gaining +60% and day traders gaining +84%. The chart below shows their normalized returns
anchored at the March 2009 bottom:

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While it may seem like day traders have collectively beaten the pants out of investors, individually today each
group has only been able to reach where the broad market was roughly in 2010. As was the case since 1997 a great
deal of money has been left on the table by those unwilling to hold positions past the close which in this day and
age is an ever-growing chunk of market participants. In this bull market (like the ones before it) a significant and
steadily reliable component of returns came from thinking more like an investor.
As with every year before it, 2014 produced several periods of worrisome economic and geopolitical news. Sooner
or later one of these hit close enough to a portfolio managers sell button, and panic ensued. In a market
increasingly dominated by automated HFT day trading, speed-based market-making strategies, and generally ultrashort-term thinking, those who preferred to Worry About It Tomorrow instead of accepting overnight risk were
accordingly giving up risk premium.
Worse, over the past year short-term thinkers have given up even more of this risk premium. And along with it,
much of their performance lead. The next chart illustrates this interesting trend. Since the 2009 advance started,
the Ratio of Cash to Overnight Cumulative Returns has been broadly stable between 1.10 and 1.20. This meant the
cash session was maintaining a 10-20% lead. Since May 2013 however, day traders started to underperform
overnight returns giving up nearly half their previous lead. At one point in October they nearly gave it all back:

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This unfolding weakness is quite significant. The S&P gained 25% since May of 2013. The overnight return was
15.3% and the cash session return was only 8.7%. Heading into next year, there is little reason to expect this gap to
shift back in favor of short-term thinking. In fact, it peaked in late 2009. And then failed again in 2011.
If history is our guide and late cycle dynamics become even more entrenched, investors seem more likely to
outperform and intraday returns to drift relatively lower. For those taking this to mean a strong market
environment ahead, we look back to 2002-2007 when the Cash/Overnight Ratio finally fell below 1.10 for good,
after a 2+ year drift lower in nearly identical fashion to what we observe today:

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BAD TRADE #5 For 2015: Its the only game in town.


Much of this section has been covered in the other four trades. Nevertheless we think a separate mention is
important. Increasingly, investors are riding trends without understanding their fundamentals. We see this
philosophy particularly prevalent in volatility, inflation expectations, and the Dollar. We see it mentioned alongside
the Fed, with QE frequently hailed as the only game in town. Its siblings Abenomics and Draghinomics now
compete for the same label. Its become a well-worn phrase. We heard it in 2011 when some described the Gold
market, in mid-2012 on Bonds, in mid-2013 on Japan, to name a few. Meanwhile pressure continues to build as
market prices dislocate further from underlying driving forces.
This year almost no market has been spared the deadly phrase. Leaders became losers and vice-versa, in a
particularly nasty game of musical chairs. Mean-reversion doing its dirty work. At one point this year European
Equities were the only game in town. So were high-flying U.S. momentum stocks. Then Japan again. Then Emerging
Markets. Then China. Then the Dollar, followed by U.S. Equities. These last two, along with a few others, still stand
unchallenged.
We worry about the velocity of price adjustment required to close the wide gap between momentum investors
extrapolating trends and what fundamentals can truly support. The consensus reasoning is that price adjustment
wont happen because markets are permanently supported by central bankers. Unfortunately in every year since
2009, despite massive coordinated central bank intervention, price adjustment did happen in virtually every major
market and often with very painful knock-on effects. So when something is hailed the only game in town weve
decided to quietly agree, pack our bags, and move to a different town.

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As we enter a new year, we thank you for the opportunity to be a part of your investment process. May the coming
year be rewarding for the patient, diligent investor. When process is followed, imagination, innovation,
understanding, and action are the pillars shared by all successful investors. Ultimately, all of them have mastered
this delicate balancing act including knowing the value of when to do nothing. The value of avoiding big mistakes
is greater than ever before. And with another long list of potentially bad trades already competing for investors
attention, we will carefully study, think, and prepare for the coming year.
Happy Holidays and onto 2015.

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