2.0 poseidon perspective february 2010

THE POSEIDON PERSPECTIVE … sound navigation through perilous cross‐currents …

26 February 2010

Dear Investor,

The old Wall Street adage is “As goes

January, so goes the year.” Table A

contains the equity returns for several

indexes for January 2010. The sad news

indicates a very inauspicious beginning for

equities in 2010. Will this brief retreat

dampen the bullish spirits which have

reigned with optimism over the past 9

months? Will the fear of a cutback in

government largesse and an end to

quantitative easing signal a retreat from

risky assets? Have the trillions of US$’s

been in vain if deflation continues to worm

its way into the economy? We believe that

many answers will be provided as

economic and geopolitical events coalesce

during the Year of the Tiger.

TABLE A Jan ‘10 1 Year 3 Year* 5 Year*

S&P 500 (3.70)% 30.0% (9.28)% (1.89)% DJT (4.98)% 31.4% (7.47)% 1.60% S&P 600 (3.45)% 37.1% (7.67)% 0.01% MSCI‐EAFE (4.44)% 35.5% (10.2)% 0.32% MSCI‐EM (5.65)% 76.3% 1.17% 11.5%

*measured as compound annual growth rate

We quickly note that the two biggest losers

in January were the Dow Jones Transports

(DJT), a leading indicator of the US

economy and MSCI Emerging Markets,

undoubtedly one of the riskiest places to

be in this world of “hot money,” currency

vigilantes, and clashing sovereign policies.

These dynamics are the sort of impetus

that can push the US$ higher in spite of

reckless deficits and aggressive monetary

policy.

We agree that the market lows of March

2009 were a much oversold position;

however, we do not believe that economic

fundamentals justify the surge of world‐

wide equity prices that has occurred over

the past year. We continue to be out of the

equity markets. We believe the big returns

have been made; there is no longer much

room to the upside; the risk of correction is

high. We will continue to endure the

mandate of patience.

During the recent panic we saw the

correlation among asset classes converge,

thereby destroying the traditional theory of

diversification. We contend that the world

is still functioning amid an unbalanced

credit bubble. Simultaneously, a

THE POSEIDON PERSPECTIVE 26 February 2010

deflationary spiral remains a serious

possibility and many previously diverse

markets now trade in tandem responses to

increased volatility. We look to Chart 1

which depicts the S&P 500 and the MS

World Index which excludes US equities.

During the last three years these two

indexes have traded in a lock‐step fashion,

a convergence of risk. So does a “world

index” support the diversification of an

America‐based portfolio?

CHART 1 GO WITH THE FLOW

Source: PSI; StockCharts

Has globalization begat the equalization of

American small‐cap companies with a

status comparable to emerging market

equities? It may sound extreme; it is

extreme. One must consider that a Silicon

Valley software firm could be included in

an amalgam with lesser investment

potential than an index which includes a

chain of Bollywood theaters? As we gaze

upon Chart 2 we see the small‐cap S&P 600

over‐laid upon the MSCI Emerging

Markets index. There are many

interpretations and explanations for the

pricing of these equity indexes but the fact

that investors now seem to value the

emerging economies so much greater than

the US strikes us as a bit unsound. One

only needs to consider such factors as the

rule of law in Russia, the censorship in

China, or the potential for a nuclear

exchange between India and Pakistan prior

to the weighing of global risk. The grass

always looks greener. We do not consider

either one of these equity classes to be


fairly valued. We note the movement of

capital from the US to under‐developed

foreign markets. We cringe at the

exuberance which is displayed in both

Table A and Chart 2. However, world

events sometimes have a way of reverting

very quickly and a quiet afternoon picnic

can easily be disrupted by stormy weather.

CHART 2 LEADING AND LAGGING


Finally, we consider the uniquely

American relationship of the insatiable

consumer with their oversized motor

vehicles. Chart 3 is a combination of the

Retail HOLDRS Index (IHR) of domestic

retail stocks and the continuous contract

for West Texas Intermediate Crude

(WTIC). Market expectation for retail sales

as displayed by the IRH pricing is very

robust. Investors appear to value very

optimistically American consumer

spending which is responsible for 70% of

the US economy. We maintain that there is

an intuitive inverse relationship between

the cost of energy and an increase in

discretionary spending. Energy costs,

especially gasoline, are a severe drag on

the economy and a burdensome tax on the

consumer.

WTIC, for a number of reasons, the China

boom, hedge fund speculation, production

costs, et al, has made an astounding

recovery in price in an amazingly short

time. Meanwhile, it has become apparent

that oil pricing has more to do with the

supply of money than the supply of crude.

Yet, these factors have supported oil’s rise


of more than 115% since March 2009. Also,

the marginal price of production is around

$70 per barrel according to the Financial

Times. Co‐incidentally, we are in a period

of above‐average inventories. We believe

that commodity prices may continue to

accommodate speculators and the China

boom. However, valuation of retailing is

beyond economic fundamentals. Once

again these are broad brush analogies

which come to mind during a time when

all manner of risky assets have surged in

price within nine months.

CHART 3 A CRUDE MISUNDERSTANDING


In summary, while Charts 1, 2, & 3 indicate

very high spirits, our contention is that the

massive reflationary efforts of the US and

other central banks have still produced

GDP inflation as the American consumer is

still in a deleveraging retrenchment. We

see this as very bearish for equities.

Walmart stores reported a decrease in

revenues for US stores during their fourth

quarter fiscal 2010 of (0.5)%, a first for the

company. Overall annual revenue growth

for the company world‐wide was 1.0%.

SOUNDINGS

We would like to extract some substantive

quotes from Jeremy Grantham’s most

recent “Quarterly Letter” dated January

2010 available on the GMO website

www.gmo.com. We do this for two

reasons. We have the highest respect for

Mr. Grantham’s skill and experience as an

http://www.gmo.com/


investment manager. We also revere

GMO’s research prowess. Hence, we

believe that these passages succinctly and

clearly elucidate a number of points which

we have addressed over the past three

months. If due, either to our lack of

communicative skills or your oversight in

perusing our Perspectives, please pay

particular attention to the following. This

is important.

Grantham accentuates the point that when

the “Fed attempts to stimulate the

economy by facilitating low rates and

rapid money growth, the economy

responds. But it does so reluctantly,

whereas asset prices respond with

enthusiasm. In our studies of the

Presidential Cycle we have shown that,

historically, where modest Fed stimulus

and some moral hazard hardly move the

dial on the economy in the third year of

the cycle, they push stocks up almost 15%

a year above normal and risky stocks

even more. Yet the Fed has been reckless

in facilitating rapid asset booms in the

tech and housing bubbles.” [our bold]

We believe that this analysis is a concise

and accurate portrayal of the past 10 years

of central bank policy. However, going

forward the utilization of these same

simplistic ideological regimes and printing

press mechanics may be very dangerous.

As Mr. Grantham points out, the Fed’s

balance sheet is “unrecognizably bad” and

government debt looks as if “a replay of

World War II.” We must add that amid

the recent deleveraging the consumer is

completely underwater and bank balance

sheets are in shambles. We view these

deleterious factors as potential prelude to a

perfect storm. Grantham postulates that

“the Fed is unwittingly willing to risk a

third speculative phase, which is

supremely dangerous this time because its

arsenal now is almost empty.” Given this

combination of investor greed and

continued financial speculation in spite of

suffering two massive bubbles within the

decade the equity markets are still

promoted across the media and academia

with such tripe as “stocks for the long

run.” The “relief rally” since March 2009 is

not sustainable unless the Fed continues its

massive quantitative easing and

government stimulus is taken to the next

stage, overdrive. Grantham points out that

“the market [S&P 500], however, is worth

only 850 or so.” He also notes that “fixed

income seems badly overpriced.”

There are many nuggets of wisdom in this

letter and Grantham ends with “Lessons

Learned in the Decade.” We highly

recommend a close review of these

conclusions. The conclusion we would like

to accentuate is “Asset classes are really

more inefficiently priced than individual

stocks on average, and therefore offer

greater opportunities for adding value and

reducing risk.” We include precious

metals as one of these “asset classes” and

state that we deem them to be much less

exuberantly priced than stocks, bonds, or

other commodities. We found Grantham’s

most astute reasoning and important

formulation regarding current market

conditions was that “The real trap here,

and a very old one at that, is to be

seduced into buying equities because


cash is so painful. Equity markets almost

always peak when rates are low so

moving in desperation away from low

rates into substantially overpriced

equities always ends badly.” [once again

our bold]

We whole‐heartedly agree with his

contention that one of the most important

drivers of equity returns is credit, interest

rates, and credit spreads. While this

includes Treasuries, investment‐grade

corporates, high‐yield, etc, Chart 4 reveals

the rising spread between Treasuries, the

30‐Year Bond and the 2‐Year Note, which

is approaching 400 basis points. While the

Fed is able to control the short end of the

yield curve the long‐end is the bailiwick of

big investors and very aggressive traders.

We watch the long Bond as it may foretell

the future of both housing and equity

markets.

CHART 4 LONG TERM RATE WATCH


The outlook for long bond rates was

shaken by the news that China was

actually a net seller of Treasuries during

December 2009. Not to worry, Japan

picked up the slack and now reigns as the

largest foreign holder of US Treasuries

with a stash of $768.8 billion. This

announcement has subsequently been

amended by the US Treasury. With regard

to the surprise announcement by the Fed

that they would be raising the “discount”

rate, the market’s knee‐jerk reaction to this

“noise” was quickly corrected by shrewd

traders. The result will have less economic


impact than a major winter snowstorm.

Yet, this announcement, Bernanke’s

testimony before Congress, the constant

barrage of an “exit strategy,” and other, at

times conflicting, non‐information alerts us

to consider the basic rule that “a barking

dog does not bite.” While all of these

factors and related derivative information

add greatly to market volatility, we believe

that the Fed will be barking for the rest of

the year.

WEATHER WATCH

We turn now to the inflation/deflation

issue. We have been struggling with this

conundrum over the past year. As we

traverse turbulent and unchartered waters

there are lucid, cogent arguments for all

variations on the eventual impact of the

Fed’s “unconventional” and unrestrained

monetary policy which has been strongly

supported by the US Treasury. Quite

frankly, we have no clear conception of

what the future may provide; however, we

are by nature contrarians and, therefore,

we have become more and more skeptical

of the inflationary specter over the next

couple of years. Our thesis is premised

upon a few simple concepts. By way of

review we return to the recent monetary

activity of the Fed. Chart 5 displays the

Adjusted Monetary Base which has grown

at an astronomical rate since 2008. This is

the result of the complementary increase in

the Fed’s balance sheet and the system’s

bank reserves held by the Fed.

CHART 5 THE SURGE TO CREATE SPENDING

Source: St. Louis Fed


However, the monetary base is not the

same as the money supply due to the fact

that banks are not creating “new” money

thru the lending process. Chart 6 provides

a graphic view of when banks stopped

lending. Midway into the recession the

Money Multiplier dropped below 1.0 and

continues to fall. The reserves which

banks have available for lending are not

being utilized. There are numerous and

valid reasons for this lack of lending

activity. They include lack of creditworthy

demand, tighter underwriting standards,

alternatives for higher returns, and less

risky methods to rebuild balance sheets.

The simple conclusion is that, while the

potential for money‐generation exists, the

transmission mechanism, banking, has not

been operational as anticipated. While the

Fed and the Treasury have “saved” the

banks which were “to big to fail,” the

banking system itself has failed in its

primary duty and is stuck in a quagmire of

poor balance sheets, non‐performing loans,

and diminishing real estate assets. Where

we go from here is the trillion dollar

question.

CHART 6 THE FAILURE TO GENERATE CASH


Additionally, we offer the information in

Table B for support of the argument that

money and credit are not being generated

in sufficient quantity to support strong

economic growth. All information is

extracted from the Fed’s H.8, page 3,

(http://www.federalreserve.gov/releases/h

8/current).


TABLE B BANKING ON THEIR ASSETS

Assets: Loans & Leases* Jan 2009 Share Feb 17, 2010 Share % Change

Comm & Ind’l Loans 1,601.9 22.2% 1,303.8 19.8% (18.6)%

Real Estate Loans 3,800.8 52.7% 3,716.8 56.4% (2.2)%

Consumer Loans 891.6 12.4% 823.3 12.5% (7.7)%

Other Loans & Leases 923.4 12.8% 748.3 11.4% (18.9)%

Total 7,217.6 100% 6,592.2 100% (8.67)% * All loan amounts are $’s billion, there is rounding in totals Source: Federal Reserve System

We briefly point to the decline of

“Commercial and Industrial Loans” down

by 18.6% and “Consumer Loans” lower by

7.7% as a huge economic restraint. We

contend that if “Real Estate Loans” were

more realistically valued this number

would have decreased more dramatically.

Overall, the results are not conducive to

economic growth.

CHART 7 LESS CREDIT MEANS MORE SAVINGS


While there are a number of sources for

consumer debt, commercial banks,

securitization schemes, credit unions,

finance companies, and nonfinancial


businesses, the best indicator of Consumer

Credit Outstanding is the St. Louis Fed, see

Chart 7 which provides a 5‐year view of

growth and decline. There are numerous

dynamics at work here. Three are: 1) a

decrease in demand for loans, 2) a decrease

in the supply of credit, and 3) a lack of

ability to repay or refinance loans

outstanding. Together these factors feed a

decreasing consumer capacity to spend.

The impact on the economy will become

clearer as we watch long bond rates, real

estate pricing both residential and

commercial, and changes in employment

growth.

Prior to any recovery in the national

economy somebody, the government,

businesses, and/or the consumer must

spend more money. In the first instance

the government is doing more than its

share. Business is on the fence and the

consumer is on the ropes. We refer again

to Table B for a summary of the decline in

lending. “Consumer Loans” by are down

7.7% and revolving debt, Chart 7, has

fallen 3.8% since July 2008

Chart 8 provides three different rates of

unemployment, not one is pretty. We

understand that employment is a lagging

indicator and, perhaps, as the economy

picks up these numbers will fall

dramatically. However, there is also a

substantial risk that any “economic”

recovery will be muted in job‐creation.

CHART 8 PAINFUL PEAKS

Source: ShadowStats

Chart 9 provides a view of Money Supply

Growth. At the present time without any

increase in the money supply we do not

anticipate a rise of inflation.

CHART 9 DECLINES INTO DEFLATION

Source: ShadowStats


This does not mean there has not been a

surge of inflation in financial securities,

commodities, and valuation of derivative

contracts. The flood of money being

created world‐wide, China being a major

generator, must find a home somewhere.

Thus, we believe the general economy is

undergoing a substantial period of

deleveraging and deflation. The current

uptake in GDP activity has been an

inventory restocking from depleted levels.

The rate of defaults and foreclosures on

residential real estate is one measure by

which households are deleveraging.

RealtyTrac reported on February 11 that

default notices were up 4% year over year

(yoy) and scheduled foreclosure auctions

were up 15% yoy. James J. Saccacio, CEO

of RealtyTrac, stated that “If history

repeats itself we will see a surge in the

numbers over the next few months as

lenders foreclose on delinquent loans

where neither the existing

loan modification programs or the new

short sale and deed‐in‐lieu of

foreclosure alternatives works.” This

prognostication is one reason we are

hearing talk from the White House about a

solution to the continuing housing crisis.

Chart 10 is the year over year percentage

change in CPI. January 2010 showed year

over year rise of 2.6%.

CHART 10 A SUSTAINABLE REBOUND?

The remarkable news was that the January

2010 CPI fell (0.1)% from the previous

month for the first time since 1982. It is

always dangerous to extrapolate too much


from one data point especially from the

questionable metrics of the CPI. However,

this was a 28‐year event; thus, it demands

attention.

Chairman Bernanke and his Fed are very

smart people and understand the

challenges to economic growth. We

contend that there is a serious and

continuing risk of deflation and/or a

liquidity trap. From the minutes of the Fed

Open Market Committee (FOMC) issued

on January 27, 2010, “The Committee also

affirmed its 0 to ¼ percent target range for

the federal funds rate and, based on the

outlook for a gradual economic recovery,

decided to reiterate its anticipation that

economic conditions, including low levels

of resource utilization, subdued inflation

trends, and stable inflation expectations,

were likely to warrant exceptionally low

rates for an extended period.” Indeed, one

could reasonably argue that we have

already entered a liquidity trap as

evidenced by the need to go beyond “near‐

zero” interest rates for an extended period.

Since this monetary policy has not

stimulated the economy, an extended

policy of quantitative easing has been

undertaken. Concurrently, commercial

banks are “hoarding” cash thru reserves

accumulation and refusal to lend. These

conditions are all definitive of a “liquidity

trap.”

PROVISIONING

The week of February 15 released three

unexpected announcements. The first was

the International Monetary Fund (IMF)

gold sale of 191.3 tonnes. This is the

second part of a sale announced last year

of over 400 tonnes total. The IMF will still

control over 2,800 tonnes. The operative

word here is “control” for the IMF does not

“own” this gold; its reserves are the

contributions from member Western

countries to back the funding of IMF’s

lending activities. The sale of any gold

stock requires not only the approval of the

IMF Board but also the US Congress and

Executive Administration led by the US

Treasury. The salient feature of this

announcement was that the offer to sell

was not subscribed by any central bank,

unusual given the great expectations that

China would leap at this opportunity.

However, central banks, we include the

IMF in this category, have a history of poor

timing for sales. The most embarrassing of

which was the action of UK Chancellor

Gordon Browne, now Prime Minister, who

schemed to sell over 400 tonnes of the Bank

of England’s gold before 2002. The gold

was sold by auction at prices between $256

and $296 between 1999 and 2002. The

most recent IMF announcement may be

viewed by cynics as one more central bank

attempt to throttle the price of gold in a

continuing bull market. So, we must

remember the contrarian contention to buy

what central banks are selling. In the

commercial market George Soros has

voted with his wallet. Bloomberg reported

on February 17 that the Soros Fund

Management increased its holdings in the

SPDR Gold Trust (GLD) with additional

purchases of “3.728 million shares valued

at $421 million.” The Soros investment in

GLD, which is the fund’s largest holding,


was estimated to be $663 million as of

December 31, 2009.

Secondly, the Fed announced a surprise

move to raise the discount rate by 25 basis

points. The insignificance of this move

was further accentuated as the Fed also

announced that the term for the discount

rate borrowings would revert from 28 days

to 24 hours, the overnight rate. This

facility, historically referred to as the

discount “window” has always been a

minor mechanism for monetary policy. It

has traditionally been shunned by banks.

The Fed Funds Target Rate which is the

Fed’s primary mechanism for influencing

short term rates remains unchanged.

However, the move may force weaker

depository institutions to resort to other

banks for short‐term funding. Thus it

creates another opportunity for large

money‐center banks to exploit their

extremely low cost, taxpayer subsidized

source of funds. With no realistic

economic impact we found this surprise

move disconcerting since the Fed has been

extremely careful to clearly signal all

policy moves to the markets. We found it

very out of character. This strikes as a

scene from Shakespeare’s Julius Caesar

when the soothsayer twice yells out his

warning from the crowd “Beware the Ides

of March.” In that case March 15 was the

day honoring “Mars”, god of war, and

proved to be Caesar’s downfall. In our

case it could be any number of threatening

situations, the GIIPS debt bombs, the fiscal

shambles of the US government, the large

and continuing appetite for commodities

in China.

Finally, AngloGold Ashanti (AU), the

world’s 3rd largest producer announced

record fourth quarter profits. We note the

following points in their announcement

(http://www.anglogold.com/Press/Press+R

eleases.htm). The company has been

working off a book of hedges that requires

continuing sales at below market prices in

order to “increase its exposure to the gold

price.” Its hedges are now less than one

year’s production. This change of tack

follows Barrick Gold (ABX) who has

announced the same strategy to eliminate

their hedge book. These moves may be

construed as expectations of higher spot‐

market prices in the future. Also, AU

forecast rising cost of production, due to

energy and labor, to $590‐$615 per ounce

in 2010. Given these cash production

prices, the noncash costs, the need for

return on investment, etc, the floor price of

gold is open to speculation but easily

above $700. Hence, at that base miners

would close up rather than produce; unlike

mercantilist who may sell at a loss, miners

with more discipline will allow their assets

to remain vaulted in the earth. These

events all have some bearing on the price

of gold. In Chart 11 we show Gold prices

in relation to the trade‐weighted valuation

of the US$. Normally, these two assets

would show strong divergence in pricing.

However, during the “credit crisis” this

was not the case. With Gold’s continued

rise since July 2009 and the US$’s rise in

November 2009 we have entered

unchartered waters. We will watch closely

to see if Gold maintains its strength in the

face of a rising US$. This may be the start

of a true “decoupling.”

http://www.anglogold.com/Press/Press+Releases.htm

http://www.anglogold.com/Press/Press+Releases.htm


CHART 11 DIVERGENCE AHEAD?


Currency markets are a world of their own,

given to interest rate expectations, inflation

expectations, and sovereign risk. Current

macroeconomic and geopolitical events

indicate that there is the distinct possibility

that the US$ and Gold, two forms of

“money,” could rise in tandem as they

have in periods of extreme stress, late 2008

and early 2009.

Investors must always be concerned by

how quickly perspectives can change. As

the price of gold approached the

miraculous 4‐digit level of US$1,000 in

March 2008 and again in February 2009

this price level was viewed by analysts as a

great point of resistance, to some, an

almost‐impenetrable “top”. In November

2010 the price surpassed US$1,200 and,

while the price has corrected, the old

hurdle of $1,000 has become a “level of

support.” We believe that current Gold

prices will build a base with some

volatility over the next several months.

From this foundation Gold will continue

its climb. So we remain content with

central bank actions being excellent

contrary indicators; buy what they are

selling. As with fashion, public proclivities

and understanding are extremely fickle

and quickly fleeting.


We celebrated a belated Chinese New Year on February 15 instead of the actual start of the

New Year on Valentines Day. We enjoyed a splendid dinner with a couple of dear friends. It

was a quiet affair of roast duck and snowfish at our favorite Chinese restaurant, Mei Jiang on

the Chao Phraya River in Bangkok. Five year ago we celebrated the Year of the Rooster at

Liu, a neoclassical Chinese restaurant, while residing at the Conrad Hotel on Witthayu (the

Wireless) Road where we enjoyed the stunning celebration with acrobatics, dancing dragons,

and firecrackers that extended 20 stories up the hotel façade. The firecracker exposition of

smoke, noise, and fire which lasted 30 minutes was marked with exuberant pandemonium.

Needless to say, a display of this sort would never have been allowed under OSHA

regulations in the US. The start of 2005 was a totally different time; like the cocky rooster it

was loud, flamboyant, and boastful. The real estate markets reflected this personality as they

approached their apex in the US; the equity markets were cooing close behind.

Now, we have entered a different age. So, we welcome the Year of the Tiger, an astrological

symbol of courage, resilience, and self‐reliance. The Chinese prepare diligently and carefully

in order to send out the old and accommodate the arrival of “good luck” on New Year’s Day.

We believe less in good luck and more in a combination of faith, hard work, and “karma.”

So, for us, age brings an understanding that less can be more, small can be beautiful, and the

quiet stillness of detachment can be enlightening. We diligently work with greater resolve to

sharpen our focus. If we achieve nothing else this Year of the Tiger we shall continue to

strive honestly and earnestly to comprehend the volatility and complexity of financial

markets but to appreciate the possibility for harmony and simplicity in life.

Sincere regards,

Brian E. Shean, CFA PRINCIPAL

POSEIDON STRATEGIC INVESTMENTS

_________________________________________________________________________________

The views expressed in this commentary are those of the author at the time of composition. The assumptions, analysis, and

conclusions are subject to change in conjunction with changes in the securities’ markets or discovery of additional or

conflicting information. All information conveyed herein has been deduced, compiled or quantified from sources thought to

be consistently reliable. This informational report is produced for general circulation and is not to be construed as a

solicitation to buy or sell securities, financial instruments, or investment products. Prior to entering any transactions for

investment products please consult a competent financial adviser and undertake proper due diligence. AMDG

2.0 poseidon perspective february 2010

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