Falcon Cap Then Now

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<p>FALCON CAPITALPan Asia Multi Strategy Long Short</p> <p>David Hamilton Executive Director (61) 411 886 155 (61) 3 9863 8559 david.hamilton@falconcap.net Simon Selimaj Executive Director/Chief Investment Officer (61) 3 9863 - 8558 (61) 417 880 688 simon.selimaj@falconcap.net</p> <p>Question No.1</p> <p>Falcons calls then and now!</p> <p>2</p> <p>Falcon Research ReportsASX 200Ominous Omens Report July 4, 2007 Rough Seas Report Sept 7, 2007 Perfect Storm Report July 7, 2008</p> <p>Hindenburg Omen Report June 23, 2007</p> <p>3</p> <p>Ominous Omens published July 4, 2007Pan Asia Absolute Return FundOminous Omens!We at Falcon Capital are cautious with respect to the US, Chinese &amp; Australian equities and wish to suggest to investors that it is now prudent to reduce exposure to high risk and leveraged equity positions in these countries. We believe that inflationary pressures are looming &amp; that rising bond yields are toxic for most equity markets. While Japan will not be immune from a major correction in the USA or China, the Japanese economy will emerge as a major beneficiary of inflation due to a recent history of falling asset prices (deflation). TH CA Fig.1 US 10-year Treasury bond yield (log-scale) Fig.2 US import prices of good from China</p> <p>Source: Bloomberg, CLSA Asia-Pacific Markets</p> <p>Source: US Bureau of Labour Statistics</p> <p>1/ USAThe US 10-year Treasury bond yield has now broken out of a 26-year trend line (see Fig 1) If the move is sustained that will inevitability, be negative for US Equities as well as loan credit spreads. Inflation pressures are rising due to rising energy and food prices and this is now clearly being factored into the bond market with rising yields. The US import index grew 0.9% month on month in May 2007 which was one of the fastest monthly rise since 2003. For many years the volume of Chinese exports have risen but the price of Chinese exports continued to fall. Each year the retail price of a Chinese TV or DVD player fell in price and we in the West scratched our heads and wondered how the Chinese could produce such products at such low prices. The net result was that for years Chinese manufacturers were exporting deflation to the Western world. This is now no longer the case as the prices of Chinese goods to the USA rose into positive territory for the first time on a year-on-year basis by 0.1% (see Fig 2). From July 1 2007 the Chinese government will cut or eliminate export tax rebates for more than 2,800 export items. China is now exporting inflation!</p> <p>4</p> <p>Ominous Omens published July 4, 2007The American housing downturn is still a problem and the latest foreclosure data shows that problems continue to build. Foreclosure tracker Realty Trac reported that foreclosure activity rose by 19% month on month &amp; 90% year on year in May 2007 to a record 176,137 filings (see Figure 3). Banks and other lenders have only just started tightening standards. Tighter lending standards will restrain housing demand and when combined with higher bond yields will deepen the US housing downturn. With inflation becoming evident in other areas of the economy the US Federal reserve has less flexibility than it did in the past to lower interest rates to support the housing and equity markets should a tumble occur. Page 1</p> <p>5</p> <p>Ominous Omens published July 4, 20072/ ChinaA slowdown in the US will significantly affect Chinas export sector, which represents over 1/3rd of the economy. It will also adversely affect capital flows which will be negative for monetary conditions in China. We also suspect that there are serious problems with the profitability of many industries in China due to rising commodity and wage pressures that have not yet been publicised. The Chinese governments inability to manage the economy has led to an excess of liquidity which has ultimately flowed into the Chinese stock market.Fig.3 Source: DataStream &amp; CLSA</p> <p>An overlay of the NASDAQ (tech bubble and bust) of the 1990s and the Shanghai A shares (see fig 3) highlights the speculation in the Chinese equity market. Based on price-to-earnings multiples, Yuan- denominated shares in Shanghai are three times more expensive now than they were two years ago! A short term bust is brewing.</p> <p>3/ AustraliaAustralia is highly dependant on exports to both the USA &amp; China and any crisis will have major repercussions on commodity producers. Our stock market is currently facing a troubling situation due to: slowing earnings growth from approx 20% to circa 9.5%. However, the danger is that the pace of earnings upgrades is now starting to ease resources are driving earnings growth while industrials are deteriorating. The strong returns in Australia have been almost entirely driven by P/E expansion against moderate growth. The result is a very stretched market in terms of valuation not seen since 2000.</p> <p>X</p> <p>All Industrials (ex NWS)1 yr forward rolling PER</p> <p>X</p> <p>18</p> <p>18</p> <p>16</p> <p>Average since 1990 (14.4x)</p> <p>16</p> <p>14</p> <p>14</p> <p>12</p> <p>12</p> <p>10</p> <p>10</p> <p>8 Average over whole period (10.6x) 6</p> <p>8</p> <p>6</p> <p>4</p> <p>4</p> <p>2Apr-61 Feb-65 Dec-68 Oct-72 Aug-76 Jun-80 Apr-84 Feb-88 Dec-91 Oct-95 Aug-99 Jun-03</p> <p>2Apr-07</p> <p>Source: IBES, Macquarie Research, May 2007</p> <p>6</p> <p>Ominous Omens published July 4, 20074/ JapanThere is one place that rising bond yields should prove rather more bullish for equities, both from a relative return and an absolute-return basis. Firstly, the yen would rise as domestic Japanese actors cease to seek yield elsewhere and as interest rate differentials narrow making the carry trade less attractive. The main impact would be an unwinding of the carry trade. Arguably, the yen carry trade is one of the largest sources of excess capital in the global system today. It has been instrumental in supplying leveraged funds for bets on high yield currencies, commodities, emerging market debt and fashionable stock markets. All of these asset classes would be losers. Secondly, Japanese asset prices would rise. This is counterintuitive in that interest rate increases are normally associated with falling asset prices. But Japanese households are net savers and rising interest rates translate to higher returns on domestic yielding assets such as term deposits. Rising interest rates also signal the death of deflation in the economy! Japan will emerge as an out performer while China and the US lick their wounds.</p> <p>4th July 2007 Falcon Capital Group 2006. All rights reserved. This publication is intended to provide general information only and has been prepared by Falcon Capital Pty Ltd (ACN 119 204 554) (AFS License No. 302538), the issuer of the Fund, without taking into account any particular person's objectives, financial situation or needs. Investors should before acting on this information, consider the appropriateness of this information having regard to their personal objectives, financial situation or needs. Offers of interests in the Fund are contained in the Falcon Capital Information Memorandum (IM). A copy of the IM is available from our website: www.falconcap.net or contact Client Services on (03)9863 8559 or 0411886155 or email david.hamilton@falconcap.net You should consider that IM and seek professional advice before making any decision about whether to acquire or continue to hold an investment in the Fund.</p> <p>Page 2.</p> <p>7</p> <p>Hindenburg Omen Monday, 9th July 2007From: david hamilton [david.hamilton@falconcap.net] Sent: Monday, July 09, 2007 2:03 PM Subject: FW: Ominous Omens This occurred on 23 June 2007 Dave Hindenburg Omen The Hindenburg Omen is a technical analysis signal that attempts to predict a forthcoming stock market crash. It is named after the Hindenburg disaster, the crash of the German zeppelin of the same name in May 1937. The Hindenburg Omen is the alignment of several technical factors that measure the underlying condition of the stock market - specifically the NYSE - such that the probability that a stock market crash occurs is higher than normal, and the probability of a severe decline is quite high. The rationale behind the indicator is that, under normal conditions, either a substantial number of stocks establish new annual highs or a large number set new lows - but not both. When both new highs and new lows are large, it indicates the stock market is undergoing a period of extreme divergence. Such divergence is not usually conducive to future rising prices. A healthy market requires some degree of internal uniformity, whether the direction of that uniformity is up or down. Conclusions The probability of a move greater than 5% to the downside after a confirmed Hindenburg Omen within the next 41 days after its occurrence is 77%, the probability of a panic sellout is 41% and the probability of a real big stock market crash is 25%. The occurrence of a confirmed Hindenburg Omen does not necessarily mean that the stock market will go down. On the other hand there has never been a significant stock market decline in history, that was not preceded by a confirmed Hindenburg Omen.8</p> <p>Monthly Report</p> <p>Economic Outlook U.S.A: We expect the US economy to be in recession before the end of this year (negative growth in Q3 and Q4), but the scale of the unwind in the credit markets has been greater than we expected and has caused us to move the anticipated timing of recovery into 2009. Oil price rises together with a weak base mean that CPI inflation will finish this year around 4.5% well above what most central banks would deem acceptable. The Fed will not have to wait long for inflation to fall back however as GDP growth weakens. We expect CPI inflation to average 1.5% in 2008. Irrespective of near-term inflation pressures the deflation in credit markets means that rate cuts should be expected at each of the three FOMC meetings this year. We expect the funds rate to be 4.5% on 31 December. Aggressive cuts will continue through 2008. This years moves are discounted, even so flight from the credit markets will push 10-year government yields to 4% by end-2007 and through this level in 2008.</p> <p>9</p> <p>Rough Seas Report Sept 2007Falcon CapitalPan Asia Absolute Return FundRough Seas Ahead!7th September 2007</p> <p>We at Falcon Capital highlighted the problems of the US housing sector in our Ominous Omens Report dated 4th July 2007. Less than a month later this provided the trigger for a large sell off in world stockmarkets. Ben Bernanke and the Fed came to the rescue with an immediate 0.50% cut in rates and the world stockmarkets rebounded. Dont TH CA be seduced by the recent rally as the structural flaws in the subordinated debt market are so profound that it is almost a certainty that the US growth will slow dramatically. For historical reasons that we will highlight below the months of September and October 2007 are particularly vulnerable. Use the current reflex rally to sell into the market and lighten position that were not lightened prior to the credit crunch. Call this a second chance!</p> <p>We are here</p> <p>10</p> <p>Adelaide Presentation Nov 2007 U.S Cracks EmergingUS asset-backed commercial paper yield, Jul 06 13 Sep 07%6.6 6.4 6.2 6.0 5.8 5.6 5.4 5.2 5.0 July 06 Sep 06 Nov 06 Jan 07 Mar 07 Source: Bloomberg May 07 Jul 07 Sep 07 A1/P1 1-day yield A1/P1 15-day yield</p> <p>While Treasury yields have fallen asset-backed commercial paper yields have soared. Banks have tightened credit controls and are less inclined to lend. A contraction in credit due to the sub-prime lending crisis will in all probability lead to a dramatic slowdown in the real economy. The U.S consumer is exhausted. Falling home prices not seen since the 1930s will affect consumption.11</p> <p>Adelaide Presentation Nov 2007 Yen Carry Trade is Over</p> <p>YEN - Carry trade nearing end</p> <p>The yen carry trade is one of the largest sources of excess capital in the global system today. It has been instrumental in supplying leveraged funds for bets on high yield currencies, commodities, emerging market debt and fashionable stock markets.</p> <p>12</p> <p>Falcon - December 2007 Monthly report</p> <p>The 2008 Investment Outlook: The Year of the Rat will be a challenging one for Global equities. Entering 2008, we see the key themes for Asian equities as: i) a US-led G7 downturn; ii) Earnings downgrades; iii/ resilient domestic Asia; &amp; iv) structural fund inflows into Asia. Theme 1: The US Downturn The US economy is rapidly decelerating. Some measures (such as housing) suggest the US may already be in recession. This will lead to a significant slowdown in Europe and Japan. Industrial World growth is expected to slow from 2.4% in 2007 to 1.4% in 2008. Theme 2: Earnings cuts Top-down macro matters at inflection points The defining event of early 2008 will be the massive cuts to earnings estimates. Since mid 2007 we have emphasized the disturbing scenario that was unfolding due to the sub prime crisis. However, the Street was emphasizing that earnings were still strong and would continue to be. Indeed, for the past four years top-down strategists have been too cautious in their profit forecasts and bottom-up indicators were more accurate. But top-down strategy shines at economic inflection points when investors need perspective. A disconnect now exists between bottom-up corporate profit forecasts of 14% in 2008 and 11% in 2009 and many top-down EPS forecasts of -3% in 2008 and 5% in 2009. We expect analysts to cut EPS estimates sharply during 1H.</p> <p>13</p> <p>ASX 200 Breaking down 15 February 2008</p> <p>14</p> <p>Falcon - April 2008 Monthly report</p> <p>Conclusion: Rather than seeing signs that the worst is behind us, we think the clouds are intensifying again. The markets across Asia and Australia are seeing; 1/ disturbing technical patterns such as very narrow breadth i.e. only a handful of stocks driving the indices, 2/ the valuation tailwind is fading quickly on our metrics, the market is back out of cheap territory. Overall fundamentals are deteriorating, and whilst still our market timing indicators are in neutral territory, markets are not far away from heading back towards sell levels. The euphoria surrounding the relief rally is fading, and we are now approaching the danger zone of bear market rallies i.e. when they typically finish. Finally, there is caution in the US, Europe and China.</p> <p>15</p> <p>Our call on Commodities 3 June 2008</p> <p>From: David Hamilton [mailto:david.hamilton@falconcap.net] Sent: Friday, 6 June 2008 3:06 PM Subject: FW: commodities to tumble SUMMARY A near perfect storm of a rolling commodity market, hoarding suppliers, slowing demand, and rapacious US regulators with a slew of proposed regulation who will stop at nothing to end the commodity speculation which has stopped traditional hedgers in those commodities from being able to hedge their positions. In formal chart terms, the global commodity complex bubble officially popped last week. This bubble had been steadily inflating since 2002 (since the last peak in the USD) and finally popped from Tuesday to Friday with oil (CL1) attempting a last run at 132 on Th...</p>