Q1 2014 Market Review & Outlook

Morgan Creek Capital Management

MORGAN CREEK CAPITAL MANAGEMENT

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Letter to Fellow Investors

The theme of last quarter’s letter, titled 10 Things I Hate About Spoos, revisited a construct we have discussed in prior letters (including Defense Wins Championships) and we analyzed a series of ten charts (actually there was a bonus eleventh too) that showed that perhaps it was time to be a little more cautious in the U.S. equity markets after such an incredible year in 2013 (to cap an incredible five year run off the bottom in 2009). To summarize, we wrote that “revisiting the reasons to be defensive in the equity markets again this year, it appears from the above charts that the strategies that produced such amazing results in 2013 may not produce a repeat performance in 2014.” It is from the second line of this quote that we draw our inspiration for the title of the letter this quarter as we will hypothesize why 2014 is likely to be the inverse of 2013, and we will also review some good evidence that the construct has already taken effect during the first four months. The Alligator is an animal that engenders some trepidation in most people and that fear is warranted based on the damage that a gator can do if you invade his habitat. To that point, there is a great line from an interview with Jack Ma, the founder of Alibaba Group, who talks about being a crocodile (yes, different than an alligator, but same idea) in the Yangtze River trying to fight the shark (eBay), “if we fight in the ocean, we lose, but if we fight in the river, we win.” The key is to avoid the Alligator’s habitat if you want to survive, so the message of this letter will be that we should avoid the traps of chasing the hot performing asset classes of 2013 and find new, less gator infested, waters to explore in 2014 and beyond. The Chinese Zodiac (“Shēngxiào” or “Birth Likeness”) is a cycle of 12 years that follows the lunar cycle in nature. Each year of the cycle is depicted by a different Animal (shown in image above) that is associated with the core characteristics of personality. The Animal represents how others perceive an individual or how that individual presents himself to the world. Additionally, there are five elements (fire, water, wood, earth and metal) linked to the Animals, also in a cyclical pattern, that create a 60 year overall cycle of different personality types. 2013 was the Year of the Water Snake, and Snake Years have historically been full of two opposing forces of conflict (1941 Pearl Harbor, 1989 Berlin Wall/Tiananmen Square, 2001 World Trade Towers) and technological innovation and progress (1953 Color TV, 1965 first desktop computer). Interestingly, related to markets, it is the only year of the twelve with a negative average return and some of the largest market drops have occurred in Snake years (1929, 1977). However, the Water element has a calming influence on the snake and there was a chance that conflicts and uncertainty (Fiscal Cliff, Egypt Uprising) would be quelled quickly and that the year would turn out to be rather prosperous (which is exactly what occurred). We actually refer to 2013 around Morgan Creek as the Year of the Coyote as it reminds us of the old Roadrunner cartoons where Wile E. Coyote would be chasing the Roadrunner, and at some point, would inevitably miss a turn, or not be able to stop, would sail off the edge of a cliff and then hang suspended in mid-air until he would eventually look down and suddenly plunge to another crash landing at the bottom of the canyon. Looking backwards, the U.S. economy faced a series of “cliffs” over the course of the year starting with the actual Fiscal Cliff in January, followed by the Taper Tantrum in May and finally the potential Government Shutdown in October, but in each case, the economy, and more importantly for this letter, the

The Year of the Alligator:

Why 2014 Will be the Inverse of 2013

Source(s): www.chacha.com

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market, never looked down and never fell (in fact, the S&P 500 never fell more than 5% during the year and never fell below its 200 day moving average); the Coyote Market had been created. We can give most of the credit for the Year of the Coyote to Dr. Ben Bernanke who seemingly repealed the law of gravity using a creation that could have come right out of the Acme warehouse (where Wile E. Coyote would get all of his performance enhancing contraptions to try and catch the Roadrunner) called QEternity (or QEInfinity, whichever you prefer) as he pumped over $1 trillion of liquidity into the economy in the form of Treasury and Mortgage Bond purchases. While it is true he threatened to begin taking away the Upsidasium in May (the dreaded Tapering threat and subsequent market Tantrum), he immediately reversed course, apologized profusely, and said he wouldn’t bring it up again (until he did a few months later) when the market corrected only a few percent. All told, he threatened to Taper four times in 2013 and in all four cases the market headed down until Gentle Ben (the domesticated Ursa Major star of late 60’s TV show featuring Dennis Weaver) would reassure everyone that he really wasn’t going to take away the honey pot. 2014 is technically the Year of the Wood Horse, which predicts that the year would be full of energy, financial volatility and impulsiveness, a year for taking on new projects and a year focused on borrowing and spending money (think debt issuance and M&A activity, both of which are nearing record levels so far in 2014). Horse years are typically marked by individuals holding firm to their beliefs and there have been a number of conflicts/wars linked to these years due to compromise being more difficult. We would not have much to add to that description of what to look out for in 2014 as we came into the year looking for increased volatility after the superior performance of global equities in 2013 and had some concerns about tensions in the Middle East that could erupt into something more dangerous. That said, our decision to rename the Year of the Horse to the Year of the Alliga-tor stems from a different observation about capital markets that we think will play out over the course of the year. The global equity markets’ reaction to the abundant stimulus (to be fair, not just from the Fed, but the Bank of Japan (“BOJ”) and a handful of other Central Banks) created the Alligator Jaws phenomenon from which 2014 gets its nickname. When you look at comparative market price charts, particularly of industries, sectors or countries (although could be individual companies as well) there is often some level of correlation, or connection, between the various indices/securities over time and a cyclical pattern of the spread between the two indices/securities that tends to move wider at some times and narrower at others. When the two lines diverge widely over some extended period of time, that pattern is referred to as Alligator Jaws for two reasons: 1) two lines on a chart, one rising and one falling do actually look like an alligator snout and 2) you know with a high degree of probability that eventually these jaws will snap shut (mean reversion is an amazingly powerful force and trends do not continue in one direction for ever, it only feels that way if you are positioned on the other side). Over the course of 2013, we saw some of the widest dispersion between certain markets emerge that we have seen in many years and by the end of the year the Alligator Jaws were open extremely wide and looked ready to snap shut. Japanese equities were up 55%, small-cap stocks in the US were up 40%, the S&P 500 was up 32%, European shares were up 25%, yet bonds were down slightly, long bonds were down (7%), commodities were down (12%) and Gold was down (26%), which when plotted together on a price chart drew a seriously gaping gator snout. So as we entered the New Year and transitioned from the Year of the Coyote to the Year of the Alligator, we expected a much more challenging environment for investors. The only trouble with Alligator Jaws is you never know precisely when they will close. It kind of reminds me of the mythical relationship between Nile Crocodiles and Egyptian Plover birds which are purported to have picked food scraps out from between the teeth of the crocs as they sunned themselves on the banks after a big meal. I remember having the thought that it seemed like a really good deal for the birds right up until the time that it wasn’t (the moral of the story is to leave the party just a little before you need to and don’t worry about getting the very last scrap…). In fact, if I were to add a second title to this letter (borrowing from the

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style of the Rocky & Bullwinkle theme from a few quarters ago) it might be Gravity Bites! So if timing is so critically important, how do we know when it is time to make a change? There are myriad models, indicators, calculations, rules of thumb, etc. for trying to time the markets - none have proven to be consistently accurate in every environment and some work better than others at different times. There are fundamental models, there are technical systems, there are momentum indicators like the January Indicator which say that as January goes, so goes the year (which doesn’t bode well for 2014) and a few (how shall we say it) less conventional approaches including the Super Bowl Indicator which says that if a team from the NFC wins, it will be a Bull Market and vice versa (good news on that front since my Seahawks won), the Hemline Index which says that skirt lengths rise with stocks and then can fall quickly along with stock prices (mixed news here as skirt lengths are getting longer, but the Midi-Skirt is the hottest trend right now), Investor Sentiment triggers (this one is a contrarian signal, if everyone is Bullish, then Bearish and vice versa) and a whole host of others. Interestingly, there is one of these non-traditional indicators that has a surprisingly good track record of predicting when market trends will reverse course (surprising only insofar as it relies on some factors that might not be considered, shall we say, conventional) that has been utilized by some of the most successful investors and traders over the decades since the original publication of this tool in the book, Stock Market Prediction by Donald Bradley, in 1950. The Bradley Date Indicator is predicated on the construct that since human beings make up the capital markets, and since human beings are influenced by “natural forces” (translation, they are influenced by the gravitational forces caused by planetary alignments, I warned that this was a non-traditional approach), there is a natural rhythm to markets that follows the seasonal pattern of the planetary movements, that is, they ebb and flow, just like the tides. More interestingly, since the calendar moves with precision, Bradley could forecast when these “Turn Dates” would occur in the future when he wrote his book in the late 1940’s, which is what he did and, therefore, we have decades of data that we can look at to see how well the dates match up with changes in trends and major market events (as well as a road map for the years ahead). Perhaps not surprisingly (otherwise I wouldn’t be writing about it here) there is an uncanny correlation over the years, which is why an increasing number of investors have utilized the Bradley Turn Dates as one element of how they think about market movements and momentum (another interesting factoid is that JP Morgan is quoted as saying that “millionaires don’t use astrologers, billion-aires do” as another example of how the concept of natural forces might be more mainstream than most might think). As you might expect, there was a major Turn Date coming into 2014, in fact it was on January 1st. So, the theory goes that markets that were in a positive trend would reverse into a negative trend (defined as more of a volatile pattern, rather than necessarily a big decline, a big decline can happen, but doesn’t have to) and vice versa. Looking back, positive trend markets included, Japanese equities, U.S. equities (NASDAQ, small and large), European equities (and the Euro), high yield bonds, MLPs and negative trend markets included Emerging markets equities and bonds (and currencies), U.S. bonds (particularly long bonds), Commodities, REITs, Gold, Gold Miners and the Yen (weakening). Markets were actually closed on the 1st, but almost like clockwork, that day actually marked the high for 2014 for a number of the positive trend markets and the lows for a number of the negative trend markets (EM took a few weeks to finally bottom as they were surprised by the late December change on the Tapering stance by Gentle Ben). So the Year of the Alligator had begun, the jaws began to snap shut and there was a big rotation of the worst-to-first and first-to-worst across the markets. Drawing the same price chart today, you see a mini-jaws forming with Commodities, Gold, Gold Miners and long bonds on top and Europe, the Yen, and U.S. (particularly small and NASDAQ) and Japanese stocks on the bottom. There has been a great deal of volatility over the first four months of the year (as described in the first quarter review section below) and it

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appears that mean reversion (and the law of gravity) do actually still apply, despite the continual proclamations from the media talking heads that those antiquated laws are no longer relevant to these new age financial markets. Going back to the theatrical inspiration for the last letter, 10 Things I Hate About Spoos, to describe how these types of reversals play out over time, we have seen this movie before. So why is 2014 turning out to be The Year of the Alligator and looking like the inverse of 2013? Clearly there is a natural cycle to markets and they tend to move from one extreme of valuation (over and under) to the other (interestingly spending very little time around fair value in the middle of the pendulum swing path), but those trends can go much further than most people expect. So while we would expect to see a switch from the overvalued state of the equity markets that I highlighted in the 10 Things I Hate About Spoos list, it is much more challenging to predict when that revaluation might occur. There are also a number of other markets that are exhibiting very high valuations, including corporate and HY bonds trading at well over par (remember, you only get par at maturity or par plus accrued if they get called), Core Real Estate where yields and cap-rates have reached 2007 levels again and certain sectors of global equity markets like biotech, social and mobile (where IPOs are being done at nearly 2000-esque valuations). However, overvaluation is a necessary, but insufficient condition, for a market reversal to occur; remembering Lord Keynes here “the market can behave irrationally longer than the rational investor can remain solvent.” To have a reversal in a market, you need a catalyst to prompt reallocation of capital away from a particular area based on the realization that future returns will be below average due to falling profits, decreasing margins, higher discount rates or some shift in the supply/demand dynamics of markets (demographics, politics, regulatory environment etc.). A meaningful change in the liquidity environment was the catalyst that the world had been concerned about for the past few years as investors were all on high alert for any hint that the Fed would “take away the punch bowl” and reduce the pace of Large Scale Asset Purchases (QE Tapering). As we discussed in the last quarterly letter, even a hint of Tapering by Ben the Barber in 2013 was enough to reassert the law of gravity back in to equity markets and there were four such periods where the Fed launched the trial balloon, markets began to deflate, so the Fed would send out their army of Governors to speak at venues all across the country saying “just kidding, full steam ahead with the S.S. QEeen Monetary.” But, then, in December everything changed. Linus (aka Ben) had waited very patiently in the “most sincere pumpkin patch” searching for the Great Pumpkin (i.e. some evidence that QE was having a positive impact on economic growth) and when the final estimate for Q3 GDP growth came in at 4.1%, Linus declared “Mission Accomplished” (sans the big banner draped on the deck of the aircraft carrier) and decided that it was time to Taper after all. Suddenly, there was a lot of confusion in the markets as participants had expected Linus to hand the football over to sister Lucy (aka Janet) and let her decide how long to keep the economic morphine drip going in the New Year. We worried aloud in previous letters that Lucy might actually pull the football away and that investors would get “Charlie Browned” (end up flat on their back), but the consensus was that Janet was an uber-Dove and that the only Prince music we would be hearing in 2014 would be 1999, and not When Doves Cry. Once again, the consensus may have been focused on the past while markets were focused on the future and the stage was set for a meaningful reversal of the 2013 trends in 2014. I struggled last quarter to come up with the final couplet for our Sonnet (some might say I struggled with the whole thing…) on the ten reasons to be cautious about equity markets and I posited a number of potential outcomes that could occur depending on how the actors in the movie played their parts. I started with an option very similar to Cat’s final couplet from the original movie “Despite all these indicators flashing red I really don’t hate the Market and we can actually find plenty of good reasons to own good quality equities in a ZIRP world (the TINA rationale, “There Is No Alternative”)? While I agreed with the concept that there were some high quality U.S. companies that

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were still attractive to own, I actually did see lots of other alternatives to outperform U.S. equities, including Southern Europe, Japan, China and, even surprisingly, Fixed Income (Europe won, Japan lost, China was mixed and Bonds were the big winners)… so I had to reject this idea. Next, I tried maybe talking about “how QEeen Janet will pick up the Bernanke Put option and actually infuse larger amounts of cash into the system in 2014 that will eventually find its way into financial assets.” I ended up rejecting this idea too, as I had finally become convinced that the Fed had to back away from Large Scale Asset Purchases (aka QE) as they were not working and, perhaps more importantly, there were fewer bonds to buy as the Fed had become the vast majority of the volume (which was, in and of itself, decreasing as the budget deficits grew smaller). Additionally, Janet has waffled back and forth during 2014 on when the Fed will raise rates and has sounded more like Lucy than Linus (Brother Ben) and markets have not loved what they have heard so far (although the 10% surge in REITs might have a little to do with some people still believing that she will eventually buy other assets following in the path of some of the other global CBs). Next, I thought about quoting my friend David Zervos who says “Spoos are for Lovers and Gold is for Haters and that the QE train is far from running out of fuel, so stay long and strong and Buy the Dips?” I ultimately rejected that idea as well, as it appeared the Taper train was on the track (as evidenced by the FOMC announcement that they will cut purchases yet again). I also thought about quoting Larry Jeddeloh, who calculated “that for every $100 Billion of QE, the S&P 500 rises 40 points, so if there is somewhere between $500 Billion (with $10 Billion of Tapering each Fed meeting) and $750 Billion (no more Tapering) worth of QE left, there are between 200 and 300 S&P points to be had in 2014 (That would equate to 2,050 to 2,150 on the index from 12/31 levels)?” This one was harder to reject as the QE purchases are occurring, but at least so far in 2014, the linkage that we saw last year has not been as direct (we have had $260B of purchases and only 36 S&P points). Finally, I considered “is it as simple as the global economy has healed enough (thanks to the Global Central Bankers massive morphine drip since the Crisis) to begin to support the current valuations and hence there will be rising GDP growth, rising profits and rising markets?” While we believe this scenario to be the case in Europe, Japan and EM, we had a hard time making the math work in the U.S. and the release of the dismal 0.1% Q1 GDP estimate seems to reinforce our thinking on this point, so I had to reject this idea too. Ultimately, I just went with a simple idea that because the Central Banks are propping up valuations with extraordinarily low interest rates (and QE), and that because we had the Variant Perception that Lucy would pull that football away, we sided with Stanley Druckenmiller who warned in November that if the Fed were to stop buying bonds, “equity markets would go down,” so it was time to favor long/short equity in the U.S. markets. We went one step further though in setting the stage for how good the environment might get for the long/short managers in looking at all the comparisons from the 10 reasons that showed how many valuation and activity indicators had not been this extreme since 2000 and we said that “with so many things pointing to similarities between the Tech Bubble and the current environment, there seems to be a relatively high likelihood that the next few years could look a lot like 2000-2002. The interesting thing about the 2000-2002 period was the slow drip downward over the three years, (9%), (12%), (22%) and the really tough year in the markets was actually 2002, not 2000, yet long/short equity managers generated really strong returns in all three years.” We talked about the seven-year cycle that seems to exist with respect to the business cycle (interesting to me that it’s precisely half of the 14 year innovation cycle I have written about in the past) and talked about how the peak in markets in 2000 and 2007 was followed by recessions and larger losses in the equity markets in subsequent years, so there was some time to prepare and get defensively positioned. The challenge, however, to heeding the call for playing defense is that at the time when you should be thinking most about defense, valuations are running wild; “everyone” (or so it seems, but actually not the case) is getting rich and the actual data shows that (unfortunately) investors pour the most money into the markets right at these market peaks (I have often said that what humans do incredibly well is buy

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what they wish they would have bought). It is kind of like the birds in the Alligator teeth, just one more bite, just one more bite, he won’t close his mouth quite yet, just one more…bite. Game over. We have heard these lines before, I will sell tomorrow, I will sell tomorrow, these valuations won’t correct quite yet, just one more... gravity bites. Down (40%), game over. Now, all stocks, and markets, don’t fall (40%) (some, in fact, fall more and some don’t fall much at all if they are priced really cheaply), but there is an interesting construct called Sand Pile Theory that shows that when a sand pile finally gives way under the weight of that last grain of sand, the pile falls, on average (40%). Interestingly similar in magnitude, the average recession related Bear Market correction in the U.S. has been (38.6%), so when valuations finally reach the extreme and the earnings prospects for companies become impaired by a slowing economy, the adjustment, like the collapsing sand pile, is swift and meaningful. The best plan of action, like when dealing with alligators, is to be far away from the pile when things begin to go wrong. We discussed another phenomenon that inhibits investors from playing effective defense. We wrote that it is, simply, “much more fun to be a “Lover” than a “Hater” so just composing a list of things to Hate was much less fun than talking about all the things there are to Love in places like Japan, Greece, Spain, Italy, India and China, as well as all the sectors/strategies to Love like private equity, venture capital, energy and natural resources and private.” It is hard to look at the downside of things, as we tend to be more optimistic by nature (a necessary element for survival). It is challenging to focus on the negative aspects of any situation for very long, as it is simply unpleasant, and we tend to like pleasant things more than unpleasant ones. To that point, we recently met with a truly outstanding manager, who also happens to be one of the last remaining dedicated short-sellers. There are very few dedicated short-sellers left as 1) it is tough to make money being short when markets rise two-thirds of the time and 2) when you are right your positions get smaller. He helped explain why it is so hard to focus on the negative aspects of any narrative and why investors tend to be continually lulled into a false sense of security at exactly the most perilous moment. The biggest obstacles we face in this regard are 1) that we are not wired to think about situations ending badly (again the inherent optimism) and 2) once we form a belief about something, we actually reject contrary evidence rather than using that evidence to help us avoid untoward outcomes. So the average person may see/hear all of the reasons that we outlined to be concerned about future returns in U.S. equities, but will dismiss most of them immediately since they contrast with the bullish narrative that is consensus today; that the energy revolution in the U.S. will lead to a manufacturing renaissance which will allow corporations to maintain above average profit margins indefinitely which will command higher P/E multiples and therefore there is no risk in the equity markets at these levels (I actually listened to a Strategist make this very case the other morning at a conference where were we on a panel together, perhaps needless to say, I might have taken the other side of this debate). Our manager friend pointed out dozens of examples of companies that would actually be hurt by this chain of events, yet were still trading at above average multiples. He talked about the huge global risks to a truly meaningful slowdown (read 1930s U.S. or 1990s Japan) in China triggered by a credit event (he also asked who will we sell all these goods we are going to manufacture in the U.S. to in that event?) and he then showed us dozens more companies that were trading at unbelievable multiples despite having no earnings, no prospect of earnings or, in some cases, were actually frauds, and said very simply “we know how this ends.” We talked in last quarter’s letter that we have heard from many managers of late how they are finding many more ideas on the short side than they had in years and it appears they are finally being rewarded after enduring a very painful couple of years. I have an Investment Rule that if I hear something once, I remember it, if I hear it twice, I write it down and if I hear it three times I do something about it. Coming into the quarter, while we had begun to talk about playing defense and were thinking critically about all the warning signs we highlighted in the 10 Things Sonnet, there were

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not that many managers (or other investors for that matter) that we talked to who were meaningfully changing their portfolios. That all changed in the past month. A few weeks ago I was talking to a friend who manages a big portion of the Soros portfolio and he mentioned that he had moved to a slight net short position in the previous couple of weeks. Hear it once. Then I was talking to my good friend, John Burbank from Passport Capital, last week and he mentioned that he had dramatically reduced his net long position in the previous couple of weeks by adding more shorts to take advantage of some really crazy valuations in certain sectors. Hear it twice. Finally, I was talking to Julian last week just to catch up on markets and congratulate him on his new class of Robertson Scholars and we got talking about our portfolios and he mentioned that he was “just about neutral” which he further explained was not a comfortable place for him to be as he felt much more comfortable with 30% to 40% net exposure. Hear it thrice. Maybe they do ring a bell at the top. Maybe these guys are “early” (Julian, like Buffet, began de-risking in 2007 and many questioned both of them then), but I am going with my Rule and we will begin to lower our exposure. This year looks to be very different from last year, but that doesn’t mean we can’t take advantage of great opportunities and generate solid returns; we will simply have to adjust our game plan, be a little more balanced and definitely be more tactical to achieve our investment objectives. For example, you could have made just over 10% so far this year by simply buying long-duration Treasuries (putting them on pace to match the 30%+ returns in 2011, not saying that will happen, but the math does work) and could have made 15% by buying gold mining companies. The problem is that those were two of the worst performing assets in The Year of the Coyote and it took some significant contrarian thinking to embrace the concept that the Year of the Alligator would turn 2014 into the inverse of 2013 coming into the New Year. Perhaps the most confusing issue for investors so far in 2014 has been the drop in interest rates as everyone (literally 100% of economists surveyed by Bloomberg) expected that Tapering meant rising rates. Interestingly, the consensus was for rising rates despite the direct evidence to the contrary that the last two times the Fed scaled back asset purchases, rates dropped, rather than surged. Another way that 2014 may differ from 2013 is that The Year of the Coyote ignored the usual trend of poor returns from May-October as the Law of Gravity was temporarily suspended, but in the Year of the Alligator, “Sell in May and go away” may turn out to be very good advice. Finally, as we suggested might happen at our iCIO Investment Summit Market Outlook event in December, the worst performing sectors of the equity market, like Utilities, might see a brighter future in 2014. Utilities, Healthcare and Consumer Staples are indeed leading the pack in 2014 and the troubling part of that story is that these are not the sectors that lead in robust economic expansions, but rather they are the sectors that lead during decelerating economic growth leading to recessions. Fortunately, there are no other signs of an imminent recession ahead, but it is just another way in which the Year of the Alligator is looking extremely different than the Year of the Coyote. Markets are cyclical and tend to follow natural patterns over time. Our job is to be ever vigilant in adjusting portfolios to capitalize on the opportunities in each environment. The cycles have shrunk over the decades and the complexity has increased due to higher levels of central bank intervention, but the keys to success remain Discipline, a fundamentally sound investment process and a tactical implementation that capitalizes on the MCCM network and takes advantage of the collective experience of the team. Like the Zodiac cycle, each New Year brings new characteristics and presents new challenges, but if you have been around a while, you have seen this animal before and can mitigate the challenges and capitalize on the opportunities.

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First Quarter Review

We opened our last quarterly letter, titled 10 Things I Hate About Spoos, with the line “How do I loathe thee, let me count the ways…” which was borrowed from a movie entitled 10 Things I Hate About You and we then went on to enumerate the top ten (actually turned into twelve) reasons to be cautious about the prospects for returns from U.S. equities over the coming years. As a quick reminder of those concerns, here is the full list (the movie was a modern take on Taming of the Shrew, so we went with the Shakespeare theme and compiled the concerns into a Sonnet). I hate your Overvaluation (Average 67% on four primary indicators) I hate your really high P/E (15.9X Forward Earnings, only higher in Tech Bubble) I hate your extended Buffet Indicator (1.18 MarketCap/GDP, only higher in Tech Bubble) I hate your future Negativity (GMO predicting negative returns from stocks next 7 years) I hate how you’ve hit Resistance (S&P 500 hit upper resistance level in long-term chan-nel) I hate how everyone has gone All-in (AAII showed 2nd highest equity ownership, 2nd lowest cash) I hate your record Bull/Bear Ratio (never had higher ratio of Bulls/Bears in investor survey) I hate that Insiders see no bargains (had not seen insider selling like this since Tech Bubble) I hate the extreme Vol Compression (VIX was moving toward levels that have triggered corrections) I hate your Singularity (John Hussman model of Bubble showed ultimate peak for S&P 500 at 1,900) I hate the Wall St. Movies (Wall Street themed movies came out, 1929, 1987,

2000, 2007, 2014) I hate How Bad things could really be (S&P 500 chart looks frighteningly like period before 1929) I hate the way the stimulus props you up, and how the CBs won’t let you fall, But, I Love how Spoos have finally entered a perfect environment for long/short after all… Our conclusion, based on the analysis of the evidence about the U.S. equity markets listed above, was that we were entering a period that was quite similar (market regimes are never precisely the same, but as Mark Twain has often been credited with saying, “History doesn’t repeat, but it rhymes”) to the 2000 to 2002 period. Given that similarity, we expected a lot of volatility overall and some real pain in some of the most egregiously overvalued segments of the market (like biotech, social media, cloud, etc.) at some point in the coming months/quarters (always difficult to predict when these bubbles will meet their “pin” with any precision). We pointed to evidence that suggested that there was a natural seven-year cycle in the markets where excesses that had built up (based on some “new normal” belief in a narrative that things would be different this time) were corrected (as Sir John Templeton was fond of saying, “the four most dangerous words in investing are ‘it’s different this time’”). We have seen this cycle play out over the decades in three-year periods around 1973, 1980, 1987, 1994, 2001 and 2008 which exhibited similar boom/bust outcomes. The cycle has been linked to Charles P. Kindleberger, a historical economist and author of some thirty books including the 1978 investment classic, Manias, Panics and Crashes. Kindleberger has been referred to as the “master of the genre” on Financial Crises and it is fitting that the boom/bust cycle should be associated with his name. The cycle has five discrete stages that repeat based on the actions of the economic participants and those participants can be divided into two groups, Insiders (investors with superior knowledge) and the Masses (the rest of investors). This division is not strictly limited to true “Insiders” of a company, like officers

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and employees, but rather, professional investors vs. the Masses. The Kindleberger Cycle begins when Insiders start selling, as they believe valuations have become too high. That selling pressure (and ultimate-ly some external event) triggers the first stage, Crisis, where prices begin to fall, slowly at first, and then more rapidly, ultimately ending in a cathartic wave of Revulsion in the second stage, where the Masses sell. The cycle then enters the third stage, Displacement, where there is a period of digestion and then meaningful restructuring which triggers the Insiders to begin buying again. As prices begin to rise, a new narrative is created to explain why this period will be the “New Normal” (think Personal Computing, Internet Technology or U.S. Energy Renaissance) and we enter the fourth stage, the Boom where there is a period of robust growth, strong equity returns and participants cease to recall the events of the last Crisis. As the Masses follow the Insiders and everyone begins to buy again, we reach stage five, Euphoria where the excess liquidity and risk seeking behavior of investors pushes prices to extremes again, which prompts the Insiders to sell and the Cycle repeats. It appears that we entered the Euphoria stage in Q1 of 2014 (right on schedule) as valuations in some areas of the market reached truly crazy levels. We said in 10 Things I Hate About Spoos that things were beginning to look a lot like 2000 and that Euphoria might be taking hold, “the lack of drawdowns has emboldened investors to raise their equity exposure to the highest level since the Tech Bubble despite growing evidence that the equity multiples have little room for continued expansion. Even though signs of vulnerability of the equity markets to the abrupt end of artificially low discount rates abound, investors are trying not to be seduced by the “easy money” allure of stocks can’t stop themselves from repeating the final words of Kat’s poem “But mostly I hate the way I don’t hate you, not even close… not even a little bit… not even at all” and they are buying. With so many things pointing to similarities between the Tech Bubble and the current environment, from valuations, to IPO a go-go (TWTR

comes to mind at $31 Billion market cap and no profits), to Story Stocks (TSLA seems to fit here with 20% of the market cap of F and GM put together and only 0.5% of sales).” Almost to the day of the letter, the selling began in TWTR and the stock collapsed in the past few months, chopping $7 billion off the market cap, but still has no profits and still sells at a stunning 29X Revenues (not earnings, because, again, they have none…), and, this is the really ugly part, the true Insiders (venture backers and later stage investors) were just released from their post-IPO lock up, so the real Twitter-bombing may get underway here in May. TSLA is a little different story in that it actually had a spectacular quarter, rising an astonish-ing 50% in Q1 (after peaking up 70%) as it got “a little help from their friends” at a large Investment Bank (that shall remain nameless, and surprisingly isn’t Goldman Sachs) which decided to issue an astound-ingly positive research report, causing a massive short squeeze in late February (I find it quite ironic that the Analyst’s name was A.C. Jones, pretty close to A.W. Jones, the father of the modern hedge fund, as hedge funds were the first “Insiders” selling TSLA and were therefore caught in the short squeeze). My friend, Michael Lewitt, who writes The Credit Strategist (which if you don’t already subscribe, you should, as it is one of best written newsletters around) summed the situation up so well that I must simply repeat what he wrote as I could not improve on his description “With TSLA stock trading at $217/share, Mr. Jones could barely contain his enthusiasm in raising his price target from $153/share based on the following thesis: ‘Tesla’s quest to disrupt a trillion $ car industry offers an adjacent opportunity to disrupt a trillion $ electric utility industry. Target raised to $320 as our volume assumptions double.’ It is not that Mr. Jones is incorrect in pointing out the potential of Elon Musk’s company to disrupt not only the automotive industry but also the electric utility industry; such potential clearly exists and everyone should be cheering on this iconic entrepreneur and visionary. The problem with this research report is that it is not research and it is not financial analysis; rather, it is a piece of writing that should properly be considered science fiction that

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belongs in the pages of Philip Dick or Ray Bradbury rather than under the sponsorship of a Wall Street firm that was two days away from profiting from underwriting a sale of convertible bonds by the company. Mr. Jones’ price target is meaningless and does a disservice to investors and, to be fair, he admits as much throughout his report, which is filled with numerous admissions that his thesis is highly speculative in nature. Short sellers owe Mr. Jones a debt of gratitude.” (I am sure that it is just a coincidence that the firm was underwriting a massive convertible bond deal for TSLA two days after this report) As Paul Harvey used to say each day on the radio, “and now for the rest of the story…,” TSLA surged 25% in the next 7 trading days after the “report” and then peaked two days after Michael wrote his piece and has now dropped (15%) to settle about 5% below the price before the report. The company now has 23% of the market cap of F and GM combined (despite still only having 0.5% of the sales), still has no profits (although they are projected to make $1.67 this year so it is almost “cheap” at 130X forward EPS) and has not shown any capacity to ramp production at the levels implied by their stock price. Perhaps most frightening is that neither of these stories even come close to being examples of just how Euphoric certain segments of the U.S. equity markets reached in Q1 2014 and why we are increasingly convinced that, as Yogi Berra said so eloquently, “it’s déjà vu all over again” and we are right back to 2000 (cue the Prince music, “two-thousand, zero, zero, party over, oops, out of time, but tonight we’re gonna party like its 1999”). Back in 2000, all you had to do was add “.com” to your company name and your valuation was instantly multiplied and the future was yours for the taking. An example was a firm that we invested in at UNC through one of our growth equity firms, Tudor Ventures. Art Technology Group (ARTG) was a consulting firm that helped companies add “.com” to their names (well, actually, they did a little more than that, but at the time they were a pretty small firm) and they were able to go public in the frenzy that was the Tech Bubble. We had invested

$5mm in Tudor Ventures’ first fund and our share of the ARTG deal was $100,000, so our cost basis was around $0.50. After the IPO and subsequent run up to $100, our lock-up expired and it was time to make the decision to sell or hold. I called the guys at TVP and they said they couldn’t talk about the company during the lock-up expiration as they were Insiders, but they could point me to two public numbers, Revenue $6 million, Market Cap $6 billion. I hung up the phone, called our custodian and screamed, SELLLLLLL… I guess everyone else decided the same thing, as the stock fell to $4 over the next few months, which still would have been an 8X exit (top decile for VC returns), but 200X was much better and UNC had $20 million more to spend on programs (it is fair to tell the rest of the story, the management team did build a great business and sold to Oracle in 2011 for $1 billion, which is a lot, but is also down 83% from the valuation where we sold 11 years earlier…). Today, all you have to do is put the word “Cloud” in your company description and your valuation multi-plies and the future is yours for the taking. Hundreds of Cloud companies have been created and many have come public to the same kind of hoopla as ARTG. One such company is Castlight Health (CSLT) which went public on March 14th at $16 and ran to just shy of $40 on the opening day. CSLT had a market cap of $3.5 billion (for a few minutes) and, wait for it, revenues of $13 million. So whenever someone says to me that the current environment is not like 2000, I have to concede that $6 million and $6 billion is worse than $13 million and $3.5 billion, but not by much. The rest of the story (as you probably have guessed) is that the market cap of CSLT is materially lower today, down some (65%), at $1.2 billion, but the problem is that is should probably be another 65% lower and trade at $5 (and that is making generous assumptions on growth). So we will come back to the Kindleberger Cycle later and we will clearly have some more to discuss about U.S. equity valuations and opportunities (we didn’t even get to Biotech yet), but these examples give you a sense of the volatility and extreme movements in the first quarter. Q1 was the proverbial “duck on the lake” for U.S. stocks, seemed quiet and

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serene on the surface (slight gain of around 1% depending on the index), but was furiously paddling underneath, as there were some big gainers and some big losers within the index. So let’s move on to the core of this section of the letter, providing an analysis of the events that occurred in the capital markets during the quarter and providing some commentary on how our views on opportunities in the various market segments played out during the period. As investors, we try to stay focused on longer periods of time, where fundamen-tals drive returns, rather than Central Bank decisions (or worse, errant comments during press conferences), short-term economic data releases or corporate earnings reports. That said, even long-term investors have to pay attention to developments in the markets that occur during shorter periods of time, particularly if they indicate that something fundamen-tal has changed in the environment. George Soros has a great quote about this, “Don’t try to play the game better, pay attention to when the game has changed.” This quote was particularly important in Q1 as we saw that the game had materially changed when Brother Ben (aka Linus Van Pelt) gave Sister Janet (aka Lucy Van Pelt) the go ahead to begin tapering the Fed bond purchases. Stan Druckenmiller (Soros’ right hand man for many years) was quoted on Bloomberg TV as saying “If you tell me that Quantitative Easing is going to be removed over six to nine months, that is a big deal, the markets will go down.” When Ben announced that Tapering would commence in January he set in motion a chain of events that would lead to a very rocky start to 2014 in the equity markets. With the Upsidasium (see Ganbaru! Kuroda-san or May The Force Be With You for a description of that magical material) being drained from the system, the force of gravity came back into play in January and valuations began to head back down to Earth. Like we described in The Not So Great Pump-kin, Lucy pulled the football away, right as global in-vestors were going all-in and they fell on their back with a loud thud. Global equities fell hard in January, with the S&P 500 dropping (3.5%), EAFE falling

(4.0%) and EM sinking (6.5%). Things were beginning to accelerate downwards when Ben and Janet did their best Sonny and Cher impersonation singing “I Got You Babe” during Ben’s swansong meeting and reminded investors that they “had their back with the new, and improved, Yellen Put” and that “Tapering was not Tightening.” The markets were soothed by the sounds of our Economic Pied Pipers and Risk-On was back in vogue. As quickly as the markets fell in January, they surged in February, with the S&P 500 jumping 4.6%, EAFE spiking 5.6% and EM recovering 3.3% (there were still concerns that EM was going to be hurt by Tapering and that investors should favor developed markets). The good times continued into March, but something changed dramatically in Mid-March (there are a few different theories as to why, which we will discuss), the equity markets turned down hard (really hard in a few places, like Biotech, Internet, Russia and the super bubble areas like Cloud and Social Media) and while the returns were mixed, S&P 500 up 0.8%, EAFE down (0.6%) and EM up a solid 3.1%. Again, the full month numbers masked the intra-period volatility. Diving a little deeper into the individual market performance for the quarter we see some interesting developments that have links to some of the trends that we commented on last quarter. In the U.S. equity market, we discussed one of the anomalies (which we believed was unsustainable) in our year-end summary stating that “there were 12 companies in the S&P 500 that were up more than 100% for the year including some expected names like Netflix and Yahoo, but also some unexpected names like Pitney Bowes and Best Buy (two companies thought to be “done” in 2012). But perhaps even more impressive than the handful of superstars are three factoids; that 470 of the 500 companies went up in 2013, the worst peak-to-trough drawdown in the index during the year was (3.9%) and the index never went below its 200 day moving average all year. With the volatility in 2014, the ratio of winners to losers is closer to 50/50 and the peak to trough drawdown in January was nearly (5.8%), but the index has still not even come close to touching (let

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alone breaking through) the 200-day moving average. The volatility was large and the outcome was an uninspiring 1.8% return for the S&P 500. Looking a little more closely at the components, the mid-caps were the best performers, up 3% and the small-caps lagged slightly (for the first time in a long time), up only 1.1%. An interesting development that will likely be talked about a lot in the next quarterly letter is the rotation from Growth toward Value by investors in the U.S. equity market. This shift only really started in earnest during March, but the results were clear in Q1 with the Growth Index up 1.4% and the Value Index up 2.3%. The spread was more pronounced in the mid-caps where Growth beat Value by double, up 4% vs. up 2%. The developing carnage in this transition can be best seen in the NASDAQ returns as the returns for each month and the quarter were down (1.7%), up 5.0% and down (2.5%) to yield only 0.5% for Q1. This rotation has continued in April and we expect to discuss how this shift will impact returns for a number of quarters in the future (it will be particularly pronounced if Lucy truly yanks the ball away or makes a few more faux pas in her subsequent press conferences). International equity markets were more mixed in the first quarter as the trends from 2013 turned upside down. Case in point, after a spectacular 2013, Japan had a rocky start to the New Year (as foreigners sold on disappointment that Kuroda-san didn’t fire his bazooka more often with more Yen printing) and fell (5.6%). European performance was split between the Core (weak) and Periphery (strong). Germany actually fell a bit, down (0.3%), while France rose 2.9% and the European Index was in-line with the U.S. in-crease at 2.1%. The PIIGS (or GIIPS as they are called now since they are performing better) had a great quarter with Greece up a stunning 18.1% (on top of a truly remarkable 51% return in 2013), Italy surging 14.6%, Ireland jumping 14%, Portugal rising 9.7% and Spain up a pedestrian 4.8% (still more than double the major developed markets). Coming into the year many strategists were prognosticating that European equities would beat U.S. equities in 2014, but they

were primarily focused on the Core countries and not the Periphery, so the race is likely to remain close as all of the major developed countries are facing the same headwinds of low growth, bad demographics and high debt. The peripheral countries have the same problems, but are valued at much lower levels, so we continue to see significantly more upside in them vs. the Core countries. Some specific opportunities that we spoke about in the last letter were the cyclical companies and banks in these GIIPS countries. Q1 was a very good one for the banks, in particular, as Piraeus Bank in Greece jumped 30%, Bank of Ireland surged 30% and Bankia in Spain jumped (only) 20%. The cyclicals were strong as well as building products companies, real estate developers and materials companies began to recover, like Sacyr in Spain, up 35%, Italcementi in Italy, up 45% and Martifer in Portugal up (only) 20%. As the European recovery continues to gain momentum, we would ex-pect to see continued strong performance from cyclical and financial services firms in the GIIPS region. Emerging markets were highly volatile as well in the first quarter of 2014, but the movements were inversely correlated to the developed markets as EM got pummeled in January and then jumped off the bottom starting on February 3rd and has nearly caught the U.S. and European markets CYTD. We came into the year with expectations that the relative value of EM to the rest of global equity markets would drive capital back into these markets and that we would see a reversal of the previous three years of underperformance. We were surprised by the decision to Taper and were even more surprised by the very negative reaction across EM and the huge capital outflows from those markets by global investors. We had discussed the pain already incurred in the Fragile Five (Brazil, India, Indonesia, South Africa & Turkey) last quarter and said that these markets had already “suffered the most due to high current account deficits and weak currencies and therefore incurred much worse damage than other EM countries,” noting that “for Q4 they produced

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(5.5%), 10.3%, (4.7%), 2.3% and (14.1%) returns respectively and for 2013 returns were a universally poor (16%), (3.8%), (23.5%), (6.2%), (26.7%)”, then went on to say that “you make the most money in EM when things go from truly awful to merely bad (quote from Arjun Divecha at GMO).” All of this was a reminder of another Soros quote that “The worse a situation becomes, the less it takes to turn it around and the greater the upside” that we felt applied to these markets as they had all taken steps to prepare for a non-QE world (hiring new Central Bank heads, raising interest rates or instituting more fiscal discipline) and we thought that they were very attrac-tively priced after the corrections. Q1 turned out quite nicely for the “Not So Fragile Five” as the BIIST countries rose 2.8%, 8.2%, 21.2%, 4.7% and 4.8% respectively. The performance in the BRICs was more mixed as Brazil and India rose (as indicated above), while Russia got clobbered by the Crimean and Ukraine political situation which led to steep losses in the markets, down (14.5%) which made the (5.9%) loss in China seem modest by comparison. We will talk more about the Russian situation in the Market Outlook section as the events unfolding there seem to be creating a compelling opportunity to buy assets at prices that will look like fantastic bargains in a few years. China continued to be a tale of two markets as “old China” continued to lag and “new China” continued to generate better returns. As an example, the Chinese banks were down between (5%) and (10%) while our favorite Chinese Internet companies Vipshop and Qihoo surged another 60% and 18% respectively. One interesting development to watch is whether the SOEs in China can enhance their governance policies and unlock value for shareholders. Sinopec made some moves in this regard in Q1 and the stock rose 10%. If this turns out to not be an isolated incident, there could be an inter-esting opportunity to mine the listed SOEs for un-lockable value in some of the largest commercial enterprises in the world that are the owners of some really spectacular assets. The last area to discuss is Frontier Markets, which continued their winning

ways, rising 7.4%, well ahead of all the other global equity markets. The MSCI Index number actually masks the dispersion in these markets (hence the need for great country/stock pickers) where there was outstanding performance in a number of areas like Qatar, up 15.0% and UAE up 24.9%, yet Nigeria fell (14.2%). Overall, we continue to believe that signifi-cant tailwinds related to Demographics, Growth and Low Debt will push these market returns higher for years to come (for a full presentation on Frontier Markets that we gave in a recent webinar contact investorrelations@morgancreekcap.com). An “in-between” area (meaning since the market is still closed to foreigners it is not classified as FM, EM or DM) is Saudi Arabia and it continues to be one of our favorite opportunities. Saudi rose 11.4% in Q1 and is up 37% over the trailing twelve months. The GCC countries continue to benefit from young, growing populations, current account surpluses and tremendous wealth generation capacity as they covert their petro-dollars into commercial and consumer enterprises. Global fixed income markets produced solid returns in Q1 after generating very disappointing results in 2013. Global interest rates continued their inexorable decline as signs of inflation remained absent from the developed markets and global GDP growth continued to fall short of expectations. The Barclays Aggregate Index rose 1.8% (matching the return from equities, not something any pundit was predicting in December), the JPMorgan Global Bond Index jumped even more, rising 3.2% as the impact of currency helped domestic investors, the JPMorgan HY Index posted another strong quarter, up 3.0% and there was a robust rebound in EM Debt as the JPMorgan Index surged 3.5%. All of these returns were solid and all of them handily beat their respective equity market returns, but the clear winner in the bond markets in Q1 was the dog of 2013, long Treasuries. We wrote last quarter “So while we continue to believe that traditional fixed income will generate negative returns for the next five years (or more), there could be a short-term opportunity to “hide” in long Treasuries if the markets get queasy from QE withdrawal in 2014”

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and this contrarian view turned out to be a real winner in Q1 as long bonds soared 7.1% as a combination of flight to quality and reduced inventory (due to Fed purchases) helped raise prices much more than anticipated. The interesting thing about these returns is that every time the Fed with-draws stimulus, rates actually fall (not rise as all the pundits predict) and there has been a predictable opportunity to profit from the early warning by the Fed that they are going to stop buying as many bonds on some date in the future. We added some exposure to long bonds in our tactical allocation, but we should have added more given our cautious view of markets and the historical pattern of returns during previous QE reductions. Another thing we wrote last quarter about bonds was that “Other than the role of Deflation hedge (or short-term hideout from volatility), we can’t come up with a compelling reason to own traditional fixed income in the current environment. We think investors would be wise (and much richer) to move capital away from Bonds toward Absolute Return strategies that have similar diversification characteristics, but enjoy a positive correlation to interest rates. If/when rates begin to normalize money that has shifted from fixed income toward arbitrage related strategies will be nicely rewarded, both on a relative and absolute return basis.” That said, we do continue to see opportunities to hold long duration bonds as a Deflation/Volatility hedge and these assets may get more valuable in the near term if the “sell in May and go away” cycle persists this year (as it should, given that the effect is more pronounced in mid-term election years). The good news on this front is that “the Source” on this trade, Van Hoisington, will be one of our featured speakers at our iCIOSummit conference on May 19-20 here in North Carolina, so we will get to hear firsthand how robust this idea will be for the balance of 2014. Otherwise, we will continue to beat the drum for investors to divest from traditional fixed income as you are nearly guaranteed a negative return over the next decade (not just in real terms, but in absolute terms) as the likelihood of interest rates normalizing and causing capital losses on bond portfolios is

relatively high. Yes, it is possible that we have become Japan and we have another decade of declining interest rates that will drive bond returns higher, but low duration fixed income is a terrible risk reward even if that eventuality occurs as the opportunity cost relative to things like direct lending, distressed debt, EM bonds and other hybrid approaches like converts and preferreds are simply too high to warrant holding those assets. One of the other areas that we thought might get a tailwind were yield assets, like REITs and MLPs and we wrote last quarter that “As some of the Fed uncer-tainty dissipated with the appointment of Janet/Lucy…there was an opportunity during Q4 for “yield” products to stabilize after a rough Q3. One scenario that could play out is that the “Lower for Longer” crew, led now by QEeen Janet Yellen, actually creates some new twist for QEternity (like buying stocks or REITs) that drives rates so low the Dollar replaces the Yen as the Carry Trade currency of choice.” It appears that investors are betting on the lower rate scenario as they poured into REITs in Q1, pushing them up an astonishing 9.9%. An alternative explanation could be that investors are now beginning to believe that the Fed just might start buying REITs (like the other Global CBs) when they get done with the Tapering of bond purchases so they wanted to be sure to own them in order to sell them to Her Majesty later in the year. Either way it was an amazing run over the past few months for the REITs (despite starting from high valuations relative to FFO and with below average yields). MLPs were more muted with the Alerian Index up only 1.9%, perhaps consolidating somewhat after a very strong Q4 last year. Reviewing the performance in the hedge fund sector, the results were solid, if unspectacular (while again the averages masked some very strong performance from some Activist Funds and some specialty funds in Healthcare and China), with the more directional strategies posting some above average returns and the lower volatility strategies continued to get beaten up by the low rate environment. To this point, we wrote

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last quarter that “Any strategy that relied on an element of cash collateral returns (market neutral, relative value, stat arb) has been handicapped in the ZIRP (Zero Interest Rate Policy) world as it is tough to make enough alpha in a dollar neutral strategy when you have a negative return on your cash (no interest less fees and expenses). Finally, any strategy that relied on trends (CTAs and Macro) has been chewed up and spit out by the choppy volatility of the past few years.” The ability to generate meaningful returns in the arbitrage and relative value spaces has been challenged for a number of years (in the post Global Financial Crisis artificial rate environment) and there doesn’t appear to be any relief in sight until at least 2015. The HFRX Absolute Return Index was up 1.3%, the HFRX Event Driven Index was up 2.8% and the HFRX Multi-Strategy Index was up 1.9% (slightly ahead of fixed income) and the HFRX Macro/CTA Index continued to struggle, losing (1%) for the quarter. Even though these returns were not materially better than bonds in Q1, the benefit to shifting from fixed income toward Absolute Return will become more pronounced as rates normalize since A/R strategies have a positive correlation to interest rates (they have floating rate elements) vs. bonds negative correlation (rates rise, bonds lose money). The equity-oriented hedge fund strategies performed in line with global equity markets (despite having much less exposure and risk) with the HFRX Equity Hedge Index rising 1.3% and the HFRX Market Directional Index rose 2.4%. The one thing to keep in mind about all of the HF indices is that the very top managers do not report, so many investors who have exposure to those top managers may experience very different results. In Q1, we saw how some of the highest quality managers (although not all) generated superior returns. The other area to note is that the HFRX Technology/Healthcare Index surged 6.2% during the quarter as some specialty managers posted very significant returns by capitalizing on both the long and the short side of the market volatility to generate profits. These results are very reminiscent of

the 2000 experience where even though the market fell (9%), there were some specialty managers who were able to generate spectacular returns (80% to 100%, or more) by taking advantage of the massive dislocations in the tech stocks as the bubble collapsed. We have also heard rumblings that as the correction has accelerated in April in the bubbliest segments of the market, some managers have positioned themselves well to take advantage of the carnage and we will see those results in the Q2 numbers. Commodities was an area where many of the smartest managers we know were quite bullish coming into 2013 and it was an area that produced dismal returns as bumper crops pushed Ag prices down sharply, industrial metals sold off as fears of China slowing accelerated and precious metals were shunned as there was no longer any need for safe havens as the equity markets surged to record highs. Oil and gas prices were actually firm during the year, but that firmness didn’t translate into gains for the indices as the GSCI fell (1.2%) despite their heavy weightings in energy related commodities. Given the carnage in the commodity space last year and the unlikely event that perfect weather would yield record crops again in 2014, we wrote last quarter that “We also think there could be a contrarian opportunity in the Metals/Mining/Steel, Agricultural Commodities (corn, cotton, coffee) and Natural Gas/Coal sectors given how dismally they performed in 2013.” It took a while for the turn to take hold during the quarter, but many (but not all) commodity prices surged in Q1, which was actually a little but surprising (even to us as we were positively disposed) given the hawkish rhetoric around Tapering in the U.S. “should” have led to a stronger Dollar, but the DXY Index actually turned down and it was clearly a “last shall be first” kind of quarter in the commodity markets. The Ags, which had been crushed in 2013, led the way and showed remarkable strength during the quarter with cotton up 15%, corn surging 15% and coffee vaulted a staggering 50% (sorry Starbucks lovers). The Polar Vortex created the perfect environment for Natural Gas to rise 5% (up more than double that intra-period) and

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even coal prices started to turn for the better (despite continued negative pressure from environmental and regulatory issues). One commodity laggard continues to be Iron Ore, which showed, once again, that the cure for high prices is, in fact, high prices. That is, the high prices of a few years ago prompted huge investment in new supply that has, in turn, driven prices down dramatically. One of the bigger surprises of 2014 has been the resurgence of the metals prices, particularly Gold and the impact on the mining shares. Gold rose 8% during Q1 (was up double that intra-period) and the gold miners surged more than double that, rising 15% (similarly were up double that intra-period). The combination of the return of fear in January as equity markets sold off and the Soros quote from above that “the worse a situation becomes, the less it takes to turn it around and the greater the upside” applied perfectly to these assets as sentiment on Gold and the Miners had never been lower coming into the New Year. There continues to be a lot of negativity about commodities in the marketplace related to China’s plans to transition from fixed asset investment to consumption and the purported end of the Commodity Super Cycle. We continue to side with Jeremy Grantham on this particular point that population growth rates are outstripping our capabilities to produce commodities in sufficient volumes (and, more importantly, at reasonable prices), so we would expect there to be outstanding opportunities in the commodity space for years to come. Overall, the first few months of 2014 have been very challenging. Global growth has become less certain, perhaps a little better in Europe, more muted in the U.S., clearly slower in China and mixed in the other EM regions. Slower growth coupled with fears of rising discount rates (despite all the evidence to the contrary on this point as Bunds hit new low yield and Treasury yields are falling, not rising) has increased volatility around growth oriented investments and the corrections have been rather abrupt in some areas like biotech, internet, social and cloud. Add the rising tensions around the escalation of the Russia/Ukraine

situation and we had a recipe for a less than robust environment for investors, which is precisely what transpired. One statistic that is interesting is that there have been 17 years where the S&P 500 has returned more than 25% and the average return in the following year has been just 6% (which is right about where the equity markets are trending after the first third). The range of outcomes is quite interesting, however, as six of the years were negative and six of the years produced double-digit returns again, with the remaining five years closer to the average. We said in January that “While once again (as usual) we look to be a little “early”, we can’t help but think that we are closer to the end of the movie than the beginning and a disciplined rebalancing strategy and a movement from long-only toward long/short might produce superior returns in the coming quarters” and we still believe that taking profits from the long-only winners from 2013 and rotating to more hedged strategies will produce an Oscar worthy performance in 2014. Market Outlook Making an intermediate term market forecast is a little less challenging than making a short-term forecast (in fact there are many who say the latter is ill advised) for a few reasons: 1) the fundamental factors that drive investment returns like yield, earnings and inflation have a larger impact than changes in relative valuation (which can be highly volatile and are quite unpredict-able), 2) the impact of unanticipated external events, or shocks, to the markets (central bank surprises, wars, weather disasters etc.) is diluted with the passage of time, and 3) there are a handful of prognosticators (think GMO) who actually have a really good track record of making these seven to ten year forecasts. These longer-term forecasts are moderately easier to compile because they can be more quantitative (less emotional) and they benefit from the natural cyclicality of markets and the concept of mean-reversion (trends that move a market/asset away from its long term trend revert back toward that mean/

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average level over time). Given the superlative track record of Jeremy Grantham (and his team, led by Ben Inker) at developing these forecasts it seems like a less effective use of time to try and improve upon that sterling track record, so we have always used the GMO 7 Year forecasts as a baseline for our thinking about the primary asset classes within equities and bonds. As GMO doesn’t prepare these estimates for other strategies like hedge funds, real estate, energy, private equity, etc., we have “adopted” the GMO process to create our own MCCM forecasts for those assets that we prepare on a periodic basis to supple-ment the monthly data prepared by GMO. I historically include Jeremy’s estimates in my quarterly market outlook slides and have used them as a baseline for my presentations at our conferences over the years. I mention all of this here as a reminder of how we must be cognizant of the intermediate to long-term trends within the core asset classes as they will provide a headwind, or tailwind, to the shorter-term forecasts that we derive from other market information and will provide a good measure of the “quality of the fishing pond” (back to my original fly fishing themes that were part of these letters, we want to make sure we are always fishing in Gold Medal Trout Streams). Unfortunately, the latest forecasts from GMO show that many of the primary asset classes look a little “over-fished” today and the expectations for returns in the balance of the decade are likely to be well below the long-term averages for traditional stocks and bonds. Running through the 7 Year forecasts GMO expects the following compound annual returns: Large-cap U.S. 0.9%, Small-cap U.S. (2.8%), High Quality U.S. 4.3%, Large-cap International 3.2%, Small-cap International 2.5%, Emerging Markets 6.5%, U.S. Bonds 2.7%, International Bonds (0.1%), EM Debt 4.7%, Cash 1.8%, Timber (proxy for Commodities) 7.6%. Importantly, I have restated these returns in Nominal terms (GMO forecasts in Real terms net of a 2.2% inflation forecast), so one caveat is that if inflation were to spike higher and the average inflation rate exceeded 2.2% over the whole

period the return expectations would increase incrementally as well (that would take some doing, however, given that inflation is hovering around 1.3% today, so we will need an equal amount of time at 3.1% just to hit the 2.2% average). The amalgamation of these results form the basis for my 0-3-5 Conundrum Thesis that I have shared with many people (and have spoken about a number of times out on the circuit) that with cash paying 0%, a diversified portfolio of Bonds (some U.S., some EMD and maybe some HY) investors are likely to get 3% and a diversified portfolio of equities (some Quality U.S., some International with overweight to Japan and some EM) investors are likely to get 5% over the next seven to ten years. I always finish by saying “mix that up, any way you want, 10/30/60, 0/60/40, 0/0/100, 0/100/0, and you can’t get to a 7% to 8% return,” which is what most individuals, endowments, foundations and pensions need to cover their spending rates. So there has to be another solution, right? There are a couple solutions, both require some skill, effort, discipline and patience to achieve, but they exist. The first is to find managers who can add meaningful alpha on top of the market beta projections that GMO has created. The challenge of this option is that alpha is a zero-sum game (so mathematically not everyone can get it, for every above average manager there must be a below average manager) and that historically finding alpha in sufficient quantities to make up the funding gap given the 0-3-5 environment compounds the difficulty. Second, investors can embrace other investment strategies that are more skill based (as opposed to market based traditional strategies) like hedge funds, private investments and more tactical management approaches that seek to capture the alpha that is foregone by those investors that cling to the tradition-al 60/40 model. We think there are opportunities in both of these areas as we will discuss and it goes back to a great quote from Howard Marks (of Oaktree Capital Management) that it remains a time to “focus on special niches and special people.” As an example of a truly special niche (that would

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require truly special people to help capitalize on the opportunity) came from my speaking at the Global AgInvesting 2014 conference in late April. My assignment was to explain why institutions didn’t have much exposure to Ag Investments and I must admit I was a little puzzled when I did the research and put together the presentation as the data makes a very compelling case that Ag exposure should make up a large component of any long-term investor’s portfolio. The data I compiled showed that for the past 20 years bonds generated about 6.5% returns and U.S. equities generated just over 8%. Bonds had very little volatility, around 4%, and equities have 4X that volatility at 16%. Hedge Funds clocked in at the same return as stocks, but with only 6% volatility. Private investments provided the best returns over the past two decades (not surprising) with RE at 9%, Timber at 9% and PE at 13% with volatility of 5%, 7% and 11%, respectively. The surprise asset class was Farmland, which produced a 12% return with 7% volatility, an amazing combination (in fact, so amazing that when you run an unconstrained mean-variance optimizer on the numbers above, the portfolio loads with 40% Farmland…), yet the data showed that institutional investors had less than 0.6% exposure to Ag Investments in their portfolios. Even more amazing was that Cambridge Associates spoke and gave return expectations for various asset classes for the next decade and said that U.S. stocks would generate 4%, International equities at 8%, EM equities were projected to deliver 10%, U.S. bonds were only likely to muster 2.5%, hedge funds were at 5%, PE was a surprisingly low 9%, yet they forecast that U.S. farmland was an 8%-12% asset, International farmland would generate 12%-16% and Ag investments in the Former Soviet Union and Africa would compound at 18% to 28% for the next ten years. Those are truly spectacular numbers and there were about 600 people gathered in NYC for four days trading ideas on how to capitalize on these opportuni-ties, so perhaps we should be adopt this very Variant Perception on which assets will dominate in the coming decade and begin to reallocate our portfolios toward energy, water and food.

Another approach that intrepid investors can utilize to try and extract excess returns in a low return environment is to continually seek to allocate capital to areas where there has either been a dislocation in prices due to an external shock or to find pockets of growth that are undiscovered and/or underappreciat-ed by the average investor. We wrote about a few of those opportunities in last quarter’s letter and said “There were still some places where these types of assets could be found like Russian oil companies, Indian cyclical companies, Japanese Exporters and Financials, Spanish and Greek Banks (and other essential services), Consumer companies in Frontier Markets and Financial Services companies in many of the Emerging Markets.” One of the challenges of buying cheap assets is that you can be “early” (sometimes the euphemism for wrong) and those assets can get cheaper in the event there are additional shocks to the system (Russia) or there is a change in the perception of the opportunity that changes capital flows (Japan). We talked about that risk in the letter as well saying “The challenge with many of these assets is that they reside in places perceived to be risky and, in some cases, are exposed to short-term risks. While cheap assets can get cheap-er, if you buy a high quality asset at a good price and the price declines due to market sentiment, or short-term capital flows, your loss is more likely to be temporal rather than permanent (think Gazprom go-ing from $9 to $8 last quarter, was $18 in 2011, and now trades at a P/E of 3). On the other hand, if you buy lower quality assets at very high prices and the market falls, chances are that those losses will be much more permanent (think buying CSCO at $100 in 2000, at a P/E of 256, price today, nearly 14 years later, is $22).” In this regard, as tensions rose between Russia and Ukraine, and economic sanctions were imposed by the West, the Russian market fell a little more and Gazprom got a little cheaper, falling to as low as $6.4 in March before recovering to $7.40 today and now selling at a P/E of 2.4. While a good case can be made that this is, perhaps, one of the worst run companies in the world and that it will continue to be a target of

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Western sanctions, the fact remains that this company sits on top of some of the largest oil and gas reserves in the world, supplies 30% (or more) of the energy to Europe and sells at a fraction (10% fraction to be exact) of the value to comparable U.S. Oil companies on a $/BOE (barrel oil equivalent) basis at $1.80 per BOE vs. ExxonMobil at $18.00 per BOE. It was less than a decade ago that Gazprom sold at a P/E of 10 (a 4X return with no growth) and it is unlikely that the Russia/Putin/Ukraine discount will be permanent (remember that markets swing from wild overvaluation to wild undervaluation over time). We think the pendulum is at the peak point of undervalu-ation in Russia and investors will be amply rewarded for buying these world-class assets at third-world prices. On the other side, we outlined in the sections above a number of examples of where there were opportunities to short bad companies/businesses at really awful prices (think CSLT here) and we expect the results will be similar to the CSCO example in the quote from last quarter’s letter. One of the reasons we were so excited about the investment environment coming into 2014 was that we noticed a different tenor in our conversations with managers over the past few months as many began to discuss how they were seeing increasingly more opportunities on the short side. In fact, we wrote last quarter specifically that “a large number of really talented long/short equity managers commented that they were seeing more opportunities on the short side than the long side as valuations in certain sectors like retail, biotech, internet and social media appeared to have gotten ahead of fundamentals.” Being excited about the opportunity to make money shorting overvalued companies is not the same as being Bearish. We clearly had concerns (10 to be exact) about valuations in the U.S. equity market, but we were not overly Bearish (contrary to popular opinion) on the overall market as there were still a number of other factors such as liquidity, interest rates, corporate profit margins etc. that were counterbalancing the high valuations. The key for us was that after an absolutely brutal year in 2013 for short-selling

(remember that the GS most shorted names portfolio trounced the markets for the year and these are deemed to be the worst companies in the indices by some very smart and talented investors) we saw an opportunity for long/short strategies to regain their advantage over long-only after a tough five years. As we enter the second quarter of 2014, that negative momentum is accelerating in the most over-valued segments of the market and the return opportunities on the short side have been nearly as attractive as they were in 2000. We continue to believe that there is modest downside risk to the U.S. equity market as a whole and that a loss similar to the (9%) drop in 2000 is possible. That said, there are some arguments against this outcome, namely that bull markets rarely end with a steep yield curve (no sign of short rate increases until at least 2015) and historically every $100 billion of QE has translated into 40 S&P 500 points (calculated by Larry Jeddeloh at TIS), so with around $600 billion scheduled for 2014, that would translate into 240 points up upside to 2,090, or a gain of 13%. Switching over to the international equity markets for a moment, we wrote about two themes that we expected to see accelerate in 2014, and said “Another theme that was developing momentum was the idea that the recovery in Europe was real and that European equities would outperform U.S. equities in 2014. There was also a growing acknowledgment that global equity managers were underweight Japan and as the Abenomics plan unfolded, there would be increasing capital flows into Japanese equities.” Our thesis on Europe has not changed much in the past few months other than to gain strength in our conviction that the recovery has taken hold and that there is very meaningful upside ahead as the core infrastructure of the peripheral countries continues to restructure. We have moved from Austerity to Stability and we are a ways away from real Growth, but the trends are all moving in the right direction, capital is flowing into the region (from investors, private equity funds, corporations looking to expand and the slow resumption of bank lending. Our

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favorite opportunities continue to be in the GIIPS markets where we anticipate additional significant upside (albeit with some volatility) over the balance of the year and into 2015. One tremendous upside surprise could also emerge if Super Mario Draghi fi-nally finds a way to perform a Euro based form of QE (currently prohibited, but he is working on it…), which would ignite a serious fire under the European equity markets. All boats would be lifted, even the Core countries where we find valuations less compelling, but the GIIPS would surge much more than the Core. We continue to think a great way to play the recovery of the Europe/EM connection is through our Global Titans theme. We wrote last quarter that “The Global Titans theme we have been talking about continues to have deep roots in Europe as companies like Richemont, Swatch and LVMH continue to gain market share in the developing markets and we expect that these high quality businesses will generate strong returns for the foresee-able future.” I am meeting with one of our favorite managers from London in NYC to talk about this theme and a number of others that he finds compel-ling. One of the most interesting things about this particular manager is he was way “early” (where early doesn’t mean wrong) to get defensive last year and ran net short in 2013 and still managed to be up 18%. He came into 2014 some 40% net short and was up 10% in Q1 and is probably having quite a good run in the recent volatility as well. One of his favorite themes is the European banks and we wrote last quarter that “If the banks avoid a serious incident, there is likely to be continued upward movement in equities in Europe and we will continue to look for opportunities to capture the recovery premium.” We are in full agree-ment with his views here and we have meaningful po-sitions in the Greek Banks and the Spanish Banks and have been looking at some other opportunities as well in recent weeks (in full disclosure we missed some huge opportunities in Ireland, Italy and Portugal, but you can’t get them all, but that won’t stop us from trying…). We will continue to search for opportunities in Greece and Spain as we see significant structural tailwinds for these countries as

they emerge from the slowdown and move staunchly into recovery. Valuations are still very low (extremely low on a CAPE, cyclically adjusted P/E, basis) and the specter of some large-scale asset purchase program by the ECB would accelerate the trends even more. For our Japan theme, Q1 was, simply stated, rough and the lack of response by the BOJ to a stronger than expected Yen, and weaker than anticipated growth, was frustrating. However, their steely resolve to wait for the GDP data from Q2 to measure the impact of the sales tax increase before making any further com-mitments to QE is admirable, even though it is tough on the NAV of our investments short-term. Avoiding a policy mistake is critical and we are willing to take the long-view on capitalizing on the Japan revitalization. We wrote last quarter that “We believe that most people still doubt the resolve of Japan (as evidenced by the outflows from Japanese equities by foreign investors in January) to deal with their challenges and that most still do not believe that Abenomics will be successful. We will take The Over. We expect there to be significant announcements this year regarding wage program incentives, tax reform, additional stimulus, regulatory reforms and a renewed focus on innovation and productivity within corporate Japan.” Nothing has changed for us relating to this view. We are confident that Abenomics is on course, that the PM has the conviction, political will and support to achieve the third arrow of reforms and that it will simply take a little time to reverse the effects of the unusually long Bear market. We actually wrote that “One benefit (perhaps the only benefit) of enduring a 23 year Bear Market is that the surviving companies have become leaner, more competitive and are positioned very well to capture global market share, re-leverage their businesses to raise ROEs and increase EPS at a very high rate.” The evidence of those earnings improvements continues to roll in and, in stark contrast to the U.S., things are getting better and better on the margin in Japan, where things appear to be getting a little less good in the U.S. (as can be seen during this earnings season so far). If the Topix companies hit their earnings targets this year

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and ROEs expand toward 10%, we would expect to see a significant re-rating of Japanese equities in the 2H of 2014. Recognizing that we had expected the 1H to be strong (historical seasonal trend of strong Nov-Apr broke down this year), we have some trepidation about having such high conviction on this theme right now, but we believe that we simply overestimated how the domestic Japanese investors would match the flight of capital by “hot money” foreign investors who saw the delay in the BOJ action as a negative and now believe that transition has played out. In hindsight (always so easy in hindsight), we should have paid more strict attention to the negative balance of capital flows in the early months of 2014. The bad news is that we had to endure some pain in the short-run, but the good news is we have more clarity around the fundamental improvement in Japan Inc. and we expect great things on the earnings front in the com-ing quarters. A final complicating factor is that there has been some resistance in the depreciation of the Yen toward the expected year-end value of 115 due to safe haven demand given the pickup in volatility on global equity markets. Our view on this point is very clear, Japan has no choice but to pursue a weaker Yen (to diminish the value of the massive debt they have accumulated) and we agree with my friend Hugh Sloane when he said to me in November of 2012, “the Yen will be weaker for the rest of your life.” We will continue to hedge our portfolios to capitalize on the erosion of the Yen/$ relationship and would expect that weakening to translate into much higher earnings for the exporters, banks and insurance companies that make up the core of our exposure in Japan today. Emerging Markets have been a very interesting story in 2014 as the fears of the impact of Fed Tapering led to a fairly sizable January sell-off and the continued volatility in these markets (after a rough 2013) had many market pundits calling an end to the Emerging Markets miracle and forecasting that developed markets would continue to trounce EM for the fore-seeable future. As usually is the case, just about the time that everyone decides that something must be true in the markets, what has become consensus turns

out to be wrong, yet again. We talked about how there was still some risk in EM in the last quarterly letter and said that “We are not in a hurry to reach out and try to catch the falling knife just quite yet (have actually found there is less chance of slicing off a finger if you let the knife hit the floor and then pick it up), but we are mindful of the wisdom of Sir John Templeton who said “Bull Markets are born on Pessimism, grow on Skepticism, mature on Optimism and die on Euphoria.” We may not be able to definitively declare that we are at the point of Maximum Pessimism, but we are certainly getting close.” Then almost to the day of penning those sentiments, Emerging Market equities have staged a very robust recovery and now lead the developed markets for the CYTD. While not every market has been spectacular (China is down about (6%) and Russia is off about (15%) relative to the S&P 500 being up a little over 2%), there actually have been some spectacular performances in the past three months as Turkey surged 30% (after a very bold increase in inter-est rates to stem capital flight), Brazil is up 25%, Indonesia and S. Africa are up 20% and India is up 18%, easily outpacing the EM Index which is up a very strong 10%. These five countries are “affectionately” referred to as the Fragile Five and have struggled in the past few years with Current Account deficits and weak currencies that have dampened equity returns, but some strong action by governments and central banks this year have led to resurgent markets and much more stable economies. There are a large num-ber of people who believe that these gains will turn out to be ephemeral (read, dead cat bounces) and that nothing has really been solved in most instances, so volatility is likely to return and investors would be wise not to pay attention to the Siren song of these dangerous shores. We would agree that there will continue to be risks in these markets, but we believe that selective investors can find very compelling op-portunities in a number of areas where demographic tailwinds, resurgent capital flows and talented man-agement teams combine to provide a very positive prospective return environment. While it may not be advisable to simply be long-and-strong, we think that

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local managers with local knowledge can add significant value to portfolios. We continue to believe that there will be outstanding opportunities for stock pickers in these markets, as the economic and demographic climate resembles the U.S. in the 1980-2000 period. Another area of continued focus and interest for us is the Frontier Markets. The Middle East and Africa have massive growth potential, huge natural resource wealth, young populations and rapidly developing capital markets which have produced (and should continue to produce) outstanding returns in recent years. We also discussed last quarter that there are other benefits to owning FM in a portfolio when we said that “An added benefit to Frontier Market expo-sure is that these markets really are uncorrelated with most other markets given that the companies serve the local countries rather than being large, global con-glomerates that would not provide as much diversifi-cation benefits as the truly local companies.” The Frontier Markets are traveling the well-worn path of Emerging Markets twenty years ago and we would anticipate that global capital will continue to flow to-ward these regions as return expectations in the devel-oped work continue to moderate. One of our favorite ideas in this space is not technically a true FM (given that this country is not included in any index as it is not open to foreign investors), but Saudi Arabia is an outstanding place to invest today as the oil wealth has created a booming consumer culture that has created significant opportunities in banking, financial services, retail, real estate and other sectors. The returns for intrepid investors in the region have been very strong, in part because of the sheer challenge of investing (foreign investors much use P-Notes, a derivative contract that grants exposure to the Saudi equity market through a financial services counterpar-ty) and partly because of the strong Current Accounts and Fiscal situations of these countries (I say these as one could include Qatar, Kuwait and UAE as exam-ples of markets where the returns have been spectacu-lar in the past year). Beyond the Middle East, Africa continues to develop very quickly and there are

examples of incredible success in certain areas such as Safaricom in Kenya, which has developed the most advanced mobile payments system in the world. In fact, Nairobi has been dubbed Silicon Savannah as a large crop of venture capital groups and technology specialty firms have risen up to capitalize on the first mover advantage that some Kenyan companies have gained in the crossover market between financial services and technology. We expect to see continued opportunities to make meaningful returns in Africa for many years to come. Finally, there are some Frontier Asian countries that look very compelling as well, like Pakistan, where there are myriad management teams that rival the best in India (well known for their prowess in technology, pharma and industrials), yet the companies sell at a fraction of the price due to fears about the politics of the region and the level of development in the capital markets. The genie is out of the bottle in the Frontier Markets and she is not headed back in, so we will continue to expand our exposure to these regions over time. We came into the year with a highly contrarian view on the prospects for interest rates and the opportuni-ties in long-duration bonds. Our view was informed by the past few years of history where we observed a counterintuitive trend of interest rate moves and QE. We wrote that “This was clearly a Variant Perception as the consensus has been that interest rates would have to rise in 2014, particularly if the Fed were to Taper (idea is that if buyer of last resort leaves market that prices have to fall and rates have to rise). This consensus is interesting given that there is abundant evidence to the contrary that shows that each time the Fed stepped out of the bond markets (ended QE I and QE II) rates actually fell.” Once again, the consensus has all collected on the wrong side of the boat and the extreme level of consensus (100% of Bloomberg sur-veyed economists believed interest rates would rise in the U.S. in 2014) was one of the better “buy signals” in recent memory. Long-bonds have surged in the first four months of the year and returns now exceed 10%. There are lots of questions about whether these returns are simply the result of a large short-squeeze

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as so many fixed income and macro managers came into the New Year short long-bonds or whether there is a structural problem in that the Fed now owns over 50% of the long-duration assets so there is simply a supply/demand mismatch which always leads to higher prices, and lower yields. In talking to one of my favorite managers who is a truly independent thinker on these types of topics, he corroborated our view that Deflation is still a bigger concern than Inflation and that he was continuing to add to his already large long bond/bund exposure in his portfolio. We would agree with is view and actually put together a very interesting slide for our Market Outlook in December that showed how interest rates looked to be setting up for a fall similar to the drop from 3.65% to 1.8% on the 10-year during 2011 and that a similar drop this time would take 10-year yields from 3% to 1.6%. If that magnitude of rate compression were to occur, the returns for long-bond owners would be very compelling and might approach the 30%+ returns of 2011. Again, we have spent less time in this letter talking about private investment opportunities because our frequent readers have heard the argument many times over the past few quarters. We continue to perceive that the Illiquidity Premium remains meaningfully elevated from its normal level since investors are substantially overpaying for liquidity given the high degree of uncertainty in the markets. There is actually a dual problem of this phenomenon as not only are investors missing out on what will likely be peak cyclical returns in the private markets, but they are likely to endure above average losses in their liquid assets either from a shock to the system that corrects valuations, or a normalization of interest rates that corrects valuations. We see tremendous opportunities across all private investment sectors, including buyouts, growth capital, venture capital, mezzanine lending, private real estate, energy lending, reserve acquisition and distressed, and we continue to find very compelling opportunities to deploy capital. We maintain our belief that investors should “double” their private investment weighting (i.e., if you are

comfortable at 20%, go to 40%, etc.) as the expected returns over the coming decade will likely be meaningfully higher for private investments than their public market equivalents areas (e.g., mezzanine lending vs. bonds, buyouts/VC vs. equities, reserve acquisition vs. commodities). If we examine the mezzanine vs. bonds example a little more closely we can posit the question of why buy bonds at 3% or 4% yields (maybe 5% if stretch to high yield) when you can make direct loans to middle market businesses (yes, you have to swap daily liquidity for a multi-year year lock-up plus a coupon) at 11% yields (plus additional upside in some cases from attached warrants). Looking at the equities example, why buy a mutual fund, or ETF, with an expected return of sub-4% (based on the GMO estimates) when you can direct investments in businesses (later stage VC or small buyouts) that are likely to provide returns in the mid-teens over a multi-year holding period. In the commodity space, we liked lots of different commodities coming into 2014 and these markets really have been the surprise of the year as Ags have surged, metals have been solid and energy has been stubbornly high (despite all the forecasts for collaps-ing Oil and Gas prices). One area we thought was quite interesting for 2014 was Gold and the Gold Min-ers. These assets experienced a simply dreadful 2013 and in The Year of the Alligator, we thought these might be the most gaping jaws around. We wrote last quarter about another smart investor who thought Gold Miners might be attractive when I said “I was interviewing Jim Grant at our iCIO Investment Summit and asked him for his “One Best Idea” (after some fumbling that is was tough to pick just one…) and he said that he thought the Gold Miners appeared to have been beaten up sufficiently to be at a bottom.” Since December of last year, GDX is up about 12%, GDXJ is up about 15% and some individual mining stocks are up more than double (relative to the S&P being roughly flat over same period). In the spirit of my hear it three times rule, first it was Jim Grant, then is was George Soros and then it was Russell Clark so it

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might be time to add some real weight to the gold miners as they have easy comps, a higher than expected gold price and there has been some mean-ingful consolidation and rationalization in the indus-try to help with the supply/demand balance that plagued these businesses in The Year of the Coyote. It has been a volatile year so far in 2014 and it does appear that Gravity Bites, as the sky-high equity returns of last year have come back down to earth (in some sectors and industries one might even say they have come crashing down to earth). We talked earlier about market indicators and the Bradley Dates that forecast a challenging first half of the year for the hot markets of 2013 and we also discussed another oft watched indicator in last quarter’s letter when we wrote “There are some market watchers who contend that what happens in January is a microcosm for the full year and if that is the case we could be in for a year like 2011 where long bonds were up close to 30% and the S&P 500 was up only 2%. While we are not sure that this year will be quite as extreme, we do believe that there is a reasonable likelihood that bonds outperform stocks in 2014.” Clearly this statement doesn’t seem as crazy as it did three months ago now that long-bonds are up 10% and U.S. stocks are flat, and one-third done does not a full-year make, so there is plenty of time to have this trend reverse. However, there is a troubling trend that equity markets tend to be weak from May to September (and particularly so in mid-term election years) and there have been a lot of people who have been warning to “sell in May and go away.” This may turn out to be really good advice this year as it does appear that a lot of factors are lining up to make The Year of the Alligator a very challenging one for investors (it has clearly been tougher on all of us than The Year of the Coyote). I ran across a very interesting quote from one of the great value investors of our time, Seth Klarman of Baupost, who said “six years ago, many investors were way out over their skis. Giant financial institutions were brought to their knees. The survivors pledged to themselves that they would forever be more careful, less greedy, less short-term oriented…Can we say

when it will end? No. Can we say that it will end? Yes. And when it ends and the trend reverses, here is what we can say for sure. Few will be ready. Few will be prepared.” I think that Seth’s quote is clearly very ominous and it packs more punch knowing that he has taken his Fund to 50% cash (similar to the move by Buffet in 2007). We all know from experience that it’s very difficult to say precisely when something like a major trend reversal will occur, but we also know from experience that we can prepare ourselves for that eventuality by paying attention to the Kindleberger cycle (when are the Insiders selling?), monitoring the valuations of the markets (The 10 Things I Hate About Spoos) and being willing to move our portfolios to a more protective position. I had the great privilege of listening to Stan Druckenmiller share his wisdom on investing last night at the ND Wall St. Forum and it was one of the highlights of my investing career. He was incredibly open about what he believes makes investors successful (and what make some investors less successful) and one of the most important takea-ways was that an investor should never feel compelled to be in every “sandbox” all the time. He said that too many investors believe that they must stay exposed to all markets all the time regardless of valuation and potential future returns, which he said is a tragically flawed assumption. He also quipped that “the concept of Bulls and Bears making money is wrong, to be a great investor, you have to be a Pig,” which means that you are only going to have a couple of really great ideas in any year, so when you have them, you have to invest BIG. He told the story of how George Soros taught him how to really size positions correctly and how his original mentor at Pittsburgh National Bank taught him how to use technical analysis to tap into the “greatest analyst of all: the market” to make sure that when they made a mistake, they exited and lost less and when they were right, to make more by let-ting those positions run. Stan compounded capital at 30% for 30 years (that turns $1 into $2,619, which doesn’t seem possible, but that is the power of the eighth wonder of the world) so we should probably heed his wisdom. We don’t have to stay in the sand-box if there is going to be a sandstorm and like the

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First Quarter 2014

Egyptian Plover, we don’t want to be hanging around looking for that one last morsel when the Alligator jaws snap shut. Update on Morgan Creek

We hope you have been able to join us for our new Global Market Outlook Webinar Series titled “Around the World with Yusko.” We host this series of topical discussions on a monthly basis and have presented our thoughts on opportunities in unique global recovery situations, consolidation industries and Frontier Markets. In addition to presenting one of our “best ideas themes” each month, we have also in-cluded a short update on the Tactical Fund following each ATWWY call. We will also continue to provide investors with our MCCM Quarterly Fund Update via a similar webinar platform on the same schedule as in previous years. These updates will focus on the spe-cifics of the MCCM family of Funds and will feature an overview of the various investment themes, strate-gies and opportunities that we see in the public mar-kets and have integrated into the portfolios. If you have not been receiving the communications for these please email investorrealtions@morgancreekcap.com. For more specific information on our Registered In-vestment Products please visit us at www.morgancreekfunds.com. Following on the success of our inaugural iCIO Investment Summit held in New York City this past December we are excited to bring the iCIO format to North Carolina this month. The Investment Summit format is designed to provide an opportunity to gen-erate high-level Conversations, Ideas and Opportuni-ties (hence CIO) amongst senior investment profes-sionals regarding the ever-changing investment envi-ronment. The speaker faculty for this spring’s Summit is truly exceptional as we are fortunate to have a num-ber of the brightest minds in the investment business joining us, including Kiril Sokoloff, Burton Malkiel, John Burbank, Van Hoisington, David Zervos, David Hornick and Dan Clifton. The registration response

has been overwhelming and it is exciting to see such a broad spectrum of participants from Foundations, Endowments, Pension Funds, Family Offices and other investment management organizations joining us in NC, which will lead to a truly outstanding exchange of ideas. The event is just around the corner, on May 19-20, 2014 and will be held at The Umstead Hotel in Cary, North Carolina. We are doubly excited for this particular event as there will be a special dinner on May 19th to celebrate Morgan Creek’s 10 Year Anniversary! We hope you can join us. Also be sure to mark your calendars for December 8-9, 2014 as we will be returning to New York City for the iCIO Investment Summit. Please go to www.iciosummit.com for details. As always, Morgan Creek current investors (in any one of our products) receive complimentary access to the event. For more details, please contact Andrea Szigethy at aszigethy@morgancreekcap.com or Donna Holly at dholly@morgancreekcap.com. As we approach our tenth anniversary, it is important to mention how grateful we are to have had the op-portunity to provide investment management services to our clients for the past decade, come this July. We could have never achieved such a milestone without the continued support, loyalty and friendship of such a tremendous group of friends and partners. It is a great privilege to manage capital on your behalf and we are appreciative of your long-term partnership and confidence. With warmest regards, Mark W. Yusko Chie Executive Officer & Chief Investment Officer

This document is for informational purposes only, and is neither an offer to sell nor a solicitation of an offer to buy interests in any security. Neither the Securities and Exchange Commission nor any State securities administrator has passed on or endorsed the merits of any such offerings, nor is it intended that they will. Morgan Creek Capital Management, LLC does not warrant the accuracy, adequacy, completeness, timeliness or availability of any information provided by non-Morgan Creek sources.

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Upcoming Educational Programs

Save the Date for Future Morgan Creek Events

The iCIO Investment Summit December 9, 2014 (welcome reception Dec. 8th) Club 101, New York City To Register: www.iciosummit.com

NC Investment Institute October 7, 2014 (welcome reception Oct. 6th) The Umstead Hotel, North Carolina To Register: www.ncinvestmentinstitute.org

“Around the World with Yusko” Webinar Series Next webinar: June 17, 2014, 1:00pm EDT To Register: Please contact IR@morgancreekcap.com

For more information on any of our upcoming programs please contact Andrea Szigethy at aszigethy@morgancreekcap.com

Q 1 2 0 1 4 L E T T E R T O I N V E S T O R S - D I S C L O S U R E S

General This is neither an offer to sell nor a solicitation of an offer to buy interests in any investment fund managed by Morgan Creek Capital Management, LLC or its affiliates, nor shall there be any sale of securities in any state or jurisdiction in which such offer or solicitation or sale would be unlawful prior to registration or qualification under the laws of such state or jurisdiction. Any such offering can be made only at the time a qualified offeree receives a Confidential Private Offering Memorandum and other operative documents which contain significant details with respect to risks and should be carefully read. Neither the Securities and Exchange Commission nor any State securities administrator has passed on or endorsed the merits of any such offerings of these securities, nor is it intended that they will. This document is for informational purposes only and should not be distributed. Securities distributed through Town Hall, Member FINRA/SIPC or through Northern Lights, Member FINRA/SIPC. Performance Disclosures There can be no assurance that the investment objectives of any fund managed by Morgan Creek Capital Management, LLC will be achieved or that its historical performance is indicative of the perfor-mance it will achieve in the future. 2005-2012 results are audited. 2013-2014 performance data is not yet audited and is subject to change upon audit. Monthly performance numbers are not individual-ly audited and only a fund’s annual financial statements are audited. Performance may differ based upon New Issue eligibility, individual dates of admission and actual fees paid. All performance reflects reinvestment of dividends (if any) and all other investment income (which should be evaluated when reviewing performance against other indices). The performance data set forth in this presentation is based on information provided by underlying managers and is believed to be reliable but has not been independently verified by Morgan Creek Capital Management, LLC. Forward-Looking Statements This presentation contains certain statements that may include "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. All statements, other than statements of historical fact, included herein are "forward-looking statements." Included among "forward-looking statements" are, among other things, state-ments about our future outlook on opportunities based upon current market conditions. Although the company believes that the expectations reflected in these forward-looking statements are reasona-ble, they do involve assumptions, risks and uncertainties, and these expectations may prove to be incorrect. Actual results could differ materially from those anticipated in these forward-looking state-ments as a result of a variety of factors. One should not place undue reliance on these forward-looking statements, which speak only as of the date of this discussion. Other than as required by law, the company does not assume a duty to update these forward-looking statements. Indices The index information is included merely to show the general trends in certain markets in the periods indicated and is not intended to imply that the portfolio of any fund managed by Morgan Creek Capital Management, LLC was similar to the indices in composition or element of risk. The indices are unmanaged, not investable, have no expenses and reflect reinvestment of dividends and distribu-tions. Index data is provided for comparative purposes only. A variety of factors may cause an index to be an inaccurate benchmark for a particular portfolio and the index does not necessarily reflect the actual investment strategy of the portfolio. No Warranty Morgan Creek Capital Management, LLC does not warrant the accuracy, adequacy, completeness, timeliness or availability of any information provided by non-Morgan Creek sources. Risk Summary Investment objectives are not projections of expected performance or guarantees of anticipated investment results. Actual performance and results may vary substantially from the stated objectives with respect to risks. Investments are speculative and are meant for sophisticated investors only. An investor may lose all or a substantial part of its investment in funds managed by Morgan Creek Capital Management, LLC. There are also substantial restrictions on transfers. Certain of the underlying investment managers in which the funds managed by Morgan Creek Capital Management, LLC invest may employ leverage (certain Morgan Creek funds also employ leverage) or short selling, may purchase or sell options or derivatives and may invest in speculative or illiquid securities. Funds of funds have a number of layers of fees and expenses which may offset profits. This is a brief summary of investment risks. Prospective investors should carefully review the risk disclosures contained in the funds’ Confidential Private Offering Memoranda. Russell 3000 Index (DRI) — this index measures the performance of the 3,000 largest U.S. companies based on total market capitalization, which represents approximately 98% of the investable U.S. equity market. Definition is from the Russell Investment Group. MSCI EAFE Index — this is a free float-adjusted market capitalization index that is designed to measure developed market equity performance, excluding the US & Canada. Morgan Stanley Capital International definition is from Morgan Stanley. MSCI World Index — this is a free float-adjusted market capitalization index that is designed to measure global developed market equity performance. Morgan Stanley Capital International definition is from Morgan Stanley. 91-Day US T-Bill — short-term U.S. Treasury securities with minimum denominations of $10,000 and a maturity of three months. They are issued at a discount to face value. Definition is from the Depart-ment of Treasury. HFRX Absolute Return Index — provides investors with exposure to hedge funds that seek stable performance regardless of market conditions. Absolute return funds tend to be considerably less vola-tile and correlate less to major market benchmarks than directional funds. Definition is from Hedge Fund Research, Inc. JP Morgan Global Bond Index — this is a capitalization-weighted index of the total return of the global government bond markets (including the U.S.) including the effect of currency. Countries and issues are included in the index based on size and liquidity. Definition is from JP Morgan. Barclays High Yield Bond Index — this index consists of all non-investment grade U.S. and Yankee bonds with a minimum outstanding amount of $100 million and maturing over one year. Definition is from Barclays. Barclays Aggregate Bond Index — this is a composite index made up of the Barclays Government/Corporate Bond Index, Mortgage-Backed Securities Index and Asset-Backed Securities Index, which includes securities that are of investment-grade quality or better, have at least one year to maturity and have an outstanding par value of at least $100 million. Definition is from Barclays. S&P 500 Index — this is an index consisting of 500 stocks chosen for market size, liquidity and industry grouping, among other factors. The index is a market-value weighted index – each stock’s weight in the index is proportionate to its market value. Definition is from Standard and Poor’s. Barclays Government Credit Bond Index — includes securities in the Government and Corporate Indices. Specifically, the Government Index includes treasuries and agencies. The Corporate Index includes publicly issued U.S. corporate and Yankee debentures and secured notes that meet specific maturity, liquidity and quality requirements. HFRI Emerging Markets Index — this is an Emerging Markets index with a regional investment focus in the following geographic areas: Asia ex-Japan, Russia/Eastern Europe, Latin America, Africa or the Middle East. MSCI Emerging Markets Index — this is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. As of No-vember 2012 the MSCI Emerging Markets Index consisted of the following 23 emerging market country indices: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Peru, Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Thailand, Turkey, and United Arab Emirates.