2.0 Poseidon Perspective February 2010

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

26 February 2010

Dear Investor,
The old Wall Street adage is “As goes (DJT), a leading indicator of the US
January, so goes the year.” Table A economy and MSCI Emerging Markets,
contains the equity returns for several undoubtedly one of the riskiest places to
indexes for January 2010. The sad news be in this world of “hot money,” currency
indicates a very inauspicious beginning for vigilantes, and clashing sovereign policies.
equities in 2010. Will this brief retreat These dynamics are the sort of impetus
dampen the bullish spirits which have that can push the US$ higher in spite of
reigned with optimism over the past 9 reckless deficits and aggressive monetary
months? Will the fear of a cutback in policy.
government largesse and an end to
quantitative easing signal a retreat from We agree that the market lows of March
risky assets? Have the trillions of US$’s 2009 were a much oversold position;
been in vain if deflation continues to worm however, we do not believe that economic
its way into the economy? We believe that fundamentals justify the surge of world‐
many answers will be provided as wide equity prices that has occurred over
economic and geopolitical events coalesce the past year. We continue to be out of the
during the Year of the Tiger. equity markets. We believe the big returns
have been made; there is no longer much
TABLE A room to the upside; the risk of correction is
Jan ‘10 1 Year 3 Year* 5 Year* high. We will continue to endure the
S&P 500 (3.70)% 30.0% (9.28)% (1.89)% mandate of patience.
DJT (4.98)% 31.4% (7.47)% 1.60%

S&P 600 (3.45)% 37.1% (7.67)% 0.01%
MSCI‐EAFE (4.44)% 35.5% (10.2)% 0.32%
During the recent panic we saw the
MSCI‐EM (5.65)% 76.3% 1.17% 11.5% correlation among asset classes converge,
*measured as compound annual growth rate thereby destroying the traditional theory of
diversification. We contend that the world
We quickly note that the two biggest losers is still functioning amid an unbalanced
in January were the Dow Jones Transports credit bubble. Simultaneously, a
THE POSEIDON PERSPECTIVE 26 February 2010
deflationary spiral remains a serious During the last three years these two
possibility and many previously diverse indexes have traded in a lock‐step fashion,
markets now trade in tandem responses to a convergence of risk. So does a “world
increased volatility. We look to Chart 1 index” support the diversification of an
which depicts the S&P 500 and the MS America‐based portfolio?
World Index which excludes US equities.
CHART 1 GO WITH THE FLOW

Source: PSI; StockCharts

Has globalization begat the equalization of interpretations and explanations for the
American small‐cap companies with a pricing of these equity indexes but the fact
status comparable to emerging market that investors now seem to value the
equities? It may sound extreme; it is emerging economies so much greater than
extreme. One must consider that a Silicon the US strikes us as a bit unsound. One
Valley software firm could be included in only needs to consider such factors as the
an amalgam with lesser investment rule of law in Russia, the censorship in
potential than an index which includes a China, or the potential for a nuclear
chain of Bollywood theaters? As we gaze exchange between India and Pakistan prior
upon Chart 2 we see the small‐cap S&P 600 to the weighing of global risk. The grass
over‐laid upon the MSCI Emerging always looks greener. We do not consider
Markets index. There are many either one of these equity classes to be
Page 2
fairly valued. We note the movement of Table A and Chart 2. However, world
capital from the US to under‐developed events sometimes have a way of reverting
foreign markets. We cringe at the very quickly and a quiet afternoon picnic
exuberance which is displayed in both can easily be disrupted by stormy weather.

CHART 2 LEADING AND LAGGING


Finally, we consider the uniquely the cost of energy and an increase in
American relationship of the insatiable discretionary spending. Energy costs,
consumer with their oversized motor especially gasoline, are a severe drag on
vehicles. Chart 3 is a combination of the the economy and a burdensome tax on the
Retail HOLDRS Index (IHR) of domestic consumer.
retail stocks and the continuous contract
for West Texas Intermediate Crude WTIC, for a number of reasons, the China
(WTIC). Market expectation for retail sales boom, hedge fund speculation, production
as displayed by the IRH pricing is very costs, et al, has made an astounding
robust. Investors appear to value very recovery in price in an amazingly short
optimistically American consumer time. Meanwhile, it has become apparent
spending which is responsible for 70% of that oil pricing has more to do with the
the US economy. We maintain that there is supply of money than the supply of crude.
an intuitive inverse relationship between Yet, these factors have supported oil’s rise
Page 3
of more than 115% since March 2009. Also, boom. However, valuation of retailing is
the marginal price of production is around beyond economic fundamentals. Once
$70 per barrel according to the Financial again these are broad brush analogies
Times. Co‐incidentally, we are in a period which come to mind during a time when
of above‐average inventories. We believe all manner of risky assets have surged in
that commodity prices may continue to price within nine months.
accommodate speculators and the China

CHART 3 A CRUDE MISUNDERSTANDING


In summary, while Charts 1, 2, & 3 indicate company. Overall annual revenue growth
very high spirits, our contention is that the for the company world‐wide was 1.0%.
massive reflationary efforts of the US and
other central banks have still produced SOUNDINGS
GDP inflation as the American consumer is We would like to extract some substantive
still in a deleveraging retrenchment. We quotes from Jeremy Grantham’s most
see this as very bearish for equities. recent “Quarterly Letter” dated January
Walmart stores reported a decrease in 2010 available on the GMO website
revenues for US stores during their fourth www.gmo.com. We do this for two
quarter fiscal 2010 of (0.5)%, a first for the reasons. We have the highest respect for
Mr. Grantham’s skill and experience as an
Page 4
investment manager. We also revere deleterious factors as potential prelude to a
GMO’s research prowess. Hence, we perfect storm. Grantham postulates that
believe that these passages succinctly and “the Fed is unwittingly willing to risk a
clearly elucidate a number of points which third speculative phase, which is
we have addressed over the past three supremely dangerous this time because its
months. If due, either to our lack of arsenal now is almost empty.” Given this
communicative skills or your oversight in combination of investor greed and
perusing our Perspectives, please pay continued financial speculation in spite of
particular attention to the following. This suffering two massive bubbles within the
is important. decade the equity markets are still
promoted across the media and academia
Grantham accentuates the point that when with such tripe as “stocks for the long
the “Fed attempts to stimulate the run.” The “relief rally” since March 2009 is
economy by facilitating low rates and not sustainable unless the Fed continues its
rapid money growth, the economy massive quantitative easing and
responds. But it does so reluctantly, government stimulus is taken to the next
whereas asset prices respond with stage, overdrive. Grantham points out that
enthusiasm. In our studies of the “the market [S&P 500], however, is worth
Presidential Cycle we have shown that, only 850 or so.” He also notes that “fixed
historically, where modest Fed stimulus income seems badly overpriced.”
and some moral hazard hardly move the
dial on the economy in the third year of There are many nuggets of wisdom in this
the cycle, they push stocks up almost 15% letter and Grantham ends with “Lessons
a year above normal and risky stocks Learned in the Decade.” We highly
even more. Yet the Fed has been reckless recommend a close review of these
in facilitating rapid asset booms in the conclusions. The conclusion we would like
tech and housing bubbles.” [our bold] to accentuate is “Asset classes are really
We believe that this analysis is a concise more inefficiently priced than individual
and accurate portrayal of the past 10 years stocks on average, and therefore offer
of central bank policy. However, going greater opportunities for adding value and
forward the utilization of these same reducing risk.” We include precious
simplistic ideological regimes and printing metals as one of these “asset classes” and
press mechanics may be very dangerous. state that we deem them to be much less
As Mr. Grantham points out, the Fed’s exuberantly priced than stocks, bonds, or
balance sheet is “unrecognizably bad” and other commodities. We found Grantham’s
government debt looks as if “a replay of most astute reasoning and important
World War II.” We must add that amid formulation regarding current market
the recent deleveraging the consumer is conditions was that “The real trap here,
completely underwater and bank balance and a very old one at that, is to be
sheets are in shambles. We view these seduced into buying equities because
Page 5
cash is so painful. Equity markets almost includes Treasuries, investment‐grade
always peak when rates are low so corporates, high‐yield, etc, Chart 4 reveals
moving in desperation away from low the rising spread between Treasuries, the
rates into substantially overpriced 30‐Year Bond and the 2‐Year Note, which
equities always ends badly.” [once again is approaching 400 basis points. While the
our bold] Fed is able to control the short end of the
yield curve the long‐end is the bailiwick of
We whole‐heartedly agree with his big investors and very aggressive traders.
contention that one of the most important We watch the long Bond as it may foretell
drivers of equity returns is credit, interest the future of both housing and equity
rates, and credit spreads. While this markets.

CHART 4 LONG TERM RATE WATCH


The outlook for long bond rates was announcement has subsequently been
shaken by the news that China was amended by the US Treasury. With regard
actually a net seller of Treasuries during to the surprise announcement by the Fed
December 2009. Not to worry, Japan that they would be raising the “discount”
picked up the slack and now reigns as the rate, the market’s knee‐jerk reaction to this
largest foreign holder of US Treasuries “noise” was quickly corrected by shrewd
with a stash of $768.8 billion. This traders. The result will have less economic
Page 6
impact than a major winter snowstorm. variations on the eventual impact of the
Yet, this announcement, Bernanke’s Fed’s “unconventional” and unrestrained
testimony before Congress, the constant monetary policy which has been strongly
barrage of an “exit strategy,” and other, at supported by the US Treasury. Quite
times conflicting, non‐information alerts us frankly, we have no clear conception of
to consider the basic rule that “a barking what the future may provide; however, we
dog does not bite.” While all of these are by nature contrarians and, therefore,
factors and related derivative information we have become more and more skeptical
add greatly to market volatility, we believe of the inflationary specter over the next
that the Fed will be barking for the rest of couple of years. Our thesis is premised
the year. upon a few simple concepts. By way of
review we return to the recent monetary
WEATHER WATCH activity of the Fed. Chart 5 displays the
We turn now to the inflation/deflation Adjusted Monetary Base which has grown
issue. We have been struggling with this at an astronomical rate since 2008. This is
conundrum over the past year. As we the result of the complementary increase in
traverse turbulent and unchartered waters the Fed’s balance sheet and the system’s
there are lucid, cogent arguments for all bank reserves held by the Fed.

CHART 5 THE SURGE TO CREATE SPENDING

Source: St. Louis Fed

Page 7
However, the monetary base is not the risky methods to rebuild balance sheets.
same as the money supply due to the fact The simple conclusion is that, while the
that banks are not creating “new” money potential for money‐generation exists, the
thru the lending process. Chart 6 provides transmission mechanism, banking, has not
a graphic view of when banks stopped been operational as anticipated. While the
lending. Midway into the recession the Fed and the Treasury have “saved” the
Money Multiplier dropped below 1.0 and banks which were “to big to fail,” the
continues to fall. The reserves which banking system itself has failed in its
banks have available for lending are not primary duty and is stuck in a quagmire of
being utilized. There are numerous and poor balance sheets, non‐performing loans,
valid reasons for this lack of lending and diminishing real estate assets. Where
activity. They include lack of creditworthy we go from here is the trillion dollar
demand, tighter underwriting standards, question.
alternatives for higher returns, and less

CHART 6 THE FAILURE TO GENERATE CASH


Additionally, we offer the information in economic growth. All information is
Table B for support of the argument that extracted from the Fed’s H.8, page 3,
money and credit are not being generated (http://www.federalreserve.gov/releases/h
in sufficient quantity to support strong 8/current).
Page 8
TABLE B BANKING ON THEIR ASSETS
Assets: Loans & Leases* Jan 2009 Share Feb 17, 2010 Share % Change
Comm & Ind’l Loans 1,601.9 22.2% 1,303.8 19.8% (18.6)%
Real Estate Loans 3,800.8 52.7% 3,716.8 56.4% (2.2)%
Consumer Loans 891.6 12.4% 823.3 12.5% (7.7)%
Other Loans & Leases 923.4 12.8% 748.3 11.4% (18.9)%
Total 7,217.6 100% 6,592.2 100% (8.67)%
* All loan amounts are $’s billion, there is rounding in totals Source: Federal Reserve System

We briefly point to the decline of more realistically valued this number
“Commercial and Industrial Loans” down would have decreased more dramatically.
by 18.6% and “Consumer Loans” lower by Overall, the results are not conducive to
7.7% as a huge economic restraint. We economic growth.
contend that if “Real Estate Loans” were

CHART 7 LESS CREDIT MEANS MORE SAVINGS
While there are a number of sources for securitization schemes, credit unions,
consumer debt, commercial banks, finance companies, and nonfinancial
Page 9
businesses, the best indicator of Consumer CHART 8 PAINFUL PEAKS

Credit Outstanding is the St. Louis Fed, see
Chart 7 which provides a 5‐year view of
growth and decline. There are numerous
dynamics at work here. Three are: 1) a
decrease in demand for loans, 2) a decrease
in the supply of credit, and 3) a lack of
ability to repay or refinance loans
outstanding. Together these factors feed a
decreasing consumer capacity to spend.
The impact on the economy will become
clearer as we watch long bond rates, real
estate pricing both residential and
commercial, and changes in employment
growth.

Prior to any recovery in the national Source: ShadowStats
economy somebody, the government,
businesses, and/or the consumer must Chart 9 provides a view of Money Supply
spend more money. In the first instance Growth. At the present time without any
the government is doing more than its increase in the money supply we do not
share. Business is on the fence and the anticipate a rise of inflation.
consumer is on the ropes. We refer again
to Table B for a summary of the decline in CHART 9 DECLINES INTO DEFLATION
lending. “Consumer Loans” by are down
7.7% and revolving debt, Chart 7, has
fallen 3.8% since July 2008

Chart 8 provides three different rates of
unemployment, not one is pretty. We
understand that employment is a lagging
indicator and, perhaps, as the economy
picks up these numbers will fall
dramatically. However, there is also a
substantial risk that any “economic”
recovery will be muted in job‐creation.

Source: ShadowStats

Page 10
This does not mean there has not been a (yoy) and scheduled foreclosure auctions
surge of inflation in financial securities, were up 15% yoy. James J. Saccacio, CEO
commodities, and valuation of derivative of RealtyTrac, stated that “If history
contracts. The flood of money being repeats itself we will see a surge in the
created world‐wide, China being a major numbers over the next few months as
generator, must find a home somewhere. lenders foreclose on delinquent loans
where neither the existing
Thus, we believe the general economy is loan modification programs or the new
undergoing a substantial period of short sale and deed‐in‐lieu of
deleveraging and deflation. The current foreclosure alternatives works.” This
uptake in GDP activity has been an prognostication is one reason we are
inventory restocking from depleted levels. hearing talk from the White House about a
The rate of defaults and foreclosures on solution to the continuing housing crisis.
residential real estate is one measure by
which households are deleveraging. Chart 10 is the year over year percentage
RealtyTrac reported on February 11 that change in CPI. January 2010 showed year
default notices were up 4% year over year over year rise of 2.6%.

CHART 10 A SUSTAINABLE REBOUND?

The remarkable news was that the January month for the first time since 1982. It is
2010 CPI fell (0.1)% from the previous always dangerous to extrapolate too much
Page 11
from one data point especially from the gold sale of 191.3 tonnes. This is the
questionable metrics of the CPI. However, second part of a sale announced last year
this was a 28‐year event; thus, it demands of over 400 tonnes total. The IMF will still
attention. control over 2,800 tonnes. The operative
word here is “control” for the IMF does not
Chairman Bernanke and his Fed are very “own” this gold; its reserves are the
smart people and understand the contributions from member Western
challenges to economic growth. We countries to back the funding of IMF’s
contend that there is a serious and lending activities. The sale of any gold
continuing risk of deflation and/or a stock requires not only the approval of the
liquidity trap. From the minutes of the Fed IMF Board but also the US Congress and
Open Market Committee (FOMC) issued Executive Administration led by the US
on January 27, 2010, “The Committee also Treasury. The salient feature of this
affirmed its 0 to ¼ percent target range for announcement was that the offer to sell
the federal funds rate and, based on the was not subscribed by any central bank,
outlook for a gradual economic recovery, unusual given the great expectations that
decided to reiterate its anticipation that China would leap at this opportunity.
economic conditions, including low levels However, central banks, we include the
of resource utilization, subdued inflation IMF in this category, have a history of poor
trends, and stable inflation expectations, timing for sales. The most embarrassing of
were likely to warrant exceptionally low which was the action of UK Chancellor
rates for an extended period.” Indeed, one Gordon Browne, now Prime Minister, who
could reasonably argue that we have schemed to sell over 400 tonnes of the Bank
already entered a liquidity trap as of England’s gold before 2002. The gold
evidenced by the need to go beyond “near‐ was sold by auction at prices between $256
zero” interest rates for an extended period. and $296 between 1999 and 2002. The
Since this monetary policy has not most recent IMF announcement may be
stimulated the economy, an extended viewed by cynics as one more central bank
policy of quantitative easing has been attempt to throttle the price of gold in a
undertaken. Concurrently, commercial continuing bull market. So, we must
banks are “hoarding” cash thru reserves remember the contrarian contention to buy
accumulation and refusal to lend. These what central banks are selling. In the
conditions are all definitive of a “liquidity commercial market George Soros has
trap.” voted with his wallet. Bloomberg reported
on February 17 that the Soros Fund
PROVISIONING Management increased its holdings in the
The week of February 15 released three SPDR Gold Trust (GLD) with additional
unexpected announcements. The first was purchases of “3.728 million shares valued
the International Monetary Fund (IMF) at $421 million.” The Soros investment in
GLD, which is the fund’s largest holding,
Page 12
was estimated to be $663 million as of Finally, AngloGold Ashanti (AU), the
December 31, 2009. world’s 3rd largest producer announced
record fourth quarter profits. We note the
Secondly, the Fed announced a surprise following points in their announcement
move to raise the discount rate by 25 basis (http://www.anglogold.com/Press/Press+R
points. The insignificance of this move eleases.htm). The company has been
was further accentuated as the Fed also working off a book of hedges that requires
announced that the term for the discount continuing sales at below market prices in
rate borrowings would revert from 28 days order to “increase its exposure to the gold
to 24 hours, the overnight rate. This price.” Its hedges are now less than one
facility, historically referred to as the year’s production. This change of tack
discount “window” has always been a follows Barrick Gold (ABX) who has
minor mechanism for monetary policy. It announced the same strategy to eliminate
has traditionally been shunned by banks. their hedge book. These moves may be
The Fed Funds Target Rate which is the construed as expectations of higher spot‐
Fed’s primary mechanism for influencing market prices in the future. Also, AU
short term rates remains unchanged. forecast rising cost of production, due to
However, the move may force weaker energy and labor, to $590‐$615 per ounce
depository institutions to resort to other in 2010. Given these cash production
banks for short‐term funding. Thus it prices, the noncash costs, the need for
creates another opportunity for large return on investment, etc, the floor price of
money‐center banks to exploit their gold is open to speculation but easily
extremely low cost, taxpayer subsidized above $700. Hence, at that base miners
source of funds. With no realistic would close up rather than produce; unlike
economic impact we found this surprise mercantilist who may sell at a loss, miners
move disconcerting since the Fed has been with more discipline will allow their assets
extremely careful to clearly signal all to remain vaulted in the earth. These
policy moves to the markets. We found it events all have some bearing on the price
very out of character. This strikes as a of gold. In Chart 11 we show Gold prices
scene from Shakespeare’s Julius Caesar in relation to the trade‐weighted valuation
when the soothsayer twice yells out his of the US$. Normally, these two assets
warning from the crowd “Beware the Ides would show strong divergence in pricing.
of March.” In that case March 15 was the However, during the “credit crisis” this
day honoring “Mars”, god of war, and was not the case. With Gold’s continued
proved to be Caesar’s downfall. In our rise since July 2009 and the US$’s rise in
case it could be any number of threatening November 2009 we have entered
situations, the GIIPS debt bombs, the fiscal unchartered waters. We will watch closely
shambles of the US government, the large to see if Gold maintains its strength in the
and continuing appetite for commodities face of a rising US$. This may be the start
in China. of a true “decoupling.”
Page 13

CHART 11 DIVERGENCE AHEAD?


Currency markets are a world of their own, great point of resistance, to some, an
given to interest rate expectations, inflation almost‐impenetrable “top”. In November
expectations, and sovereign risk. Current 2010 the price surpassed US$1,200 and,
macroeconomic and geopolitical events while the price has corrected, the old
indicate that there is the distinct possibility hurdle of $1,000 has become a “level of
that the US$ and Gold, two forms of support.” We believe that current Gold
“money,” could rise in tandem as they prices will build a base with some
have in periods of extreme stress, late 2008 volatility over the next several months.
and early 2009. From this foundation Gold will continue
its climb. So we remain content with
Investors must always be concerned by central bank actions being excellent
how quickly perspectives can change. As contrary indicators; buy what they are
the price of gold approached the selling. As with fashion, public proclivities
miraculous 4‐digit level of US$1,000 in and understanding are extremely fickle
March 2008 and again in February 2009 and quickly fleeting.
this price level was viewed by analysts as a

Page 14
We celebrated a belated Chinese New Year on February 15 instead of the actual start of the
New Year on Valentines Day. We enjoyed a splendid dinner with a couple of dear friends. It
was a quiet affair of roast duck and snowfish at our favorite Chinese restaurant, Mei Jiang on
the Chao Phraya River in Bangkok. Five year ago we celebrated the Year of the Rooster at
Liu, a neoclassical Chinese restaurant, while residing at the Conrad Hotel on Witthayu (the
Wireless) Road where we enjoyed the stunning celebration with acrobatics, dancing dragons,
and firecrackers that extended 20 stories up the hotel façade. The firecracker exposition of
smoke, noise, and fire which lasted 30 minutes was marked with exuberant pandemonium.
Needless to say, a display of this sort would never have been allowed under OSHA
regulations in the US. The start of 2005 was a totally different time; like the cocky rooster it
was loud, flamboyant, and boastful. The real estate markets reflected this personality as they
approached their apex in the US; the equity markets were cooing close behind.

Now, we have entered a different age. So, we welcome the Year of the Tiger, an astrological
symbol of courage, resilience, and self‐reliance. The Chinese prepare diligently and carefully
in order to send out the old and accommodate the arrival of “good luck” on New Year’s Day.
We believe less in good luck and more in a combination of faith, hard work, and “karma.”
So, for us, age brings an understanding that less can be more, small can be beautiful, and the
quiet stillness of detachment can be enlightening. We diligently work with greater resolve to
sharpen our focus. If we achieve nothing else this Year of the Tiger we shall continue to
strive honestly and earnestly to comprehend the volatility and complexity of financial
markets but to appreciate the possibility for harmony and simplicity in life.

Sincere regards,
Brian E. Shean, CFA
PRINCIPAL
POSEIDON STRATEGIC INVESTMENTS
_________________________________________________________________________________

The views expressed in this commentary are those of the author at the time of composition. The assumptions, analysis, and
conclusions are subject to change in conjunction with changes in the securities’ markets or discovery of additional or
conflicting information. All information conveyed herein has been deduced, compiled or quantified from sources thought to
be consistently reliable. This informational report is produced for general circulation and is not to be construed as a
solicitation to buy or sell securities, financial instruments, or investment products. Prior to entering any transactions for
investment products please consult a competent financial adviser and undertake proper due diligence. AMDG
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businesses, the best indicator of Consumer CHART 8 PAINFUL PEAKS

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