White Paper

“The Case for Emerging Managers”

By Brad Rundbaken

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“I believe the banking institutions are more dangerous to our liberties than standing
armies. If the American people ever allow private banks to control the issue of their
currency, first by inflation, then by deflation, the banks and corporations that will grow
up around [the banks] will deprive the people of all property until their children wake-up
homeless on the continent their fathers conquered.”
Thomas Jefferson

The purpose of this White Paper is to demonstrate how government policies, a

broken Wall Street business model, avoidance of proper risk management and
future economic trends pose extreme danger to the future of all pension and
investment accounts.

On December 23, 1913 The Federal Reserve Act was passed which transferred control of
the money supply of the United States from Congress as defined in the U.S. Constitution
to the private banking elite. The Federal Reserve is not a federal government entity or a
reserve but rather a legalized cartel of the money supply owned by private national banks
under the assumption it is protecting the public’s interests. From 1921 to 1929 the
Federal Reserve increased the money supply by 62% and fueled what is known as the
Roaring Twenties. Loose monetary policy and easy loans caused a fivefold increase in
the Dow Jones Industrial Average over the second half of the 1920s. When the New
York banking industry had a mass calling of these margin loans it resulted in the market
crashes on October 24th and 29th otherwise known as “Black Thursday” and “Black
Tuesday.” Instead of expanding the money supply after this dual stock market crashes the
Federal Reserve then decided to contract it, which resulted in a period known as the Great
Depression.

After World War II the United States became a dominant world power both militarily and
economically. In 1945 the U.S. had a manufacturing industry that was the envy of the
world. In 1944 The Bretton Woods Agreement, which pegged the U.S. dollar to the
currency of 44 Allied nations was established. This agreement gave the U.S. a huge
advantage in the world of currencies because they were now the only country legally
allowed to create more of the reserve currency, which were U.S. dollars.

In the early 1970s the U.S. began running a trade deficit for the first time in the 20th
century due to escalating costs from the Vietnam War and domestic social programs. This
resulted in many of the United States trading partners questioning the U.S. balance sheet,
which resulted in the request to transfer the payment of U.S. dollars into gold. The
redemption in gold was upheld by the Bretton Woods Agreement and it threatened to
drain the U.S. Treasury supply of gold. On August 15, 1971, President Richard Nixon
closed the gold window in order to prevent this from happening. This decision left no
currency in the world tied to gold and the gold standard became extinct.

Fast forward: it’s 1982 and the public debt had tripled to $1.25 trillion and at the present
time it stands at over $14 trillion. The debt explosion has led to monetary inflation
around the world, which has resulted in the formation of the many economic bubbles
since 1982.

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These include:
1. The global stock market boom of 1982-87
2. The Japanese stock market boom of 1988-90
3. The Dot-com boom from late 1994 to early 2000
4. The U.S. and global housing market from 2001 to 2006.

The establishment of the Federal Reserve has caused the U.S. dollar to lose over 95% of
its purchasing power since 1913 and the accumulated U.S. Debt has surpassed $10
trillion and is approximately $10.68 trillion and is rising fast.

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Dr. Hyman Minsky proposed theories linking financial market fragility, in the normal life
cycle of an economy, with speculative investment bubbles endogenous to financial
markets. Minsky claimed that in prosperous times, when corporate cash flow rises
beyond what is needed to pay off debt, a speculative euphoria develops, and soon
thereafter debts exceed what borrowers can pay off from their incoming revenues, which
in turn produces a financial crisis. As a result of such speculative borrowing bubbles,
banks and lenders tighten credit availability, even to companies that can afford loans, and
the economy subsequently contracts.

Hyman Minsky's theories about debt accumulation received revived attention in the
media during the Subprime mortgage crisis of the late 2000s. Minsky argued that a key
mechanism that pushes an economy towards a crisis is the accumulation of debt. He
identified 3 types of borrowers that contribute to the accumulation of insolvent debt:
Hedge Borrowers; Speculative Borrowers; and Ponzi Borrowers.

The "hedge borrower" is one who borrows with the intent of making debt payments from
cash flows from other investments; The "speculative borrower" who borrows based on
the belief that they can service interest on the loan but who must continually roll over the

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principal into new investments; and the "Ponzi borrower" (named for Charles Ponzi) who
relies on the appreciation of the value of their assets (e.g. real estate) to refinance or pay-
off their debt but who does not have sufficient resources to repay the original loan,
otherwise. Source:Wikipedia

The growth of U.S. deficit spending combined with tax cuts has shifted the United States
from a credit nation to a debtor nation. According to Minsky’s Financial Instability
Hypothesis the U.S. is now using Ponzi financing to finance its debt. With the US debt
levels growing even as the economy weakens, our creditors may eventually decide not to
loan us vast sums of money. The current major holders of US treasuries are China,
Japan, Russia, sovereign wealth funds, pension funds, insurance companies and investors.

During the Great Depression money did not disappear, credit disappeared primarily due
to the policies of the Federal Reserve. When credit replaces money in modern economics
this generally leads to the formation of bubbles, which leads to the defaulting of debt
which causes credit to disappear and economies to collapse. The modern day credit
contraction began in August 2007 is still in progress and, is spreading like a cancer. The
government’s response has been a massive bailout which currently totals $4.28 trillion
dollars! The decision by the Federal Reserve to increase credit instead of contracting it is
a very different course of action than that taken before the Great Depression. The current
economic decisions of the government and Federal Reserve places the United States in
unchartered financial territory.

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Parasitoidism is the relationship between a host and parasite where the host is ultimately
killed by the parasite. The US economy, pension funds and investment accounts
representing todays [host] have been inhabited by the Wall Street investment bankers
[parasites] for a long time and the result is a potential collapse of the entire global finance
system. At the very least, this system is restructuring (deleveraging, recapitalizing, re-
evaluating, etc). The current situation is so dire that not only is the host in imminent
danger: so are the parasites whom have now been given a $700 billion bailout from the
US taxpayer. Excessive credit caused the current economic meltdown and more credit
which was passed by the Congress stands to only make the situation worse.

I agree with Thomas Jefferson when he said the following:

‘The issuing power should be taken from the banks and restored to the people, to
whom it properly belongs.”

In order to manage risk and have consistent rates of return in real estate and the stock
market it requires a deep understanding of fundamental and technical analysis along with
the ability to forecast macro and mircro economic conditions into an overall strategy.
This type of forecasting and analysis would be the equivalent of being a real estate,
securities and economic analyst rolled up in one individual and group. Unfortunately,
very people have this set of skills.

Below is an example of this type of forecasting over the past two years when almost
every economist and Wall Street analyst had it wrong.

"I think it's a lending bubble. Lending is out of control. The way some people finance
their homes is crazy."
Brad Rundbaken.
Post and Courier
September 14, 2006
http://archives.postandcourier.com/archive/arch06/0906/arc09143421433.shtml

For the country, "We are not so much a housing bubble as a lending bubble," he said.
"Many lenders are involved in high-risk financing scenarios with borrowers when they
push high-risk loans and do not expect loan defaults when the market turns ugly," he
said. "My main worry for the local real estate market here is the possibility of nationwide
recession, which could drag down the U.S. real estate market even further."
Brad Rundbaken
Post and Courier
September 16, 2006
http://archives.postandcourier.com/archive/arch06/0906/arc09163423604.shtml

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"As far as the economy goes I feel the national economy is going to get worse before it
gets better. There are a couple of major problems out there that are looming and if
kernels in a bag of popcorn represent risk then we are starting to see some kernels pop."
Brad Rundbaken
Q4 2006 Commentary- The Charleston Market Report
January 23, 2007
http://trendocracy.blogspot.com/2010/05/2006-charleston-market-reports.html

"I know many of you are feeling good because of the stock market reaction after the cut.
This euphoria in the market will not last forever with some of the existing problems
related to leverage and easy credit. The 50 bp rate cut will now put even more pressure
on the US Dollar to the downside. In order for The Fed to ditch the inflation
argument/fight and drop rates they must be analyzing some worrisome data on the
economy and a potential recession. So now inflation is contained? BS!!!"
Brad Rundbaken
Trendocracy: “The Bernanke Dollar Put and Interest Rate Call”
September 21, 2007
http://trendocracy.blogspot.com/2007/09/bernanke-dollar-put-and-interest-rate.html

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Countrywide
“Tomorrow is judgement day for Countrywide becauase they are releasing their
earnings. I expect them to be brutal.”
Brad Rundbaken
Trendocracy
October 25, 2007
http://trendocracy.blogspot.com/2007/10/countrywide.html

**In early 2009 Countrywide (CFC) was TOAST.

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Indy Mac Bancorp
"Another Anatomy of a Collapse? Time will tell.”
Brad Rundbaken
Trendocracy
July 30, 2007
http://trendocracy.blogspot.com/2007/07/indymac-bancorp.html

**On July 7, 2008 IndyMac imploded.

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Predictions for 2008
“Oil will hit $125-$150 per barrel. Sell your Suburbans in Mt. Pleasant soccer moms!”
Q4 2007 - The Charleston Market Report
January 20, 2008
http://trendocracy.blogspot.com/2010/05/2007-quarterly-charleston-market.html

The Dollar, Oil and Commodities

Speaking of a major trend changing before our eyes let’s look at oil and the dollar. I
know The Fed has been printing money like it is going out of style and you would think
the dollar would continue to weaken BUT what now appears to be happening is the US
Dollar is getting stronger after years of a negative trend. In my opinion, this is one of the
main reasons we have seen the price of oil drop dramatically from recent highs. What
about the Russians invading Georgia and that big pipeline that they are bombing? This is
why I place less emphasis on fundamental analysis and use technical analysis. Folks, it
takes billions upon billions of dollars, pesos, euros or whatever currency the traders are
using to make these trends change. Once they change they usually last a while.

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Commodities have been a very strong play since early 2000 and as of July I am
completely out of commodities right now. I am not saying commodities are not coming
back but there is a major correction going on right now and if I want to be long I would
rather wait until the commodity funds regroup at a lower price before I add money. This
Dow Jones Commodity Index has been pummeled since early July. Maybe this means a
break from some inflation in our food and energy!

iPath Dow Jones AIG Commodity Index

Why would I want to "Buy and Hope" as this is merely an example of another falling
knife right now? Another trend I am seeing that is confirmed by oil and the dollar is that
international investments are going out of favor and US investments are coming into
favor. It makes no sense but that is where the money is going. We are witnessing a
global economic slowdown and many countries outside of the US are
experiencing housing busts and inflation problems that may be worse than ours. Go
figure!

The dollar has been in a downward trend since 2001-2002, which was when it was at its
peak. The monthly momentum in the US Dollar has been negative for 15 months and
just turned positive.

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 PowerShares DB US Dollar Index Bullish Fund (UUP)

Chart courtesy of Dorsey Wright

A narrowing interest rate disadvantage between the dollar and euro — or the dollar and
the pound — would be hugely supportive for the greenback. The move in the US Dollar
will continue to put downside pressure on commodity prices.

Ever since the dollar has begun to rally we have seen the price of oil deteriorate. It
would appear that oil and commodities are pulling back because of profit taking
and a slowdown in the global economy. The fundamental answer to the US Dollar
getting stronger would be Stagflation (slower growth and higher inflation) in other
countries such as the UK.

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Below is a chart of the United States Oil Fund (USO). Although this fund is trading
above its trend line it is showing weakness and the Energy Sector we follow has turned to
unfavorable status recently.

USO

Chart courtesy of Dorsey Wright

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The chart below shows a clear inverse relationship between the US Dollar and Oil. Kind
of cool huh? Maybe only if you are a geek like me. :)

Charleston Market Report – August 2008

August 12, 2008
http://trendocracy.blogspot.com/2010/06/2008-monthly-charleston-market-reports.html

*The results since this analysis in August 2008 are compelling.

Below are the results as of 11/24/08 since this article was published.

DJP

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USO

UUP

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Risk – A Moving Target
Risk, in theory, is at least two (2) things:
1.) Relative and
2.) A moving target often difficult to exactly quantify but once felt becomes measurable.

Volatility in the stock market is high and the credit market is frozen as we start this very
important week and Holiday Season. If the Congress gets too political and stalls on
passing a bailout bill you will see larger banking institutions fail and a panic could start.
Again, we are in un-chartered territory.

The Asian markets are down and the futures of the stock market are down. The main
technical indicator I follow, The NYSE Bullish Percent, has switched to "Defense" on
Friday. If Congress stalls and/or passes a poorly conceived Bailout Bill the Dow Jones
could drop a couple thousand points. It is conceivable that the DOW could fall back to
7000-8000 if this Bailout Bill gets stalled in Congress. Not only would we have a
huge correction in the stock market but also we could see a major run on banks all
over the world.

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Trendocracy
September 29, 2008
http://trendocracy.blogspot.com/2008/09/risk-is-high.html

In conclusion, 2009 and going forward will require a tactical inflation protected portfolio
(TIPP) approach to both real estate and investments with a high degree of risk
management. To manage investments with a consistent – absolute - return with upside
potential and downside protection will require a unique set of knowledge and analytical
skills. The future investment environment in real estate, stocks, bonds, commodities and
currencies will be much more difficult due to a higher degree of volatility, inflation,
higher taxes, budget deficits, demographics, monetary policy and an economy that must
shift from debt based to credit based in order to survive.

Epilogue – The Emerging Space

Whatever your fundamental financial beliefs and to whatever degree you agree or
disagree with the contents of this analysis one thing is certain, things have changed.
Perhaps things had been changing for a while and this recent financial morass is an
economic catharsis of emerging markets and the changing diverse markets rebuking the
contrived “delivery” of modern day capitalism by the heretofore once (all) powerful and
mighty financial institutions and their “captains of industry”. Clearly, these institutions
had the data (and accordingly the knowledge) to understand that markets change and
were changing. Perhaps, they were (are) to narrow in their approach and are simply
concerned about profits while they de-emphasize process. Remember, process leads to
results.

What good were those captains if collectively; they seemingly with malice and nefarious
greed ran our economy aground? Many of these captains blamed the “sub-prime”
borrower for the start of the crisis. Do you ever wonder if “sub-prime” is used as code for
minority or diversity? Is it likely that a borrower, with bad credit, questionable
employment history and no money down gave a loan to themselves?

Fact of the matter is, the market and ecomony in many areas had begun to mature and
“traditional” growth models were slowing. We make the argument that perhaps the last

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vestiges of accelerated growth and upside return potential are with: the emerging markets
and the emerging manager. Given the launching points of both (while the emerging space
is volatile) they represent less capital risk and higher growth potential relative to other
markets. More volatile – it depends. All markets have volatility.

The US emerging markets and emerging mangers have traditionally lacked direct access
to institutional capital and infrastructure support, but there is no denying the power of
their consumer dollars and market growth, particularly the emerging US consumer. Thus,
the emerging markets and managers are part of the solution because remember at one
time, the United States was an emerging market full of emerging managers. They created
a new revolutionary structure and a brand of capitalism that was not only different but
highly sustainable and envied by the world. This was not without a changing of
paradigms, changing of the “old guard” and a new way of thinking at the very least, a
more direct and robust approach. After hundreds of years, a Great Drepression and
several crisis’ later we face similar challenges. How will we respond?

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