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What’s Next?

An Outlook on Themes That Will Drive Markets

James Cullen
Portfolio Manager
The Gruesome Twosome

• US Economy – Leading Rest of World Down?


• Credit Contraction – Balancing Deflation/Inflation

• Commodities – Demand, Scarcity, and Inflation


• Financials – Is There Any Earnings Power?

• What’s Priced In?


US Economy
• Are Components for Rebound in Place?
– Oil Prices Have Eased from Peak
– Policies in Place to Add Liquidity
– Fed, Treasury Finally Seem to Grasp Problems
• Or Oncoming Train at the End of Tunnel?
– Commodity Prices High vs. Historical Average
– “Home Wealth Effect” Effectively Destroyed
– Financials Constrained, Only Plugged Losses
– Rest of World Economy Generally Weakening
What Top Executives Are Saying
• “Not only is the U.S. in a recession, but the rest of the world is slowing down…
I've never seen anything quite like it… We think we're going to be relatively flat
through 2009 and we don't see the start of a recovery... until the latter half of '09
and '10…And that's basically moved out a year, year and a half from what
everybody thought about four or five months ago."
– Alan Mulally, CEO, Ford Motor
• “In my 33-year career I cannot recall a more challenging environment in the food
industry, particularly with the unprecedented cost inflation.”
– Douglas Conant, CEO, Campbell Soup
• The challenging market conditions continue and there’s not yet any evidence of
the overall housing market bottoming out... However, there are a few early signs
of a market rebound in some individual markets...
– Ara Hovnanian, CEO, Hovnanian Enterprises
• “Wal-Mart’s customer is reflective of society in general… Our customers
represent a broad income segment and they are all challenged today. When
energy and oil prices go up - on top of inflation and health care and core food
items there’s a great deal of pressure on the customer.
– Lee Scott, CEO, Wal-Mart
• This is an extremely, and I stress extremely, rare event. It also speaks to the
more general notion that, in today's highly disrupted financial markets, the
unthinkable is thinkable.“
– Mohamed El-Erian, CEO, PIMCO Investments, on Lehman’s Bankruptcy
European Economy
• Housing Bubble Unwinds
– Huge Property Bubble in Ireland, UK, Spain
• ECB At Top of Tightening Cycle
• Euro is Strong – But Overvalued?
– US Economic Weakness and Strong Euro
Hurting Exports

Economic History Might Not Repeat… But it Rhymes


European Housing Bubble
The Global Slowdown Thesis
• European Housing Bubble Bursting Could Create
US-Style Effects Across Continent
• Demand Destruction Crimping Export-Dependent
BRIC Manufacturers; Slowing Growth in Emerging
Market Economies
• “Global Decoupling” a Myth
Credit – Investment Grade
• “Blue Chips Face Growing Funding Costs”
– WSJ, Aug. 15th: Citigroup, American Express, AIG all
offered debt at 10 Yr. Treasuries + 300-475 bps.
• Wells Fargo (only AAA/Aaa-rated Bank in US)
Had Callable Preferred Offering @ 5 Yr. + 550
– CFO Noted “At Least We Have Access to Capital Markets”
• Lack of Liquidity Brought Down AIG
– Facility from Government at LIBOR + 850
Credit – Investment Grade
Credit - Speculative
• Moody’s: Defaults to Rise Substantially
• Already Doubled Year-over-Year (1.4%2.7%)
• Acceleration in Defaults Likely (4.9% by Y-E)
• 1-Yr Forecast: Only Getting Worse (7.4%)
• General Motors 7-day commercial paper @
5.25%, up from 4% previous day: Sept. 17th
Credit Ratings of Portfolio Holdings

Aaa - 8.94%
Aa - 7.2%
A - 13.07%
Baa - 11.01%
Ba - 14.82%
B - 4.99%
NR - 30.91%
Is The Commodity Bull Run Over?
• Unwinding of the “End of the World” Trade
Crushed Many Commodity Positions
• Emerging Market Demand Has Weakened
– But Speed, Magnitude Says Technical Correction

Areas of Interest:
Steel, Coal, Copper, Mining Equipment
Stocks We Own:
CALM, HGT, UPL, XOM, XTO
Financials
• "And if this were about a company here or there failing, I wouldn't be for
intervening in any way, shape or form. This is about our way of life, our society,
our economy, the American people's jobs, their savings. This isn't about Wall
Street. That's how serious this crisis is. And while I hope it works and we want it
to work, there's no guarantees here.“
– House Minority Leader John Boehner, R-Ohio.

• Will New RTC Save or Japan-ify Financials?


• Investment Bank Model Died This Weekend
• Is Earnings Power Permanently Impaired?

Stocks We Own:
BAC, GS, JPM
To Summarize…
• Expect the Unprecedented
• US Economic Growth Got in a Fight with a Brick Wall
• Credit is Oil to Economy’s Engine; Extremely Scarce
• Europe Could Follow US into Downturn
• If Europe Falls, What Supports Asia/South America?

• Potential for Equity Market to Bottom


Equity Market Bottom?
• Confirming
– Short Seller Witch Hunt
– Credit Quality Has Impact, Requires Consideration
– Implied Volatility High
– Liquidity State (Extremely Dry, But Fed Moving to Counteract)
– Corporate Buybacks
• Disagreeing
– Panic?
– Corporate Defaults (esp. Speculative) Not High
– Short-Lived Bear Market
– Global Financial Leverage Still High
– Housing Prices Need to Fall Further