Poseidon Perspective No. 24 September 2010

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

SEPTEMBER 2010 NUMBER 24

On approach toward shallow waters we markets, political change from November
have always found that the best 2010 elections, and potential tax‐selling
preparation is a thorough review of the prior to year‐end. We begin with a review
appropriate charts. Hence, we embark on of monthly returns year‐to‐date. In Table
a reading of numerous graphics in an A we find that the frothy returns of March
attempt to establish our position. Our and July, and thus far in September, will
focus is the equity markets, the soundness bring equity returns into positive territory
of the economic recovery, the myriad for the end of 3Q2010. However, we
actions of the Federal Reserve, and maintain that the returns on equity over
consideration of our bearings going the past 3, 5, and 10‐year periods are not
forward. We believe this exercise is adequate compensation for the on‐going
preparation for continued volatility in risk.

TABLE A
Jan ‘10 Feb ‘10 Mar ‘10 Apr ‘10 May ‘10 Jun ‘10 Jul ‘10 Aug ‘10 YTD*
DJInd (3.46)% 2.56% 5.14% 1.40% (7.92)% (3.57)% 7.08% (4.32)% 4.15%
S&P 500 (3.69)% 2.86% 5.88% 1.48% (8.20)% (5.39)% 6.88% (4.75)% 3.02%
Nasdaq (5.38)% 4.24% 7.15% 2.63% (8.29)% (6.56)% 6.87% (6.21)% 4.95%
S&P 600 (3.46)% 4.24% 7.65% 5.75% (7.27)% (7.16)% 6.25% (7.55)% 7.35%
MSCI‐EAFE** (4.44)% (0.88)% 5.81% (2.10)% (12.1)% (1.16)% 9.41% (3.34)% 1.02%
MSCI‐EM** (5.65)% 0.25% 7.95% 0.96% (9.18)% (0.91)% 8.00% (2.15)% 6.45%
Gold (1.37)% 3.34% (0.39)% 5.93% 2.99% 2.31% (4.96)% 5.61% 18.24%
*All returns are thru Sept. 24, 2010
**MSCI Barra Indexes

Additionally, most equity index returns Market Operations (POMO) of the NY
YTD have resulted from a September 2010 Federal Reserve. We also note the appetite
surge. We suspect that this has been in for risk as reflected in the returns to date of
response to the frequent liquidity the S&P 600, a small‐cap index of higher‐
interventions by the Permanent Open risk US companies which exceeds the
THE POSEIDON PERSPECTIVE SEPTEMBER 2010
MSCI‐EM, traditionally a higher risk, puts as insurance during price volatility in
emerging market index. Finally, we May thru August are now out of the
include Gold, the continuous futures money with the rise of the S&P 500. This
contract, in this chart as a reminder that in may reduce annual returns. There is no
most cases Gold prices lack a correlation free lunch.
with equity market returns. During March
and July when equity indexes were up CHART 1 DECLINING RISK?
substantially gold prices fell. Yet, Gold
advanced strongly in May, June, and
August when equities were subject to
strong selling pressure. We will address
the precious metals in more detail in the
October 2010 Perspective.

The equity markets appear to have reached
a manic‐depressive stage. This increased
volatility may be in response to more
emotive media hype about the economy,
Source: PSI; StockCharts
general noise with specious information

value, and high frequency trading. The
In conjunction with increased volatility in
higher level of investor uncertainty is
index prices we look at Chart 2 for an
reflected in Chart 1 with the YTD pricing
assessment of investor sentiment. Based
for VIX, the volatility index and Wall
upon information from the Investment
Street’s fear gauge. The VIX is also
Company Institute (ICI),
indicative of the insurance cost against a
www.ici.org/research, we see that Long
price fall in the S&P 500. The VIX is back
Term Equity Mutual Funds have suffered a
to its price level at the start of 2010 with
steady stream of money outflows during
substantial oscillations. We contend that
the past five months. The figures are in
some investors will sell the underlying
$millions for domestic equity funds. In
asset when the cost of insurance becomes a
spite of this no‐vote from some investors
serious drag on returns. The spike in the
the S&P 500 continues its upward journey.
VIX during May 2010 corresponds to the
Research from ICI also shows that total
Euro crisis generated by sovereign debt
fund net out‐flow YTD thru September 22,
concerns in Greece, Spain, and Ireland.
2010 was $61.2 billion. During the same
These economic imbalances have not been
period Total Bond inflow was $618.8
corrected, only removed from the “front‐
billion. The point is relative value and
page” of media focus.
direction. Quite clearly, not only has

money been drawn out of equity funds,
The bad news for the September 2010 rally
but new money is gushing into bonds.
is that all those investors who bought S&P
Page 2
CHART 2 LOSS OF FAITH OR NEED FOR SECURITY?
Source: Investment Companies Institute via ZeroHedge.com

Chart 3 illustrates the price of the 10‐year point (0.45%) return for purchasing the 2‐
Treasury, thin black line, left scale, relative year Treasury. These are the fruits of the
to the S&P 500. While the ICI flow of Federal Reserve’s “exceptionally
funds includes all manner of bonds, the 10‐ accommodative monetary policy” and
year Treasury Note is a world of its own. ZIRP. This is not sustainable; the last time
This security is more than a bellwether; it the 10‐year Treasury was above 125 was on
is the risk‐free bedrock of bonds. Libor’s March 20, 2009; at that time the S&P 500
importance notwithstanding, there is was 768. Since traditional metrics and
probably no more closely tracked credit correlations have digressed long‐term
instrument in the world than this securities, both stocks and bonds, face
barometer of the US economy. Hence, the increasing risk with limited upside returns.
unusual high volatility over the past three
years points to uncertainty and Chart 3 reveals the turmoil in equity and
equivocation. This in itself is a cause for Treasury markets during 2008‐09. Yet, the
concern. The rapid price escalation since chart does not clearly reveal a major point
April 2010 has crushed the 10‐year yield of transition in 4Q2008. At this time the
which has now fallen 2.62% from above 5% dividend yield of the S&P 500 surpassed
in June 2007, see Chart 13. This coexists the yield‐to‐ maturity of the 10‐year
with the horrendous penalty of a 45 basis Treasury which was below 2.2%. Another
Page 3
reference point is the DJ Industrials equities, exemplified by the raging bull
dividend yield which now stands at 2.73%. market from 1982‐1999 may have passed
There are many interpretations for this its zenith. This should be expected after
shift, yet one that corresponds to the two equity market crashes in the past
outflow of funds from equities is that decade. The popularity of bonds has
stocks are losing their appeal in the face of driven the yield back to where it was at the
a massive flight to bonds. Beginning in the collapse of Lehman Brothers. However,
1960’s retail investment in equities was flow‐of‐funds into bonds is the equivalent
highly promoted by Wall Street brokerage. of the most everyone massing on the
This burgeoning business thrived until starboard side for the view. We believe the
October 1973. However, the equity better position is a move to port. We see
investment style quickly regained potential for value opportunities in US
momentum in 1982. This was the time equities after a moderate correction. Bonds
when bond yields had peaked as Fed can certainly go higher. Yet, further gains
Chairman Volker hiked interest to smother are limited to continuing Federal Reserve
inflation expectations. As yields fell, ZIPR and renewed QE II. However, this
bonds and stocks rose in tandem until move may also support continued over‐
2000. Yet, the tell‐tales now point to a new valuation of equities.
era of investing. The preeminence of US

CHART 3 DELICATE BALANCE

Page 4

SOUNDINGS close to 70% of GDP and consumption has
Willie Sutton was famous for explaining been fueled by credit we believe that the
that he robbed banks because “that’s consumer and the banking system are
where the money was.” We see Chart 4 as intimately linked to any future prosperity
an introduction to some commentary on or lack thereof. While the RTH has done
“money” and the continuing economic extremely well in its rebound above 2007
“recovery.” It appears that investors no price highs, banks as represented by the
longer expect the banks to be the Bank Index (BKX), left scale, have remain
repository for cash flow. Expectations below 50% of their 2007 peak. For the
point to the major retailers as the new store consumer the choice is consumption or
of wealth. We premise this upon the savings. Yet, the equity market appears to
recent pricing for the Retail Holders’ ETF have priced‐in a retail boom which will
(RTH). We must deduce that the exceed the consumption binge of 2006‐07.
investment community believes that the We believe that in the course of household
consumer is still “king” and retains deleveraging consumption will be quite
substantial spending power. We find this muted relative to the 2006‐07 period.
preposterous. Since consumption remains

CHART 4 WHO HAS THE MONEY

Page 5

We look at consumer dynamics in greater Separations” was 4.43 million. This
detail. The first, and we believe the most differential is expected to continue in July.
important, is employment. We begin our The sad fact about unemployment is that
review of the employment situation with the private sector of the economy is not
the measure of “separations” or those creating enough jobs to handle the rate of
leaving the private sector. This measure is attrition. Secondly, the economy is not
from the Bureau of Labor Statistics (BLS), creating new jobs for the back‐log of
www.bls.gov/jolts, job openings and labor unemployed who have lost their jobs over
turnover. The BLS reported that while the the past 3 years. So a rising increase in job
total number of job openings has increased hires does not offset the increasing rate
and the “Total Hires” in June 2010 was 4.25 (see Chart 5) of job separations.
million, during the same period the “Job

CHART 5 LONG, HARD WINTER
Source: ShadowStats.com
We monitor John Williams ShadowStats includes the Bureau of Labor Statistics
(shadowstats.com) for numerous (BLS) U‐3 and U‐6. Additionally,
government statistics because we find his Shadowstats produces its own measure of
site timely and informative. Chart 5 is a “alternative” unemployment in accordance
recent summary of unemployment which with the traditional, versus the current,
Page 6
metrics of the BLS. This is shown as the piling on more debt. Yet, while rate of
blue line. Whichever indicator one chooses change and direction are important, there
the current challenge of unemployment is has been only a small decrease in Total
indisputable. It is the biggest hurdle for Credit Outstanding, from $2.58 trillion in
economic growth. Many conservative June 2008 to $2.42 trillion in August 2010.
prognosticators believe that current levels The rate of deleveraging is 3.2%. At this
of unemployment will continue for years rate it will take another decade or more
putting great strains on the public sector. before the consumer has the spending
The impact on consumer spending will be strength of the late 1990’s. The consumer
a continuing cutback. is still massively over‐leveraged. The
sources for consumer credit, better jobs
Next, we look at other potential sources for with higher salaries, higher limits on more
increased consumer spending. Credit credit cards, house equity as ATM, etc,
cards don’t look like a good suspect. Chart have dried up. The retrenchment has
6 reveals the fall, nearly 17%, in Revolving begun.
Credit Outstanding.
CHART 7 THE BURDEN OF DEBT
CHART 6 REDUCED BORROWING

Source: ShadowStats.com

One way to measure the impact of
Source: St Louis Fed
decreasing credit expansion is to look at
the valuation of two finance companies. In
Chart 7 provides a combined review of Chart 8 we display the prices for Visa (V),
total consumer credit outstanding and its right scale, and MasterCard (MA), left
year‐over‐year change. The negative rate scale. While both showed peaks in May
of change means that consumers are not 2008 they also revealed great strength in
Page 7
April 2010. As leading indicators of the recovery in consumer spending. Investor
credit business they are not optimistic. response reveals a very tenuous recovery.
From its high of $306.51 on May 30, 2008 Is there still confidence that dynamic
MA is down (33.8%) and V from a high of money‐lending schemes, high fees, and
$96.29 on April 23, 2010 is down (27.8%). extraordinarily interest rates will continue
We interpret this as an indicator of a failing to drive greater profitability?

CHART 8 RETURNS ON REVOLVING CREDIT


We contend that the strong recovery in press releases, FOMC meeting minutes,
retail consumption and RTH prices from Permanent Open Market Operations
3Q2009 thru 1Q2010 is coming to an end. (POMO), and the System Open Market
The recent weakness in V and MA Account (SOMA). Most of our information
indicates consumer exhaustion and is taken from the web sites of the Federal
correlates with the 10% price correction Reserve Board of Governors and the
during April‐June. twelve regional member banks of the
system (ie, www.federalreserve.gov,
WEATHER WATCH www.newyorkfed.org, etc;).
We briefly address inflation, interest rates,
money supply, and Fed policy. We have The FOMC has undertaken several
been following the Fed through speeches, unconventional policies over the past 2
Page 8
years to preclude the US economy from over 60 years and, more importantly, we
sliding into a deflationary spiral. This is are approaching two years at this rate. The
commonly referred to as reflating the long‐term gyrations in this rate provide
economy. In Chart 9 we see the past 5 some indication of the severity of the
years of the CPI. The recent drop in boom‐bust cycles in the US economy.
consumer prices is the first substantial
decrease since the 1920’s. A continuation CHART 10 INTEREST RATES
of the 2008 decline is what the FOMC has
been desperately attempting to avoid.

CHART 9 PRICE REFLATION

Finally, the money supply, M‐2, is
presented both in aggregate and as annual
change in Chart 11. Long‐term growth of
money supply has been in the 4.5‐7%

range, thus the current 2+/‐% precludes
The primary mechanism for increasing
any serious growth in GDP. Consumers
inflation is the control of interest rates and
are foregoing the available money in the
money supply through the Federal Funds
system in a reversion to savings. The
Rate (FFR) and Open Market Operations.
current rate is border‐line for deflationary
Chart 10 shows the Federal Funds Rate, the
expectations.
rate at which depository institutions lend

balances to each other overnight. The
We do not doubt, given enough time, the
range for the target FFR is established by
ability of the central bank through the
FOMC. It is currently 0.00‐0.25%. Over
FOMC and New York Fed’s open market
the past 30 days it has ranged from 0.15‐
0.21%. The current target is the lowest in
Page 9
operations to radically boost the money caveats. While fiscal stimulus has arrested
supply. the economic decline “growth in private
final demand – notably, consumer
CHART 11 SLACK DEMAND? spending and business fixed investment –
must ultimately take the lead.” The pace
of growth dependent upon household
spending is dependent upon job growth as
well as “households repairing their
financial positions.” Also, housing prices
remain “depressed.” While large firms are
able to tap public securities markets, small
firms dependent upon banks are starved
for capital. In the face of a collapsing US$
Chairman Bernanke blithely states that
“the arithmetic contribution of net exports
to growth in the gross domestic product
Source: ShadowStats
tends to be much closer to zero, and that is

likely to be the case in coming quarters.”
On 27 August 2010 Chairman Bernanke
His policy outlook is restrained to the
delivered his widely anticipated address
communications game coyly played out in
from the Fed’s annual economic
the FOMC meeting minutes. After the
symposium in Jackson Hole, Wyoming.
institution of ZIRP in December 2008 this
Such a spectacle is always well covered in
policy will continue. Regarding the Fed
the press; yet, we must address his
over‐sized balance sheet he speaks of the
comments. Chairman Bernanke and the
“logic of the portfolio balance channel”
FOMC control the banking system and
and “the stock view” versus “the flow
wield great power across the financial
view.” Much verbiage is allotted to the
economy. Nothing they say or do should
justification of “Committee” actions. He
be taken lightly. However, we struggled to
then discusses “Policy Options for Further
find the guiding spirit, the courage, or
Easing.” What we hear is that the past is
moral conviction in this important
prologue. Fed policy is discussed and
announcement.
decided by a coterie of bankers and

economists in Washington and New York
Mr. Bernanke acknowledged the
prior to being foisted upon the markets.
prominent role that monetary policy plays
We will hear about the convoluted
in “promoting the economic recovery”
justifications in later press releases,
and, unfortunately, “economic recovery
speeches, and FOMC meeting minutes.
and repair remains far from complete.”
Finally, we note that his prognosis reveals
His economic outlook is the common
that “it is reasonable to expect some
litany of concerns with the standard
pickup in growth in 2011 and in
Page 10
subsequent years.” We expect a dangerous New York and Manager, System Open
continuity of policy mistakes. Market Account (SOMA) on March 8, 2010.
The title “Preparing for a Smooth
Upon consideration Chairman Bernanke’s (Eventual) Exit” reflected the policy tools
dissertations are like Jell‐O, colorful, and strategy likely to be used by the Fed to
opaque, impossible to grasp, and always unwind its bloated balance sheet. Unlike
less than filling. Fed policy has been previous “tightening” cycles the Fed is
ineffective except to support private faced with three primary factors which are
interests at public expense. We must unique and unproven. The first is a policy
consider Chairman Bernanke’s past record decision which incorporates interest rates
for faulty judgment. He did not suspect or with balance sheet level and composition.
recognize the biggest housing bubble in US The next considerations are the tools
history. He has not acknowledged the utilized and the scale to which they are
gargantuan costs of the continuing employed. This strategic matrix is new in
banking crisis. He refuses to accept the this current cycle. Finally, Mr. Sack states
impotence of continuing ZIRP. He harshly that “we will be operating in a framework
criticized the Japanese for their monetary of interest rate reserves that has not been
policy; but he is building upon the same fully tested in U.S. markets.” We
folly. Yet, he is willing to gamble the appreciate his acknowledgement of the
economic future on a greater QE risk.
experiment. Such willful incompetence
from the de facto head the US banking The speech goes on to review the
system is frightening. Why does the successful outcome from short‐term
Federal Reserve continue to consider liquidity facilities in response to the
mandates of unprecedented, both in financial crisis and the smooth exit from
quantity and duration, liquidity and these arrangements. However, changes in
quantitative easing that have not worked monetary policy will face some greater
to overcome the current economic malaise? challenges. Unwinding the holdings in the
This is an admission of failure. Why do we Fed’s balance sheet is a potential source of
continue to reward failure? It resembles disruption in markets due to its sheer size
the reckless surrender of oversight and and the scale of activity. Hence, under any
regulation by Congress to the powerful strategy for policy change the Fed’s asset
and effective lobbying of the mega‐ holding will remain “elevated at the time
financial and global banking interests. the FOMC wants to raise short‐term
interest rates.” The tools for change
In order to provide a recent backdrop to include reverse repos which would be
Chairman Bernanke’s excessive available to an expanded set of
uncertainty we look back six months to a counterparties such as money market
speech given by Brian P. Sack, Executive mutual funds and term deposits with
Vice President, Federal Reserve Bank of banks to reduce excess reserves.
Page 11
Finally, Mr. Sack addresses necessary part of any rational, effective
“vulnerabilities.” The two areas of concern discussion since when everyone is of the
are: 1) Confusion in the marketplace which same opinion then there is not much grist
might prompt “volatility in asset prices.” for the mental mill. Second, the current
This can be mitigated with clear monetary paradigm and consul of
communication which includes direct and leadership has continued to promote a
valuable information. 2) The robustness of potential folly that is beyond our
“risky asset prices” may not be sufficient to comprehension of risk management. We
withstand a “rising rate environment.” believe that Mr. Hoenig touches upon one
This engenders the most concern among of the most important but frequently
those “who argue that the current low overlooked aspects of current monetary
policy environment has fueled an policy. The fact that extended zero‐interest
unsustainable rise in asset prices beyond rate policy (ZIRP) and quantitative easing
their fundamental values.” We must be (QE I and soon to be QE II) are high‐risk
included in this camp. The cure is seen to experiments in which the technicians are
be “a period of sustained, above trend unaware of the degree of risk which is
growth to absorb the substantial slack in being undertaken. They either are not
place, which is an environment that should cognizant of or choose to ignore the
be quite supportive of risky asset prices.” seriously detrimental consequences. Mr.
Hoenig states “Economic conditions are far
In conclusion we hear that the Fed is from satisfactory, unemployment is simply
“operating in uncharted territory along too high, and we want a stronger recovery.
several dimensions.” In particular Mr. But as much as I want short‐term
Sack voiced concern about impact of improvement, I am mindful of possible
SOMA activities on the stock market. The longer‐term outcomes, I worry that the
real conundrum is that this speech and FOMC is inadvertently adding to
policy propositions were made when the “uncertainty” by taking such actions.
Fed was anticipating a shrinkage of its Remember high interest rates did not cause
balance sheet. Now in September 2010 we the financial crisis or the recession.” We
face a FOMC that is considering an applaud this forthright analysis and
expansion of its balance sheet. We are concern.
flabbergasted but not surprised.
Mr. Hoenig goes on to make several
On August 13, 2010 Thomas M. Hoenig, important points:
President of the Kansas City Fed and 1) The trend data indicates a “modest
dissenting member of the FOMC gave a recovery” and, while monthly data is
speech called “Hard Choices” at a town mixed, the overall picture is “consistently
hall meeting in Lincoln, Nebraska. We positive.” “While the recovery is not
salute this outspoken opinion for two where we would like or expect it to be at
reasons. The first is that dissent is a this stage,” he astutely reveals that
Page 12
“volatile monthly data should not drive In conclusion, Hoenig reiterates that “the
policy actions.” recent financial crisis and recession was
2) “The financial collapse followed years of not caused by high interest rates but by
too‐low interest rates, too‐high leverage, low rates that contributed to excessive debt
and too‐lax financial supervision as and leverage among consumers,
prescribed by deregulation from both businesses, and government.” Finally, he
Democratic and Republican reminds us that “there is no short cut.”
administrations.” The economy had
become so out of balance due primarily to Unfortunately, the FOMC brings a great
increased debt, both public and private, deal of uncertainty into the securities
that reverting to a system of greater markets. Many investors, proprietary
stability and strength will take time. trading desks, and hedge funds hang on
3) In order to accommodate a rebalancing every word that emanates from their
of the economy a move to a “tight policy” sacrosanct meetings and operations.
on interest rates is not yet required. According to the “Monthly Report on the
However, a clear path forward which Credit and Liquidity Programs and the
includes a policy of increasing rates is Balance Sheet” dated July 28, 2010 on
necessary. This would allow the www.frb.gov, the Fed’s Total Assets were
continuation of slow deleveraging while $2,329 billions while Total Capital is $58
accommodating economic growth. The billion. Thus, the cynical evaluation is that
“rebalancing” of the US economy, the System Open Market Account (SOMA)
consumers, businesses, and government is leveraged at 40 times and thus operates
will take time but the attempt to accelerate as the mother of all hedge funds.
this transition through ZIRP “brings its
own unintended consequences and We contend that the probability of
uncertainty.” substantial QE II is very high and that a
4) Market participants are the great short period of deflationary pressure
beneficiaries of ZIRP; but they should not during the next 12 months will be followed
direct policy. They will cry for an by a rapid surge of inflationary pressures
indefinite ZIRP because “They are earning which will put immense pressure on
a guaranteed return on free money from interest rates. In the midst of this turmoil
the Fed by lending it back to the the “trillion $ question” is what happens to
government through securities purchases.” the US currency?
Hoenig states that “I find no evidence that
deflation is the most serious threat to As we noted above Mr. Hoenig clearly
recovery today.” The Fed continues to use described the banking arbitrage which
the fear of deflation to mask a “dangerous allows them to generate continuing profits
gamble.” from the Fed’s ZIRP.

Page 13
CHART 12 GRINDING FINER Asset values, stocks, bonds, derivatives, etc

are climbing in value on the threat by the
FOMC to buy anything and everything in a
new round of quantitative easing. Even
housing is showing some price gains in
“hot” markets like New York and
Washington.

PROVISIONING
During the 4Q2010 we expect continuing
volatility in global markets. In addition to
pertinent information and media noise the
US financial markets will have to wrestle
The collapsing spread between the 10‐year with greater central bank market activity,
Treasury and the FFR makes it harder for Treasury Dept. refinancing with increasing
banks to grind out the free money for the innovation, regulatory mandates (ie, SEC,
rebuilding of their balance sheets. As CFTC, etc), continued high frequency
recently as April 2010 the banks borrowed trading (HFT), and accounting (FASB,
at the FFR, zero to 0.25%, and bought GAAP) changes. As a result, markets will
Treasuries yielding more than 3.75%, see not reflect fundamentals as we have
Chart 12. Now they have lost more than measured them in the past. We surmise
100bps as the rush into Treasuries shrinks that asset price correlations will continue
their yield but has increased their capital to converge with market uncertainty. The
gains. When, not if, they decide to move massive movement of funds out of US
on to greater risk and more robust returns equities and into bonds and foreign
the Treasury market could be in for a very markets is a reflection of the growing
rude surprise. stretch for yield and changing perception
of risk. Since we are not in a “trading
Chairman Bernanke’s Fed has been mode” we have refrained from any serious
operating as if the increased liquidity and allocation to the equity markets. Our
bank reserves will stave off further preference for a longer time frame, 3‐5
recession. We find this proposition years, means that we will have to forgo
questionable. The Austrian school of potential short‐term trading profits.
economics would argue that GDP growth Undoubtedly, the time will come when
creates the demand for money which will equity prices again present good
be met by increased supply. The obverse is investment value. In the meantime we
not true, increased supply of money will must watch macro‐economic factors for
not create greater demand for production. indications of trend reversals.

Page 14
CHART 13 RELATIVE TO WHAT


Chart 13 exemplifies our concerns. The and the time lag are significant. Again, the
sharp decline of the US$, right scale, and US$ made a substantial rise early in
the resumption of diminishing yield on the 1Q2010 prior to and coincident with a
10‐year Treasury, left scale, display two Euro‐financial crisis. We then saw a 30%
fundamental patterns of weakness. The drop, during April thru September, in the
currency and its bond are mutually 10‐year Treasury yield. Since May 2010 the
dependent yet may trade within a spread US$ and the yield have been declining in
which oscillates widely. These movements tandem. The instability of US$ rates over
may appear to be random in character. the past three years is detrimental and
Yet, we believe there are numerous forces costly to efficient markets and global trade.
at work which command patterns. The This inefficiency means major exporting
financial panic in 4Q2008 was preceded by countries attempt market interventions for
a strong demand and surge in forex rates economic support to maintain any
for the US$. Three months later the potential trade advantage thru foreign
demand for a risk‐free asset resulted in a exchange rates. One result is a large
collapse in the yield of US Treasuries. accumulation of US$ denominated reserve
There are numerous explanations for the assets. As a spring is coiled more tightly it
dramatic price fluctuations; however, develops the potential for a sudden and
during this period of turmoil the dynamics powerful “unwinding.” The unwinding of
Page 15
major bets in the currency markets could Bonds are currently expensive unless one
mean massive reversals in foreign stocks, believes in a Japanese experience for the
bonds, real estate, and/or commodities. US economy. So, we suspect that investors
Just as important, volatility in the US bond have priced into the bond and Treasury
market is a major drag on world financial markets the expectations of deflation. An
markets. economic consequence noted frequently by
the FOMC. Thus, as contrarians we must
We believe that two of the most important believe that that there is a serious
indicators to watch are the bond yield and opportunity here. One trade is to be
forex rate for the US$ as they are the investing at the long end of the interest
harbingers of inflation. The failing strength rate curve with duration of 10‐20 years
of the US$ may reveal diminished support depending upon risk appetite. This allows
for FOMC. If the US$ continues its slide for a 10‐15% gain over the next 12 months
below the 80‐level a strong signal is being as interest rates continue their path down.
sent. As any further correction in the US$ The trick will be to get out before the
would put great pressure on inflationary inevitable reversal begins. Otherwise, wait
drivers including the price of oil and other with cash.
commodities.

CHART 14 BEARING POINT, SHIFT TO THE EAST

Page 16

Chart 14 which depicts the Japanese Yen strategies for the US Treasury and Federal
(JPY or XJP), right scale, and the US$ over Reserve to enforce a reflation of the US
the past decade. Unfortunately, we cannot economy. However, upon reflation we
include the last great move of the Yen, the question the discipline of government and
50% appreciation during 1985‐1987. This central bankers to increase interest rates
was terminated in less than 2 years with high enough and quickly enough to
the collapse of both real estate and equity prevent rapidly escalating inflationary
bubbles. We may now be building toward expectations. At that time bond markets
a similar dénouement. will be bloodied.

The JPY has appreciated 45% over a 3‐year In a world of closely correlated asset
period as the carry‐trade players have paid returns, diversification can prove to be an
off yen denominated debt, buying JPY, and expensive form of insurance. Hence, we
taken on US$ funding by selling US$’s. summarize our current strategy for asset
Thus, one consequence of ZIRP is the US$ allocation.
replacing the JPY as the basis for a global 1) Bonds are expensive. Yields are grossly
carry‐trade. We believe this is the inadequate. Yet, some potential capital
precursor to more serious US$ devaluation appreciation is available over the short‐
which began in June 2010. The central term.
banks of Asia and the petro‐producers 2) Stocks are overvalued; we await lower
have supported the US$ in their recycling prices and higher dividend yields.
of trade generated currency into US 3) Cash is costly to hold due to negative
government and agency debt. The rise of real rates but we view security and
the JPY may also result from foreign availability to take advantage of new
central bank purchases, especially China, opportunities as worth the penalty.
as a means to diversify their reserves away 4) Gold is a strong performer in a
from US$’s. continuing bull market subject to
corrections. We look to accumulate on
The global financial system rolls from crisis weakness. The same is true for silver.
to crisis without any dramatic
restructuring in the banking system, Investing demands patience. Rashness
derivative swaps, or foreign exchange reveals a lack of character.
commitments. There exist a number of

It was a restless summer which seems to have quickly slipped into history. However, there
was a series of events whose implications continue to resonate with shifting tonality. The
circumstances and prospects involve Hayabusa, Tokai/Sharp, Senkaku, Qixiong, and the rare
earth elements. We will explain.

Page 17
Hayabusa, Japanese for peregrine falcon, is the name of an unmanned spacecraft which

PHOTO 1 ROCK SOLID
returned to Earth on June 13, 2010. It was
launched on May 9, 2003. The Project
Manager Junichiro Kawaguchi called
Hayabusa “a High‐tech Space Ship as its key
technologies, a plasma reactor that supports
cutting edge industries, robot technology
with visibility, development of heat
resistance, and power saving technology –
are expected to be applied to various other
fields.” Its mission was to “bring back
samples from an asteroid and investigate the
mysteries of the birth of the solar system.”
Source: JAXA

The craft contained a separate landing vehicle, the MINERVA, a 10cm by 12cm robot mini‐
lander designed to depart from the main craft, gather asteroid material samples, and return
to the “mother‐ship.” This amazing execution of nano‐type technologies unfortunately failed
in part of its operational phase. Yet, the true success of this mission was the advancement of
aerospace engineering concepts, operational testing of cutting‐edge technologies, continuing
leadership in the development of composite materials, the record‐setting time for ion engine
operation, and increased progress in solar power. For example, the Autonomous Navigation
System “enables the probe to approach a far‐away asteroid without human guidance.” The
ion engine ionizes a propellant, Xenon gas, and then “electrically accelerates and emits the
ions to propel itself forward.” This and more information on technological developments is
available from the Japanese Aerospace and Exploration Agency (JAXA), the website is
www.jaxa.jp/projects/sat.

Tokai University’s solar car, the Tokai Challenger, is powered by Sharp’s compound solar
cells developed for outer space applications. Their cell conversion efficiency is 30%, the
highest in the world. Sharp is the only manufacturer whose solar cells are approved for use
by the Japanese Aerospace Exploration Agency. In 2009 the Tokai Challenger won the 3,000
km, Australian “Global Green Challenge.” This summer it entered the “grueling” South
African Solar Challenge 2010 with very high expectations. We believe that currently Japan is
pursuing the some of the greatest advances in technology at this stage of the 21st century.
The research and development utilizing advanced engineering spans motors, magnets,
materials, bio‐technologies, robotics, optics, miniaturization, and artificial intelligence.
Page 18
PHOTO 2 SPEED FROM LIGHT

Meanwhile on September 7, 2010 the Japanese Navy captured a Chinese fishing trawler off
the Senkaku Islands, known as the Diaoyu islands in China. The ownership of these rocky
outcroppings is contested among Japan, China, and Taiwan. There are potentially huge oil
and gas reserves in the area. While the Japanese released the boat and its crew, authorities
detained and arrested the captain, Zhan Qixiong. The Chinese response to this “grave”
situation was forceful and immediate. The NY Times reported on September 23, 2010 that
the Chinese government had blocked the exports of rare earth elements to Japan. If true, this
would be in violation of World Trade Organization agreements. We view the threat as more
indicative as a “show of force.” However, any confrontation in Asia is inherently risky as at
any stage one party may be forced to avoid a “loss of face.” Hence, rapid escalation breeds
uncertain and outsized responses.

“Rare earths” are not really rare at all; they are found throughout the earth’s crust. They are
found in almost all massive rock formations. However, they are concentrated in two
minerals ores, bastnaesite and monazite. Rare earth elements Samarium, Erbium, and
Promethium are necessary for current uses in magnets, lasers, nuclear batteries and active
ions. They are essential in the production of cell phones, laptop computers, cruise missiles,
radar systems, wind turbines, solar cells, hybrid vehicles, and industrial catalysts. Rare
earths are an indispensible factor and resource in the development and advancement of clean
Page 19
energy technology. Estimates of Chinese reserves are in the range of 57% and China
currently produces 93% of the metals according to NY Times. Needless to say, “rare earths”
are an integral part of Japan’s continuing advances in an “ultra‐tech” economy.

There are at least two implications from this geopolitical and economic confrontation. The
first is that trade issues which include currency exchange rates will be utilized in the pursuit
of political ends. Secondly, probably more importantly, China has once again shown its
ability to cut quickly to the heart of any major confrontation. Chinese politics is not adept
with the scalpel but is quick to use the cleaver. This attempt to coerce the outcome of a minor
altercation by withholding resources critical to Japan’s economic advancement is an
indication of serious friction. The activities, timing, and responses combine to reveal the
current political tensions and intense economic competition in East Asia.

Concurrently, the currency wars have begun and they will be intense. The economics of a
competitive currency in relation to the US$ is a keystone for countries dependent upon
exports. The recent declines of the Euro and the US$ have exacerbated this competition. In
this arena China is exerting the power of its monetary reserves. Recently, China began
buying JPY driving up the value of the JPY. In order to protect its export machine the
Japanese central bank begins a regime to increase purchases of the US$. The end result is
China exchanges US$ for JPY, a nice move for diversification away from a falling currency
while avoiding any yuan appreciation.

So what’s the point? While Japan has suffered a 20‐year battle with deflation and lost its
place as the world’s Number 2 economy, this is not a second‐rate nation. This is not an
economy built on low‐tech, low‐margin basic manufacturing. Do not underestimate the
power of advanced education, hard work, solidarity, and savings. The hardball tactics and
geo‐economic ploys will get much more complex as the economic battles escalate. The
theater of rising development and power has shifted and many battles will be fought in Asia,
both East and South. Is the world’s largest economy becoming an ineffective policeman and
a consumer sideshow?

Brian E. Shean, CFA
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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CHART 12 GRINDING FINER Asset values, stocks, bonds, derivatives, etc

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