3.0 Poseidon Perspective March 2010

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

30 March 2010

Dear Investor,
The reflation of prices in most equity continue throughout 2010 or until bond
markets continued during February 2010. markets demand an end to “free” credit.
While there are several expedient reasons
for this increased risk‐taking, we believe TABLE A
that economic fundamentals do not justify Feb ‘10 1 Year 10 Years*
current prices. We contend that all major DJ Indus 2.56% 46.2% 0.28%
equity markets are now overbought and S&P 500 2.85% 50.3% (1.98)%
Nasdaq 4.23% 62.4% (6.91)%
present an unattractive investment option
DJ Tran 6.12% 65.4% 5.76%
at this time. The expansion in valuations S&P 600 4.22% 62.5% 4.75%
may continue for an extended period if the MSCI‐EAFE (0.88)% 50.1% (1.20)%
Federal Reserve’s FOMC refuses to raise MSCI‐EM 0.25% 87.5% 6.52%
interest rates. Yet, we see increasing risk to WTIC 9.29% 78.0% 10.2%
*10‐year values are the compound annual growth rate
equity portfolios. Bonds do not offer a

reasonable alternative since the FOMC will
A look at the 10‐Year returns in Table A
eventually have to begin raising short‐term
presents a strangely dysfunctional view of
rates. The returns offered for holding cash
equity returns. Large‐cap developed
and short‐term Treasuries are the penalty
country equities (DJI, S&P 500, MSCI‐
extracted from prudent savers and risk‐
EAFE) show little or no appreciation over
adverse investors as central banks around
10 years. American high technology
the globe support bank balance sheet
(NASDAQ) has seriously lost money
restructuring and encourage risk‐taking.
mimicking the bubble and loss of Japanese
Precious metals are still cheap but they are
equities since 1990. The American
subject to a downside in any major asset
transportation industry, small‐cap
sell‐off. Without access to well‐managed
companies, and emerging market equities
hedge funds most investors must continue
(DJT, S&P 600, MSCI‐EM) show solid but
to suffer the costs of a poorly regulated
not spectacular gains over the same period.
banking system. This situation may
Oil extends a spectacular rise despite
THE POSEIDON PERSPECTIVE 30 March 2010
developed countries battling the “Great investor is forced to sell at an inopportune
Recession.” Volatility reigns as liquidity time, the haircut can be severe. The
sloshes thru global markets; historical returns in Table A certainly endorse the
correlations do not hold; we are strategy to buy when assets are “cheap.”
confounded. One year ago when fear dominated the
markets everything looked cheap relative
We make a few more observations. to today’s prices. Yet, we are quickly
Table A exonerates Jim Rogers who has returning to the “credit bubble” highs of
promoted commodities investing for 2007.
almost a decade. While not all
commodities have done as well as crude SOUNDINGS
oil, measured here by the continuous Along with the resurgent gains in the S&P
contract for West Texas Intermediate 500 there has been recent complacency in
Crude (WTIC), others such as copper, iron Wall Street’s notorious “fear gauge”, the
ore, and nickel have done much better. VIX. We look at this index with an overlay
The 10‐year return on copper from 81.1 in of the S&P 500 in Chart 1. The VIX, left‐
2000 to 340.3 in 2010 equate to a CAGR of hand scale (LHS), exhibits a few blips last
15.4%, more than twice the annual return autumn and a January fright; otherwise, it
from Emerging Market equities Yet, most has been on a steady slide since November
markets have exhibited a crash, boom, 2009. How then can this “indicator” be
crash, recovery cycle over the past 10 utilized as a forecasting tool for the
years. The returns on the DJ Industrials, prudent investor? Not much, as noted in
S&P 500, and the Nasdaq Composite over the March 20 Financial Times. The FT
the past year rescued these indexes from reported that Birinyi Associates published
terrible long‐term losses. The DJI was in a study which concluded that “it is a
steady decline from 2000‐2003, advanced measure of current volatility with little or
thru a boom during 2004‐2007, crashed no predictive or indicative value regarding
again, and has now regained 75% of its the course of the market.” The VIX
“boom price.” The S&P 500 loss from appears to be a legitimate coincident
2000‐2003 was a decline of 47% which was indicator reflecting the general reactive
reversed during 2004‐2007 to another high, panic of money managers. We must agree
then prices collapsed again in 2009 and has with Birinyi and will speculate that,
resurrected to 75% of that high during perhaps, the inverse is true. The VIX is a
2008‐2010 surge. We examine NASDAQ buy signal after a short lag of time. Sounds
returns more closely below; however, the counter‐intuitive, yet this appears
point is to question whether market conceivable. Should one be using the VIX
volatility is fully compensated by potential as a contrarian indicator? Birinyi
future returns. We argue that it is not. Associates concurs that on occasions the
Thus, the past 10 years reveal the great risk VIX might “be useful in that it appears that
in the “buy and hold” strategy. If the
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high volatility might actually be a for compensation of future risk? If the risk
contrarian indicator.” Academics and premium is adequate, then perhaps we
money mangers have long equated have reached the summit in equity prices
volatility with risk. If the current return on and future returns will be much lower. In
equities is based upon previous volatility consideration of minimal or declining
(risk) and we are entering a new period of future returns, we see a continuation of
low volatility (risk) where returns will be market complacency.
much lower, what is the proper measure

CHART 1 GROWING COMPLACENCY

Source: PSI; StockCharts

While the VIX is at best a coincident Index. These are all closely‐followed,
indicator of equity market direction there comprehensive statistical measures. The
are other so‐called “leading indicators.” results are generated by exogenous
The best known and most publicized are statistical algorithms. However, many
the economic indicators published market strategists prefer actual market
monthly by The Conference Board prices, such as the VIX, to reveal trends
(www.conference‐board.org). These and momentum. We note two indexes in
include the Consumer Confidence Index, Chart 2, the Dow Jones Transport Average
Leading Economic Index, Coincident (DJT or TRAN) and the Baltic Dry Index
Economic Index, and Lagging Economic (BDI). These indicators provide some
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revelatory market information about are velocity and duration; these two
economic activity. However, the most transport indexes are not solid
important vectors in equity market moves prognosticators.

CHART 2 LEADING INDICATORS?


Yet there is one indicator which has substantial debt load on the balance sheet.
tremendous impact on equity market However, as financial markets are
pricing during both upside and downside forward‐looking mechanisms current rates
moves; it is short‐term interest rates. There do not matter as much expectations for
are abundant studies which document the future rates. In the case where interest
correlation between interest rates and rates are extremely low, such as 2003‐4 or
future equity prices. The simplest 2009‐10, even the expectation of rising
explanation for the validation of this rates will not adversely impact equity
relationship is the principle of efficient prices in the early stage of rate increases.
substitution in products to accommodate Therefore, as is clearly indicated in Chart 3,
the risk/reward trade‐off demanded by the extremely low short‐term rates
investors. As interest rates rise money will mandated by the Fed have provided the
move out of equities and into bonds. thrust for exorbitant equity gains.
Another impact of fluctuating interest rates However, this is at a cost to savers. With
is the cost to companies which carry any inflation in the system “real interest
Page 4
rates” are negative. At some point this impact was a surging equity market for 2
may change suddenly and unexpectedly. days. March saw new highs for both the
The market impact will be severe. DJI and DJT. This is a strong technical
indicator that we have entered new phase
After their March 2010 meeting the FOMC of a “bull market” in equities. Much of the
once again pledged to keep interest rates media is bullish on the economy.
low “for an extended period” and the

CHART 3 NOWHERE TO GO BUT UP
Source: St Louis Fed

Yet, as we can determine from Chart 3 we Treasury, which the Fed cannot control.
are in unchartered waters with regard to We watch the 10‐Year Treasury which is
interest rate policy. Rates since 1960 have the basis for so many derivative products
never been so low, for so long. How much including residential mortgage rates. We
longer the Fed’s Zero Interest Rate Policy watch employment and housing statistics
(ZIRP) will drive equity markets higher we as both factors have strong impact on the
do not know. However, we know that consumer driven economy. We watch and
short‐term rates driven by the Federal we wait.
Funds Rate cannot go lower. Therefore,
we watch long‐term rates, the 30‐Year
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A larger picture of current interest rate basis points above the 30‐Day note. The
conditions and equity prices is presented chart clearly shows the lowest rates in over
in Chart 4. As an indicative rate we chose 10 years and reflects the ZIRP and 0‐25
the 3‐Month Treasury which yields about 3 basis points range for the Fed Funds Rate.

CHART 4 POWERFUL MEDICINE


In December 1996 then‐Chairman of the its high close of 5,048 on March 10, 2000 to
Fed Greenspan uttered his infamous 1,114 on October 9, 2002 a decrease of
phrase “irrational exuberance” in reference (77.9)%. The crash recovery to 1,911 in
to the equity markets. In spite of this 2003 and stability in 2004 at 1,920 meant a
concern the Fed flooded the market with gain of 72.3%. The climb in prices
liquidity in mid‐1998 in response to continued in 2005, up 8.85%, in 2006 up
ridiculously exaggerated concerns about 10.6% and a peak in October 2007 at 2,859,
the potential for computing glitches in the up 156% from the bottom. In March 2009
Y2K transition. Finally, the Fed began to the index crashed again to 1,268. Once
increase rates from June 1999 thru late 2000 again, a bounce from the bottom and lower
while the NASDAQ represented in Chart 4 interest rates has resulted in a gain to
as “COMPQ” had rocketed from below 2,395, up 88.9%. Interest rates will
2000 to above 5000. When the bubble someday move higher; maybe the next
burst in 2000‐01 the Nasdaq collapsed from NASDAQ crash will not be as bad.
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The period of low interest rates from 2004 regurgitate Bloomberg headlines or media
thru 2008 did not reflate the entire speculation. However, given the potential
NASDAQ bubble and herein lies a impact on the global economy and global
valuable lesson. Once burned really well, securities’ markets we are compelled to
investors did not return to the same address how economic developments in
fantasy. However, new money and old China may impact our investment thesis
investors found another playground, real and expectations. We face an environment
estate. The market came with very loose where the Euro is under attack, the US is
lending practices similar to stock margin becoming seriously over‐burdened with
requirements in the 1990’s. Massive credit debt, some resource‐based economies are
availability and low rates released the raising interest rates to preclude booming
explosion of mortgage debt both asset prices, and Brazil has instituted, with
residential and commercial which brought Russia considering, a capital inflow tax.
the financial system in the US to its knees China still demands the greatest attention.
in October 2008. The consensus among Wall Street’s bullish
proponents contends that China has
We now face the next stage in financial and become the growth engine for the world
monetary evolution and, while the past is economy. We have considered the wealth
not prologue, the economy has been of reporting, analyzing, and speculating on
wallowing in the ZIRP environment for the China economy with a healthy dose of
over a year. The equity bubble has been skepticism. There has been so much
reflated and commodities are well on their “noise” in the media that we were relieved
way to a potentially huge bubble. The to see Edward Chancellor’s White Paper,
FOMC will meet again April 27‐28, 2010. “China’s Red Flags” March 2010, available
At this time there will have to be a at the website www.gmo.com. We will
decision. The current trail follows a review in detail this work by Mr.
dangerous precipice. Chancellor, author of “Devil’s Take the
Hindmost: A History of Financial
WEATHER WATCH Speculation”, capital market researcher,
We have reached a critical period where and member of the asset allocation team at
the focus on US economic events is viewed GMO.
through the prism of China. The Chinese
economy is viewed as a problem, the Mr. Chancellor utilizes his research and
potential solution, or a bothersome published works on speculative manias to
conundrum. The extremities of opinion create the framework on which he builds a
have attracted a wealth of political diatribe credible critique of the current economic
and media attention. Investor sentiments exuberance in China. He regards his
and self‐righteous prognosis are as varied previous research as hallmarks for
as the personalities. We will not “leading indicators of financial distress.”
We have collapsed the two sections of his
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paper, the first which identifies the have some interesting sociological
indicator and its rationale and the second implications.
section which makes the appropriate and
current relevance to China. The ten 2. “Blind Faith in the Competence of
hallmarks are: Authorities; The Communist Party of
China”
1. “A Compelling Story; the China Dream” The state controlled growth over the past
The first indicator is the incredible magnet two decades has masked a multitude of
of China to draw upon outsiders’ sins. Unlike the gangster capitalism which
overwhelming desire (greed) to make resulted from the breakup of the former
money. China’s population exceeds 1.3 Soviet Union, the “Red Capitalism” of
billion people and the expectation is that China is highly respected for its avoidance
over the next decade that 300 million of of the Asian Financial Crisis of 1997 and
these people will emigrate/transform from the current global “credit crisis.” One of
indigenous, subsistence farmers to city‐ the major wonders is that so many ardent
dwelling consumers. Meanwhile, China capitalist have become “fervent admirers
has surpassed Germany as the world’s of an economy managed by communism.”
largest exporter. China is expected in 2010 However, past growth has been managed
to surpass Japan to become the world’s by means of capital investment and export
second largest economy. China is the growth. This cannot continue especially in
largest consumer of commodities and is the face of the “great recession” in the
the largest market for automobiles. Thus, West. A move to more consumption‐based
the expectation is that China’s GDP will growth begs the question of effective
rise in excess of 8% per annum well into allocation of capital in a state‐directed
the future. Chancellor points out that few economy. Chancellor states that “In China,
analysts question the possibility of an GDP growth is no longer the outcome of
interruption to these years of extraordinary an economic process; it has become the
growth. The other unquestioned object.” There is evidence to support
assumption is that the continued exodus contentions that local government
from the farm to the city will produce decisions on infrastructure or real estate
middle class consumers. He also astutely developments “are driven by the necessity
notes that China’s population will begin to of meeting their growth targets.” This
decline in 2015 and that the number of misallocation is further skewed by
persons joining the workforce will “fall off favoritism shown to state‐owned
quite rapidly.” We would also note that enterprises (SOEs) which receive
few analysts have yet to seriously study preferential treatment and creates a
the demographic implications of China’s forcing‐out of smaller entrepreneurial
“one child policy.” A young adult enterprises from access to capital and local
population, predominantly male, may government support.

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3. “General Increase in Investment; The growth expectations. This type of
China Investment Boom” aggressive over‐development was one
During 2009 fixed asset investment (FAI) major cause of the Asian financial crisis of
in China climbed 30% resulting in its 90% 1997 severely impacting economic growth
share of economic growth. Astounding in Korea, Thailand, Indonesia, and
but not surprising since infrastructure Malaysia.
accounted for two thirds of 2009 stimulus
spending. Many projects undertaken are 4. “Corruption”
instituted to meet government GDP Chancellor reminds us that “All great
growth targets. These include airports, speculative manias have been
highways, bridges, and high‐speed accompanied by rising levels of fraud.”
railways. Chancellor mentions the You Examples in the US include Enron and
Tube clip of “new” Ordos, a “ghost town” WorldCom during the TMT bubble; Bernie
which was built to accommodate one Madoff and Allen Stanford during the
million residents near to the “old” Ordos recent credit bubble. However, in China
which is in Inner Mongolia. Also available major economic degradation results from
are clips which expose the world’s largest unreasonable and punitive land seizures,
retail mall which is hardly occupied, an lax building standards and shoddy
eerie sight. The new town of Chenggong in construction, poisonous pollution, and lack
South China’s Yunnan province was built of enforcement of existing regulations.
to alleviate Kunming’s congestion. The Endemic corruption will lower growth and
mock English “Thames Town” was built as increase systemic risk. This level of
a bedroom community for Shanghai. corruption can be expected in an emerging
Similar to the overcapacity of telecom market economy but is not acceptable in
assets developed in the US during the TMT the world’s second largest economy. The
boom of the late 1990’s, the justification is Carnegie Endowment believes that the
that with projected growth rates, the indirect costs of corruption are incalculable
capacity will eventually become and will eventually have a serious
productive. As in the case US TMT impairment on growth. China is currently
“bubble” this outcome is highly unlikely in ranked number 79 on the Transparency
the mid‐term. International Corruption Perceptions
Index.
The problem of over‐investment also
plagues the manufacturing sector. 5. “Easy Money”
Capacity underutilization has been Chancellor refers to economist Friedrich
identified in shipbuilding, steel, flat glass, Hayek who “claimed that asset price
iron, cement, poly‐crystalline silicon, and inflation followed from excessively low
wind power. Investment at this level is interest rates.” Monetary and credit
quickly subject to diminishing returns. expansion generate easy money which
However, it is justified by aggressive feeds through to “inflation, either in the
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general price level or in asset prices.” up by the US. Meanwhile, China has
Either result is a misallocation of capital. enabled other Asian countries to also build
The appropriate level of real interest rates large foreign currency reserves which may
is a burdensome issue, as much an art as a provide a false sense of economic security
science. However, a “rule of thumb during times of global stress. There is an
suggests that rates should track economic apprehensive shadow‐play in this current
growth over the medium term.” In the US entanglement. China reflects a larger,
“the prime rate has averaged around 1 more intense replay of Japanese export
percentage point more than US nominal policy during the 1980’s. Meanwhile, the
growth over the past forty years.” Yet, in United States after a period of gross
China “the prime rate has averaged overconsumption is following the Japanese
around 9 percentage points less than path of credit‐bubble resolution which
GDP.” In 2009 there was a $1.4 trillion includes ZIRP, quantitative easing, and
issuance of new loans. This twin policy of “zombie banks.”
low interest rates and exorbitant money
growth has generated high inflation with 7. “Rampant Credit Growth; the Current
booms and busts over the past twenty Credit Boom”
years. See Chart 5 which includes the During 2009 banks in China increased
Shanghai Stock Exchange Composite lending “by nearly RMB 10 trillion, a sum
(SSEC) below for an example in the equity equivalent to 29% of GDP.” This huge
market. Low interest rates in China like in impetus to the economy went largely to
the US punish savers and investors who infrastructure projects, property
find themselves squeezed between fear of development, and state‐owned enterprises.
inflation and the desire for higher returns. One can look to the current US malaise to
see the results of massive, short‐term credit
6. “Fixed Currency Regimes; Exchange growth. As with US “subprime lending”
Rate & Capital Inflows” there must also be a concern about the
The fixed rate of exchange between the deterioration of underwriting standards
Chinese renminbi (RMB) and US$ has when a credit surge of this magnitude
produced massive capital flows by way of occurs. “Economists at the Bank for
foreign direct investment even with International Settlements have shown that
limited capital controls. This massive sharp deviations of credit growth from
investment also contributes to abnormally past trends have predicted financial crises
low interest rates. The extremely large with an 80% success rate.”
foreign currency reserves held by China
are a reflection of an untenable imbalance 8. “Moral Hazard”
in global trade. These reserves are not a Chinese banks which are among the
stalwart defense against asset booms and world’s largest in assets are state‐owned.
busts. The other side of this unstable They are viewed as “a key instrument of
equation is the “vast external debts” run Beijing’s economic policy” and, thus,
Page 10
deemed “to big to fail.” However, the to provide full transparency in providing
problem of moral hazard knows no information on problematic loans mean
geographical demarcations and one need that true evaluation of a bank’s capital
to look only to Japan in the 1980’s and the strength is questionable. “Few seem to care
United States in the mid‐2000’s to see the about the practice of concealing nonperforming
potential pitfall of compromised lending. loans since it’s generally assumed that so long
The Asian financial crisis of 1997 involved as the economy continues growing quickly,
poor lending decisions at government bad credits will turn good over time” (EC’s
influenced banks. In the late 1990’s italics).
Chinese banks were estimated by Standard
& Poor’s to have “non‐performing loans 10. “Rapidly Rising Property Prices; The
around 50% of total outstanding loans. In Bubble”
this instance the bailout and Once again, Chart 5 indicates the rapid
recapitalization “appeared relatively recovery of the SSEC in 1H09 which
painless.” During the most recent ramp‐ coincides with China’s massive fiscal and
up in lending Hong Kong banks operating monetary stimulus. “High stock turnover,
in the mainland were cutting back on new a rising number of new share issues, strong
loans. early trading gains, and the establishment
of new stock exchanges are all classic sign
9. “Precarious Financial Structures; Risky of speculative euphoria.” Once again,
Lending Practices” market gains, high valuations, the SSEC
Unfortunately, the US‐Euro‐Jap model of trading at “38 times historic earnings” are
lending which greatly reduced standards justified by “the country’s tremendous
during the boom‐times may have rubbed growth prospects.”
off in China. Many of the infrastructure
projects, toll roads, bridges, airports, and Chancellor continues that the real “red
railroads, sponsored by local government flags” are flying over the “frenetic property
authorities “appear to have little or no market.” Residential real estate is powered
current cash flow.” Once again, the by low returns on cash, the volatility of
expectation is that the economy will grow stocks, and “a widespread belief that
into this excess capacity thus generating property prices can only go up.” Lowered
the revenue to fund the investment. As lending rates, increased loan‐to‐value for
with moral hazard, risky lending practices mortgages, discounts to second‐home
and working‐around capital requirements, buyers, residency permits to buyers, and
sometimes, become standard banking tax benefits, worked their magic with
practices during the boom times. While stunning results. The increase in sales of
“Wall Street analysts are given to claiming residential properties from 2008 climbed
that China’s credit system is robust 87% to RMB 3.8 trillion in 2009. The
because loans are not securitized,” other average house price rose 8%. New
off‐balance sheet tactics and the reluctance construction has followed rising by 16%
Page 11
thru November 2009 and the expectation to in the People’s Republic” and have been a
rise another 20% in 2010. Unfortunately, “major beneficiary of the real estate
migrant workers cannot afford new boom.” State‐owned enterprises have been
housing prices in the cities, but home called upon to support continuing
ownership ratios have climbed to 70%. development. This circus is underway at a
Much of the take‐up is now in the hands of time when vacancy rates are rising. In the
“investors” because, on a national basis, Pudong district of Shanghai building
home prices have “climbed to around 8 continues despite vacancy rates of 50%.
times income.” In Beijing, “the house price
to income ratio has climbed above 15 times We find that Chancellor makes a
(its average 2000‐2008 was 10 times). By compelling argument. In his book he has
comparison, Tokyo condo prices peaked in noted comparative, historical
1990 at 9 times average household developments. The biggest questions are
incomes.” Once again analysts are not when this will unwind and what the global
concerned. repercussions will be.

The commercial property market reflects a Chancellor is not alone in expectation of a
similar hyper‐expansion. “Commercial breakdown in China’s growth. Harvard
real estate investment grew by 21% last economist Kenneth Rogoff is in agreement
year. The total amount of floor space with the eventual correction in China’s
under construction in China is equivalent extraordinary record in development.
in size to Rhode Island. Bank lending of During an interview in Tokyo in February,
$202 billion in January 2010 will assist Bloomberg quoted him to say “You’re not
continued growth. Gross area under going to go a decade without a bump in
construction in China rose to 3.2 billion the road.” Rogoff believes that economic
square meters in 2009.” This amount growth could plunge to 2% after the
equates to approximately 35.2 billion collapse of a “debt‐fueled bubble.” He
square feet or the equivalent of a 27 square believes that real estate is a prime catalyst
foot cubicle for every person in China. Jim for the collapse as prices in Beijing and
Chanos, see below, uses this analogy. Shanghai have “taken a departure from
According to Bloomberg Downtown reality.” However, Rogoff believes that the
Manhattan has 87 million square feet of correction will be a fairly short painful
office space; thus, China has under period in the continuation of China’s
construction over 400 “Downtown strong economic growth.
Manhattans.” The nefarious development
loop which incorporates money flows from James Chanos, President of Kynikos
state‐owned banks, precarious credit Associates, hedge fund manager, and
expansion, corruption, misallocation, and respected short‐seller, made a fortune and
blind faith is completed through local a reputation shorting Enron a decade ago.
governments “which own title to all land He lectured at St Hilda’s College, Oxford
Page 12
University on January 28, 2010, available superpower’s accumulation of currency
on YouTube. The title of his presentation reserves eventually resulted in real estate
was “The China Syndrome, Warning Signs and stock market bubbles in 1989, a
Ahead for the Global Economy.” Mr. currency revaluation, and the lost decades
Chanos was not making a call for from the 1990’s until now. We would like
imminent doom in China. However, he is to reiterate that while China is in a unique
sounding an alert to those who believe that position, there are two close historical
continuing development in China will be correlatives. The Chinese policy makers
the engine for global growth. In fact, a are well aware of the past and especially
slowdown in China for any number of the Japanese experience. However, the
reasons but most importantly, excess credit current explosion in lending and resultant
collapse, would put a sharp dent in world development of overcapacity in
GDP growth. Excessive FAI has resulted manufacturing, infrastructure, and real
in overcapacity in many sectors of the estate are the indicators for eventual
economy. This excess capacity is creating correction. China’s foreign currency
strong deflationary pressures. The record reserves cannot protect them from
levels of FAI are not sustainable and are themselves. Chanos suggested that the
creating massive maintenance costs for the best way to play the coming correction in
future. The result has been a large up‐tick China is by shorting those providers of
in commodity prices especially industrial materials who are most susceptible to a
metals and materials. Chanos has major correction
admitted it may take 4‐5 years for his
scenario to play out In Chart 5 we note the bubble expansion in
Chinese equities expressed by the rise of
The Chanos hypothesis has much credence the SSEC from March 2005 thru October
if we look to the history of trade 2007, from 1,172 to 6,092 or 420% in 31
domination and world currency reserves in months which equates to a compound rate
the 20th century. He points to the two of 5.46% per month. The downside was
times when one nation so dominated just as quick but not quite as low and
world trade that its currency or gold commodities followed the trail in less than
reserves rendered it the role of economic a year. As during the Japanese experience
superpower. The first was the United in 1980’s and American experience in 1996‐
States from post‐World War I era into the 2006 the equities’ bubble and collapse
1920’s. During this period the US morphed quickly with the added stimulus
accumulation of gold led to stock market of very low interest rates into speculative
and real estate bubbles of late‐1920’s, real estate. In Chart 5 we have shown an
followed by a major currency revaluation, underlay of the Commodities Research
and the subsequent economic collapse of Bureau (CBR) index. Both indexes have
the 1930’s. This experience was repeated recovered from their bottoms but remain
in the 1980’s in Japan where an export substantially below their tops. The pattern
Page 13
is analogous to the US pattern where complex association of supply, demand,
investors burned in equities moved exchange rates, and differentiation among
quickly into real estate. The case of industrial, agricultural, and precious
commodities is a different and more metals. We look a bit closer below.

CHART 5 FOLLOWING THE LEADER?


PROVISIONING economy was growing at 2% and not the
During the Summer 2009 there was a great 7.8% which the government reported.
deal of concern about the Chinese Whatever the real rate of growth happens
economy as equity markets began a quick, to be we look at the markets for
steep decline. At the time Asian investor verification. In this case we look at the
and economist Marc Faber told CNBC that commodity building blocks for rapid
“The Chinese government is one of the few development, WTIC and Copper. One
governments in the world that knows its could also look at cement and iron ore with
GDP numbers three years in advance.” He similar results. In Chart 6 we show the
followed with “I’d be a bit careful about prices of these basic development
China.” In his estimate the Chinese commodities over the past 13 years.
Page 14

CHART 6 BUILDING BLOCKS


The prices clearly indicate a response to spread across the globe thru a carry‐trade
market factors which began in 2004. In accommodated by ZIRP. This “cheap
retrospect we can intuit the factors in price money” policy and China’s abundant
volatility which are, supply, demand, cheap labor are the magnet for the third
speculation, and exchange rates. In brief, pillar of production, materials.
mining or other extractive industries are a Commodities are a natural haven and
long‐term, capital‐intensive undertaking hedge for those investors who harbor
and unlike farming where output can be inflation expectations and the possibility of
ramped up quickly with the use of untilled continuing volatility in stocks and bonds.
land, the supply is constrained in the Finally, we meet the exchange rate
short‐term. Yet, global demand has been conundrum. The major commodities are
growing primarily due to rapid priced in US$’s as the US$ weakens
development in South and East Asia. commodities such as oil, copper, and
Speculation follows on demand. The precious metals rise in price. Many
massive money creation which has commodities provide a solid hedge against
resulted from quantitative easing first in a vulnerable US$. An appreciation of the
Japan, then England and now the US has Chinese currency in terms of the US$
created an abundance of “hot money” would make commodities cheaper for
Page 15
China and may accelerate demand driven development. Any interruption in the
by potential stockpiling. The complexity of continuing expansion of China and India
these uncertainties is exacerbated by the will greatly impact prices. The other
size and speed at which money flows now conundrum is what these prices are telling
travel thru the global financial system. We us about inflation. Commodity prices have
believe that oil and copper are indicative of traditionally been closely linked with
the commodities which are directly linked inflation expectations.
to Asian and emerging‐country

CHART 7 BACK TO BOOM TIME


In Chart 7 we look more closely at the challenge at this point is how to interpret
speculative play on metals by means of the multi‐variate factors which denominate
investing in the duopolistic producers of reasonable valuations for mineral assets.
iron ore. The two are BHP Billiton Ltd. Chart 7 describes the pricing which equity
(BHP) and Rio Tinto plc (RTP), huge multi‐ markets have assigned as indicative of
national miners. The continuing demand current valuation. Jim Chanos has
for iron ore by steel manufacturers presented a clear narrative based upon
especially in China, Korea, and India are China’s future demand for his vision of
reflected in the valuations of these value in contradiction to these prices. Who
companies, boom, crash, re‐boom. The is correct, time will tell.
Page 16
adjustments, and the acceleration of Asian
The growing frustration and confrontation development are influences which have
between the US and China is a sign that not fully revealed their true suasion and
further economic disruption might be jostle upon the nexus of world financial
expected between the world’s largest saver markets. The hyperactive moves by
and largest debtor. While exchange rates markets to the continuing bombardment of
may not be the most important issue that statistical and speculative information over
the two nations must address, it has the past 2 years appear to have rejuvenated
become the most media intensive. The US global optimism and risk‐taking, perhaps,
credit crisis, global economic stimulus excessively. There are times to act and
packages, central banks’ monetary times to contemplate. Therefore, we sit.

We arrived back in Northern Virginia in time for the vernal equinox on March 20, 2010, that
brief period when day and night are nearly equal with daylight in ascendance. An end to the
harsh rains gave way to warm sunny days with sharp chilly evenings. The arrival of Spring is
a hectic time for nature. The birds, the bees, the flowers, the trees display a beauty and an
energy which seems out of control. Cherry trees exploded in pinks and whites. Daffodils
popped up overnight. The uncanny combination of moisture and warmth produces
shocking change. The impact is radiant and vibrant. The beauty in nature is beyond our
control.

The spring display of power and change was preceded almost a week by Daylight Saving
Time (DST), a minor but well publicized change. It is man’s attempt to adjust more
productively to the cycle of nature. This ruse which shifts an hour of daylight from the early
morning to the later evening has never been popular with farmers or others who work
closely in tune with the sun. Even now the UK debates the benefits and parameters for
British Summer Time, the equivalent of DST. London businessmen battle with Scottish
farmers over issues of scheduling daylight and coordinating time zones with continental
Europe. However, these prerogatives are menial in comparison to the real command of time
which was instituted by the railroads in the 19th century. It was the economic power of the
railroad first in Europe and then America to determine and set time zones and standards.
Profitable train travel, passenger and freight, demanded adherence to well‐structured
timetables for the economic and social benefit of all. Setting of standards is an onerous task;
for once established these standards may be very hard to change. We are creatures of habit
and sometimes ignore our “rational self‐interest” in favor of inertial sloth. Sometimes we
ignore or fail to perceive many of the aggregated consequences of simple expediencies. The
rationale for the government mandating of DST was “energy savings” at the end of World
War I.

Page 17
Almost one hundred years later we continue a practice which is irrelevant in accordance to
its original purposes. Some economists will always be able to justify with vigor a standard
which is politically advantageous. However, government mandates can have long‐term
implications similar to building a dam. This intrusion upon nature is great benefit to those
who are in need of hydroelectric power or those who suffer the seasonal flooding which
occurs downstream. Yet, the dam is a terrible burden to those “relocated” from the
upstream storage area. The demands for stability and protection are subject to surrendering
autonomy. We barter the vagaries of nature for the fiat of men. This remains as true in the
world of financial markets as in the physical realm. Once the standard is set or dam is built
the question will remain who controls the “flow”, the rate of change. Democracy assumes
that it reflects the will of the people. Who will vote for higher interest rates?

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
Page 18

3.0 Poseidon Perspective March 2010

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