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THE BROYHILL LETTER

“Monetary policy is not a magic elixir that can solve every economic ill. Doctors must diagnose the disease correctly if they are to prescribe the
correct medicine. Otherwise, they could do the patient more harm than good.”
– Charles Plosser, President of the Philadelphia Fed

Executive Summary

Our choices today are rife with unintended consequences. A major corollary of current Fed policy aimed at aiding the
recovery is continued liquidity flows into emerging markets and natural resources. The combination of competitive de-
valuation and Quantitative Easing points to continued strength in emerging markets and rising commodity prices now, but
the potential for speculative extremes are not far on the horizon. It is too early to say with confidence that the Fed will be
successful in blowing another bubble, but the odds are certainly stacked in favor of the printing press. After experiencing
the bursting of two Fed-induced bubbles in one decade (neither of which monetary policy makers take responsibility for),
investors should monitor sentiment and emerging market credit spreads closely for signs of exuberance, which would also
be reflected in extreme valuations and lopsided fund flows. Third time’s a charm?

We don’t expect QE2, a new program of large-scale asset purchases, to provide much of a lift to cyclical growth. We doubt
job prospects will be improved dramatically by the central bank acquiring another trillion (or two, three or four . . . ) of
treasury bonds, or that housing activity will increase given that roughly half of US homeowners are underwater on their
mortgages today. In the long-term, printing presses cannot stimulate aggregate demand, create new technologies, update
infrastructure, reduce unemployment or pay down debt. Policies that place particular emphasis on short term “highs” have
often produced violent “crashes” over the long term. At present, markets are entirely dependent upon the Fed to increase
“household wealth by keeping asset prices higher than they otherwise would be,” as promised by Brian Sack Executive,
Vice President of the Federal Reserve Bank of New York. But as investors, we are not rewarded for our policy suggestions,
nor are we rewarded for portfolio positioning based on what should be done. Rather, we must play the hand we are dealt,
and the combination of a Bernanke-led printing press kicking off a classic Third Year rally in the Presidential Cycle may
well be the ace in the hole for risk assets over the next twelve months.

Year Three Little Birds

“Don’t worry about a thing, ‘cause every

little thing gonna be all right.” Three Little
Birds is a song by Bob Marley & The Wail-
ers from their 1977 album Exodus. It is
one of Bob Marley’s most popular songs,
and allegedly, a Greenspan-Bernanke
favorite as well. We are worriers by na-
ture. But history would suggest that Fed
promises during Year Three of the Presi-
dential Cycle are enough to encourage
speculation and ignite even the most dor-
mant animal spirits. Upon closer inspec-
tion, Year Three rallies are often born
during the fourth quarter of the second
year. According to work done by William
Hester of Hussman Funds, the twelve
month period beginning in October of
the second year of the Presidential
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Cycle has enjoyed total returns in excess of 28 percent. Not too shabby, especially when one considers that we have not
registered more than a marginal loss in a single Year Three for almost a century. The reason is unmistakably simple. Presi-
dents really like being re-elected and a really accommodative Fed in Year Three can do wonders for an incumbent’s odds.
It appears that President Nixon grasped this concept rather quickly. Evidence from the Nixon tapes clearly reveals that
Nixon pressured then Fed Chairman Arthur Burns to engage in expansionary monetary policies prior to the 1972 election.
Blaming a modest rise in the unemployment rate as one of the reasons he lost the 1960 election, he demanded an expan-
sionary monetary policy in the run-up to the 1972 election.

No investment strategy this simple, or this predictable, should work in practice. Anything this easy to spot and this easy to
follow should ultimately be arbitraged away over time, like any other once-working anomalies of markets past. But, despite
what academic theory would suggest, Fed policy of over-stimulating asset prices and over-encouraging moral hazard has
consistently generated spectacular returns in Year Three. The truth is in the data. The chart below from GMO illustrates
just how well the more speculative quarter of the market has performed over this period. Given the Unusual Uncertainty
of today’s macroeconomic landscape, coupled with Fiscal Gridlock in Washington, Bernanke & Co are under even more
extreme pressure to reflate the economy. Between November 3rd and Election Day 2012, the monetary spigots will be
running Wide Open (without a doubt, one of my favorite recently discovered Southern phrases, right up there with “bless
your heart”).

Source: GMO Quarterly Letter - Night of the Living Fed - October 2010

Manias, Panics and Crashes

Economic historian, Charles P. Kindleberger, provided investors with a conceptual framework for thinking through the
foundations of history’s biggest speculations based largely on the work of the now (in)famous Hyman Minsky. The five
stage model (illustrated below) starts with a random “displacement or some exogenous shock to the macro system” which
always jolts expectations and leads to New Era thinking – a New Normal if you will. The majority of the time, said dis-
placement has been in place for years prior to the ultimate investment stampede. Easy money fans the flames of specula-
tion as the public’s attention is captured by rising prices. It also helps when there are convenient vehicles to invest in the
New Era allowing the public to participate en masse – coincidentally, we understand if the new physical copper ETFs were
fully subscribed, they would take about 50% of total LME stocks off the market.
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Ultimately the boom becomes euphoric as

participation becomes widespread and theo-
ries chase prices higher, all the while justify-
ing why normal measuring sticks of valuation
are no longer relevant. “There is nothing so
disturbing to one’s well-being and judgment
as to see a friend get rich,” but inevitably
booms turn to bust when credit growth
slows and prices stop rising. Once prices
begin their descent, speculators rush for the
proverbial exit of the crowded theatre, bank-
ruptcies increase, frauds are discovered and
revulsion sets in. The policy reaction to the
bust (i.e. Quantitative Easing) caused by the
collapse of the previous bubble, often sets in
motion a chain of events leading to the next
Financial Mania.

Easy Money

It may appear premature to begin contemplating the next invest-

ment stampede, but bull markets often originate from the ashes of
the previous bust. New opportunities emerge from the displacement
caused by the prior bubble, and flourish on a diet of easy money and
credit. The return of speculation is the primary determinant of where
credit inflation manifests itself. Here, the cost of borrowing is key.
With the developed world mired in a Liquidity Trap, interest rates
across the G7 should hover around the “zero bound” for as far as
our eyes can see. The result is that as long as China and friends con-
tinue to peg their currencies to the Burning Buck, emerging markets
will continue to import US monetary policy pushing related asset
prices higher.

The growing prospect for an emerging market bubble has all of the
elements described above. It qualifies as a New Era candidate with
displacement in the making for some time, as BRIC share of global
GDP has grown significantly in the past quarter century. It is now
easy for investors to allocate to the emerging world with an almost
unlimited number of liquid ETFs available in the marketplace today.
Decoupling is slowly coming back in vogue and valuations remain
fair, suggesting that as prices move higher, money will follow and
potentially push them to extremes. Finally, the secular nature of this
shift, combined with the cyclical stimulus in place today, make the
prospects for such a move that much more attractive. Emerging
Markets share of global GDP has risen from 21% to 37% from 1990
through 2008. Their share of Market Cap was still just 12% of world
markets. To get a sense of what a bubble looks like in 1990 Japan
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represented 40% of the world’s entire market capitalization!! We have a long way to go.

Bull markets emerge in waves much like the rise in commodity prices experienced over the past decade. Resource bulls,
close relatives to emerging market bulls, point to the kind of arithmetic that shows China’s per-capita commodity utiliza-
tion as a fraction of America’s. The obvious implication is that there is quite a large move ahead of us – a move that is
easily visualized by the average investor. Importantly, bubbles are often based on long term expectations condensed into
a short term time span – perhaps as short as a twelve month period such as Year Three of the Presidential Cycle. Of
course, commodity prices also have the additional tailwind of lower real interest rates Cruising Aboard QE2. Lord John
Maynard Keynes warned that, “There is no subtler, no surer means of overturning the existing basis of society than to
debauch the currency.” Put simply, too much money chasing too few goods provides commodities with pricing power rela-
tive to fiat currencies. Look only as far as the recent move in gold for a view of this trend in action. A Fed Boss enamored
with Easy Money provides assurance that real interest rates will remain low, which should favor the long term gold price.
Consequently, November and December have historically made up a significant portion of gold’s annual gains, even when
beginning the fourth quarter near highs for the year.

Bottom Line

When the facts change, we change

our mind. We have remained defen-
sively positioned for most of the
year as risk was clearly elevated by
monetary authorities debating glob-
al “exit strategies” and fiscal policy-
makers arguing for increased auster-
ity. Despite measures of sentiment
registering excessive pessimism dur-
ing the third quarter, we maintained
this focus on capital preservation
in front of the historically risky
months of September and October.
In hindsight, we would have been
better served buying last quarter’s
“lows” in pessimism, but the poten-
tial for a larger “waterfall decline”
prevented us from doing so. Fast
Source: Robert Shiller, Broyhill Asset Management
forward to today - with a green light
from the Fed and Bernanke’s petal
to the metal as we enter Year Three, the facts have changed. True, valuations remain largely unfavorable (although emerg-
ing market equities are more reasonably priced) and broad macroeconomic risks have not vanished, so we are not throw-
ing caution to the wind. But incredibly, the record indicates that even elevated starting valuations have not reduced the
magnitude of gains in Year Three. One only needs to look back to the tech bubble for an example. After over-stimulating
the market in years one and two, Greenspan had markets partying like it was 1999 in Year Three. But in two thousand zero
zero . . . party over, oops, outta time.

The year 1999 was also similar in that it was another period of highly correlated asset prices. Like gold’s tendencies into
year-end, winners extended their lead in the fourth quarter. Policy mistakes reinforced this phenomenon then, and look
likely to repeat this mistake again. Our work indicates that emerging markets and natural resources have the most
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appreciation potential ahead of the

coming liquidity avalanche, while
long term treasuries still provide
insurance against a deflationary
relapse in the near term. But we
would not chase the market higher
at these levels. The recent advance
has brought most markets back
to their April highs as the MSCI
World Index has now gone almost
50 straight days without as much as
a 2% correction. Persistent strength
has left investors complacent and
equities extremely vulnerable to
disappointment. With expectations again elevated, any unexpected developments should serve as a catalyst for a sell-off.
Unless the Fed dazzles investors with “shock and awe,” the market appears to be set up for a classic “buy the rumor, sell
the news” reaction. Under such a scenario, we would expect emerging markets, natural resources and related assets to
underperform given the high beta and correlations across markets. So for investors underweight risk today, a correction
should relieve the current complacency, provide an attractive entry point and set the market up for a year-end rally. An
abrupt decline that cleared overbought levels and injected renewed fear into the psyche of speculators might provide a
better base for the typical Third Year Boom.

- Christopher R. Pavese, CFA

The views expressed here are the current opinions of the author but not necessarily those of Broyhill Asset Management. The author’s opinions
are subject to change without notice. This letter is distributed for informational purposes only and should not be considered as investment advice
or a recommendation of any particular security, strategy or investment product. This is not an offer or solicitation for the purchase or sale of
any security and should not be construed as such. Information contained herein has been obtained from sources believed to be reliable, but not
guaranteed.