It is old news that the market has enjoyed a very strong rally since last March. In my opinion, it has occurred on the back of misguided confidence that the next economic boom would soon follow.  I give an abundance of credit to the news headlines, government stimulus, and market interventions for encouraging a short-term burst of economic activity which has everyone salivating again.

Like Pavlov’s dog, Americans have learned that when the NYSE’s bell rings or the government spends, they get fed.  We have been conditioned to think that this business cycle will unfold like other cycles in our recent past, a steadily rising market and a vibrant economy a foregone conclusion.  However, this cycle feels different and diligent analysis reveals economic circumstances are significantly more severe than anytime since the end of World War II.

After pausing to think, I believe investors are beginning to perceive the divergence between the stock rally and the economic reality.  The S&P 500 shed 7.6% over the past two weeks.  Maybe market participants realize that a recovery may not be sustainable without consumers, 18% of which are now under-employed and must spend sparingly while the other 82% have chosen to spend frugally out of fear that their incomes may be at risk.  To add insult to injury, credit and money supply continue to contract.

The market was overdue for a selloff.  Corrections of similar magnitude have given birth to a series of large rallies and higher stock indices since March, but my market indicators  have flashed an intermediate sell signal. If the market does not stabilize right now, you can count on a damaging selloff from these levels.  Investors should lighten stock and commodity holdings on any market strength.  Better yet, lighten anyway.  If you smell smoke in a barn full of dry hay, flee the barn.

Greg Mattlage

The following represents an email I sent to Catamount clients on November 27, 2009.  I’m publishing the email on my blog because it has particular relevance to topics that I intend to discuss in the near future.

Dear Clients,

The markets produced neurotic action today in the wake of Dubai’s debt default.  The stock index futures were down substantially in overnight trading, but the U.S. markets recovered a lot of the losses in the early hours of today’s trading session.  The S&P 500 Index only lost 1.63% in what promised to be a more precipitous fall. Many traders, anticipating a continuation of the 9 month stock rally, probably treated this as a buying opportunity.  It could be just that – another buying opportunity.

However, any circumstance involving a country defaulting on its sovereign debt warrants close surveillance because many severe market dislocations have occurred on the heels of similar events.  An example would be the Asian Paper Tiger crisis in 1998 which took the S&P 500 down 22%. Given the fragile state of the nascent economic recovery, it wouldn’t take much to rattle confidence in overextended financial markets.  We’ll have a better read on the situation by Monday.

It’s interesting to note that, while investors were dumping commodities and stocks in reaction to the Dubai news, the U.S. Dollar rallied sharply against a broad basket of the world’s currencies.  In other words, investors were apparently fleeing risk assets for the safety of the greenback.  This gives us some insight into how certain markets might respond if global economic conditions falter.

Coincidently, the U.S. Dollar Index rests very near where it bottomed on July 15, 2008.  Oil prices hit all-time highs on July 14, 2008.  In the ensuing 4 months, the U.S. Dollar rallied 20%, oil prices fell 55%, and the stock market shed 40%.  This is not a prediction, only an attempt to point out that this could be a pivotal juncture for the financial markets.  If the dollar reverses and rallies, commodities and stocks may swoon – and this could foreshadow deteriorating economic conditions.   If the dollar breaks below this key support level, the risk trade will likely continue – and maybe the economy will continue to mend.

Best Regards,

Stocks have been rallying with little pause since March 9.  Last Friday, the Dow Jones Industrial Average closed above 9500 for the first time since November of last year.  After falling 58% from the October 2007 high, the S&P 500 has rallied 54% from the bottom.  Still, the market remains 35% below peak levels.

The rally has been fueled by expectations of an economic recovery.  Those expectations have been largely driven by increases in a series of economic statistics that are reputed to have strong predictive value about the direction of the economy.  These “Leading Economic Indicators” have risen for the last 3 months possibly signaling that economic conditions may improve in the near future. On the other hand, certain “coincident economic indicators,” in free fall until July, have yet to confirm that the economy is on the mend.

On the surface, the rebound in certain economic data, including a revival of the stock indices, appear encouraging.  What lies below the surface should still give pause for concern. The decline in economic activity has leveled off, but at extremely low levels.  As most of you know, consumer spending drives nearly 70% of the economy and the consumer remains notably absent from this so called “recovery.”  In my view, consumer spending has been and will remain anemic for some time.  I cite soaring unemployment rates as the primary reason among a host of others.

Involuntary unemployment rates are at the highest levels since the Great Depression.  While the unemployment rate reported by the mainstream financial media stands just below 10%, a more accurate measure released by the Bureau of Labor Statistics (aka: U6) but not widely disseminated, calculates unemployment closer to 18%.  The U6 definition includes those who have given up the search for work, those who have exhausted their unemployment benefits and subsequently fallen off the unemployment rolls, and those who want full-time work but have involuntarily settled for part-time work due to economic circumstances.

According to sources, the U6 definition of unemployment more closely reflects the method that was used in the 1930s.  If this is truly an “apples to apples” comparison, today’s unemployment numbers are not that far below the 28% unemployment experienced during the Depression.  Oh brother! Or should I say, “Oh brother can you spare me a dime.” This is obviously not a laughing matter since the typical American family has a minuscule pile of savings and maxed-out credit to fall back on. They absolutely need their jobs to put food on the table and shelter over their heads.

Most economists would argue that employment is a “lagging indicator,” meaning that the job market is the last thing to improve coming out of a recession. Then again, unless these economists are pushing 80+, most have never seen unemployment this high and I think all will agree that this has not been a run of the mill recession. It never is when a massive debt bubble collapses. During the Great Depression, extremely elevated unemployment rates became more the cause than the consequence of low economic activity.  I would hate to see high unemployment cause a self-reinforcing negative feedback loop leading to further economic deterioration.

Let me be clear, I’m not forecasting the greater depression. Hopefully, the vast money printing initiative that our leaders have embarked upon will lead us to lasting expansionary cycle chock full of new high paying jobs.  Of course, when the government spends a dollar, it must come from the private sector’s pocket through higher taxes or loss of purchasing power.  That’s one less dollar that can be used toward creating private sector jobs.   I have serious doubts about whether robbing Peter to pay Paul will create a high quality job market, but I suppose anything is possible.

On the other hand, the stock market seems to be pricing in a much more robust consumer spending cycle than the unemployment picture can support. The equity markets are overextended by almost every measure going into September which is historically the worst month for stocks followed by October which is only a scant better.  Any hint that the recovery is illusory could lead to much lower stock prices. Of course markets can remain irrational longer than anyone might anticipate. We should be prepared for anything.

We have plugged our noses and waded into stocks because nobody wants to be on the beach when everyone else is having fun in the water. All the other kids are probably laughing because we are wearing our life preservers, carrying spear guns to ward off sharks, and holding onto lifelines to prevent being swept away by deadly riptides.

In other words, we’re partially invested in the markets with tight downside risk controls.  I will be watching for signals to add or reduce exposure. I look forward to the day when it’s advisable to throw caution to the wind…. For now let’s proceed with care.

By proceeding, I acknowledge that I have read and understood the Disclosure and Copywrite Statements.

In my Year End Review, I predicted that the capital markets would present historic challenges for investors in 2009.  Though my writings have been plenty fervent for more than two years, that quote may go down in history as an understatement.  It could be analogous to the weather man forecasting a severe winter storm and getting a blizzard….worthy of Everest!  My sincere hope is that non-client readers have heeded my warnings and taken cover.  Catamount Capital’s Managed Portfolios continue to survive the onslaught.  Here are the results through the end of February 2009.

2008           2009

Catamount Managed Portfolios                 -2.66%          -1.11%

S&P 500 Index                                         -38.49%        -18.62%

Dow Jones Industrial Average                 -33.84%        -19.52%

The S&P 500 closed today down -56.3% from its all-time high on October 11, 2007 - chilling numbers for buy and hold investors.

Consider unwinding the “buy and hold” brainwash and finding an investment manager who “gets it.”  Admittedly, that is no easy task in today’s myopic investment world!  Read my February 22, 2009 comments.

By proceeding, I acknowledge that I have read and understood the Disclosure and Copywrite Statements.

Lately, I’ve been fielding numerous calls and emails from people that have recently engaged in gut wrenching conversations with their investment advisors about their hemorrhaging portfolios. Apparently unsatisfied with the answers, they have asked me to provide a second opinion. The range of explanations follows a common theme as investment advisors attempt to justify why they chose to remain fully invested and took little action, if any, to mitigate their client’s losses. Since the comments follow such a common thread, I thought it might be an interesting topic to write about. Here are my thoughts.

Most of the excuses cited by these professionals fall along the lines of the typical group-think propaganda that now pervade the industry. I’ve heard comments like, “You can’t time the market,” “no one could predict this mess.” I have also heard attempts to fend off redemptions and preserve client confidence such as “It’s a mistake to lock these losses in,” “The government stimulus will save the day,” “stay the course,” “fight the good fight,” “the worst is already priced in the market,” and “Invest for the long haul.”  Recite those cliches to a 60 year old who bought them in 1997 and whose portfolio has not earned a dime. Watch his reaction.

When I was rookie at a major Wallstreet firm, I was encouraged to recite the same shallow wisdom and sell the very investment programs that most advisors employ in their practices today. These programs rest their philosophy on some version of Modern Portfolio Theory (MPT). The key tenant to MPT is the assumption that investors are generally rational and rational investors diversify their holdings in the market and, therefore, the market is inherently efficient. The theory further suggests that, because the market is efficient, attempting to outperform the broad market can be regarded as an exercise in futility. Because the broad markets generally trend upward over long periods of time, MPT prescribes that investors simply commit their capital and remain fully invested in a diverse portfolio through all market cycles. Advocates of MPT preach that you must “stay the course” to achieve investment success.

This theory inherently discourages the use of cash and ignores the merits of alternative strategies (i.e. market neutral, short selling, hedging, non traditional asset classes, etc.)  Of course, a traditional diversified portfolio will essentially mimic the market and, therefore, investors committed to this approach must be willing to endure difficult market cycles and resist “timing the market” in order to realize long-term gains. With some due credit, this philosophy advocates diversifying company, industry, size, and geographic specific risks.  However, by nature, MPT leaves investors entirely exposed to “Systemic Market Risk” and ignores the fact that most asset classes are closely correlated.  As evidenced by the facts outlined stated in my January 14 blog, you can see that modern portfolio theory is just a “theory” and bears, in my controversial opinion, several colossal shortcomings at least as it relates to practical money management for individual investors.

For one, it assumes that individual investors can wait long periods for their returns. But, if the average lifespan of an individual is 87, who can wait 10,20, or even 30 years for a return on their investments? Originally, MPT was used primarily by institutions (i.e. endowments, pensions), organizations that could afford to take a very long-term (30+ years) view. However, over time, MPT has been adopted in mass by the investment industry and applied to non-institutional investors (individuals). Today, the basic philosophy of MPT has become popular convention even among investors with very rudimentary understanding of investing and the capital markets.

In my view, investment professionals have taken this line of thinking much too far over the last 10 years. It has become the herd mentality of most investment advisors and investors. I believe it is one of the primary reasons why 99% of all funds and money managers posted huge losses last year. The herd was fully invested in a market that was systemically overpriced.  The buy and hold mentality failed miserably in 2008 and has for a whole decade. Factually, the S&P index is little higher than it was in 1997.

Please don’t misconstrue my comments. I’m not suggesting that markets can be timed precisely, diversification is useless, or long-term investing is a farce.  As I stated in my last blog, I don’t consider myself a market timer.  Furthermore, I use reasonable diversification as an effective tool for managing risks, and I believe that investments are worth holding for long periods if bought and held at prices below intrinsic value and sold when above intrinsic value. But theoretical investment models should never replace common sense, critical thought, and/or fundamental analysis.

At the end of the day, a portfolio’s success rests on the investor’s skills and the time he or she devotes to it. Sometimes it is better to pick a small number of out-of-favor investments and wait for the market to turn in your favor than to rely on market averages alone. That is precisely what we are doing at Catamount Capital.

Investors need to do some soul searching.  There have been several 15-20 year cycles in stock market history that were flat or down.  So far the S&P has posted a full decade of 0% returns for “buy and hold” investors.  Can you really afford to ride out an entire market cycle even if that means zero or even negative returns for another 5-10 years?  Are you willing to endure further and potentially significant losses?

If your advisor promotes a narrow minded approach or lacks a robust analytical process, make a change.  It may be imperative to your financial well being.

By proceeding, I acknowledge that I have read and understood the Disclosure and Copywrite Statements.

The numbers are in. The S&P 500 Index returned -38.5% in 2008 and -41.9% since the bear market began in October 2007. Most of the world’s stock markets behaved worse. Virtually every asset class including real estate, commodities, & bonds suffered severe losses.

Of the 10,720 domestic and 3,333 international equity funds, only 1 professional fund manager posted a positive return. Most of those managers lost 35-50%. On the other hand, Catamount Capital’s managed portfolios just barely slipped into negative territory after being up through the end of November. Catamount’s clients fared well compared to 99.992% of professional fund managers and the vast majority of the investment industry for one primary reason. We pared and hedged our exposure to the capital markets before the bear market began.

A number of investment professionals have criticized my tactics saying “Isn’t that market timing? Market timing is a losing proposition.” Here’s my response.

First of all, I really don’t consider myself a market timer – just a conscientious student of history, economics, finance, and the capital markets. From a macroeconomic perspective, anyone in my field who was paying attention could see that an enormous credit bubble was forming and that asset prices had become divorced from real fundamentals. I saw burgeoning credit, widespread real estate speculation, soaring home prices, and unbridled consumer spending. The evidence was everywhere. For instance, the savings rate for Americans was negative for several years while real wages and income from “productive” work weren’t rising. People were financing their lifestyles with debt and asset price appreciation. Credit was available for anyone and everyone regardless of their ability to repay, ordinary people had second homes (investment property), low income earners were driving expensive automobiles, and everyone was spending their home equity on vacations, boats, and flat screen TVs. It was the biggest credit bubble in history by a long shot – a perfect prelude to a meltdown.

Nobody can predict exogenous shocks (wars, natural disasters), but, it was not an exogenous event that caused the credit crisis, the bear market, or the recession. The Federal Reserve simply began withdrawing the gushing liquidity from the credit markets and the artificial boom came to an end. Like any bubble that bursts, the fallout has been messy but not completely unexpected given its magnitude. I’ve heard investment professionals refer to the Lehman failure as the exogenous event that caused the market meltdown, but let’s be honest. Lehman wasn’t the root cause of the stock market meltdown. There were a host of financial institutions that failed (i.e. Countrywide, INDYMAC), were severely impaired (i.e. Fannie & Freddie), or were bailed out (Bear Stearns) before Lehman closed its doors. If analyst couldn’t see in advance that the housing/credit bubble would end badly, certainly they should have been on alert well in advance of Lehman’s demise.

So there’s my global macroeconomic view. For grins, let’s consider the situation from another analytical perspective to see if we would have reached different conclusions about the prospects for the market in 2008. Let’s look at stock valuations.

From a pure bottom-up perspective, stock valuations across the board were toward the high end of the historic range before the stock market tanked, particularly when you consider that corporate earnings were at record levels and being propelled by record “debt driven” consumer spending. In other words, corporate earnings were artificially inflated by debt driven consumer spending and were bound to suffer “reversion to the mean.” Mean reversion of corporate earnings would portend that stock prices were very high relative to normalized corporate earnings. I would think bottom-up investment analysts would factor this into their models but evidently they did not. In my calculation, the vast majority of stocks as an asset class were priced for absolute perfection before the bear market began. Historically, stocks have not been a good long-term buy and hold investments unless they are bought well below their average P/E ratios. Stocks should be sold when they are trading above their intrinsic value.

To me, there was no top-down (macro) or bottom-up rationale for investing in equities in 2007. Therefore, participating in the stock market (on the long side) represented pure speculation or momentum investing. If you are momentum investor, you had better have a method to follow trends, track momentum, and assess market sentiment (some form of technical analysis) to let you know when momentum is no longer working in your favor. In the absence of sound macro economics and compelling valuations, I leaned on technical analysis and intuition to navigate through the bear market. The technical indicators for the broad markets began to deteriorate in August of 2007 and have not signaled a definitive change in market direction since. In conclusion, fundamental, macroeconomic, and technical analysis all pointed to difficult markets.

As you know, I have expressed grave concerns about the condition of the capital markets and economy for 3 years. My comments may sound like Monday morning quarterbacking. But, take a look the chart of the S&P 500 attached to your email. On the chart, I have superimposed a series of comments I published and archived on my blog site. Catamount portfolios have trounced the S&P 500 Index by more than 12% annualized since inception. Catamount Capital opened for business in January 2006, 3 years ago.

From my lense, the economy and capital markets will present historic challenges for investors in 2009. Tremendous opportunities will follow for investors equipped to navigate these waters. Catamount remains at the helm and alert for what lies ahead.

Here’s to a better year in 2009.

All the Best,
Greg

Dear Clients,

Here’s an update. I invested 10% of your portfolios in the S&P 500 index on Friday. As such, we participated in yesterday’s rally by adding about +1.5% to the total value of your portfolios. As mentioned in my blog last Thursday, a rally was overdue but did not expect a 10% move. In stock market history, only 2 other days experienced a rally of this proportion or even in the ball park. Both days occurred in bear markets. Yesterday was an anomaly.

The market opened significantly higher again this morning but began to sell-off almost immediately. Based on my indicators, the market is due another day or two of consolidation (sideways or downward action) particularly after such a strong upswing. If the indexes can stabilize, there may be little more upside. But when the rally losses momentum, I suspect the markets will get trounced again as investors focus on the economic backlash caused by frozen credit markets. Even if the credit markets start to function correctly, the economy has already suffered severe damage that will be reflected in the economic data over the weeks and months to come.

With all that said, the extremely oversold conditions presented a trading opportunity, not a long term buying opportunity. Anyway, it may not hurt to nibble a little in here. I may look to add to our current long positions within the next couple of days.

If you are worried about missing the train, you shouldn’t be. Bear market bottoms rarely turn this quickly. We will have ample opportunity to scale into stocks when a new bull market begins. So far, pundits have declared 3 or 4 bottoms that have proven false. There were 6 or 7 false bottoms in the 1929, 1973, and 2000 bear markets. It’s important to keep days like yesterday in perspective. Survey results indicate that the vast majority of private investors chose or were ill advised to remain invested the market despite the economic headwinds. Most non-clients with which I have spoken lost 40-50% of their portfolio values. To use a $100,000 hypothetical example, investors who remained fully invested watched their portfolios deplete from $100,000 to $60,000 in the last 12 months. Naturally, events like yesterday’s enormous rally appeal to human instincts for greed. And, it all sounds incredible until you consider that most people’s tattered hypothetical $60,000 portfolios only increased to $66,000 on the rally. Factually, a future return of 67% is required to climb back from $60,000 to $100,000. Based on S&P 500’s average annual historical return, that objective could take 6-10 years.

By comparison, $100,000 invested in Catamount managed portfolios edged up to approximately $101,000 over the trailing 12 months and gained roughly 1.5% yesterday to end at $102,500. Obviously, smaller percentage gains on a larger capital base can produce significant absolute profits even with a fraction of the exposure.

The key take away: Never allow your portfolio to sustain large losses in a bear market. I’m watching the situation vigilantly.

The S&P 500 Index closed at it historic high at 1565 exactly 1 year ago.Today it closed down (-41.9%) to 909.If measured from its all time intraday high of 1576 on October 11, 2007, the index is down -42.3%.I feel extremely fortunate to report that we have sidestepped the disaster. Catamount’s Managed Portfolios are +1-2% over the same time period.

In my September 17 comments, I stated that the precipitous sell-off in the market deserved a reprieve and that any bounce should be used to liquidate stocks.A violent two day rally offered little time to react, but, hopefully you took action.What ensued was a vicious capitulation for the history books.The S&P 500 shed a shocking 28% in the 14 trading days since September 19^{th .}

As you may know, I have expressed grave concerns about the condition of the capital markets for a couple of years as evidenced by the cautious, if not gloomy tone of my blogs dating back to November of 2006.If you really want to get depressed, you can read them in chronological order below. Anyway, what I saw brewing was a burgeoning credit bubble, widespread real estate speculation, soaring home prices, unbridled consumer spending, rich stock valuations and rampant inflation – a perfect prescription for a meltdown. Unfortunately, my greatest fears are now playing in a theatre near you. Despite my preparedness, I’m astonished at the fury of this latest selloff.

So, where do we go from here?In my February 2, 2008 comments, I encouraged readers to at least entertain the notion that the stock indices could fall to the lowest levels of the bear market of 2000-2003 which were approximately 770 for the S&P 500 and 7200 for the Dow.This would equal a 50% drop from peak to trough.The indices are not far from those depths. Given the facts, it may not be perverse to assign some probability to an even greater decline. However, bear markets rarely reach bottom in such a linear pattern as they are characterized by a series of dramatic selloffs and powerful rallies.It usually takes 18-24 months to complete the cycle which means we might have another 6-12 months remaining.

Indicators suggest that stocks could stage a rally soon.The next upswing could be one to remember, but, if I had to guess, the market will succumb to gravity and eventually rollover to test the lows of the last bear market. Of course our investment strategy will evolve as the facts and circumstances change.

We are in treacherous and seldom traveled territory and making sound investment decisions under these conditions is more art than science.Having avoided the first 42% of this decline should offer some comfort and cushion for Catamount clients. Thank you for your support and patience.

Instead of Monopoly, U.S. Treasury Secretary Henry Paulson and Federal Reserve Chairman, Ben Bernanke should patent a new board game called “Bailout.”

American’s should be concerned about the game of “bailout” being played by the Fed, the U.S. Treasury, and the Lords of High Finance (aka. Wall Street). It is quite evident that big money was pocketed by the Wall Street alchemists who created and perpetuated this artificial bubble in our housing and credit markets. Of course, the Federal Reserve enabled the racket with its massive monetary expansion campaign since the turn of the century.

Now the U.S Treasury, in partnership with the Federal Reserve, has overstepped its boundaries by planning to tap the American taxpayer for the cost of rescuing financial institutions that acted irresponsibly, immorally, and, in many cases, illegally. As a side note, I wonder if the $200 million executive golden parachute packages are included in the $700 billion invoice?

In my opinion, enterprising, hard working Americans have much to lose and little to gain from salvaging greedy financial institutions. The plan may re-capitalize some banks, but it will not bring any lasting relief to American homeowners, consumers, and tax payers. On the contrary, it will shift more wealth from Main Street to Wall Street by privatizing the gains and socializing the losses of the mortgage market. Worse yet, if the plan is approved by the legislature, it will send a message that poor business conduct bears no consequence, and it will encourage more of the same behavior. If our leaders approve this plan, what’s left of our capitalist system could be in serious jeopardy.

Our leaders assume we will approve their profligate spending as long as tax rates don’t escalate. Spending $700 billion without raising taxes would be a grand illusion, but don’t be deceived. The Federal Government doesn’t have to levy higher taxes to extract its pound of flesh. The hidden tax called “inflation” has been our government’s extraction instrument of choice for many years. Our leaders will simply print money for their programs at the expense of your future purchasing power. For politicians, it’s a better solution than raising our taxes. Congressional leaders can continue their unfettered spending without immediate backlash from constituents.

Let’s watch the legislative branch to see if our representatives will be complicit in this scheme by authorizing limitless powers and a blank check to the Federal Reserve and the U.S. Treasury. It will be interesting to find out whether our congressmen and senators will represent us or simply hang us out to dry.

Voice your concerns to your Senators and Congressmen ASAP. For north Texans, Sen. Kaye Bailey Hutchison, Sen. John Cornyn, Rep. Pete Sessions. You can write them online.

By proceeding, I acknowledge that I have read and understood the Disclosure and Copywrite Statements.

I’m sure you’ve been watching the headlines. The news is horrific. Fannie Mae and Freddie Mac, which hold the majority of residential mortgage paper in the United States, had to be rescued and put under conservatorship of the U.S. Treasury. Lehman Brothers, one of the largest U.S. investment banks filed for bankruptcy. The New York Branch of the Federal Reserve extended an emergency $85 billion loan to the nation’s largest insurance company (AIG) to avert a bankruptcy and a worldwide financial meltdown. In other notable news, Merrill Lynch sold to Bank of America to avoid collapse and Washington Mutual is teetering on failure.

Asset prices have been falling across the board including stocks, bonds (except for U.S. Treasuries), commodities, and real estate. The S&P 500 is -27% since its peak on October 11, 2007 and -21% in year-to-date. Until recently, energy was the only industry sector in the S&P 500 posting a gain, but is now -17% for the year after falling 27% since July. The market is now pitching a perfect no hitter to all industry sectors.

On a side note, Catamount clients can sleep soundly knowing that the managed portfolios have held steady. It will be Monday before more precise performance numbers can be reported, but the portfolios are up slightly in 2008 (in the +1-2% range). Catamount portfolios have outperformed the S&P 500 by more than 30% on a trailing 12 month basis.

The conventional wisdom has fervently argued that the emerging markets and other developed international markets would decouple from the problems in the U.S. and continue to fuel global growth and overseas investment opportunities. In my February 2, 2008 comments, I issued a warning to the contrary, stating that the world markets would catch cold if the U.S. economy sneezes. That prediction has come to pass. The broad international stock index, (MSCI EAFE) is -28%, and the emerging market (MSCI EMIF) index is -36% YTD. This is proof positive that the world is extremely interdependent and inextricably linked. The more frightening fact is that the globe is still, for now, exceedingly dependent on the American consumer to import their products. Unfortunately, U.S. consumers, having pursued the illusion of prosperity (aka. “credit”), have buckled under the weight of their debt. The rest of the world is finally beginning to feel the pinch.

Of course, the credit bubble was aided and abetted by the loose credit standards of our banking and financial system. It was compounded by the massive proliferation of credit derivatives that were invented by crack investment bankers to circumvent traditional lending standards and regulations. The unfettered creation of derivatives allowed our financial system to become so over leveraged that it’s difficult to fathom, much less quantify the risks. Under the circumstances, it doesn’t take too many loan defaults to create an avalanche and there are more than enough delinquent loans to go around. Residential foreclosure rates are at record levels and will surely worsen because the problems are not confined to the subprime market. The problems span the entire credit spectrum from subprime to prime, from residential to commercial, and from real estate to industry. Incidentally, much of this bad paper was sold to foreign investors. Now, a full scale deleveraging of the world economy and financial markets is underway.

Many economist and experts are becoming increasingly concerned about inflationary pressures. In my opinion, they’ve missed their bus stop. This inflationary cycle has been in motion since 2003 and is either complete or very near its end. The only remnants of the inflationary cycle have been high commodity prices. Although I’m a believer that the structural bull market in commodities is still intact, it comes as no surprise that commodity prices have succumbed to gravitational pull of a slowing world economy. Oil, natural gas, industrial metals, precious metals, and agricultural commodities have corrected severely and could continue to tumble in coming weeks. These price drops will translate into lower inflation readings in a month or two.

In reality, the forces currently in play appear very ‘D’eflationary. Of particular relevance, the Banks are tightening credit in an attempt to remain solvent. Already more than 100 banks crowd the FDIC’s watch list and some respected experts predict 1,000 banks will close their doors. Any liquidity that the Federal Reserve has bestowed on the banks has been horded to shore up balance sheets and write down non-performing loans. Therefore, the money supply is not being pushed through to businesses and consumers who are credit worthy. A contracting money supply portends deflation in the near term. By the time the deflationary cycle ends , the Federal Reserve will have pumped so many greenbacks into our economy that the next inflationary cycle will begin again in earnest. (Beware future tax payers!) Until then, these undercurrents may be destructive to all asset values.

After the precipitous sell-off in the stock market, I anticipate a respite soon. But any rally should be used to lighten your stock holdings. This is not your garden variety bear market. It will likely get much worse when it resumes. In addition to other absolute return vehicles, Catamount Capital views a larger cash position as a key element of our immediate investment strategy. Individuals and businesses that have stockpiled cash, maintained low debt burdens, and reduced exposure to illiquid assets (i.e. real estate, cyclical businesses, facilities & equipment) have seen their wealth grow as asset prices and consumer prices deflate. In a deflationary cycle, cash gains real purchasing power even if portfolios do not increase in nominal dollar terms. Increasing purchasing power is the essence of wealth creation. When the time is right, we intend to buy assets and businesses at bargain prices - but not yet.

Keep your powder dry and be sure to park cash with a healthy financial institution.