Twelve Month Outlook - Investors May Get "Freight Trained"

Freight Trained - (Rodeo Term) Being run over by an animal that is traveling at top speed.

Investment Conclusion
I believe the equity markets and commodity prices perform reasonably well, albeit volatile, through much of the fourth quarter due to the recent monetary stimulus injected into the world economy. I also believe the significant sovereign debt outstanding results in each round of monetary stimulus having a diminished impact, reducing its impact in both duration and strength. Therefore, I believe there is a risk that investors move back into the market over the next few months chasing the monetary-driven valuation increases, only to become exposed to a significant correction in 2012 once the monetary stimulus diminishes. To put it more colorfully, investors potentially get run-over when a perceived bull run turns on them.

More specifically, I believe the equity and commodity markets peak at some point in the next 2-3 months and then begin to reverse. Without additional significant monetary stimulus in the first half of 2012 I expect the equity and commodity markets to move sideways to down during the first two quarters. Around mid-year I expect a violent correction in the markets due to one or more of the following causes: (1) decelerating growth associated with austerity, (2) accelerating inflation associated with monetary policies, and/or (3) major sovereign debt defaults associated with excessive debt levels. After this correction I expect equity markets to continue downward for an extended period of time before bottoming with the S&P 500 around 700, consistent with my previous views within my Sagflation thesis.

The following are four points supporting my argument that inflationary pressures move the markets over the next few months:

(1) ECB Switches to Monetary Stimulus
The European Central Bank, ECB, cut rates to 25 bps to 1.25% in a "surprise" move. The takeaway, in my mind, is that the ECB is prepared to aggressively stimulate the European economy through rate cuts over the next few months to offset an economy that is slowing due to the debt crisis. This moves likely drives commodity prices higher and possibly stocks higher due to more liquidity in the world financial markets. The change of course also likely weakens the Euro, although the US dollar also likely continues to weaken relative to a basket of foreign currencies due to the Fed's low interest rates and monetary stimulus.

(2) Europe Appeases Markets in Short-term 
My takeaways from the European Greek debt agreement were: (1) Over $1 trillion may be injected into the market, adding inflationary pressures, (2) market activity was perverted, setting an ominous precedent, (3) maybe contagion has been avoided stemming from Greece but what about Italy and other countries, and (4) a short term solution was created that may or may not accomplish its goals, if implemented at all. In short, the agreement pushes these issues into 2012 and likely amplifies their negative impact next year.

(3) The Federal Reserve Remains Expansionary
While the Federal Reserve did not announce any additional quantitative easing programs, it did say it "is prepared to employ its tools to promote a stronger economic recovery." I believe this wording positions the Fed for further quantitative easing. The Federal Reserve also expects to maintain the low interest rates. While the Fed obviously doesn't want to jump into action at the whim of the markets, it appears more focused on driving growth in the economy. My takeaway is that the outlook from the Fed's position is inflationary since they appear to be shifting to more worry about growth than inflationary.

(4) Japan Focused on Healthy Exports
Japan's central bank is focused on weakening the Yen to aid its export-driven economy. The central bank has agreed that the future purchases of financial assets may be warranted, setting the possibility of a sort of quantitative easing in Japan, adding liquidity and inflationary pressures to the world markets. This implies that each of the three major world currencies are implementing an expansionary monetary policy, increasing the likelihood of inflation building in hard assets, like gold, copper and other commodities. It also likely pushes stock valuations higher, until inflation pressures accelerate above 3-4% in the larger developed economies of the world.
 
My current positions I expect to let run until one of the following occurs: (1) the stock price approaches its 52-week high, which for many of my holding represents over 50% upside; (2) the S&P 500 climbs over 1,375; (5) worries about a sovereign nation defaulting begin to dominate the market; (4) inflation concerns begin to dominate market movements in the US; (5) the yield on the 30-year treasury tips above 4.5%; or (6) 1Q of 2012. Once one of these criteria are reached I plan to begin executing my exit strategy. I suspect the market may move up aggressively through much of the fourth quarter as portfolio managers who are under-performing their benchmarks attempt to make-up the difference, but the last week may prove a much more volatile quarter.

Positioned for Stock Market Pullback

As commodity prices continue to pull back, I believe it is more and more likely that we enter a period of deflation since the scales in my previous analysis begin to tip towards price declines. This potentially has a material impact on stock valuations with an outlook of slower earnings growth and smaller PE multiples. It also favors bonds since the real yield on bonds will increase in a deflationary environment.

The length and depth of the deflationary period may be determined by the future actions of the Fed. If the Fed aggressively pursues QE3, then we could see a relatively short and shallow dive into deflation of under a year and less than negative 1% as measured by CPI starting in 2012. If the Fed chooses to let the markets run their course, then the deflationary period could be longer and deeper and stock market compression results in slower consumer spending due to a decline in wealth. Since I do not expect the Fed to voice any opinion on the QE3 for at least a few months, I believe the markets may increasingly factor in deflationary pressure going forward.

The PE multiple of the SP500

Source: http://www.multpl.com/

Borrowing from Schiller, the PE multiple of the SP500 is about 23x, relatively high compared to the mid-teen historical average. As outlined by Ed Easterling of Crestmont Research, during periods of stable prices the PE of the market increases. If, however, either inflation or deflation occur the PE of the market likely declines. See the following chart, which highlights the impact of inflation/ deflation of PE ratios.

Source: Crestmont Research

Under my sagflation thesis, I expect prices to fluctuate between inflation and deflation as fundamental economic forces and an activist monetary policy increase price instability. This implies wild gyrations in the stock market as the discounting of future earnings swings significantly due to changing expectations about future price trends and passes through the PE sweet spot of 0-4% inflation to either 5+% inflation or deflation, which typically result in low teens to single digit PE multiples.

So where is my money? A large weighting towards Treasuries with exposure to consumer staples whose costs likely decline, utilities in the domestic natural gas markets (where prices have remained low), tech companies with good dividend yields and that provide stable cash flow, fertilizer materials for growing food with a high dividend yield, and generic pharmaceutical.

The following is summary:

62% in 30-Year Treasury
6% IBM
5% BWP
5% KMB
4% TNH
4% FGP
4% CALM
3% UTL
2% TEVA
2% CA

December Performance - Up 8.5%

For December the balance increased 8.5%, after all fees and dividends received. The performance exceeded the increase in the SP 500, which increased 6.5%. By the end of the month I moved to a more conservative portfolio with almost 30% in cash. For the quarter the value of my IRA increased 13.4% relative to the 10.3% increase in the SP 500.

The largest position remains the inverse 20+ year Treasury ETF (ticker TBT) at 14%. Commodities also account for a significant portion of the portfolio, with the agricultural market basket (ticker DBA) at over 11% and palladium (ticker PALL) growing to 6%. The geographic positions each account for over 4%, with Matthews China Fund (ticker MCHFX) at 9%, Chile (ticker ECH) at just under 5%, and Hong Kong (ticker EWH) at just over 4%. For individual stocks the largest position is Citigroup (ticker C) at just over 4%. The weightings highlight an on-going belief that debt costs likely continue to rise in the U.S., benefiting banks, and commodities and inexpensive manufacturing likely outperform the market, in general.

Every position but two increased during the month, highlighting the breadth of the market rally during the month. GT Solar (ticker SOLR) bounced back after a weak November, increasing 33% up until I sold the position on December 22. American Axle and Manufacturing (ticker AXL) and MKSI Instruments (ticker MKSI) both increased almost 20%.

My positions focused on China underperformed during the month, which I believe is largely due to concerns about a rising interest rate environment. While a short-term concern, I remain confident these positions should perform well due to healthy trends in the Chinese economy and increasing pressure to allow further appreciation in the yuan relative to the dollar.

After such a strong run in December and spotty U.S. economic indicators (notably housing and unemployment causing concern), I expect somewhat of a pullback in the market in the first half of January. I plan to use this anticipated pullback to re-enter positions at more attractive prices.

		31-Dec	Dec.
Name	Ticker	% Portfolio	Chg
RF MICRO DEVICES INC	RFMD	0.0%	11.3%
KULICKE and SOFFA INDS INC	KLIC	0.0%	12.1%
HUNTSMAN CORP	HUN	0.0%	1.3%
FREEPORT MCMORAN COPPER and GOLD INC.	FCX	0.0%	15.9%
GT SOLAR INTL INC COM	SOLR	0.0%	33.3%
DUOYUAN GLOBAL WATER INC SPONS ADR	DGW	1.4%	2.1%
JEFFERIES GROUP INC NEW	JEF	2.9%	10.3%
CA INC COM	CA	1.8%	6.8%
LYONDELLBASELL INDUSTRIES N V COM CLASS A	LYB	2.6%	17.8%
CHINA GERUI ADVANCED MATERIALS	CHOP	3.5%	5.4%
PERKINELMER INC	PKI	1.9%	10.8%
AMERICAN AXLE and MFTING	AXL	0.0%	19.5%
CITIGROUP	C	4.3%	7.7%
EXCEED COMPANY	EDS	3.1%	(7.8)%
MKS INSTRUMENTS	MKSI	2.8%	20.3%
MULTI SECTOR COMMODITY TR PWR DB AGR	DBA	9.7%	11.2%
ETFS PALLADIUM TR SH BEN INT	PALL	6.0%	14.5%
PROSHARES ULTRASHRT LEH BROS 20+ YR TREAS	TBT	13.9%	6.5%
ISHARES INC MCSI CHILE INVESTABLE MKT INDEX	ECH	4.5%	3.9%
ISHARES INC MSCI HONG KONG INDEX FD	EWH	4.3%	0.2%
MATTHEWS CHINA FUND	MCHFX	9.0%	(2.1)%

November Performance - Up 1.5%

Performance Overview
In November my IRA account balance increased 1.5%, which is after all expenses and fees. The S P 500 was essentially flat. November was a wild ride as the portfolio raced up about 5% in the first half of the month before settling back.

During the month I entered a few more positions, reducing the percentage of cash in the account to about 10%. Domestic equities account for 38%, international equities 23%, commodities 15%, and inverse bond 14%. Within the equity positions, hardware is now the largest position followed by industrial materials. This weighting, coupled with the commodities positions, continues to highlight my opinion that deeper in the economy's supply chain, where I believe inflation is building, is a better place to position investments. In addition, it highlights a large weighting towards international with a large portion of revenue for domestic companies coming from overseas, specifically China and Asia. This weighting reflects my view that inflation, in the form of asset prices, likely continues to grow in this region for the foreseeable future. It also reflects my view that the yuan likely appreciates against the dollar as the Chinese government is forced to loosen the exchange rate in order to lessen inflationary pressures.

The largest drivers of growth in the account came from American Axle and Mfting (ticker: AXL), Kulicke and Soffa (ticker: KLIC), Huntsman (ticker: HUN) and ETFS Palladium (ticker: PALL). Each are positions greater than 4% and were up 11%, 11%, 12% and 8%, respectively. The reasons for the increases in AXL and KLIC, in my view, include relatively low expectations coupled with a brightening fundamental outlook. For AXL it appears as though car and truck sales have stabilized and 2011 should provide modest growth within the U.S. and international markets remain bullish. For KLIC the business is quite volatile but the U.S. economy continues to improve and the secular driver of the adoption of more copper components should drive business in 2011. For PALL the improving U.S. economy and robust growth in Asia is driving demand for Palladium.

The worst performances came from GT Solar (ticker: SOLR), MKS Instruments (ticker: MKSI), and China Gerui Adv Materials (ticker: CHOP), which were down 19%, 6% and 4% respectively. GT Solar has suffered from estimate cuts as analysts have fretted over supply growth outpacing demand, especially as government subsidies for solar likely come under pressure. I don't argue against the possible weakening of fundamentals as supply increases, however I believe the demand may prove more robust than expected and a weakening dollar should help the company. SOLR is trading under 6x the lowered consensus EPS estimate for C2011, suggesting a healthy risk/reward. MKSI is trading under 8x the consensus calendar C11EPS estimate, and thus my belief that the economy is improving should prove this valuation conservative. I do expect CHOP to begin to move upward, at the latest, when either production comes on-line mid-2011 or investors' risk appetite increases.

Proshares Ultrashort 20+ Yr Treasuries (ticker: TBT) has moved sideways during the quarter. An interesting tug-of-war is occurring in which Fed Treasury purchases, European contagion fears, and political unrest on the Korean peninsula are raising prices. Alternatively, healthy holiday demand trends thus far by U.S. consumers and rising inflationary concerns in Asia and in the U.S. are pushing prices down. I see the forces pushing the prices up and yields down as temporary in nature, and therefore I expect TBT to perform quite well during 2011.

Summary
The following is a summary of my positions and their performance during November:

Name	Ticker	% Portfolio	Chg
RF MICRO DEVICES INC	RFMD	2.1%	(3.8)%
KULICKE and SOFFA INDS INC	KLIC	4.4%	10.8%
HUNTSMAN CORP	HUN	4.8%	11.7%
FREEPORT MCMORAN COPPER and GOLD INC.	FCX	4.1%	6.9%
GT SOLAR INTL INC COM	SOLR	3.4%	(18.9)%
DUOYUAN GLOBAL WATER INC SPONS ADR	DGW	1.5%	0.0%
JEFFERIES GROUP INC NEW	JEF	2.9%	0.9%
CA INC COM	CA	1.9%	(1.3)%
LYONDELLBASELL INDUSTRIES N V COM CLASS A	LYB	2.4%	8.7%
CHINA GERUI ADVANCED MATERIALS	CHOP	3.6%	(4.3)%
PERKINELMER INC	PKI	1.9%	(0.6)%
AMERICAN AXLE and MFTING	AXL	6.6%	10.9%
MKS INSTRUMENTS	MKSI	2.5%	(5.9)%
MULTI SECTOR COMMODITY TR PWR DB AGR	DBA	9.5%	(2.1)%
ETFS PALLADIUM TR SH BEN INT	PALL	5.6%	8.1%
PROSHARES ULTRASHRT LEH BROS 20+ YR TREAS	TBT	14.3%	2.3%
ISHARES INC MCSI CHILE INVESTABLE MKT INDEX	ECH	4.7%	1.0%
ISHARES INC MSCI HONG KONG INDEX FD	EWH	4.6%	0.9%
MATTHEWS CHINA FUND	MCHFX	10.0%	0.5%

A Couple Positions Placed on Emerging Turnarounds

Bought ~2% position in Computer Associates, ticker CA, at $22.94.

Bought CA primarily for the changes made in the business over the past year, which includes new management and acquisitions in the cloud computing sector. Generally, this is how I like to invest by identifying companies making good investments in their business that should lead to improving returns. Stock trades around 11x 2011 non-GAAP EPS consensus estimate, slightly lower than IBM and Oracle. While the company is by no means a pure play cloud computing company (legacy mainframe business provides stable and substantial amount of cash flow), and it has significant hurdles to migrate its business in this direction, more cloud-oriented software companies like Salesforce.com (Ticker: CRM), Amazon.com (Ticker: AMZN), and Concur (Ticker: CNQR) trade north of 40x 2011 EPs estimates. So I realize it has been "dead money" for years, but I expect the business to gradually look better over the next few years, offering accelerating EPS growth and possible multiple expansion.


Bought ~2% position in A shares of LyondellBasell, ticker LYB, at $28.00.

Complex business analyze due to its breadth, recent emergence from bankruptcy court and recent listing on the NYSE. However, it boils down to this: the company has pricing power, should benefit from a weakening dollar (although difficult to pin-down due to hedging activity), and it fits in my macro strategy of investing deep in the supply chain where inflation is most likely to emerge first. As time rolls forward the business trends should become clearer and analysts should pick up coverage, providing greater clarity for investors.

The stock trades at an EV /TTM Sales of about 0.7x, comparable to other chemical companies like DOW, GRA, and ASH.

LyondellBasell plans to release the results for the September quarter before the market open on Friday October 29.

LyondellBasell participates in the entire petrochemical value chain, from refining to specialized petrochemical product end uses. They are the largest producer of polypropylene and polypropylene compounds; a leading producer of propylene oxide, polyethylene, ethylene and propylene; a global leader in polyolefins technology; and a producer of refined products, including biofuels. Additionally, LyondellBasell is a leading provider of technology licenses and a supplier of catalysts for polyolefin production. To learn more about their business please look through recent presentations.