Y H& C December Newsletter

Y H & C Monthly Newsletter- December 2009 Edition #19

US Economic & Financial Markets Outlook: The End of 2009 Approaches, All
Kinds of Extremes Are Noticeable, and What to Look for In 2010.
First, I hope everybody had a great Thanksgiving and had a nice time with their friends
and family. November of 2009 was a good month for the U.S. equity markets as the Dow Jones
Industrial Average gained 3.09%, the S & P 500 added 5.74%, and the NASDAQ market
increased 4.86%. In my opinion, the most interesting development in the financial markets has
been the continued weakness of the U.S. dollar against any major currency, and in conjunction
with dollar developments, the sustained rise of the price of gold to almost $1200 per ounce.
Over the last two weeks of November, at one point gold was up 8 days in a row. The dollar hit
an all time low against the yen (85 yen/dollar), and has weakened against both the Euro and the
Pound.
The end of the year can always be relied upon to bring extreme situations as some
underperforming money managers can be counted on to pile into anything that has worked for
the rest of the year, including specific trades, stocks, indexes, or currencies (or any
combination) that have outperformed a benchmark or the broader markets in general.
Depending on the specific situation, asset managers who have good performance will tend to be
very conservative as the year ends as the year has been good and it makes no sense to take large
chances now. Still, the developments of the dollar and gold show that extreme situations often
take place at the end of the year. A couple of other “noticeable” asset prices include the current
low 30 year mortgage rate of 4.97%, the extremely low U.S. Treasury bond yields of .68% for
the 2 year, 3.20% for the 10 year, and 4.20% for the 30 year. There are certainly a few stocks I
believe are extremely overbought, one in particular would be Amazon.com (forward P/E ratio of
53, trailing P/E ratio of 78, Price/Book value of 16). The most applicable word for this kind of
behavior is “lemmings” as the imitators can be counted on to join the bandwagon, no matter
what the price.
Now that we have looked at a few extremes to end 2009, I think the most pertinent
question investors should ask themselves is “What is going to transpire for the U.S. economy
and financial markets in 2010? With respect to the economy, I think at some point one has to
believe all the stimulus money the government has allocated towards reviving the economy
($700 billion) has to have some positive affect (many would argue that point). There are a few
statistics that may seem to indicate the economy is slowly healing. First, the most recent quarter
of GDP came in at a revised positive 2.8%. Second, weekly initial unemployment claims fell
below 500 thousand for the first time in many months. Many corporations have reported decent
quarterly financial profits, due mainly to cost cutting. I believe 2010 should see the economy
slowly continue to gradually improve, with the caveat that no large financial institution can
have a “Lehman” type situation. Naturally, low and behold, as I speak one has possibly taken
place.
As I write this newsletter, many financial analysts are worried about the Dubai debt
situation and its ripple effects on the global economic climate. If the economy continues to
slowly improve, one market you can count on to change will be the bond market. As
confidence improves, bond yields will go up, my guess in around June or July of 2010. Just as
significant will be to look at the unemployment numbers to get a good reading on whether or
not the economy is creating or losing jobs. I think if the country in general do not see the
employment picture starting to improve by the summer of 2010, there will be a huge change in
Congress during the mid term elections. Just a caveat, forecasting the economy or stock prices
is, in my opinion, a waste of time. I refer to the following quote by Warren Buffett, “We
believe that short term forecasts of stock or bond prices are useless. The forecasts may tell you
a great deal about the forecaster; they tell you nothing about the future.” (Warren Buffett,
Berkshire Hathaway Annual Report, 1980)
So, what does all of this mean for the future, especially in the stock market? One thing I
know is the only constant is change, and with changing circumstances comes opportunity. The
change may take very slowly or with remarkable speed, but as in 2009, 2010 will present many
investment opportunities for investors who do their homework and focus on situations that most
investors would not even consider.
Global Economic & Financial Markets Outlook: With One Month Left in
the Year, Global Stock Markets Rebound Strongly
With one month left in 2009, Global stock markets have rebounded impressively from
the disaster of 2008. Let’s look at the global indexes to get some indication of how strong the
bounce has been. The World Index including the United States is up an impressive 33.34%.
Interestingly enough, the same index which does not include the U.S is up 41.25%, which
shows the U.S. market underperformed relative to the rest of the world.
The continent where the most outperformance took place is in Asia. Take a look at
some of these results: Hong Kong +56.2%, Indonesia +116.9%, South Korea +48.7%, Taiwan
+65.2%, Thailand +58%, Australia +61.5%, Philippines +66.45%, and Singapore +66.06%.
These numbers are staggering in the extent of the gains, and it shows the volatility that is
inherent in emerging markets. Volatility in an index or stock is your friend if you are sharp
eyed and focus on what you want. Indeed, if you were concentrating on an opportunity to buy
into Asia, the end of 2008 and the beginning of 2009 would have been a great entry point.
The region where many investors have kind of neglected because they don’t have a
BRIC country included (Brazil, Russia, India, China) is Western Europe. Interestingly enough,
the performance there has been pretty strong. Spain, a country with almost 20%
unemployment, has an equity market +37%, which might say something about how much
unemployment and stock market performance is correlated. Norway is +90.00%, and
Switzerland is +67%, again showing great returns were possible almost anywhere in the world.
Another interesting fact is France was +26.78%, and Germany +23%, and compared to the U.S
still outperformed our major indexes.
My observation to sum it all up is that 2009 started out with most investors scared to
death about investing anywhere. Those that risked their capital in the first three months of 2009
have been rewarded, in general, with great returns, showing once again a great time to invest is
when the world is screaming to put your money under a mattress. You could make the case that
the world is awash in liquidity and ultimately the world will pay for this with inflationary
pressure down the road. At this point, however, compared to the end of 2008, investors can live
with the current situation far better.
The Psychology of Investing: John Paulson: A Great Example of Conviction and
Trying to Make 82X on Your Money.
I want to share with you a bit of information I gleaned from reading about John Paulson.
John Paulson is a hedge fund manager who shorted anything housing related from early 2005-
2008.
‘The two Paulson credit hedge funds invested a total of $1.2 billion of cash and racked
up nearly $10 billion of gains all in two remarkable years. Paulson’s other funds enjoyed about
$10 billion of their own gains, all from obscure protection on mortgages most experts said
would never get into trouble.’ (The Greatest Trade Ever, Pg 262, Greg Zuckerman, Broadway
Books.)
One of the key takeaways from the book is that if an investor is trying to build a big
position, there are going to be people on the opposite side of those trades, and many times each
side believes they have the correct position. In Mr. Paulson’s case, he built huge positions that
many investment banks on Wall Street sold him. In fact they could have easily discouraged him
when the positions did not initially go his way.
‘When the ABX index tracking subprime mortgages were introduced in July 2006,
Paulson’s team immediately bought CDS protection on that too…. At first, traders were happy
to sell CDS insurance to Paulson, thrilled at the mounting commissions. By selling Paulson
mortgage protection, they also could create product for bullish investment vehicles to buy. At
Morgan Stanley, a trader hung up the phone after yet another Paulson order and turned to a
colleague in disbelief.
‘“This guy is nuts, he said with a chuckle, amazed that Paulson was agreeing to make so
many annual insurance payments.’ “He’s just going to pay it all out?” Soon, however the
traders began to wonder when all the buying would stop. The more CDS insurance they sold
Paulson, the more they were on the hook to find bullish investors willing to take the other side
of the transactions. Some worried that they might be stuck with Paulson’s trades if they
couldn’t find enough investors to take the contracts off their hands, a dangerous position if
housing crumbled.’ (The Greatest Trade Ever, Pg 154, Greg Zuckerman, Broadway Books.)
The traders ultimately had very good reason to be concerned, it turns out. In fact, the
top CDS trader from Goldman Sachs (Josh Birnbaum) stopped by Paulson’s office to ask how
much protection Paulson ultimately wanted to buy.
‘If you want to keep selling, I’ll keep buying,’ he said. ‘We have a few clients
who will take the other side of your trades. And I’ll join them.’ Birnbaum was trying to tell
Paulson he was making a big mistake. Not only were Birnbaum’s clients eager to wager against
him, but Birnbaum was too. Paulson seemed unmoved. “Keep buying, Brad (his head trader).”
(The Greatest Trade Ever, Pg 154-155, Greg Zuckerman, Broadway Books.)
I also wanted to quickly include a personal experience. A long time ago I used to own
the stock of Diedrich Coffee (DDRX- I sold it about 7 or 8 years ago so don’t think I made a
killing on this one, I tried to though). It is a small company located in Irvine, CA that used to
own coffee shops in Orange County, CA, but moved into the wholesale coffee business.
Anyway, I owned the stock for about 5 years and in that time the company was never profitable,
and the stock sold for anywhere from 1 buck to 3 bucks. Earlier this year, during the huge
downturn, the stock sold for 39 cents. Last week, the company entertained buyout offers from
Peete’s Coffee and Green Mountain Coffee Roasters for, you will not believe, 32 dollars a
share. If you would have bought at the bottom, and no one ever does, that would be 82X your
money. The next time people discount the stock market, try and remember that. Ok, thanks for
reading this month and as always, if you have any comments, questions, or concerns, or you
would like to discuss your personal investment situation, please email me at info@y-hc.com.

As always, on any company mentioned here, past performance is not a guarantee of future returns. One should research any investment and make sure it is suitable with your objectives, risk tolerance, risk profile liquidity considerations, tax situation, and anything else pertinent to your financial situation. Also, the CFA credential in no way implies investment returns will be superior for any charterholder.

Yale Bock, CFA
President, Y H & C Investments