Downside Risk for Bond Investor

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Gnostam LLC PO Box 960 Inverness, CA 94937

March 13th, 2011 Newsletter

Independent Investment Advisor

DANGERS FROM THE US BOND MARKET: Bill Gross the largest Bond Fund Manager in the world announced this week that Pimco, manager of the Bond total return fund had sold his entire holding of US Government Bonds. This is big news. As can be seen from Figure 1 below, the rate of increase pf US Debt as a % of GDP is on the sharpest increase since

1941 when the US started its massive WWII spending. In nominal terms the average interest rate for US government bonds for the period from 1790 to date is around 6%. Today we have rate around 3.40% for the 10 year and Fed Funds at 0.25%. This is clearly an unsustainably low rate of interest and clearly this is Bill Gross’ motivation for the sale of his massive position in US government debt. [Continued on Page 3] Although the US

Figure 1. US Government Debt as % GDP 1792 to 2010. Source: US office of management and budget.

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Gnostam LLC performance Graphs

Gnostam was established in February 2004. Since inception the annualized rate for return for a client portfolio managed by Gnostam LLC has returned a total 9.56%. For the period from January 2007 to date, the managed portfolio has returned an average of 1.53% vs. -‐2.55% of the S&P 500. Please see table below.

Chart 1 Gnostam Performance

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Government inflation statistics show that inflation is tame, the exclude almost

every item that has gone up in price, such as energy, all foods, such as wheat and corn

Chart 2. US Interest rates cycles

Fig 3. US Inflation rate Jan 1990-‐Jan 2011

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Portfolio Changes and Recommendations for February 15th 2011

2011 will be a difficult year for investors. Too much money has come into the market, especially money that chases returns, such as mutual find money. There is almost no chance in my mind that the market will go much higher than it is at the moment. I would sell most stocks that are financial and related to housing, and retail. Instead, buy rare metal miners, gas pipelines and gas producers. Once the value of solar stocks has come down, they may be a place to look. Gas pipeline strong buys are as follows: Kinder Morgan, [KMI] El Paso, [EP] Williams Partners, [WPZ] Plains All America, [PAA] Most of these will be subject to consolidation in my view. I would add the following utility, UGI, which is a liquefied natural gas play. In genomic equipment and services, Life technologies, [LIFE] while expensive has an almost unique exposure to the high quality earnings from genomic research and genomic tools. If I were a Pfizer, this is the type of company I would want to acquire. Semiconductor Equipment has great potential for producing superior returns in the first quarter of 2011.

The following is a table of our best buys:

• Photronics [PLAB] 12.2 x multiple;

• Kulike & Soffa [KLIC] 11.9 multiple;

• Cambrex [CBM] 8.9 multiple; In Oil and Gas exploration, valuations of the deep-sea drillers [<4,000 feet] are attractive. With the new Petrobras find, there has been a re-deployment from the GoM to the deep offshore drilling areas off the coast of Brazil, and rates are expected to climb by 11% in 2011. Best choices are:

• Helix Energy, [HLX] 12.7 x multiple;

• Diamond Offshore [DO] 11.33 x multiple;

Solar Plays that may be of interest: LDK SOLAR, [LDK] $14.45 MEMC [WFR] is a buy FSLR is a short.

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have been rising consistently and are one of the reasons for the revolts in the Arab world. The real shock to bond investors will come

when they realize that there are fewer and fewer buyers of US Government bonds. The Japanese will probably have to sell some positions following the terrible Tsunami/Earthquake. The Chinese have

been grumbling for years about the failure of the US Government to provide for a stable currency. Most bond investors who have bought US Treasuries from abroad have been loosing their shirts in a total

return basis, if their base currency is the Euro or say the Ozzie $. In fact the only real buyer of Treasuries in size is the US Government and the Fed.

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WHY A RISING BOND YIELD MATTERS. Consider this scenario. The US Treasury and the Fed buy entire portfolio’s of junk or underwater assets of banks in 2008-2009. This is because the banks are unable to finance these portfolio’s in short term money market’s as the money market does not believe banks are solvent. Not to mention the impact on the cost to service US Government debt at higher rates. For over 2 years large US banks [Bof A, Citibank et al] have been recapitalized by a massive subsidy from the US taxpayer. The banks can borrow at 0.25% and re-invest in Treasuries at 3.5%. As there are only 2 ways to make money in bonds, [interest rate risk or credit risk] the US government is subsidizing the banks “interest rate risk”. There is no interest rate risk for the banks as long as Ben Bernanke artificially guarantees access to 0.25% Fed Funds rates, a 3.25% unleveraged spread, which once leveraged the customary 10-20 times is a >32.5%. No wonder banks are making money. And they are paying senior bank employees great bonuses, while banks shareholders have lost 1.5% on aggregate over 5 years. In essence the banks have survived with the value destroying capabilities intact. All this time banks have not lent. They have loaded up their balance sheet with US Government debt and earned from the spread between short term an long term Government debt rates. The banks in essence have privatized their losses, [we the taxpayers own those] at the very time when we should be spending our way out of the recession. That and absurdly high entitlement spending make holding US Government debt unattractive. Remember US Government debt is the benchmark upon which all other debt is

priced. This game cannot continue for ever. Something has to give, Either:

1. Short term rates will rise regardless of the Fed, or bond investors will no longer accept a 3.4% return for holding long term, debt, given that the US $ has devalued 3% in one year relative to the Euro;

2. Or inflation will accelerate and destroy the value of US government debt.

It seems that Bill Gross is not waiting around for option 2. What happens if 5-30 year rates as it seems will rise to a “normal” 4.5%-7% range?

1. The banks will be in terrible shape. The value of their “long” dated financial assets will implode by 20-25%. The cost of funding these positions will rise, making it necessary to sell bonds into a down market;

2. The banks will be too big to fail yet again, and the Fed will have to bail them out again;

3. Our Asian investors will finally throw in the towel on US Government debt;

4. All debt will loose value; 5. Bond funds will begin to unwind; 6. Pressure will be put on money

market funds again as funds flow into these as only safe haven, only to flow out just as fast once the opportunity cost of holding 0% balances is taken account of.

So I would urge you to do what Bill Gross has already done.

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Sell your bonds. It may be your last chance to do so without losing your shirt. Resist the urge to buy Muni Bond funds. They will underperform, and you will lose money on them as they face redemptions and are forced to sell into the worst Muni market in 50 years. What to do if you are a Euro Investor? The $ has taken a real beating. And the Treasury never speaks of the need for a strong currency any longer.

The supply of dollars is conspicuously on the rise. With interest rates at close to zero in the U.S. since the financial crisis of 2008, and the Federal Reserve Board no longer able to lift the economy by lowering interest rates, the government has turned to "printing money," boosting the money supply through quantitative easings. The most recent, involving purchases of up to $600 billion of Treasury bonds, is expected to run through June.

Given the concern that Treasury rates now have almost nowhere to go but up, which would reduce the value of bonds, money has been flowing to those economies with higher growth rates than the U.S., such as China and Brazil, but whose interest rates are comparatively low because they are linked to those of the U.S. That's led to a boom in borrowing and spending, and investing in

nonfinancial assets—all the commodities that are in big demand to keep these economies humming. China, in particular, has been buying up hard assets worldwide, often instead of dollar-denominated investments.

As long as monetary policies remain linked to the U.S., inflation pressures will only intensify in emerging markets. Emerging countries will be left with no choice but to adopt independent monetary policies and revalue their currencies, or risk social chaos. Such a move is politically sensitive; although it will increase the purchasing power of their constituents, it will cut into business exports. Likewise, if a decoupling of exchange rates comes to pass, U.S. consumers can expect to see the value of their money depreciate, and U.S. companies can expect exports to rise.

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A similar scenario is being played out in Europe, where Germany's economy has been vibrant and inflation is a threat, while Spain, in particular, as well as Ireland and Portugal and Greece are mired in debt and depressed economies—yet all are tied to the same currency and interest-rate policies. SWISS FRANC AS A SAFE HAVEN: This has clearly been the winning currency in terms of safe haven. As can be seen from the chart below, this is the place to hold your cash if you want it to hold its value. $ TO LOOSE RESERVE STATUS?

Barry Eichengreen, a professor of economics and political science at University of California at Berkeley, penned an opinion piece in The Wall Street Journal predicting that the dollar's reign as the dominant world

currency will end in the next 10 years. The greenback, he says, is likely to share the throne with the renminbi and the euro. He sees the dollar eventually dropping 20% in order to make U.S. goods more appealing for export.

Barron's Randall W. Forsyth began predicting the end of the dollar's hegemony in December.

Reflecting the growing pessimism, short positions in the dollar, or bets against it, on the International Monetary Market currency-futures exchange reached the highest level ever during the first week of March, reaching some $41.5 billion and exceeding the previous record of $38 billion in November 2007, according to Nomura Securities. The short position is broad-based, but it appears to be biggest against the Canadian dollar, the Australian dollar, the Swiss franc and the Japanese yen.

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It's getting easier for individuals to take their own dollar positions. It can be as simple as buying stock in big multinational companies found in the Standard & Poor's 500; they derive ever-increasing portions of their profits from overseas sources, which gives them a natural hedge. Coca-Cola (ticker: KO), IBM (IBM) and ExxonMobil (XOM) are prime examples.

Alternatively, any number of online brokerage firms, including TD Ameritrade's thinkorswim platform, make sophisticated software tools and automated trading available. Foreign-exchange specialists FXCM (FXCM) and Gain Capital (GCAP) each came public within the past few months, taking advantage of the heightened interest in currency trading. Another, Utah-based Interbank FX, says it is watching its competitors' experiences closely and considering its own initial public offering.

Certificates of deposit in euros and other nondollar-denominated world currencies are also available. EverBank, a Jacksonville, Fla., consumer bank, offers such a service through its Brentwood, Mo.-based world-markets division.

One of the most effective approaches is to pick a good exchange-traded fund, the same strategy many investors are following for gold. ETFs based on currencies and currency strategies have flooded the market, especially in the past few years, as demand has heated up. The assets of the these funds now total $6.3 billion, approaching the level of the red-hot energy ETFs.

Rydex SGI launched the first currency exchange-traded fund in 2005, the CurrencyShares Euro Trust, which is essentially a euro-denominated money-market fund. Since then, Barclays iPath, Invesco Powershares, WisdomTree and

Van Eck Global's MarketVectors have all entered the fray, with nearly 40 funds now available to investors to pursue strategies as simple as hedging a portfolio or as sophisticated as predicting a currency's direction, based on technical analysis.

Pimco's Gross recommends ETFs tied to currencies of faster-growing emerging markets, such as China and other Asian countries, plus Brazil and even Canada and Mexico.

WisdomTree Dreyfus Emerging Currency Fund (CEW), at nearly $400 million in assets, is a popular, actively managed offering that invests in eight to 12 emerging-markets currencies in equal proportions, using derivatives such as swaps. The fund is invested currently in Mexico, Brazil, Chile, Poland, Israel, Turkey, South Africa, China, India, South Korea, Taiwan and Malaysia. It had a 6% total return for the past 12 months.

BY FAR, THE BIGGEST OF THE currency ETFs is the PowerShares DB U.S. Dollar Index Bullish (UUP), with $873 million in assets. There's also a bearish version of that fund, but this isn't necessarily the way to hedge against a falling dollar. An advantage of ETFs is that they can be shorted, and research conducted by Ned Davis Research suggests that long-term investors could do as well, if not better, by shorting the bullish fund than by investing in the bearish fund, owing to complications related to daily rebalancing and compounding.

There are also less popular exchange-traded notes linked to currencies. ETNs are more like bonds, in that they pay no interest but carry a guarantee that the issuer will make a cash payment at maturity equal to the return of an

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underlying index. However, exchange-traded notes carry credit risk; they are treated as unsecured debt of the firm that issues them.

No one's recommending that the average investor start actively trading in foreign exchange, but to maintain a competitive rate of return on investments, and to assure a standard

of living that is competitive with the rest of the world, U.S. investors must become better acquainted with the relative values of global currencies as a matter of course—and not just when planning vacations abroad. A truly diversified portfolio will now also need to hold some currencies.

Some of America's more savvy corporate titans have gotten a jump on the coming shifts in the structure of the currency market. In the past six months, and for the first time, Caterpillar (CAT) and McDonald's (MCD) have received approval from the Chinese government to issue bonds in Hong Kong based on the Chinese renminbi—so-called "dim sum" bonds—to finance their business projects in China. The moves save the companies the expense of converting bonds issued in dollars into renminbi.

CHINA, NOW THE WORLD'S second-largest economy behind the U.S., went even further in mid-January when its 70%-government-controlled Bank of China began allowing individual and corporate accounts to buy and sell renminbi at its New York and Los Angeles branches.

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Gnostam LLC 5731 Kirkwood Place N Seattle, WA 98103 USA E-‐mail: [email protected] www.gnostam.com

Disclaimer:

The information and any statistical data contained herein have been obtained from sources which we believe to be reliable, but we do not represent that they are accurate or complete, and they should not be relied upon as such. All opinions expressed and data provided herein are subject to change without notice. Gnostam LLC and/or its shareholders, directors, officers and/or employees, may have long or short positions or deal as principal in the securities discussed herein, related securities or in options, futures or other derivative instruments based thereon. The securities mentioned in this report may not be suitable for all types of investors. ALL investments involve different degrees of risk. You should be aware of your risk tolerance level and financial situations at all times. Furthermore, you should read all transaction confirmations, monthly, and year-end statements. Read any and all prospectuses carefully before making any investment decisions. You are free at all times to accept or reject all investment recommendations made by the Gnostam LLC. As you know, a recommendation, which you are free to accept or reject, is not a guarantee for the successful performance of an investment and we are expressly prohibited from guaranteeing accounts against losses arising from market conditions.

Past performance is no guarantee of future results, and current performance may be lower or higher than the performance data quoted.

Investment Disclaimer All investments involve different degrees of risk. You should be aware of your risk tolerance level and financial situations at all times. Furthermore, you should read all transaction confirmations, monthly, and year-end statements. Read any and all prospectuses carefully before making any investment decisions. You are free at all times to accept or reject all investment recommendations made. All products sold are subject to market risk and may result in the entire loss to the client's investment. (For example: excessive withdrawals may result in the depletion of your account). Please understand that any losses are attributed to market forces beyond the control or prediction of Gnostam LLC. As you know, a recommendation, which you are free to accept or reject, is not a guarantee for the successful performance of an investment and we are expressly prohibited from guaranteeing accounts

Individuals are limited to trading the equivalent of $4,000 renminbi a day and $20,000 a year, but it's another step toward putting the renminbi in a league with the dollar, yen and euro.

The foreign-exchange market is far too big for investors to ignore, and it's only getting bigger. By some estimates, its trading

volume is already eight times as large as that of the world's stock markets. All those folks who spent much of the past decade buying emerging-market stocks might now do well to consider those countries' currencies.

Downside Risk for Bond Investor

Economy & Finance

Transcript of Downside Risk for Bond Investor