THE MKC GLOBAL REPORT

MANAGER’S COMMENTARY
April 2010
The market does not beat them. They beat themselves, because though they have
brains they cannot sit tight. - Jesse Livermore

As stocks pulled back in January, many investors began to question the sustainability of the asset rally. If
January’s decline was indeed just a pause, how much higher could the markets take us? After all, stocks pulled back
nearly 10% in January, energy prices have largely remained in a trading range since last October, U.S. Treasury
markets have done nothing and some “soft” commodities like sugar and cocoa have reversed course.

Since January’s lows, stocks and many other markets suggest that existing trends will continue for the next
couple of months. The internal strength of the stock market is admirable. The breadth continues to improve, with
multi-decade highs on the advance decline line, a measure of the number of advancing stocks versus declining
ones. Also, energy markets, particularly gasoline prices look ready to breakout to higher levels as do metals such as
copper and gold.

Although it looks like assets can continue to appreciate for another couple of months, this is not a decade
for buy and hold. Looking back at only cyclical bull markets within secular bear markets from the Dow Jones and
Japan’s Nikkei 225 show an interesting perspective on the current situation. The Nikkei was included in this
analysis as their market environment shares strong similarities with ours (quantitative easing, low interest rates
and asset deflation). Over the last 80 years, the average gain in this style environment is about 58% over a period
of about 14.5 months (71% and 17.5 if calculating only the Dow). This places the current rally in the 85th percentile
of all cyclical bull markets in terms of magnitude and about the 50th percentile in terms of duration. Keeping a close
eye on your portfolio and resisting new positions seems prudent at this stage. Within a secular bear market, the
end of a cyclical bull market will be followed by a cyclical bear. These cyclical bear markets tend to be shorter and
less dramatic, averaging about -37% and lasting just over 11 months. Although not as large as their bull market
cousins, it still is not an event one should ride out, if avoidable. Below is a different view of current market
valuations from a PE standpoint, courtesy of Société Générale’s Dylan Grice.

Of all the sectors, the grains seem poised to move the most, and that is to the downside. A popular trade
over the last few months has been to buy grains, like corn and soybeans, due to depressed prices (down 60% from
’08 highs) and record low food inventories around the world. I take issue with both points. First, in my view of
markets, weakness begets weakness and strength, strength. To step in and be a buyer of grains, sector wide price
stability and at least a hint of price appreciation must exist. Until that time, the MKC Global Fund will be short or
absent the market all together. Second, the fact that the world faces low food inventories is interesting but not

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necessarily helpful. Often the fundamentals for a market can argue for a price level very different than the one at
hand. For example, the Financial Times published an article last August explaining the case for lower aluminum
prices due to massive over supplies. Prices moved higher by almost 25% after the article. The fundamentals don’t
always immediately impact market prices, and often prices can react counter-intuitively. Record low food
inventories suggest tight supply and impending price appreciation. Unfortunately, prices have not rallied at all and
instead seem to be gunning for their 2009 lows. The grain markets made incredible runs into 2008, setting all time
price records. Why can’t their prices drop another 25%?

The “soft” commodities include: sugar, cocoa, coffee, cotton, frozen concentrated orange juice, lumber and
rubber. They are vital markets for a portfolio manager as they typically correlate very little to other markets,
providing genuine opportunities to diversify. Throughout 2009 the sector as a whole rallied unanimously. Now,
that consistency is beginning to fray as sugar and cocoa prices have pulled back dramatically. Part of this certainly
can be attributed to a stronger dollar, but to a larger degree it could be a function of investors and traders
beginning to veer away from risky assets. Not many markets are more volatile than orange juice, where prices can
trade up or down 7% in one day.

This transition out of risk could easily be a central theme in the latter half of 2010. As one of my favorite
fund managers, Hugh Hendry explained perfectly:

“… [The markets are] all one trade, there’s no diversification. You’re either in the market or you’re not…If
you find an environment where you can’t diversify, if you find an environment where you have to share the trade
with everyone then the risk is that at an inopportune moment where you might have to exit that trade you find that
everyone is joining you. So, that would be a moment where your capital is in jeopardy.”

January’s decline was the first taste of this risk aversion and liquidation. Often, a market will give
participants multiple exit opportunities. The early ones (like December 2009) are utilized by conservative
institutional organizations and value funds. Aggressive traders look to exit later as the market rally continues and
reaches its momentum high (or low). After this point, conditions become increasingly dangerous and adverse price
action punishes those still involved.

The current market environment is becoming increasingly inconsistent as commodities and stocks begin to
erode their high correlations. If the price action of the last few months is any indication, it looks as if commodities
will stall and decline before equities. As stocks rallied into March making new highs, many commodities struggled.
Commodities in general, but particularly grains, could give the best and earliest entry into a profitable short trade.
The economic fundamentals support this thesis as we find ourselves in a deflationary environment with inflation
seeming to be a remote possibility for some time.

Hopefully, it has been made clear through past commentaries that the MKC Global Fund will not initiate a
position based on any projections or personal opinions. Instead, we follow market prices, letting them show which
direction they want to move. If I forecast, it’s simply an intellectual pursuit. Surfing works the best when one
effortlessly rides the waves toward the shore rather than fighting their natural direction and somehow trying to
ride them out to sea. The same philosophy applies to trading.

Lastly, the misconceptions about interest rates and U.S. Treasuries continue to plague investors. Included is
an article I wrote addressing this market and the dangers of assuming interest rates will rise too soon or
prematurely shorting U.S. Treasuries (or European and Japanese government bonds). This should be a convincing
alternative view.

Shorting U.S. Treasuries, a Historic Sucker Bet

If forced into a career other than one in finance, researching investor psychology and groupthink would be
of great interest. The thought process for an individual during an investment is complex. The number of emotions
combined with the financial stakes creates a decision-making process worth studying.

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 At times, investors can show a remarkable tendency towards herd mentality. This is clearly evident in
several historical markets and since then mainstream investors have tried to capitalize on this behavior via the
popular “contrarian” strategy in investing. Most people feel instinctively drawn to an established opinion, the
consensus. People enjoy positive feedback and the feeling of being validated by the majority who share a similar
opinion. This phenomenon has been well documented and can be seen throughout investment history: The South
Sea Bubble, Tulip Bulb Mania, railroad stocks, gold in 1979, the Tech Bubble, residential real estate, etc. These are
prime examples of investment groupthink. To a lesser extent, this same mentality occurs outside periods of
incredible asset appreciation as well and it is particularly evident right now in regard to the public’s perception of
the United States Treasury market.

The immensely popular investment idea, namely to short U.S. Treasuries, may be the largest sucker bet in
many, many years. Instead, buying longer duration government bonds (U.S, European or Japanese) before the final
stage of an epic 30 year bull market could prove to be one of the smartest trades of the last decade. Although
buying Treasuries may or may not be the best trade in terms of sheer magnitude of price movement, it will prove
to be the essence of investing; finding genuine value in a loathed asset and knowing when to part company with the
crowd. Buying Spring Wheat in 2005 or shorting crude oil in the summer of 2008 may prove more financially
rewarding, but buying government bonds will be more satisfying since very few believe in a potential advance.

In 2009, the debate between inflation and deflation was fierce. Now it seems the general public agrees that
inflation hides around the corner due to massive money printing. Marc Faber enjoyed comparing the United States
to Zimbabwe and stated that “Ben Bernanke appears to have Robert Mugabe as his mentor”. So far, we have seen
little evidence of any inflation; instead on the contrary, prices have been falling. According to Bloomberg the
financial crisis eradicated almost $14.5 trillion dollars in wealth compared to the almost $3 trillion spent in bailout
and stimulus programs. Three trillion has not been nearly enough to cause hyper-inflation in this environment
compared to the contraction in credit and wealth. The monetary base has exploded, but so has reserve bank credit.
The money isn’t getting out to the economy, and the velocity of money (an important component to inflation)
continues to shrink.

David Rosenberg, Chief Economist and Strategist of Gluskin Sheff recently presented some interesting data
in regard to the average U.S. household balance sheet. The data shows that U.S. households own $800 billion in
Treasury notes compared to $3.5 trillion in corporate bonds and municipal paper, $4.6 trillion of consumer goods,
$7.7 trillion of deposits and cash, $18.1 trillion of equities (after the bear market) and $18.2 trillion in residential
real estate (after three years of dropping values). A quick back-of-the-envelope calculation from that data shows
that Treasuries make up less than 2.7% of total household liquid (excluding consumer goods and residential real
estate) assets and less than 1% of total assets. Treasuries are clearly under-owned, especially in the face of another
downturn in equities when investors will demand safe assets.

For many years now, traders and portfolio managers have been salivating at the idea of shorting Japanese
Government Bonds, citing the country’s high debt to GDP ratios and history of quantitative easing. Japan is the real
world proof that U.S. and European government bonds can continue to move significantly higher and yields can
move much lower than anyone thought possible, even in the face of what seems like unsustainable government
debt. JGBs rose to a high in 2003 and that high is about to be challenged again. That high in bond prices saw a
corresponding low in yields of 1.049%. If the yield on U.S. 10 year notes drops to the same level the bond price
would rise to approximately $146.00, a 24% rally from current levels.

Some trades are good enough to assume just from a contrarian standpoint. The basics of a contrarian “play”
is that when everyone moves to one side of the trade, there are so few new buyers (or sellers) to get on board and
maintain the price movement that prices will swing the other way. The case for a contrarian trade in government
bonds is perfectly clear. CNBC and Bloomberg routinely have guests and analysts making their all too common case
for shorting government bonds. The financial gurus (some of which I respect very much) like Jim Rogers, Marc
Faber, Peter Schiff and Nassim Taleb all preach the same trade. In fact, Mr. Taleb recently stated that “every human
should short U.S. Treasuries”, a statement he will most likely regret for some time. Financial magazines such as
Smart Money and Forbes have published feature articles about the Treasury “bubble” and impending high interest
rates. Many financial bloggers and small speculators love this trade as well, typically citing the previous sources for

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their research. Even Pro Shares launched two Ultra-Short Treasury ETFs in early 2008, which would rise in value if
U.S. Treasuries declined. It seems that all components of a contrarian trade exist. At some point all these market
participants will be absolutely correct, government bonds will decline dramatically and interest rates will rise.
They are not wrong, just too early.

Lastly, from a trading standpoint, following the current price trend can often be prudent. Picking tops and
bottoms is dangerous sport and general investors should avoid it at all costs. In managing the portfolio for MKC
Global Investments, we require some degree of a rising market to be a buyer and a declining one to be a seller.
Government bond markets fulfill this requirement as well. Treasuries declined over the last year, but are up over 2,
5, 10, 20 and 30 years. Needless to say, the trend is up. Very few people remember, or have taken the time to look
up what a chart of the 30 year U.S. Treasury bond looked like when it bottomed in 1981. Above is that chart. Note
how it began its bottoming phase with a massive spike down, a retracement of that decline and then the final
largest descent to its ultimate low. Some people may think that the run-up in bonds 14 months ago was the blow-
off stage of the bull market. Instead it actually shares the same qualities with the 1980 price spike that preceded the
final leg down and ultimate turning point instead of marking it. The data indicates that bond prices could make
new highs and not by a token amount either. The rally 14 months ago wasn’t fitting for the finally of a 30 year bull
market. With that said, prices can easily decline for several months or even a year before moving higher. There
may be enough ammunition from eager speculators initiating short positions to subdue any rally or even take us to
2009’s lows before prices ultimately turn higher.

History has shown repeatedly that historic bull markets, lasting for many years, end in capitulation and a
state of euphoria. The government bond markets have not witnessed that stage yet. As a market participant, due to
the complexity of markets, knowing just half of the applicable fundamentals is great when planning a large trade.
Any more is fantastic. For some, a convincing contrarian indication or a strong price trend is valuable and can be
enough in itself to take a position. Right now, for the government bond markets, we are faced with a trade where
the fundamentals, price trend and a strong contrarian component are in place. Buying U.S. Treasuries will be one of
the greatest trades of this generation; do not be seduced into shorting U.S. government bonds too soon.

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