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Mid-Week Ad Hoc Commentary

(December 17, 2009)

Dear Subscribers and Readers,

As 2009 draws to a close, I want to thank all of you for your ongoing support and loyalty. The last five years of hosting has been a wonderful and humbling experience, and I look forward to many more years of writing to come. The global financial markets have been and always will be an interesting animal - from the days of the Medicis to the Rothschilds, Barings, Schroders, Morgans, and the rise of the Asian financial system - and I look forward to sharing our ideas as we try to navigate the second decade of the 21st century (although officially, the second decade does not begin until January 1, 2011).

Our regular guest commentator, Rich Konrad, will be posting his thoughts tomorrow (Rick is now writing for us on a twice-a-month basis). I will be back with a "full-blown" commentary this weekend, but in the meantime, I want to comment on a few important developments.

The U.S. Dollar

As we discussed in our November 1st commentary, we have been turning bullish on the U.S. Dollar Index (the March 2010 contract is trading at 77.75, up from 76.58 since then). More importantly, buying U.S. Dollars (or buying call options on the U.S. Dollar Index) represented a low-cost and low-risk way of hedging one's "risky" portfolio, as many investors have bought risky assets (Chinese real estate, emerging market sovereign debt, etc.) through U.S. Dollar-denominated loans. Any pull-back in these assets, of course, would benefit the U.S. Dollar. Interestingly, in the wake of Dubai's financial crisis, many sovereign wealth funds in the region have been unloading U.S. Dollar-denominated holdings in U.S. commercial banks (such as Citigroup). While this could simply be a trade based on emotions (i.e. getting rid of something after having made just a small profit because one can't handle the volatility) - it could also be something more significant: Could countries within the Gulf Corporation Council be having more liquidity problems? This is hard to believe (at least five years ago) with oil at $70 a barrel - but it is rumored that Dubai may have another $80 billion or so of off-balance sheet debt that needs to be funded over the next 12 to 24 months. Other countries in trouble, such as Venezuela and Mexico, may also be desperately seeking U.S. Dollar liquidity.

Technically, the U.S. Dollar index is now acting very well. The technical bullishness of the U.S. Dollar index is further reinforced by its severe oversold condition in late October/early November, as well as fundamental factors such as the shrinking U.S. current account deficit, and the ongoing vulnerability of the Euro as countries such as Ireland, Spain, and Greece deal with the most severe crisis in the region since the ERM Crisis of 1992.

Interestingly - if the likes of Abu Dhbai, Venezuela, Saudi Arabia, and Mexico are seeking U.S. Dollar liquidity - the best way to do so would be to pump more oil. In the case of the OPEC countries, that would mean cheating on their quotas. Coming in the face of a ramp up in Iraqi, U.S Gulf Coast, and Brazilian oil production in 2010, my sense is that oil prices will remain stagnant next year, if not decline outright.

The Federal Reserve

The FOMC statement released earlier today was basically a non-event, although it did clarify the Fed's strategy and timeline of exiting the various special liquidity facilities that were created during and in the wake of the financial crisis. That being said, the Fed remains flexible - and as thus, I would not be surprised if the Fed eases again if the housing and credit markets fail to revive or grow next year, especially since inflationary pressures (particularly if the U.S. Dollar is strong and oil prices decline) will likely be a non-event for at least the first half of 2010.

Federal Aid to Cash-Strapped States and Municipalities

In previous commentaries, we mentioned that the troubling state of state and municipal finances - particularly those in California and New York - could be the next source of systemic risk if no further federal subsidies or aid are provided. Despite the subsidies provided by the Build America Bonds program, states such as California are still fiscally constrained and would have to raise taxes further or cut services and funding to schools, police and fire departments given ongoing budget shortfalls. If nothing is done, municipal bond yields could spike again - raising the cost of public financing for all states and municipalities across the country and potentially impeding the slowly recovering U.S./global economy.

Earlier this evening, the House passed the $154 billion "Jobs for Main Street Act," which would among other things, provide $75 billion in aid to states to boost infrastructure spending and most importantly, to prevent public sector employees (teachers, fire and police personnel, public university professors, etc.) from being laid off. In a "normalized economy," any federal government's efforts to create jobs tend to be a wash, as higher state borrowing tends to "crowd out" private borrowing. Since the private sector is generally more efficient, it is nearly always better for the government to stay out of the picture, except in areas where there are genuine "market failures" such as basic education. Even in a recession, it is generally more efficient for the government to stay out, as it takes time for the government to implement programs to create jobs. Moreover, investing in heavy-equipment-intensive infrastructure projects generally tend not to create that many jobs anyway.

This time is different, however. Unlike other post World War II recessions, there is a genuine labor shortage in many public sectors such as education and other basic services. More importantly, there is already an infrastructure to support any additional hiring (or re-hiring), as well as many qualified unemployed individuals to fill this gap. Contrary to many arguments that this would "increase our children's debt burden," I would argue that the (re)hiring or teachers and professors is the best investment we could ever make. The $75 billion aid to states and municipalities is probably the best "bang for the buck" in both the short and the long-run in terms of any of the stimulus provisions I have seen - whether it's investing in our children's future, creating jobs, or improving states' budgets.

Assuming the "Jobs for Main Street Act" is passed by the Senate early next year, the outlook for U.S. equities remain decent for 2010. In the short-run, we expect U.S. equities to continue to consolidate, with a breakout to the upside possibly later in the second half of January or early February. In the meantime, enjoy the rest of the week - I will speak to you again this weekend.

Signing off,

Henry To, CFA

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