[POSITIVE EXPECTED VAL(YOU) - NEWSLETTER] January 11, 2013

Macro

Value

Positioning

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[POSITIVE EXPECTED VAL(YOU) - NEWSLETTER] January 11, 2013

Positive Expected Val(you), otherwise known as positive expected value or +EV, is a common poker term that can defined as such: "In probability theory the expected value of a random variable is the sum of the probability of each possible outcome of the experiment multiplied by the outcome value (or payoff).

In other words, and in simpler terms, its about making good choices. While I wont make specific recommendations in this newsletter, I will tell you exactly what I am looking at and where I am putting my money to work.

With that said, lets get to work

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[POSITIVE EXPECTED VAL(YOU) - NEWSLETTER] January 11, 2013

Youve heard it before, you will hear it again. Equities are the last to know. Is that the case in this current bull cycle which dates back to the beginning of 2009? I believe so and here is why. Corporate Bond ratios are not confirming these higher highs in equities. The divergence in performance between equities and these bond ratios continue to widen (as shown below).

The 5 year chart above shows the ratio of high yield corporate bonds (HYG) and investment grade corporate bonds (LQD) in white.

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[POSITIVE EXPECTED VAL(YOU) - NEWSLETTER] January 11, 2013

The green, red, and blue lines are US equity indices. The yellow dashed line on the chart indicates where the corporate bond ratio made its 5 year high. As one can see equities have continued to perform to the upside while the corporate bond ratio has stagnated.

One of the more concerning charts is the ratio between the US Treasury Inflation Protected bonds, or TIPS (TIP), and US Treasury bonds 20+ years in duration (TLT), in white. This is a chart that goes out 10 years and tells a scary story.

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[POSITIVE EXPECTED VAL(YOU) - NEWSLETTER] January 11, 2013

In 2006 we saw equities move deep and fast away from this ratio, only to find themselves back at a meeting point in 2008/ 2009. We are now at this same point, but the percentage gap is even greater than in 2007. I look at this ratio as an inflation/deflation indicator. It has made new lows recently, back within the 2009 range. Is it wrong and are yield going to rise and inflation pick up as some believe due to a growing economy? I beg to differ

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[POSITIVE EXPECTED VAL(YOU) - NEWSLETTER] January 11, 2013

In white is the ratio between the S&P 500 Index and the US Treasury 10 year note yield (TNX). In red is the S&P 500 Index. What is apparently clear is that yields have been collapsing on the back of higher equity prices. So much so that in this current 4 year bull cycle we have seen this ratio move parabolic. What does this mean? To me, one thing: easy and cheap money has fueled this massive bull rally in stocks. But I dont need to tell you that. Ben Bernanke and the Federal Reserve have already done such:

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[POSITIVE EXPECTED VAL(YOU) - NEWSLETTER] January 11, 2013

And make no mistake about it rates cannot rise because of our current debt load and future debt loads. We are currently paying 13.5 cents in interest on our debt for every $1 of government revenue. Rising rates and rising debt makes this unsustainable. The Keynesian endpoint as some would say.

The last ratio chart I want to share with you is the Silver to Gold ratio using the SLV and GLD ETFs as proxies. Again, we are comparing this to major US stock indices (blue, red, green).

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[POSITIVE EXPECTED VAL(YOU) - NEWSLETTER] January 11, 2013

The purple boxes highlight the disconnects. We are again experiencing equities making higher highs while the silver to gold ratio remains stagnant and range bound over the past the last year. At some point we will need to recalibrate. Does the ratio rise and reconnect with equities or are equities wrong again and down they go?

So knowing this, I am doing a few things. One, I am staying away from any long equity positions. If risk is on, I would rather be long high yield debt or silver or commodities in general. I am not long either at this point.

I am also staying away from US Treasuries. I believe we will see asymmetrical returns in bonds and equities over the next 5 years. Like I told my wife, You wish your 401k offered exposure outside of

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[POSITIVE EXPECTED VAL(YOU) - NEWSLETTER] January 11, 2013

stocks and bonds because in the coming years, youre going to be searching for a safe haven.

As a value investor, I look for value anywhere and everywhere. At this time I believe that the greatest value is in volatility, in particular in FX and Emerging Market equity volatility. In next weeks newsletter I will cover this in depth with the specific parts of the world where I find volatility at levels that simply baffle me. Til then

My personal holdings at the time of writing this newsletter: - MSCI Brazil ETF (EWZ) option spreads - Currencyshares Canadian dollar ETF (FXC) option spreads - Eurodollar (ED/GE) June 2013 future contracts - short pos. - Currencyshares Euro ETF (FXE) risk reversals short pos.

This newsletter is for information purposes only. Do not take this newsletter as investment advice.

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