Market Commentar y

K E S S L E R I N V E S T M E N T A D V I S O R S ,
August 20, 2009
I N C .

Full economic recovery, U.S. inflation, and the

Fed removing accommodation – still years away
Summary and Contents Guide
How too much focus on equities (the “less bad” rally) and the anticipated end of recession wrongly cali-
brates today’s place in the business cycle -- and overlooks consistent patterns of falling inflation and
Treasury yields after recessions end. (page 1 & throughout)

U.S. economic indicators throughout 2009 point to strong disinflationary trends and enormous slack in re-
source utilization – while higher prices on commodities only act as a “tax” on consumers who can’t de-
mand higher wages (page 2)

Too little money is now moving in the economy as households differentiate saving from investing, and as a
historic share of unemployed remain out of work for six months or more. (page 3)

The Fed signals it will keep rates historically low and keep policy options open (despite self-serving media
hype) a Fed posture underscored by major absence of the demographic and business conditions which
accelerated an unusual and vicious cycle of U.S. inflation in the late 70’s. (page 4)

Unintended consequences: warnings by officials helped create “alternate universe recession,” then rebound
in long rates increased economic damage and elevated consumers’ costs of carrying debt, weakening the
economy & lengthening the recession. (page 5)

As banks cut off consumer credit lines abruptly, enforcing a drop in consumer spending, the consumer credit
crisis begins anew, even as liquidation sales demolish securitized mortgage pools. (pages 5, 6 & 7 )

Declines in commercial real estate threaten that mortgage market -- and vice versa – as the second-order
effects of recession take hold. (pages 7 & 8)

Lower costs or carrying debt / borrowing will be necessary for consumer spending to be renewed -- whether
policymakers get rates and yields down sooner (the easy way), or a worse recession and “bust cycle”
mechanisms drag them down later (the hard way). (Page 8 & 9)

Headwinds from traders anthropomorphizing the equity market’s “rational” abilities – and ignorance of
tools to exploit value in the Treasuries -- let markets dismiss comprehensive historical data and analysis
for the short term, and reinforcing opportunities for returns on UST (page 10 & 11)

Objective analytic tools, designed specifically to tell when inflationary pressures are mounting, provide no
evidence of an inflationary cycle approaching, contradict simplistic beliefs on asset correlations & rein-
force direct observations (page 11)

Rallies in equity and commodity markets built on artificial and temporary stimulus by governments, a sur-
feit of investment capital, the investor herd mentality & corporations cutting costs to the bone -- are not
crystal balls or sustainable trends, but vulnerable investments and economic blips (pages 12, 13 & 14)

Noticing that investors follow a housing index built by a noted academic, but disregard his findings that a
big common denominator in setting p/e ratios (and thus equities prices) is investor sentiment (that has-
n’t absorbed changes from deleveraging) (page 14)

Why the return of actual of GDP (not popular rate of change figures) to pre-recession levels (and inflationary
pressures) looks years away (page 15 & Chart on page 16)
Market Commentary August 20, 2009
K E S S L E R I N V E S T M E N T A D V I S O R S , I N C .

Full economic recovery, U.S. inflation, and the

Fed removing accommodation — still years away
Anyone setting their investment strategy these days by watching what the
financial markets are doing day to day — as many market participants would
appear to be engaged — would be confused in 2009. Particularly influential is
activity among equities and along the U.S. Treasury yield curve. Assumed
relationships between these asset classes have been self-reinforcing. Hot money
is visibly reacting to each piece of economic and corporate data (and each breath
of political rhetoric). Traders then pile in (or out) — often supporting market-
moving bets on momentum with complex hedged positions in futures and
options which are not immediately reflected in directional moves in equities
markets averages. (Also, some participants now use ETFs that may differ from
index funds in their impact on index averages and debt issues.)

The hot money reactions and media chatter about them are not necessarily based
on thorough research. For example, day to day commentary on financial markets
uniformly fails to identify the typical fall in inflation which has lasted roughly 1.5
to 3 years after recent recessions have ended. Similarly, market observers do not
seem cognizant of the overriding trend downward in 10-yyear Treasury yields
during that period. Only in this deep recession is the public finally being made
aware of the historical pattern of joblessness — and economic weakness —
persisting and even increasing after the formal end-date of recession.

Informal commentary often confuses the technical end of recession (when real
GDP stops falling) with recovery to the nominal levels of real GDP (rather than its
rate). Recovery requires a return to actual measured level of economic
productivity prior to the onset of decline. Historically, only at this point of full
recovery is the U.S. economy vulnerable to inflationary forces overriding
longstanding slack in the labor force and other productive capacity. Otherwise,
a rise in GDP may be termed “growth,” in popular parlance, but except in
isolated pockets of the economy it will not look, feel, or operate like growth.
Similarly, equities gains that do not exceed earlier index averages do not operate
in the broader economy as a positive wealth effect. While relief over the
anticipated end of recession is legitimate, false impressions are easily fostered.
The “end of recession” does not signal that:

„ The economy has recovered to its levels of production before GDP started
falling;

„ Inflation must take off (especially not from consumers bidding up prices in
stores or demanding wage increases);

„ Jobs have stopped disappearing (or that everyone will be quickly rehired); or,

„ Interest rates must rise, (particularly not longer-term rates associated with
10-year Treasuries).
August 20, 2009

In due time and with ample historical precedent, however, fundamental economic
forces do assert themselves and market prices do revert to underlying measures of
valuation.

A variety of economic indicators show disinflation firmly entrenched

Reality again began to filter in as the Bureau of Economic Analysis revised away a
previously reported upward trend in core inflation as measured by the core PCE
deflator (a number once watched closely by former Fed Chairman Greenspan and the
markets). The new analysis revised the core PCE deflator downward in April and
showed it falling in May. Then it slid in June to 1.5% year-over-year. Also, non-farm
unit labor costs plummeted in Q2 to produce a negative measure for four quarters.

Fundamental relationships again prevailed as the popular CPI (Consumer Price Index)
measures of inflation made news, inflation fears abated, and Treasury yields
dropped, particularly on the inflation-sensitive 10-year maturity. The overall CPI was
unchanged for July and posted a historic 2.1% decrease, year over year. Core CPI rose
only 0.1% in July, and fell to a 1.5% rate year-over-year, the lowest in 2009. This week,
releases of the PPI (Producer Price Index) also showed a clear pattern of disinflation.
The monthly July figures were both negative (core and overall). More important, the
volatile overall year-over-year figures have remained in negative territory since
December, while the year-over-year core rate for July of 2.6% was lower than any in
the previous 12 months, and has trended downward since December.

Despite a monthly gain in Industrial Production for July, on a year-o over-yyear basis
it fell by 13.1%, the kind of decline last seen in the mid-1 1970s and late 1950s.
While capacity utilization, the primary measure of slack in resource utilization, also
edged higher in July, at 68.5%, it languished far below previous lows in the early
1980s — and even further below its record of capacity being put to work any time
in over 40 years. Even though manufacturing has continued to migrate overseas,
over-investment in overall economic capacity in the boom years has given
economic growth enough rope to hang itself. Concrete resources are in great excess,
from labor to retail space to office space. In a slump, the ability to use technology
to enhance productivity lets companies jettison jobs and overhead, rather than
contribute to expansion.

With more infrastructure and workers idle than at any time in the memory of most
market participants, we find it bizarre that any serious student of economics or
markets would believe that GDP merely turning around from depressed levels would
spark an inflationary spiral. In this environment, incidence of higher commodity
prices imported from overseas (or prices on consumer goods tied to oil or other
commodity price spikes) can only act as a “tax” upon the consumer (and on
business), not spark cost-p
push inflation. Anecdotal accounts in the press uniformly
report that consumers are trading down (or simply acquiring better goods at
discount prices) not bidding prices up. Most important, unemployed consumers
simply cannot demand a raise, and the employed workforce, worried about losing
their jobs and the survival of its employers (corporate or otherwise) is in no position
to do so. Many small business owners have stopped taking salaries. The inflationary

Kessler Investment Advisors Market Commentary p. 2

 August 20, 2009

feedback loop is broken. Many retailers have surrendered pricing power and the
hotel industry has slashed its rates.

On the too-m much-m money front: government spending is being criticized as

inadequate stimulus...state government spending is suffering from lower tax
revenues...the Fed balance sheet reportedly has not expanded in months...and lack
of velocity (lack of circulation of money) tempers overall money supply concerns. If
you listen carefully to officials reflecting on the worst days of the credit crisis, it is
easy to understand why a chunk of domestic stimulus money went to state
budgets. In addition to the usual pork barrel spending, the Congress made sure
that the states could funnel money to municipalities to pay the police, firemen, and
teachers if worst case scenarios were realized, and federal officials did not protest.
(Central government may have learned its lessons from the failures of centralized
response to Hurricane Katrina once essential local services broke down.)

Unprecedented actions were taken to avert and forestall (and potentially deal
with) economic collapse. Comparatively little has been done to counteract the
more gradual recessionary forces of deleveraging and the additional dampening
outcomes associated with reining in banks and the so-called shadow banking
system. Consumers are under great pressure. Households are beginning, as they
did several generations ago, to differentiate saving from investing, and the
savings rate is returning to familiar levels. With the exception of 2001, when the
savings rate was 1.8%, savings rates associated with recessions dating back to
the end of World War II reached 7.0% to 10.9%. Savings may be held in cash, used
to invest, or used to pay down debt — but they do not represent spending.

Outside of Treasuries, it is hard to find an investment that does not carry

substantial economic risk. Domestic purchases of Treasuries have increased. Yet
recently, a spasm of outflows from longer-maturity Treasuries had apparently
flooded into equities, seemingly on the flimsy hope of corporate profits being
driven up by fewer job losses. This occurred even as lost income savaged the ability
of households with unemployed workers to meet financial obligations on homes and
credit cards — and to increase or continue retail spending. At the same time as
Treasury yields fell and equities indices rose, The New York Times drilled down into
the data and reported on August 8 that the share of unemployed (one third of a
total 14.5 million unemployed) remaining out of work for at least six months (27
weeks) is the greatest in 61 years of recordkeeping. While overall household
savings rates are rising, members of this group are spending down what savings
they have accumulated and, in the absence of savings, working their way through
credit lines. This reporting points to major “disconnects” between underlying
conditions in the U.S. economy and the headline equity and commodity market
reactions to harbingers of eventual growth.

Equity markets which historically anticipate improvements in GDP, appear to

have their antennae reaching out only for forward-looking catalysts that signal
growth. Equity investors have fastened on reports of each incident of incremental
“second derivative” news about a less steep rate of negative change. This is
especially true of professional investors bent on getting fully invested ahead of

Kessler Investment Advisors Market Commentary p. 3

August 20, 2009

recovery. Call it the “less bad” rally. Yet, overriding conditions of massive
unemployment, lost wealth, and limited access to credit appear to control — and
hold down — the real U.S. economy, inflation, and those interest rates which are
based on high quality credit.

Hard for the Fed to stimulate growth, expand its balance sheet, or jawbone freely
These sober realities are reflected in the most current statements from last week
from the Federal Open Market Committee (FOMC) of the Federal Reserve, which has
determined to maintain a historically powerful accommodative stance and to
telegraph that it will keep interest rates low well into the future. We agree with other
commentators that in signalling (with its statement) that it would phase out rather
than more quickly fulfill its quantitative easing commitment, the FOMC appears to
be buying itself some time and retaining powerful policy tools. With the world tuned
in to its public pronouncements, it is walking a tightrope.

Any benefit the Fed would hope to achieve by “talking up” economic improvements
or by painting a happy face on its research and projections seem to be overridden by
its need to justify its stimulative policy stance in the face of recent market hysteria
that any bottoming out in the economy equals a full fledged rebound and imminent
inflationary spiral. Even media coverage of the Fed is contaminated by television
journalists raising teaser questions designed to keep viewers tuned in. Throw-away
segue phrases keep asking audiences over and over again, “When the Fed will raise
rates?” and “Will inflation and interest rates soon rise?” The suggestive repetition
validates worries picked up from superficial analysis.

Moreover, market participants who were not economic adults during the anomalous
high inflation years in the U.S. tend to conflate limited above-ttrend inflation of a
digit inflation. We reiterate
percentage point or two with the threat of runaway double-d
here that a number of factors which drove up inflation as the baby-b boomers reached
maturity have disappeared or are no longer so influential. These include: the effects
of a sharp bulge in population as the first baby boomers started earning, spending,
and competing for consumer goods...enlargement of the workforce from increased
participation of women (whether as two-income households or independently in
new household formation) driving per capita earned income higher...the collective
bargaining power of a unionized workforce being proportionately very much larger
than that of today and negotiating contracts with automatic raises tied to the
CPI...an employment culture of stable workforces and mutual loyalty between
employees and employers that embedded annual cost of living increases and
punished “job-hopping”...a comparative absence of outsourcing...and finally, a far
smaller and slower ability to ship manufacturing production and service abroad than
exists today (at the minimum, think of current competition from overseas call centers
run by banks and technology companies and electronic delivery of the output of
knowledge workers of every sort.) The accelerators that once boosted feedback in
vicious inflation cycles are not in place.

Yet each time that fear of inflation (from any source) takes hold and long term rates

Kessler Investment Advisors Market Commentary p. 4

 August 20, 2009

back up, economic damage increases: mortgage and refinance rates rise,
applications fall — and property values, homeowner equity, and consumer
spending are undermined. By now this pattern is familiar. Mortgage interest rate
trends may be self correcting, but the economic damage is cumulative, with real
cascading effects of asset deflation from foreclosure, and with the corrosive
disinflationary impact of bankruptcies, demand destruction, profit losses, and job
losses. Houses do not get “un-foreclosed.”

Over the past year, the Fed and the Treasury and various government officials did
massive damage via high profile talk about the exceptional seriousness of the credit
crisis, helping to frighten corporate leaders into precipitate reductions in their
workforces. Repercussions of the resulting job cuts and reduced corporate spending
were also serious. Understandably, scary pronouncements by officials were
designed to counteract popular resistance to extraordinary economic measures, but
they helped precipitate an “alternate universe” recession, one not caused directly by
a collapse (averted) or freezing (realized) of the global credit system, but one
triggered indirectly, via massive layoffs and cost cutting.

Now the twin forces of downturn (direct reduction in capital from losses in real
estate and investments based on securitized mortgages and indirect damage from
moves to avoid business losses) are converging, compounded by the ongoing march
of the overall deleveraging process that necessarily accompanies the removal of the
easy credit that spawned the crisis. Yet cheap credit (not easy credit) is needed more
than ever. Since there is no room to cut the Fed funds target rate, and since
ideologues rail against any mention of quantitative easing that would lower
benchmark rates, there is little benefit to any public Fed focus on economic
weakness. The Fed leaves it to other economists to hypothesize on double dip
recessions. They are hard pressed to limit enduring damage and overcome
whatever history will tell us we are experiencing.

No one seems to be trading on consumer credit being cut off abruptly

News that is less familiar and upon which few market participants trade is the
wholesale shutting down of U.S. consumer credit lines. These actions are, in part,
a response to the passage of the Cardholders Bill of Rights and are, in part, a
response to supervisory crack-down and the need to strengthen banking balance
sheets. The responses encompass a corporate effort to pre-empt restrictions that do
not come into effect until February 2010 by reducing bank exposure, as
documented in a full page article in the July 6 Barron’s, entitled “How to Live With
Less Credit.” Such news accounts of single or “one-off” events that identify and
document structural change in the economy do not lend themselves to trading
(whether of the knee-jerk or thoughtful variety). The article cited Senior Loan
Officer Surveys published by the Federal Reserve this year, noting that the 45% of
senior bank officers cutting credit in January subsequently increased to 65% (finally
putting a public spotlight on the obscure but increasingly critical report on lending
practices which we had cited earlier). With its July survey (published in August), the
Fed reported that “domestic banks continued to tighten standards and terms over

Kessler Investment Advisors Market Commentary p. 5

August 20, 2009

the past three months on all major types of loans to business and households....” The
tightening may be less severe or pervasive than earlier actions, but it is cumulative
— each turn to the screw compounds borrowers’ difficulties. Big news about such
structural change is not moving the markets. It will do so after effects flow through
to impact conventional data.

A more anecdotal and equally powerful record of the growing consumer credit
crunch was the August 12 article in The Wall Street Journal, on the D1 front page of
the “Personal Journal.” section, entitled “Cardholders Get a Rude Surprise At the
Register.” This documents the growing practice of card issuers and banking
institutions legally cancelling credit cards and reducing longstanding credit lines
without prior notice to cardholders (in some cases with no notice to card holders).
The headline on the jump page reads “Credit-Card Issuers Pull the Plug.” According
to this article, these reductions in credit are not being made in response to late
payments or other delinquencies, or even to borrowers carrying excess balances.
Lines of “available credit” being reserved by consumers under economic pressure as
a back-up resource are being targeted for cancellation for lack of use. Banks are
quoted in the article as stating that open credit lines are “a credit risk to the bank”
and present “large potential liabilities.” The newspapers report that the
unceremonious terminations of credit are far from isolated instances. Banks aren’t just
cleaning house on generous credit lines extended earlier. Other articles report on
banks granting fewer new credit lines to fewer new applicants. The pervasiveness of
these unilateral actions suggest several far-reaching implications:

„ One, that investors who enthusiastically are returning banks to earlier market
capitalization are ill advised to assume that the future operating practices of these
institutions will bear any resemblance to the practices under which they achieved
the earnings that warranted the earlier prices and p/e ratios;

„ Two, the implicit new banking models characterized by far less extension of
credit, along with much more stringent lending standards, are largely dependent
on the various artificial forms of support, including U.S. Federal Reserve and
Treasury support that fit hand-in-glove with increased scrutiny and reserve
requirements — and little guidance is being given for profitability (at eventual
lending levels far below the former volume of business), once the temporary
supports are removed;

„ Three, that the will of consumers to spend and thereby drive up inflation is being
systematically and thoroughly overridden by a factual inability to spend as
massive deleveraging is enforced (and enforced without adequate notice) by
lenders.

Congressional efforts to protect overextended consumers from seemingly arbitrary,

heavyhanded, and sometimes sly practices of credit card issuers seemingly have
backfired. Banks and consumers alike are scrambling in an odd and frantic dance to
protect themselves from each other. Investors have been blissfully ignoring this
rather methodical panic, while national economic leadership continues to downplay
(or ignore) the need to “bail out” the balance sheets of consumers — who make up
70% of the economy and who are defaulting at an unrestrained rate (now well over
Kessler Investment Advisors Market Commentary p.6
 August 20, 2009

a quarter of a million per month) on the toxic mortgage-backed assets responsible

for the credit crisis.

(These “assets,” which to some extent are “written off,” are still on the books of
banks, pension funds, and other institutions, perhaps in false hopes of an earnings
pop when asset values might be restored. Academic analysis of a securitization pool
of 3.5 million mortgages, many handled by the largest home loan servicing banks,
showed an average loss of 64.7% of the original loan balance on 32,000 liquidation
sales in June, according to a report by Gretchen Morgenson in the July 5 “Sunday
Business” section of The New York Times.) With the exception of the investment
banking firms that underwent metamorphosis into bank holding companies, and
which profit from trading and activities other than direct lending, zombie banking
is here. Comparisons to interest and “inflation” rates in Japan, and to minimal
growth there, can no longer be dismissed or discounted.

For consumers — many of whom did not appreciate all the fuss about keeping
liquidity flowing between financial institutions and making counterparties whole
— the credit crisis is only beginning (renewed auto financing offers by a
automakers notwithstanding). Otherwise solvent, but illiquid, households are now
feeling greater strains. Many households had enough ready credit to not be worried
about having to mark their house to market (via an appraisal) in order to borrow.
No longer. Reports that circulated of families that surrendered their homes, but
kept their credit card payments up to date to finance relocation or to maintain
living standards, resonate with irony.

Congress has now moved on to other concerns. The FDIC is busy with failures of
institutions that are not too big to fail. The Fed and the Treasury still have not
taken sufficient action to assure availability of consumer credit and to bring down
consumer and mortgage borrowing costs. The resulting local and regional
economic damage increases the potential each day, month, and quarter for a
prolonged and deepening recessionary and disinflationary cycle to continue.

Consumers who can save are doing so, as the higher savings rate attests. The
absence of robust business activity throughout the U.S. is not without strong
consequences. Financial news reports are starting to transmit a drumbeat from the
so-ccalled “next shoe to drop” of commercial mortgage defaults, and we think it
could be a centipede of dropping shoes. While defaults on office towers do make
headlines in the twenty-first century, unlike the downturns of earlier decades (think
the 1970s and 1980s), the visual and physical representation of an increasingly
devastating business downturn is not so much urban decay but the spreading rash
of empty storefronts in still well-kept “strip malls” not far from suburban interstate
highway exchanges. In spite of falling rents, chain stores and mom-and-pop
retailers alike are closing up shop.

Cataclysmic events usually don’t make headlines until strains from less visible fault
lines add up. With all the attention to the crises and defaults in the banking sector,
it is easy to forget the revealing pattern of consumer mortgage defaults. The
foreclosures progressed from expected defaults caused by “exploding” subprime rate
resets on properties with little equity (which could have been relatively easily

Kessler Investment Advisors Market Commentary p. 7

 August 20, 2009

counteracted by prompt Fed rate reductions), through the unanticipated defaults

on holdings of the better credit classes which started out with better loan-to-value
ratios, and ultimately to surprising absolute auctions on high-end trophy
properties. New strains on borrowers — falling property values, massive job
losses, and “small” business failures — have helped keep defaults and
foreclosures at historic high water marks.

It is less apparent that the U.S. is now facing the second-oorder effects of recession
which in turn are being compounded by constrictions in credit similar to those that
slammed homeowners so severely once the effects of toxic waste kicked in. New
categories of lenders are feeling the strain. Only in the last month did a major
financier of retailer inventory hit the wall. (“Factors” are not too big to fail.) Most
financing on commercial buildings in the U.S. needs to be rolled over frequently;
prevailing market valuations and local costs-per-square foot for leasing matter as
much as financing rates. Rigid accounting rules limit flexibility — and foster
vacancies when prospective tenants can not or will not pay market rates. The
emerging challenges in commercial real estate will reveal the potential for any
“covenant light” contracts written in this arena during the liquidity boom to
flummox holders of obligations. While sectors and regions may rebound, the full
effects of the reversal of easy credit are far from being played out.

We maintain that recovery turns on whether the economic leadership wakes up

and gets U.S. rates down far and fast, or whether they keep propping up the
institutions they lead and supervise, while ignoring the crumbling consumer
economy — in which case rates simply will get lower later. Borrowing costs are
the fulcrum. Excess attention on the stock market and on the timing of the end to
falling GDP are a distraction. (The path of recovery to nominal real GDP levels
matters, too; see chart p.16.) In times of historically low rates, it is not intuitively
obvious that the costs of carrying debt are too expensive, but consider the
continual ramping up of household indebtedness since 1992. Interest rate costs
currently remain simply too expensive given the size of the household debt already
assumed. Overly burdensome debt is only resolved by two means of deleveraging:

„ By one means, debt can be eliminated via a process of default on obligations

and, alternately, by forced or unfavorable liquidation sales that diminish or
wipe out borrowers’ equity;

„ By another means, debt can be paid off — slowly from revenues and personal
income and more quickly by liquidating assets.

The only antidote that mitigates damage to the lenders and borrowers alike is to
lower the cost of carrying debt. Savings from lower rates can be used to pay down
debt — or spend. Yet, on the whole, consumer and corporate borrowing costs are
now relatively close to their levels prior to the crisis, especially when viewed
through a lens adjusting for the depth, breadth, and length of this recession. (In
the extreme example, since financing costs had already reached zero for some
borrowers prior to the Chrysler and GM bankruptcies, no one expects cheap
financing to return these automakers to profitability.) Anticipation of a full and

Kessler Investment Advisors Market Commentary p.8

 August 20, 2009

fast economic recovery under such conditions is clutching at straws (green shoots
or otherwise).

Absent sufficient central bank intervention, rates (and profit margins and inflation)
necessarily will drift down on their own — but only when the full “bust” cycle plays
out. At some point, higher rates will not be extended to less creditworthy borrowers,
they will simply be cut off entirely. Even the high yield — or junk — market can
shrink. Private equity needs rates to be even lower in a recession than in a robust
growth economy. Unfortunately, too many players in today’s economy seem to
think the Fed has overplayed its hand, when its moves have been entirely
insufficient in addressing the credit crisis in the consumer sector, asset deflation,
and other recessionary forces.

Mortgage defaults remain at the heart of consumer and banking problems.

Mortgage rates have simply not been brought down proportionately to the cost
reductions that occurred around much milder recessions and “jobless” recoveries.
The Greenspan Fed famously signalled that it did not need to identify and address
asset bubbles, as it could compensate for their collapse by cutting rates. Now that
such efforts have been proven inadequate (or at least incomplete), asset deflation
is bleeding out consumers and fostering disinflation. The retail consumer pays up
to borrow, yet earns less interest.

Not only are banks slashing consumer credit lines, but also they seem to be
scrimping on rates they pay on “time deposits” such as certificates of deposit (CDs).
Lack of return may have driven investors of working age back into equities, but not
all depositors. For a still-large population of retirees whose childhoods were colored
by the immediate effects or family memories of the Great Depression, any drop in
interest rates on CDs simply diminishes their spendable income or forces them to
consume capital, which in some cases runs out. These are the people whose houses
are as yet unencumbered by borrowing. With property taxes elevated or rising, their
next step is to downsize and throw more housing inventory on the market. This is
the mechanism of a bust cycle, and although there will be well-publicized triumphs,
the evidence is not that a downward trend has been reversed, just slowed. We wrote
often throughout the years about the potential of longest, strongest economic
expansion in history, and the longest bull market, to correct. The Fed’s efforts to
extend that cycle indefinitely now seem deluded, as the pendulum is swinging
heavily back from overexpansion over a protracted period. It’s no surprise to us that
the dimensions of correction are turning out to be commensurate with that of over-
expansion.

Economies, financial markets diverge amid battles over ideology & terminology
To be sure, earlier in the year, many financial markets were priced for: global
economic collapse, another Great Depression, unremitting seizure in the credit
markets, accompanying pricing aberrations, and a variety of market events that
have been successfully averted. Understandably, subjective bets on worst case
scenarios are unwinding. That does not mean that financial markets have reverted
to rational pricing, or that institutional and private traders have sufficient insight

Kessler Investment Advisors Market Commentary p.9

August 20, 2009

(or a true factual basis) for evaluating the direction in which markets over time will
thrash out that pricing. So, yes, we dare suggest that financial markets sometimes
fail to reflect hard facts, and the renewed buoyancy of equities in 2009 does
nothing to disprove this observation.

Suffice it to say that some of the growing public complaints about market
“speculation” seem to be grounded in the inability of investors to reconcile the
supposed omniscience of equity market pricing with wild swings in that pricing.
Investors wonder how the equities market, in particular, could be right about
prices and values a year ago (last August), and then also right this past March,
and then also right again now. Doubt is especially strong on valuing corporate
common stock, as billions in market capitalization evaporated quickly — and in
some cases permanently, while in other cases only temporarily. These divergent
outcomes were not suggested by earlier market pricing.

Certainly, if we all returned to the days where corporations were compelled to pay
out most of their earnings in dividends to compensate investors for accepting the
risk of having the stock price fall (even perhaps to zero) and in order to compete
with Treasuries (and we should), then apologists for equities would be less
defensive about acknowledging the universal “speculative” component of
investment in equities, as distinct from excess capital driving markets in a
speculative fever. Taking a risk related to corporate performance is different from
taking a risk that a rapid market run-up in equities prices will stall or collapse.
Commodity markets, too, have reminded investors how rapidly they can retrace
a parabolic price spike, calling into question the reliability of prices posted
immediately prior to the reversal. These days there is a lot of “story” in equity
and commodity pricing, as prices in electronic exchanges to move rapidly on a
free exchange of ideas (some without much factual basis). We raise warning
flags when flawed strategies seem to leak over into Treasury markets,
particularly when the ideas assume a fixed correlation with other markets.

So we go back to basics. We remind our investors that the short end of the U.S.
Treasury yield curve anchors all maturities and remains governed by U.S. central
bank monetary policy, observed in its most basic form as a transparent Fed funds
target rate. We contend that the long end of the yield curve is substantially
governed by inflation (and only to a lesser extent the component inflation
expectations), plus the available real rate of return (as calculated against
measured inflation). In many ways even the risk-return dynamics of investment
grade corporate debt are more akin to equities than to these benchmark debt
securities (because corporate debt issues rely on corporate performance and
exposure), but that does not create fixed negative (or positive) correlations — either
with returns or with the direction of price-and-rate fluctuations.

Our primary investment strategies are unfamiliar to many investment advisors

and market strategists. Our uses of the repurchase and futures markets are
designed to benefit investors by the correct determination of primary market
trends and by efficient yield curve management and by efforts to extract additional

Kessler Investment Advisors Market Commentary p.10

 August 20, 2009

value over time by calibrating duration exposure. Investment managers who do

not use these tools do tend to regard Treasuries as a benchmark for returns on
other securities. They tend to dismiss strategies that can achieve highly
attractive and competitive returns over time at relatively low quoted yields. As
a result, our market calls often face considerable headwinds. It should go
without saying that if this were not the case, the opportunities for attractive
returns would be diminished greatly.

Investors in any Treasury market strategy, whether going long or short,

investing for the long term or the short term, holding Treasuries for cash, or
using repo or futures, are all able to benefit from comprehensive historical data
on market rates and prices in relation to economic data, and accompanying
mathematical analysis. The same analysis cannot be produced with
mathematical rigor for individual corporate debt issues that bear different
ratings at different times and may move from investment grade to junk and
back, and cannot be applied with any reliability to IPOs or new companies. Those
trades operate in the realm of “animal spirits.” The data on Treasuries and the
factors that impact them allow sophisticated historical comparisons and
correlations with the performance of other asset classes and categories — and
most critically with central bank policy and economic indicators that reliably
affect prices, value, and the direction and volatility of pricing.

Such research is very different from simplistic assertions that outlays by the
Federal government or the Federal Reserve — or the end of recession — must
result necessarily in runaway inflation and rising Treasury yields. If we were to
unearth evidence that inflation was about to shoot up — or skyrocket — we
would quickly communicate our findings, and invest accordingly. Our modeling
is objective and sensitive to a reversal in primary yield trends and we keep
strategies poised to exploit such moves. Yet, we have found no such evidence of
an upcoming inflationary spiral. Inflationary forces are not “coiled like a tight
spring” as retail brokers like to say. After one-a and-aa-h
half decades of over-
consumption, there is not much pent up demand in the U.S. or developed
countries, and consumers elsewhere have much lower (not higher) incomes with
which to buy goods and services, an unlikely recipe for bidding up prices. Inflation
which other countries may produce at home need not transmit to the U.S.

At present, we believe various market mis-perceptions centered on variations

in the rate of change of economic data (and on bullish equities-oriented
interpretations of weak corporate revenues and earnings) temporarily have
damaged returns on longer maturity Treasuries, especially in Q1 and Q2 of
2009 and into the present. It does not surprise us that what appears to be the
biggest domestic bear market equities rally in living memory has had some
overflow effects on the market for U.S. Treasuries. However, as we have stated,
in the end, returns on Treasuries are not determined by price movements in
other asset classes or categories.

Among those ideas we think are unfounded is a prevalent assumption that

Treasuries will or should remain inversely correlated with equities, a link which

Kessler Investment Advisors Market Commentary p.11

August 20, 2009

did not maintain in July, but which recurred in early August. Even though gross
assumptions about asset class correlations and even currency and GDP can promote
sporadic money flows such as we have seen (and move markets in the short term),
in general they do not drive returns on Treasuries. We remind investors that inverse
correlation of Treasury markets with equities is far from a constant in the markets.
Even, from time to time, prices at one end of the yield curve move inverse to equities
prices, and at the other end move with equities. Similarly the U.S. dollar can track
with or against equities or even Treasuries (or certain commodities) under various
conditions. Lock-step Treasury market reactions to moves in other markets can be
something more than market noise, but they are seldom a causal factor establishing
primary market trends — and are not so right now.

Equities rallies mask profound and continuing economic weakness

So why are we paying so much attention to equities here? We do so because these
markets are overlooking underlying economics and seem to be providing false signals
about near term and intermediate-term economic growth and inflation. Rallies in
equities index averages seem to be getting a wrong understanding of the economy
in much the same way these markets (and the Fed) misunderstood excess liquidity
did before problems at Bear Stearns, Lehman, and AIG brought to light vulnerable
fault lines. In other words, the “cash coming in from the sidelines to drive the
markets higher” has limits — and has other purposes to which it may be applied in
the future as deleveraging continues (such as living expenses for retail investors and
operating expenses and capital investment for corporations). The analysis on which
the equities markets and the Fed all dine seems to offer little appreciation for the
importance of the weakness that can derail trends dramatically. Think of the rusty
link in the chain, the bulge in the front tire, the storm clouds (or drought) beyond the
horizon. (Pick your analogy.) Some of the uniquely artificial stimulus and
discrepancies we see are as follows.

„ Rallies in homebuilders, automakers, and banking/financial stocks are not riding

on a rising tide of growth in those spaces, but are clearly dependent on
government support. The dubious engines of growth include generous (expiring)
one-time tax breaks for first time homebuyers, automaker bailouts that
encompassed reductions in price competition by closing dealerships, “clunker”
subsidies to auto buyers that supposedly destroyed gas-guzzler inventory that
would otherwise be auctioned off to second-line used car dealers, and most
important, all of the historically cheap borrowing and special guarantees
supporting banks and their counterparties. Even municipal spending is being
propelled by the Federal government, via “Build America” guarantees. Artificial
support eventually ends.

Plaudits about energy independence not withstanding, such extreme re-flationary

efforts as destroying inventory and reducing retail outlets suggest to us that
Congress and federal officials think deflation — not inflation — is a real threat.
However, diverting a couple of hundred dollars a month from discretionary
expenditures into vehicle payments (including financing) is likely to backfire as a
deflationary force in an environment where consumer borrowing has been capped.

Kessler Investment Advisors Market Commentary p.12

 August 20, 2009

„ Reductions in temporary housing market stimulus have implications for

banking. It bears repeating that some of the toxic assets in banks and other
financial institutions have been written off, but they have not gone away.
Many securitized obligations are deteriorating further with foreclosures in the
housing market and threats to the commercial real estate mortgage market as
vacancies rise and mortgage terms expire, requiring renegotiation. Since
banking institutions continue to hold assets that are not marked-to-market on
a daily basis, they remain vulnerable to an unprecedented extent and are being
propped up — for the moment — with an ability to invest in a lucrative carry
trade or lend at unprecedented multiples. This backing is apparently not
enough for bankers’ efforts to earn their way out of their balance sheet
problems. In addition to cutting off that consumer credit the banks had
extended on a longstanding basis, these efforts reportedly involve saddling
consumers with much higher fees and charges, and raising rates on non-
collateralized borrowing such as credit cards. Such increases “tax” consumers
and reduce discretionary spending.

„ On a global basis, some rebounds in commodity prices appear tied to

speculative inventory building and even hoarding. Increasingly, commodity
players are admitting to “learning” that fair value has been obscured.
Increasingly, former advocates of the rough and tumble “free-for-all” version of
free market trading admit that liberalization of rules governing commodity
trading has led to an era of market participants holding outsized positions and
affecting forward pricing to the extent that costs yet-to-be-realized often flow
through to current retail price points.

Electronic commodity exchanges fed by a surfeit of investment capital are

proving to be less dependent than assumed on classic relationships of supply,
demand, and capacity in the material world. There is only limited need for
speculative positions on the opposite side of commodity hedges sought by
those who produce or consume large volumes of commodities. Observers see a
difference between demand for actual commodities based on prospective use or
consumption (in relation to the capacity to produce a supply of goods) — and
the demand for opportunities to take financial positions on the direction of
commodity prices on an electronic exchange. Very roughly speaking, the
contrasts in these two worlds are similar to the differences between the
sustained investments of stable owners in breeding and training of race horses
(and purses they may win) and betting by mere spectators on those horse races.

„ Perhaps most important, throughout the corporate earning season, the

equities markets have reacted forcefully (and bullishly) to reports of earnings
rising in relation to analyst estimates. (We remind investors that the size of
analyst communities covering a company can start at a handful, vary
dramatically by targeted company, and contract or expand without warning.)
Often enough, revenues have dropped precipitously from the previous quarter,
or virtually collapsed from a year earlier. Think drops of 30% to 50% or more.
Yet the very event of reports on earnings (which also may have plummeted)
exceeding some arbitrary average or consensus of analysts’ opinions can light

Kessler Investment Advisors Market Commentary p.13

August 20, 2009

a fire under equities prices. (Is it right that every analyst’s opinion be given
equal weight?) Where rising top line and bottom line growth were once
required to push up equities prices, sometimes now it only takes “less worst”
losses to achieve the same kind of pop.

A related explanation of the flow of money into the stock of money-losing

companies is the propensity for professional money managers who need to get
more fully invested in equities to hold their noses and jump in. They keep their
jobs by staying with the pack.

„ The most obvious boost to equities is the overall contributions to earnings from
an unusual boost in productivity for a recession, broadly attributed to cost
cutting (in general) and to reductions in labor (in specific). Profitability trends
built on cost cutting are by their nature unsustainable. There are limits to
economizing one’s way into bottom line and top line growth — and not just
mathematical limits. For example, firing knowledge workers in a service
economy has lasting ramifications. Also, while the anticipated replenishment
of inventories drawn down in crisis may boost national GDP for a quarter,
sooner or later individual corporations will have to pony up the cost of
restocking. In an economy that is some 70% based on consumer spending,
firing workers is bound to reverberate into lower overall domestic consumer
spending and lower overall corporate revenues, which is not bullish for equities.

We can find no credible explanations for some anomalies in corporate versus

market performance we have seen. In the equities markets, sometimes good
news is bullish and sometimes bad news is bullish. In the corporate bond market,
simply avoiding bankruptcy has become bullish. Equities rallies extend on the
attractive and popular belief that they necessarily foretell economic recovery.
Positive “bull run” price trends (even in isolated sectors) point to a closed system
of self-referential markets that can resist becoming aligned with underlying facts
and economic forces.

To a large extent, financial markets have been operating with outdated

guideposts from the era of excess liquidity and free-fflowing credit. Companies
with p/e ratios uncharacteristic of their sector are said to “trade like” some other
sector. No one knows where acceptable p/e ratios will sift out as the economy
eventually rights itself in a new credit era in a deleveraged global economy. The
critical role of shifting sentiment in setting p/e ratios established by Dr. Robert J.
Shiller (whose views have been popularized and legitimized by his prescient calls
on the equity and housing markets and his contributions to the Case/Shiller
housing index) is rarely given the importance it warrants. Sentiment, we would
venture, is the ultimate self-referential feedback system. We conclude that some
relatively rich market capitalizations and p/e ratios promoted by sentiment
remain highly vulnerable to a recalibration of expectations that can only occur
once some critical mass of market and economic participants begin to actually
experience what it is like, not only to fear the worst recession since the Great
Depression, but also to work through it and emerge from it.

Kessler Investment Advisors Market Commentary p.14

 August 20, 2009

U.S. needs to make up half a trillion dollars to get back to the GDP of 2008
Inflation fears, supply concerns, and equities market trends substantially drove the
Treasury market in Q2 of 2009. Better-than-expected earnings for Q2 and better-than-
expected global economic numbers created a popular argument for strength and
speed of recovery — and 10-year U.S. Treasury yields backed up. Yields had run up
as markets moved on fears of low probability scenarios. Chief among them was a
damaging market trend that misconstrued rising equities markets as predicting an
explosive, inflationary economic rebound that would catapult the U.S. domestic
economy past recovery into true growth.

Our position is that recovery requires the weakened U.S. economy to slowly climb out
of an unusually deep hole (and to do so without the boost of free-fflowing credit). Any
rebound in earnings consistent with an unusual recessionary gain in productivity
(associated with wholesale layoffs) and a drawing down in inventory is not
synonymous with corporate growth or significant overall expansion. Unfavorable
yield trends are now only beginning to show themselves to be overdone as Treasury
auctions succeed and fears subside. Yields on the 10-yyear U.S. Treasury have not
approached the 3.95% high of June.

The most important market misperception, in our view, involves equating the end of
recession (a halt to falling GDP, assuming real GDP soon stabilizes), with full recovery
and with a resumption of growth over the peak nominal real GDP of mid 2008. A
resumption of true growth remains over a half trillion “2007 dollars” away. The end
of recession means that GDP stops falling – not that the economy has recovered.
Historically, in a now typical recovery where job growth lags GDP, inflationary forces
(especially as measured by annualized 6 month core CPI) do not kick in until a year
or two after recession ends. Yields on 10-yyear Treasuries tend to trend dramatically
lower for 1.5 to 3 years after recessions end. The yields’ eventual turn higher (in
response to inflation pressures) typically is truncated by Fed dampening actions
which generally raise short term financing costs for everyone. This well-established
time line was largely ignored by market participants so far this year.

Even presuming that Q3 2009 will show no decline in real GDP, when assuming a
recovery which sustains an annualized real GDP rate of 3% to 1%, we do not project
a return to 2008 levels of real GDP before Q3 2010, and possibly not until Q2 2013.
The time lines represent paths to recovery based on three scenarios that may return
nominal GDP to the levels where inflationary forces can be a factor (as plotted in the
chart on the last page of this commentary). So, inflation might not be a factor until
2013. Even then, aggressive Fed tightening could let the air out of the 10-yyear yield.
In the final analysis, markets have been trading almost exclusively on slim news that
primarily affects equities and commodities because of a news gap. The underlying
conditions have not changed — and in this context no news is bad news for the
economy, and is only good news for investors positioned long on U.S. Treasuries.

— Robert Kessler, Chief Executive Officer

Kessler Investment Advisors, Inc.
The Kessler Companies International Limited

Kessler Investment Advisors Market Commentary p.15

August 20, 2009

DISTANCE TO FULL RECOVERY, INFLATION THREAT

Three Paths of Recovery to Real GDP of 2008

US $ in (Charted in 2007 Dollars)
Trillions

Q3 Q2 Q2
2010 2011 2013

2% th
row

th
at g
DP

w
G
eal

o
r
gr
3% at 1%
at

Chart assumes recession ends here

(for purposes of calculation)

Three sets of assumptions of an annualized growth rate of real GDP at 1%, 2%, and 3% suggest that the slack in
the U.S. economy will not be absorbed for a year or two at best, and possibly not until Q2, 2013 — and that
true inflationary pressures will not be felt until that time. During this period, higher prices from commodities or
other imports are likely to be experienced as a tax on consumers and a narrowing of corporate profit margins.

Issued by

Kessler Investment Advisors, Inc. The Kessler Companies International Limited

An SEC-Registered Investment Advisor Authorised and Regulated by the Financial Services Authority

1200 17th Street, Suite 110 105 Piccadilly, London W1J 7NJ United Kingdom
Denver, Colorado 80202 Tel. +44 (0)20 7629 9941

Tel. 303.295.7878
Fax 303.291.8459

A wholly-owned subsidiary of The Kessler Companies, Inc.

Our specific investment strategies vary with the investment objectives In this document references to The Kessler Companies, Inc., Kessler
of each account. Although we consider the information contained in Investment Advisors, Inc. and Kessler & Company Investments, Inc.
this publication to be reliable, we do not guarantee its accuracy. The providing services directly to clients are to be read in context The Kessler
opinions expressed in this publication are for general information Companies International Limited (A wholly owned subsidiary of The Kessler
only and are not intended to provide specific advice or Companies, Inc.) will provide services directly to the clients.
recommendations. Clients should consult their financial and tax
advisors with regard to their own circumstances prior to relying on
any material contained in this publication. © 2009 Kessler Investment
Advisors, Inc. All rights reserved.

Kessler Investment Advisors Market Commentary p.16