All things pass our way again. My New Era Not articles published in Corporate Finance Review from 1997 to 2000 reviewed economic and market climates and the relative performance of stocks, bonds, cash and commodities for the most part since 1874. These works laid the foundation for Reflexive Asset Allocation (RAA, Figure 2) introduced in Fighting Your Grand Father's Wars, a presentation that I gave in 1998-2001.

Our grandfathers fought wars prior to 1946 that taught them to how to defend and advance asset values during inflationary booms/busts and deflationary booms/busts. Their biggest fear was a deflationary bust. Prior to 2008, 1998 was the worst year for hedged portfolios that were not prepared for a deflationary bust. Such busts are rare, which is why most portfolios are unhedged for them.

After the Russian debt default earlier in the month, on August 31, 1998, Treasury Secretary Robert Rubin told us we were facing "The worst global financial situation we've had in the last 50 years." He also said we were gazing into the abyss. Prior to 1998, there was little interest in hedging deflationary busts. Interest waned again after the debt bubble was re-blown with a fresh blast of air during the fall of 1998. The cure included a massive round of global interest rate cuts and a Federal Reserve-orchestrated bailout of Long Term Capital Management, a leveraged hedge fund that had wasted nearly $100 billion in capital, while threatening the financial system.

I started developing Reflexive Asset Allocation (RAA) after the near collapse of the financial system in 1998, but its roots extend back to 1988. RAA is a by-product of George Soros's book, "The Alchemy of Finance," which introduced his theory of reflexivity.[i] Since my first reading in 1989, I have tried to stop seeing asset prices as they should be. Mr. Soros teaches us to interpret asset prices for what they are likely to represent. He warns that observer bias limits the value of our interpretations because price extends beyond economics.

We Are Mr. Market

Reflexivity operates on the assumption that markets are often inefficient in pricing assets because financial markets cannot discount the future correctly. According to Mr. Soros, investors are both participants and observers of asset price discovery. Mr. Soros's best articulation of his behavioral investment theory was at the World Economy Laboratory Conference in Washington, D.C., on April 26, 1994, when he said of investors: "They do not merely discount the future; they help to shape it."

Recent fears of a deflationary bust are greater than they were in 1998. The time is ripe for revisiting reflexivity and its impact on asset allocation. Reflexivity is centered on the awareness that price discovery is not scientific because it is dependent upon active bids and offers of participants who are simultaneously observers and interpreters of market prices. The scientific method requires observers to be independent of their empirical evidence (independent and dependent variables). Investors never were and never will be independent observers.

If most investors were passive buyers and sellers, there would be little information embedded into asset prices. Ironically, this void would result in greater market inefficiency, not less. Reflexivity is a seminal concept for guiding financial management (asset modeling) and central bank policy (economic modeling) because it indentifies the dangers and unintended consequences derived from too much quantitative analysis. Since 2007, inefficient prices have enabled black swans to destroy black boxes (CDOs, MBSs, SIVs and the like), which in turn disabled our economy, consequently vaporizing credit/liquidity and breeding financial firm insolvencies.[ii]

Applying Reflexivity In Asset Management

Understanding reflexivity is easier for traders and tactical asset managers than it is for strict adherents to Modern Portfolio Theory (MPT) who are married to the efficient market hypothesis. Traders know that MPT is dependent on fresh supplies of cash that foster orderly and liquid markets, the Hyman Minsky principal.[iii]

MPT is a bust when panic reigns as it often has since 1920 (Figures 1 and 2).[iv] MPT's popularity is a product of the boom times from 1985 through 1999. Boom times have always been fueled by ample supplies of new credit (leverage). Credit-driven liquidity tightens bid/ask spreads, making it possible for observers to proclaim that markets are eternally efficient, until they are not (2000-2002 and 2007-2008).

All things pass our way again. Most MPT adherents have relied upon data inputs from market observations made after 1946. In the post-World War II era, deflation has been rare. There were a few mild instances of year-over-year (YOY) declines in consumer prices in 1949, 1950, 1954 and 1955.

The absence of deflation inputs in MPT asset allocation models and our generation's inexperience with panic-led liquidations skewed quantitative models into optimizing portfolios for inflation risk. The endowment model is a prime example of negative reflexivity. Void of deflation inputs, endowments have been primarily optimized to hedge inflation risk. These models see bonds and more liquid assets as a bad bet.

The Yale model is very popular in our investment world. It holds a long-term 90% equity to 10% fixed-income allocation.[v] Generally, this model has an illiquidity bias. The Yale endowment believes that the more liquid an asset class or security category, the fewer opportunities there are for active management to generate alpha.

Yale entered 2008 with only 5% in bonds. They do not see diversifying value from corporate/foreign bonds. They usually hold about 5% in Treasury bills for operation needs, which completes the fixed-income allocation.

Yale ignored a deflationary bust risk right as we began to slide into the abyss. Asset deflation and default risk were evident when they established their asset allocations for 2008. Investors who follow their model lost more than 30% of their portfolio values in 2008. Figures 1 and 2 improve upon the Yale endowment model.

Booms, Busts & Other (More Normal) Times

Figure 1 displays the percent of time that we have spent in booms, busts and other times (somewhere in between) over the past 90 years. Since 1920, we have been in a bust 25% of the time. Hard times decline to 23% and 15% when the starting times begin in 1946 and 1984. Other times rise from 36% to 47% of all occurrences when observations begin in 1984 rather than 1920. Boom times consistently account for 38% to 40% of all periods, which have enabled financial asset returns to exceed Treasury bills since 1920.

Figure 1 supports the reflexivity theory. The Yale endowment is an example of observers lacking independence from their dependent variable (market prices). Observer bias keeps us from widening our data universe. Poor input quality limits our ability to hedge portfolios for all economic climates prevalent since 1920, especially the period from 1920 to 1946.

Since 1990, the U.S. has displayed economic/market cycles similar to those in the 1920 to 1946 period. Default risk dominated the former and latter periods. Great deflations and re-inflations ruled asset prices.

Figure 2 incorporates the historic economic drivers of asset allocation since 1920 shown in Figure 2. We borrow from GaveKal Research, a Hong Kong-based research firm. They identify extreme scenarios that investors need to prepare for, namely, inflationary busts/booms and deflationary busts/booms. Figures 1 and 2 expand upon their insights.

Here are our enhancements. First, we defined the conditions for each boom and bust scenario. Inflationary booms display moderate inflation ranging from 2% to 5% yearly with real gross domestic product (RGDP) growth greater than 3.5% annualized. Inflationary busts are periods with annual inflation above 3.5% with RGDP below 2.5%. Deflationary booms experience CPIs above -1% but below 2% with RGDP above 2.5%. Deflationary busts are hell. The CPI goes below -1% with growth below 1% yearly (T-bills rule).

In summary, since 1920, assets have sourced returns through factors driven by an inflationary boom 19% of the time. Inflationary busts rule is 16% of the time. Twenty percent of all observations were a deflationary boom. A deflationary bust prevails only 9% of the time. These percentages are in the table at the bottom of Figure 1 and at the top of the boxes found in the middle two columns in Figure 2. Extreme booms and busts comprise 64% of all experiences. Does it not make sense to balance portfolio assets to hedge booms/busts?

Building Hedged Portfolios With Alternative Investment Styles

We employ scenario frequencies to build all-weather portfolios. There are hedges to help us endure our four seasons. We weight 64% of assets to match four scenario frequencies. We are free to allocate 36% to match the scenario expected the most or to reflect other (normal) times. Today, we would allocate 4% to 5% to a contingency reserve. The rest of the portfolio is overweight to bust and boom scenarios because normal times are not expected until after 2016 (financial restructures take at least a decade). We also could employ an alpha overlay with 5% to 10% in short-term Treasuries to collateralize long/short commodity, bond and currency exposures. We will review this soon.

Follow your gut and research. The Arrow Insights (AI) 75/50 Portfolio is positioned mostly for an inflationary bust with a 72% allocation to inflation hedges—gold bullion, emerging markets, energy, agricultural stocks and Treasury inflation-protected securities (TIPS)—while short the 20-year T-notes as well as foreign and consumer discretionary stocks. The portfolio is balanced with half of the assets defending against an economic bust and half positioned to profit from a boom.

Figure 2 displays our scenario strategy for building a hedge fund of funds allocation and the AI 75/50 Portfolio. By example, to hedge a deflationary bust we would allocate 9% of assets to no- or low-leveraged assets, bond-timer hedge funds, short-biased hedge funds, market-neutral funds and managed futures. Experts often recommend a similar amount to these hedges. In the bottom left-hand corner is a red-shaded box labeled Deflationary Bust with a big-picture tip. Here we suggest that investors buy government bonds and gold while selling stock and negative cash flow assets (new ventures and junk bonds).

There are red (deflationary) and green (inflationary) shaded boxes in Figure 2 with tips for each scenario. Portfolio allocation headings are at the top of the center boxes along with the scenario's frequency. Under each is a bulleted list of manager styles appropriate for each scenario. Hedge fund managers and exchange-traded funds (ETFs) best suited for deflationary and inflationary times receive 25% and 39% of portfolio assets.

Current ETF allocations listed are for the AI 75/50 Portfolio. These ETFs are at the bottom of the middle boxes. For example, for a deflationary bust there is a 20% allocation to EFU, GLD and SCC. This is an overweight allocation to this scenario because it exceeds its frequency by 11%.

If you add the AI 75/50 allocations at the bottom of the four middle boxes, you get 185% in ETF exposure. On March 31, 2009, exposures were 146%. The discrepancy is from ETFs that hedge more than one scenario.

Besting MPT

This process is tedious, but it works. Passive allocations that employ this process beat MPT optimizers hands down! Why? Because alternative investments are a mixed bag of active styles with changing asset exposures making it hard to make the right inputs for optimization. Another alternative is to substitute managers for manager style replications appropriate for each scenario (more on this later).

Our RAA process maintains core allocations appropriate to each scenario. Doing so limits observer bias and adds structural reflexivity. Management does not have to predict the future. The portfolio is positioned for climates that eventually pass our way. Sources of return must be varied and rich enough to limit losses. In future newsletters, we will demonstrate RAA results.

A New Partner

A huge factor in asset allocation decisions is government influence in our investment world. It causes us to hedge an inflationary bust more than other scenarios. Since September 2008, Uncle Sam has been the single largest investor in our economy, with more than $14 trillion in commitments to private-sector businesses.

This factor overrides our concern about our entrance into a deflationary bust in December 2008. We entered this climate for the first time since 1954. The 1954 sojourn was brief, as were those in 1949, 1939, 1928, 1929 and 1921. We are very concerned because our only enduring trip into this climate after 1920 was the Great Depression from 1931-1933. Recent rates of change in YOY inflation and RGDP declines have been the most severe since then.

In spite of our concern about a deflationary bust, for now we are very committed to an inflationary outcome. From October 2007 through October 2008, we were in an inflationary bust due to past accommodative fiscal and monetary policies. Trillions more in government commitments to the financial system and huge fiscal deficits will only get larger as we continue the status quo. Governments have historically opted to repay debts with a cheaper currency. Federal Reserve Board actions and the Fed's stated strategy will reinforce the inflationary bust cycle that was in place prior to November 2008.

However, past debt accumulations limit our options and place us on a path toward an inflationary bust. The chickens have come home to roost since they flew the coop during the 1980s (the birth of our debt bubble).

In 1982, real 10-year Treasury note and T-bill yields peaked near 9.2% and 7.2%, respectively (Figure 3). Nominal yields near 16% for notes and 19% for bills were the highest yields ever (Figure 4). Back then, inflation stayed above 6% from March 1977 through June 1982. Notes and bills peaked near 16% and 20%. It is no wonder that investors were obsessed with inflation hedges, hated bonds and were indifferent to stocks.

The Yale model still holds a bias for bonds that stems from the ravages experienced by bond investors in the 1980s. What Yale failed to account for was that after an excessive level of private debt, Treasuries are the supreme diversification asset. Yale declined to balance its assets to hedge inflation risk and deflation risk. It had the evidence and the time to do so, because given our circumstance since 2003, students of history knew that inflation risk would not override default risk until a large portion of private debts (at risk of default) became the liabilities of the U.S. government. This realization would have helped Yale to protect assets better in 2008.

A Debt Bubble Primer

We need a history primer from time to time. After inflation and bond yields peaked in 1982, fiscal observers voiced outrage at federal deficits that averaged $206 billion yearly from 1983-1992. These unprecedented peacetime deficits increased public debt from $789 billion in 1981 to $3.0 trillion (48.1% of GDP) in 1992. Disinflation enabled this debt explosion.

Deficits did their Keynesian trick. They were the initial impetus for stimulating the economy out of the 1980 and 1982 recessions. Dramatically falling interest rates and tax cuts then picked up the slack and propelled the greatest bull market of all time (August 1982 to September 2000). After 1994, the job of maintaining high equity and bond values was left to an ongoing debt bubble, which began in 1982. The present ramifications from decades of accumulating debt are either a deflationary or an inflationary bust. Here is our status:

The U.S. government debt, commonly called the public debt, is the amount of money owed by the federal government of the United States to holders of U.S. debt instruments. Gross debt includes public debt plus intra-governmental debt obligations, such as the debt held in the Social Security Trust Fund.

Figure 5 needs to be updated since its release at www.budget.gov/budget in 2008. As of April 7, 2009, the gross federal debt was $11,152,772,833,835.89, or about $36,676 per capita. In 2008, $1.1 trillion was added, with about $1.2 trillion more expected in 2009. Although debt as a percentage of GDP looks tame compared to the 1940s and 1950s, back then we were a creditor nation. We have been a debtor since 1985, and this makes a world of difference, because in depressions, beggar-thy-neighbor foreign policies eventually prevail.

In 1984, the percent of U.S. government debt held by foreigners was 15.9%. Foreigners owned a little less than 35% of all Treasuries by 2000, and today they own more than 50%. Our 1985 debtor status opened the door for a future tipping point for an inflationary bust. It also distorted MPT.

Portfolio management was in its infancy in 1985. Back then, MPT-driven asset allocation helped investors to overcome their resistance to bonds and stocks. It helped, but it was not—and still is not—a panacea. To be effective, MPT must adjust its historic inputs for the ramifications of our debt bubble. The debt bubble distorted MPT inputs as the bubble was blown from 1985 to July 2007 and as it has imploded since.

The bubble eventually distorted inflation and business cycles. Debt expansion and trade deficits enabled a benign recycling of excess U.S dollars. First during the early 1980s, easy credit financed the leveraged buyouts, which enabled the transfer of our manufacturing base to offshore enterprises. The recycling of trade-deficit dollars from foreign manufactured goods enabled abnormally low interest rates, which fostered an unsustainable consumer debt expansion (even higher trade deficits) and then the subprime debt crisis.

Our nation's cumulative government, business and consumer debts make up our total debt. When our debt exceeded 200% of GDP, the above factors suppressed inflation until the U.S. dollar began a severe decline in 2001. Our debt to GDP ratio rose from 2:1 in 1984 to more than 2.5:1 by 1987 for the first time since the late 1920s. Currently, our debt/GDP ratio is more than 3.5:1, or 350%, with three-fourths of load held in the business and consumer sectors. We have about $50 trillion of unfunded liabilities. As more and more private debt becomes liabilities of the government, inflation risk rises, because very little of the debt-financed income-producing assets will contribute to GDP growth, which also hampers productivity.

Figure 6 compares debt/GDP, personal disposable income (DI)/GDP and corporate profits to CPI growth (rolling 10-year cumulative growth). Debt loads are more difficult to carry when we are experiencing declining incomes and profits. The collapse in the DI/GDP ratio reflects meager personal wage growth since 1984. Corporate profits also peaked in the third quarter of 2006 and are decelerating at their fastest pace since the 1930s. Corporate taxes as a percent of GDP have declined from 4% to 5% in the 1950s and 1960s to 2.4% in 2008, while individual tax receipts have remained near 8% over the past 60 years. In spite of huge tax relief, corporations still are suffering. This is very troubling because even with tax breaks, profits have plunged.

Serial debt creation and lax monetary policy snatched us from the abyss in 1998. Easy money and an unregulated shadow banking system prevented a bursting of the debt bubble after the equity/credit implosion in 2000-2002. The bubble was doomed in 2005. This was when our incomes could no longer carry our load. In the past, nations have leveraged private debts until they were paid, defaulted on or were assumed by the government.

Since the mid-19^th century, the U.S. has owned a no-default option. Uncle Sam can transfer private debt to the government's balance sheet via asset purchases, bailouts, backstops, etc. He can print money to monetize some or all of the transfer. As he does, the risk of an inflation bust rises. In this grand poker game, the U.S. has played with a loaded deck and held the right cards. Our current hand is weak.

Foreign players now own the casino, and the house always wins. Players win some hands but they lose a lot more. The house is beginning to fear the U.S. is a compulsive gambler that will eventually ask for more than the house is willing to credit. This condition is rare. The last time foreigners owned so much U.S. debt was in the mid-19th century, when Europeans bought bonds for the construction of railroads, canals and highways. We may be near our house limit. Foreigners can see that their loans are not financing infrastructure assets (and other future income generators) that enhance the value of their investments. Self-interest rules.

Foreigners see us wasting their loans on saving an insolvent financial system, which might be why foreign debt purchases fell sharply in January 2009. Offshore banking centers sold Treasuries. Central banks sold U. S. agency bonds, resulting in a $43 billion decline in foreign net investment in January 2009 compared to January 2008's $35 billion surplus.[1]

Our Not-So-Brave New World

All participants define the markets-traders and MPT adherents alike. One of the best ideological dichotomies is "Brave New World or Bust" by Marc Faber of Marc Faber Ltd. published in welling@weeden on January 20, 2006.[ii] In this article, Mr. Faber gives his perspective on Louis-Vincent Gave's market views derived from GaveKal Research's economic theories.[iii] We will turn our attention back to Reflexive Asset Allocation (Figure 2) after we have disputed the foundation of the GaveKal thesis that deficits are not an issue because globalization and great platform companies (their concept) have moderated our economic cycles.

The Not-So Great Moderation Disguised Risk

Figure 7 originated in 1997. It is important for it to predate GaveKal's book, "Brave New World," published in 2005, because there is nothing worse than a backseat driver critical of a recent wrong turn. We all make a wrong turn from time to time. A 1997 origin adds weight to our dispute.

Quite often, bad investments stem from an untested theory of how the world works. Investors who followed the advice given in GaveKal's book since its release are by now quite likely timid. Back then, GaveKal proposed: "It is truly different this time!" with religious zeal and, called nonbelievers blind.

GaveKal preached that we lived in a brave new world transfigured by platform companies into a permanent state of economic moderation and robust corporate profits. They envisioned a heaven of persistently higher equity valuations sustained by high leverage. In this new age, developed countries had closer ties to the cyclicality inherent to labor and inventory-intensive production.

Developing nations were feeding the developed world their manna of consumption products. In doing so, the developing nations inherited the severity of our past economic and profit cycles while we inherited our great economic moderation and huge trade deficits. Deficits were of little concern. They were simply a sign of a manageable symbiotic relationship. This view was wrong and egocentric.

Figure 7 shows the emperor with no clothes. He is weakened by structural trade and debt imbalances unsustainable by recycled trade dollars. The emperor is left with a bubble economy that is overly dependent upon the financial sector. What exposed his nakedness?

Plotting the differential between reported earnings growth (EG) and our nation's nominal gross domestic product growth (NGDP) rapes the emperor. This simple exercise blows up the Brave New World.

Figure 7 plots the monthly change in the S&P 500's (S&P) EG and NGDP since 1947. EG historically has been about 0.50% (6% annualized). The monthly change in NGDP has been close to 0.60% (7.2% annualized). Normally the difference between EG and NGDP is -0.10% (0.50% minus 0.60%) or slightly below zero.

The table embedded in Figure 7 shown as EG-NGDP stands for reported earnings growth minus nominal gross domestic product. The symbol LQ is also in the chart. LQ represents low quality stocks. HQ references high quality stocks or firms with high dividends and steady earnings growth.

Wild swings in EG minus NGDP occur in unstable times. Notice the monthly standard deviation (SD) in EG-(minus) NGDP was 1.50 from 1968-1999, a period of sustainable debt carry (a leveraged P/E). After 1999, as our nation's debt-to-GDP ratio exceeds 3-to-1, the debt buildup distorts the market's sustainable EG and our economic growth rates (low-quality MPT inputs).

NGDP drives corporate earnings, not GDP net of inflation (real or RGDP). Economic growth must remain higher than EG's 6% historic earnings growth rate to support long-term equity valuations near the S&P's historic mean price-to-earnings ratio (P/E) near 16. It is important to note that a P/E near 16 has seldom been likely while the world is deleveraging.

Near the end of the 1990s bull market, the debt bubble reinforced a belief that earnings could consistently grow by 10% or more and that sustainable NGDP was 10% (3.5% net of inflation) or higher. From 1987 through September 2000, a flood of liquidity and our false perceptions were the primary drivers of low financial market volatility, low earnings volatility and low economic volatility (more low-quality MPT inputs).

Figure 7 alone disputes GaveKal's thesis. A great economic moderation was NEVER at hand. Absent their Brave New World, high asset valuations (credit & equities) collapsed when the liquidation of assets to repay debts began (August 2007).

There never was even a slight moderation in the excess EG over NGDP. The proof is in the monthly SD of EG-NGDP. From 1999 through March 2009, it was 4.11, which is nearly three times more volatile than the excess earnings over economic growth recorded from 1968 through 1999 (the old world). Old world economic and earnings volatility was much tamer than it was during GaveKal's Brave New World.

Estimating Future Returns And Investment Leaders

EG-NGDP helps us to estimate future equity and debt returns. It aids rotations to and from LQ to HQ securities. Since November 2008, it and other factors signaled a rotation to LQ assets. At the peaks and troughs of the EG-NGDP trend line (the blue line below), old market leaders die while new leaders are born.

Earnings Collapse

In the February and March InPerspective, we focused on the collapse of S&P 500 earnings from near $86 in the third quarter (Q3) of 2007. Last month showed an estimate near $16 by the 2009 Q2, which at that time was only 12.5% below the $18.29 estimate for all of 2008. The $16 estimate for 2009 Q2 now looks too optimistic. Figure 8 is from the April 6, 2009 issue of Barron's. It shows reported earnings at $14.88 for 2008 Q4, which is the first time they have published earnings below $28.75 since June 2003. The actual result posted at the S&P Internet site was -23.25 per share on April 9, 2009.

Estimates by Standard & Poor's for 2009 are still at $28.51, but given the huge misses since 2007, negative surprises are likely to continue in 2009. S&P estimates a negative P/E ratio of -467.52 by 2009 Q3, which is unprecedented on a 12-month basis.[i] This is so shocking that I almost copied it from their site verbatim below.

Our March InPerspective also saw the possibility of a deleveraged S&P price trough in the 219-607 range with a bottom no more than 12.5% below the 666.79 intraday low on March 6, 2009 (S&P price 587).

The Latest Rally

Our point of the week for the March 13, 2009 InFocus is below.

"The markets have most likely made intermediate-term bottoms on March 6 that may take the $SPX back to the 850-950 price level over the next couple of months."

Figure 9 below was Figure 4 then. It is updated through April 13, 2009, with the S&P at 858.73. We still expect this rally to top out in the 850-950 range no later than the end of May 2009. We then expect a decline near 740, and if that fails, a retest of the lows near 667 by year-end. Technical estimates do not affect the maintenance of a structural balance among assets that hedge booms and busts.

Portfolio Exposures & Convictions

Figure 10 is composed of a focused list of indexes and assets classes (we keep an eye on these and many more) and corresponding ETFs. Returns are through March 31, 2009 and April 3, 2009. AI 75/50 portfolio weightings are labeled in the third column. Red highlights are for sectors that were shorted through 2x inverse ETFs (Figure 11). Our long ETFs are either overweight (OW) or neutral weight (NW) relative to the Dow Jones Global Index.

AI Portfolio Performance (objectives should be evaluated over 36-month periods)

Like the Hedge Fund Research Global Hedge Fund Index (HFRX), AI's secondary objective is to provide an absolute return (consistently positive returns). As of March 31, 2009, hedge funds are down -24.6% while the AI 75-50 Portfolio is up 4.6% since the S&P 500's peak in October 2007. The AI 75/50 model has outperformed its benchmark, the HFRX and the S&P 500 (Figure 12). AI 75-50's primary objective is to capture 75% of the S&P's upside and 50% of its downside, which requires us to hedge beta nimbly while maintaining core beta (equity and bond exposures). The portfolio's 11.7 annualized standard deviation (ASD) is higher than that of the HFRX but much lower than that of the S&P's volatility since the market's peak.

Upside & Downside Risk

In our last InPerspective, our view was that there was significantly more risk from being too short (low beta exposures). We saw the market as being extremely oversold after being down about 60% since its prior peak. This is from last month's issue.

"Oversold Panics, even those that lead to depressions, experienced 30% to 90% counter trend rallies while remaining in a bear market."

Even if we were wrong, we thought it best to add beta in late February and early March 2009. As of April 13, 2009, the S&P is up nearly 29% off its prior low.

Over the past five weeks, the market gave us an opportunity to reduce beta and to reestablish defense. Since last month's lows, we added back short exposures through the repurchase of the UltraShort Consumer Services ProShares (SCC). We also initiated exposure in the ProShares UltraShort MSCI EAFE (EFU) and added to the ProShares UltraShort Lehman 20+ Year (TBT). In addition we sold the PowerShares FTSE RAFI US 1000 (PRF) and the Telecom Holders Trust (TTH). We also sold all of the PowerShares UltraLong Crude Oil ETN and invested the proceeds in the Energy Select Sector SPDR (XLE).

All positions and our strategy view for all holdings are listed in Figure 13, along with our beta-non beta allocations and themes (see the February InPerspective for more).

As of March 31, 2009, we were up 4.4% month to date, while also up 5.9% year to date.

Endnotes

[i] George Soros is an American currency speculator, stock investor, businessman, philanthropist and political activist. Soros is the chairman of a hedge fund group known as Soros Fund Management and the Open Society Institute and is also a former member of the Board of Directors of the Council on Foreign Relations. In 1970 he co-founded the Quantum Fund with Jim Rogers, which created the bulk of the Soros fortune. Rogers retired from the fund in 1980. Other partners have included Victor Niederhoffer and Stanley Druckenmiller.

The Alchemy of Finance (Simon & Schuster, 1988) ISBN 0-671-66338-4 (paperback: Wiley, 2003; ISBN 0-471-44549-5)

[ii] A George Soros quote dated April 26, 1994: "I must state at the outset that I am in fundamental disagreement with the prevailing wisdom. The generally accepted theory is that financial markets tend towards equilibrium, and on the whole, discount the future correctly. I operate using a different theory, according to which financial markets cannot possibly discount the future correctly because they do not merely discount the future; they help to shape it. In certain circumstances, financial markets can affect the so-called fundamentals, which they are supposed to reflect. When that happens, markets enter into a state of dynamic disequilibrium and behave quite differently from what would be considered normal by the theory of efficient markets. Such boom/bust sequences do not arise very often, but when they do, they can be very disruptive, exactly because they affect the fundamentals of the economy."

Reflexivity is based on three main ideas: (a) investor bias can grow, spread and disrupt market pricing mechanisms (b) it appears intermittently and is revealed as part of the trend-following habits of investors and (c) investor observations and participation can influence valuations and economic conditions.

[iii] John Serrapere, Defend to Advance, The Minsky Moment, InPerspective, Issue 1, February 2009.

[iv] John Serrapere, Panic P/Es, Active Indexer, October 2008, www.indexuniverse.com.

[v] The Yale model was developed by David Swensen and Dean Takahashi. David F. Swensen has been the Chief Investment Officer at Yale University since 1985. Mr. Swensen's book, "Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment" outlines his investment thesis.

[1] Laura Mandaro, MarketWatch, March 16, 2009

[ii] Marc Faber was born in Zurich and schooled in Geneva, Switzerland, where he raced for the Swiss National Ski Team. He studied economics at the University of Zurich and, at the age of 24, obtained a Ph.D. in Economics magna cum laude. Faber resides in Thailand and is best known for the Gloom Boom Doom investment newsletter.

[iii] Louis-Vincent Gave is CEO of the global financial services firm GaveKal. Educated at Duke University and Nanjing University, Mr. Gave is a former member of the French army. Since the 1990s, he has worked in global finance in Hong Kong, London and Paris. He left Paribas Capital Markets in 1999 to launch GaveKal Research. He is the main author of two books, Our Brave New World and The End is Not Nigh. GaveKal is well-known for its economic research on how platform companies have changed the world by enabling economic cycles in the developed world to undergo a permanent moderation that supports higher security prices and financial firm valuations.

[i] Recently a subscriber to John Mauldin's Weekly E-Letter directed my attention to Mr. Mauldin's coverage of the crash in equity earnings titled: Thoughts From The Frontline, Is That Recovery We See?, April 10, 2009.

John Serrapere works on research and consulting projects through Arrow Insights. He welcomes comments and suggestions at This e-mail address is being protected from spambots. You need JavaScript enabled to view it .