1. EYE ON THE MARKETS Feb 16, 2011
Dear readers,
This is the inaugural edition of "EYE ON THE MARKETS". This newsletter delves into critical areas of the macro-economy,
investment management and anything that is pertinent to navigating the ups and downs of equity markets. This initial
piece sets the landscape for what I believe are the most relevant issues today. I welcome your feedback and critique.
Underpinning these views is the contention that macro events will continue to have an overwhelming influence on
movements in stocks. Along these lines, I argue that equity markets will be impacted more by global emerging trends
and geo-political perturbations than company specific fundamentals. Periods of relative calm (March 2009 to December
2009; February 2010 to April 2010; and September 2010 to February 2011) have been interspersed by bouts of panic
and market sell-offs. The panoply of crises has included: European sovereign debt, municipal bonds, mortgage put-
backs/robo-signing, and more recently the events in the Middle East and Japan; all while the US is undergoing fiscal
duress. Further evidence that markets are highly sensitive to macro events is revealed in the high degree of correlation
between stocks, even in unrelated sectors. Historically, the average correlation of S&P stocks was approximately 35%, it
has now risen to 60%. In my opinion, there is little evidence that trading patterns will normalize and revert to the
relative benign 2002 - 2007 period. With that in mind, investors need to be ever-more vigilant managing their
investments. I don't believe anyone can credibly foretell what the end game is. Nevertheless, it is absolutely imperative
for you/your advisor to map out a blueprint for each major scenario that may unfold and adopt contingency plans when
things go awry.
Positive influences in the Macro-economy
The relative health of corporations has improved dramatically since late 2008 and early 2009. Earnings growth has
been robust. S&P earnings per share have increased from $61 in 2008 to $84 in 2010. In 2011, companies are projected
to realize another 12% - 14% growth. Global M&A activity swelled 22% to $2.4 trillion in 2010, the first year to increase
since 2007. Corporate balance sheets have strengthened with leverage ratios ratcheted down meaningfully. Cash as a
percentage of debt was barely 40% at the height of the sub-prime debacle; now it’s approximately to 65%. Another
positive sign is the increased levels of corporate share repurchases and dividend payments (financials firms have started
to reissue dividends).
Broad indicators suggest that a nascent revival in manufacturing is taking shape. The Philly/NY Fed, PMI and ISM have
all surged to multi-year highs. A healthy manufacturing sector is a necessity for sustainable recovery. Manufacturing is
responsible for nearly two-third of private sector R&D. It generates more economic activity per dollar of production
than any other business sector in the country. In addition, manufacturing has a network/derivative effect, wherein
residual employment outside its immediate domain may also be created. Anecdotally, digital manufacturing could
foster a rebirth and bring jobs back to the US. Examples include: 3D printing, additive manufacturing, rapid prototyping,
rapid manufacturing, and Layered Manufacturing. Because these processes require skilled labor and will greatly
improve throughput, companies can bring jobs back onshore yet still maintain margins through greater efficiencies.
Technologies currently being utilized for digital manufacturing include stereo-lithography, ink jet printing or deposition,
selective laser sintering, fused deposition modeling, aerosol jet deposition, among others.
* The US is still the heart of R&D.
I am heartened by the recovery taking shape in technology. U.S. R&D expenditure in 2010 was about $400 billion, well
ahead of all Asian countries combined, as well as Europe. Venture capital investments surged 19% in 2010, with total
deals rising 12% to 3277. Within tech, software alone comprised 18% of the VC pie. Export of "cloud-based technology"
into the rest of the world from optical components, to storage, to enhanced mobile computing, has also been a
promising development.

2. Many argue that with China and India churning out millions of new science and technology grads each year, the US will
soon be displaced as the home of innovation. What critics fail to realize is that R&D infrastructure in emerging countries
are still decades behind. The world's brightest minds are filling up American grad schools and science academies.
Emerging nations are mainly deploying capital into infrastructure, housing, and health services, focusing more on the
basic needs of its people. Therefore, the knowledge gap in transformative industries may remain wide for decades to
come.
* Rotation of capital flow back into the US.
Continual shocks around the world underscore the view that US investments will remain a safe haven and the target of
global investor, thus, a key beneficiary of future capital flow. However, if your sole measure of US monetary strength is
the dollar (DXY), then that contention would be false. There is a great deal of deserved consternation about the US
fiscal situation. But looking at the rise in foreign reserves even as the Fed's pump priming is in full force, adds credence
to the notion that the US is a safe haven. A sustainable European economic recovery may not be in the cards for years
to come, Japan's debt woes are being exacerbated by its recent natural disaster, and less apparent are the structural
issues inflicting larger "emerging economies". With uncertainty abound, investors will steadily commit a meaningful
percentage of assets to "stable investments". Like the Swiss Franc, gold and other precious metals, I believe capital will
continue to look for relative safety in US investments. In recent weeks, equity fund flows are beginning to rotate back
into US equities.
Monetary Authority
2005 2009 2010
China 0.769 2.399 2.62
Japan 0.823 1.074 1.10
EU 0.173 0.648 0.77
Russia 0.155 0.447 0.48
India 0.137 0.279 0.30
Foreign exchange reserves
($ Trillions)
-25,000
-20,000
-15,000
-10,000
-5,000
0
5,000
10,000
15,000
20,000
Domestic Equity
Foreign Equity
*
* Emerging market growth is not just the BRICs.
Because of the interdependence between various economies the global growth story driven by the BRICs may not be a
panacea. However, there are signs that Southeast Asian and Latin American countries are experiencing a similar
industrial boom as the BRICs. Emerging nation (ex/ BRIC) GDP growth rates are estimated to be from 6% to 8% in
coming years. As infrastructure develops and operating efficiencies improve, growth will only accelerate. These
countries offer: 1) labor and resource cost advantage vs. BRICs, 2) propitious location adjacent to important trade
routes, and 3) a large latent consumer base. Chile and Colombia, in my opinion, confer standout opportunities in Latin
America. Chile is highly leveraged to commodity prices (mines and cattle). Given the political reforms following
Pinochet’s reign, Chile has been much friendlier to foreign investments. Per capital GDP has already surpassed that of
Souce: IMF Souce: ICI
Souce: Federal Reserve ofNY Souce: Federal Reserve ofNY

3. Brazil. Like Australia, given its relative small population and abundant exports, favorable operating leverage should
position Chile for faster relative growth. Colombia is at an earlier stage of development as compared to Chile. Given the
political transformation and large natural resource deposits, Colombia also offers much potential. Colombia’s favorable
tax laws (offering 50% tax breaks on sales into local markets) provide it with a competitive advantage. I believe
Colombia could be a smaller version of Brazil in coming years.
Emerging Market Drivers
Country Positive Developments
Indonesia Recovering currency, improving liquidity, recovery in manufacturing competitiveness, improving terms of
trade, carry plus growth attracting capital flows, strong consumption
Malaysia Strong domestic demand, Government pump-priming under ETP/Budget
Philippines Improved confidence and steady remittances growth leading to stronger consumption, post election
euphoria leading to reform, underowned market.
Mexico US cyclical upswing, acceleration in consumer demand
* Russia, is it finally investable?
The Russian ETF is up 30% in the last 6 months, nearly double that of the S&P over the same period. Yet, the P/E ratios
of Russian companies (5x - 7x forward earnings) are still less than half that of comparable companies in the US.
Historically, political risks have made staying away from Russia fully warranted. Will Russia remain a difficult place to
invest, I believe so. However, some positive signs are improving its risk/reward prospects. Unlike his predecessor
whose focus was to quash dissent and to maintain order, President Medvedev has been relatively more progressive.
The global oil trade has been tremendously beneficial to the Russian economy. Slow steps have also been taken to root
out corruption. Over 2,000 government enterprises will be privatized over the next couple of years. This dynamic will
seek to force out corrupt officials that make a living taking bribes. Russia has also been plowing billions of dollars into
the high-tech city of Skolkovo in the hopes that it will replicate Silicon Valley. Investing in Russia will never be a panacea.
That said, given the abundance of natural resources, changing political landscape and severely discounted valuations, it
may be worthwhile to give Russia a second look.
Stocks seem to have an underlying bid
Many have argued that the nascent recovery has transpired in a vacuum, underpinned by an activist Federal Reserve.
Quantitative easing measures (buying of treasury/mortgage securities/monetizing debt), have been clear attempts by
the Fed to drive capital into risk based assets. There is little indication that the FED will deviate from this path short of
witnessing signs of a sustainable recovery in employment. Fed funds and corresponding lending rates will be pinned at
historically low levels ("Low for Long"). In my opinion, until we see a 7% unemployment rate, QE3 and even QE4 are
potentially on the table. If the mid-term election was a referendum on profligate spending, little by way of reform or
curtailment of spending will take hold. Oh, we've heard about proposals for modest adjustments to the budget, but
changes will be cosmetic. Politicians on both sides of the spectrum realize that people want tax cuts as well as fiscal
responsibility, but don't want any entitlements removed. The math simply doesn't work.
Recovery, by anyone's measure is tepid and arguably fleeting
In previous recoveries, GDP growth rates have averaged 5% to 6%. Given the state of employment and housing, we are
currently growing at half that rate. As Bernanke has publicly admitted, it will take at least 4 to 5 more years before the
unemployment rate start to normalize. What's at issue is the "negative feedback loop effect" -- lack of jobs triggers soft
consumer demand, which weakens corporate visibility and the desire to hire and to spend on capex. The fear is that the
cycle will repeat itself until it is broken.

4. The stimulus and QE(s) are the government attempts to use public sector resources to help the private sector get on its
feet. However, this approach is perpetuated under the philosophy that other exogenous elements will not derail the
recovery, and that the down payments (QEs) will not escalate to a point where it undermines long term fiscal stability.
What Bernanke did not account for is the pace of resource cost escalation. Flow of capital into emerging economies and
the US easy money policies have been the primary culprits. As emerging economies grew investors have flocked, which
fueled more liquidity into the system. In early-stage development, countries tend to focus on its infrastructure where
the building blocks are basic materials, energy and consumer goods. Naturally, it leads to food and energy inflation.
Since most commodities are priced in the US dollar, Bernanke’s own policy in weakening the dollar has further driven
food, energy and raw material prices higher. We have already witnessed margin compression for some US companies in
4Q10, and I expect a broader swath of industries to be impacted in 1Q11.
From the onset of QE2, I failed to see how it was going to spur animal spirits (over time), especially with the US
consumer. Much of the population have a limited amount of investments in stocks and hard asset, so inflation has only
a marginal benefit on the asset side. However for lower and middle-income workers, wage increases tend to lag
commodity inflation. Since most household disposable income goes into food, gas and utilities, inflation has a greater
impact on the liability side. As an added burden the largest asset on a family's balance sheets is the home, wherein
home values continue to trough.
Unfortunately, food and energy prices will continue to surge given rising global population, infrastructure build and
greater global consumption, compounded by a shortage in natural resources and lack of ready substitutes.
Troubling Developments
Issues involving sovereign debt, MUNIs, mortgage put-backs, inflation and of course "the US debt bubble" have been
targeted by global governments for several years. Yet, none of which have really been put the bed.
1) The European sovereign debt crisis. At its origin, the formation of the European Union was Germany and France's
attempt to piggyback off of potential hyper-growth in Eastern Europe, and the PIIGS. I would argue that if Germany and
perhaps France had a chance to do it over again, there would not be a formal European Union today. Because it's too
late to turn back, the risk is even more severe to let these countries fail. With these countries in fiscal disrepair after
years of profligate spending, the only way to meet interest and debt payments is through spending cuts. Every troubled
nation will be forced to take a bailout with the harshest austerity terms. Going forward with austerity, how can the EU
possibly be a meaningful contributor to global consumption and growth. Even with a plausible austerity program, as
public sector induced liquidity slow, ratings agencies will be forced to downgrade, which will then increase rates on any
new loans issued by the PIIGS. I ask again, "What is the End Game."
2) Municipal debt crisis. Meredith Whitney has been vilified for spooking the public with her rhetoric about the size of
state and local government deficits. So what are the facts? Thus far, some 44 states and the District of Columbia are
projecting budget shortfalls totaling $112 billion for fiscal year 2012. State and local governments can't print money like
the Fed. They can't run fiscal deficits. The Federal government by law can't bailout local governments, although it had
already done so with the "Build American Bonds". Tax hikes and job cuts have been announced in several jurisdictions,
and the pushback has been intense. But like the European sovereign debt crisis, short-term remedies will not help the
structural damage -- slowing growth, compressed tax revenues and mounting inflationary pressures.

5. 3) Housing. Both new and existing home sales hit multi-year lows recently. I agree that it's a necessary ill so the
industry can work down inventories. But will it matter? According to S&P, the shadow inventory of foreclosures now
stands at $450 billion (shadow inventories are mortgages that are at least 90 days delinquent or somewhere in the
foreclosure process). S&P also estimates that it would take the New York market 10 years to work through its inventory,
with faster markets requiring a minimum of 3 years. Out of 20 markets surveyed, only Miami saw its inventory stay flat
in 2010. In Minneapolis, supply rose 61% to 35 months. Las Vegas went up 48% to 30 months, and Portland jumped 47%
to 45 months. The government has thrown everything but the kitchen sink at the problem, yet there is little by way of a
workable solution.
Emerging markets are not a panacea either:
1) China is softening, 2) Brazil is over-spending, and 3) decoupling doesn't exist.
Underneath the veil, "the belief that China will lead global growth in the coming years", there are some disturbing
trends. Emerging economies including China are not immune to the root causes that led to unrest in the Middle East.
Rapid increases in consumption, overbuilding in housing and commercial real estate and devastating droughts have led
prices higher, while wages have remained relatively stagnant. Chinese authorities have tried to cool down the economy
by upping reserve requirement ratios and toughening lending standards. However, structural inefficiencies within
Chinese lending bodies remain inert. Banks are still making billions in non-performing loans to state-owned enterprises
and commercial real estate developers. For decades, enterprises have greased the palms of local government officials,
who act without fear because they are backed by members of the central government politburo. Despite Premier Wen
Jabao's attempts to make changes from within, reform is stunted from the start. The Chinese politburo is actually
divided into dozens of imperceptible factions, each out to protect its own interests and constituents.
Nevertheless, the collective fear of civil unrest, remain of the utmost import to communist party leaders. Therefore,
China will continue to fight inflation by stifling imports, subsidizing domestic production and boosting wages, but that
will have negative consequences for multinational companies. US companies that supply to China have already been

6. flashing warnings signs, from tech companies, to autos to industrials, and many others. Anecdotally, Li & Fung has
warned US buyers of “a new era in sourcing w/higher prices” -- pointing to possible wage hikes.
Brazil has been heralded as one of the beacons of global growth given the rapid surge in domestic GDP and rise in
personal income. In fact, many investors that I speak with continue to focus their entire Latin American interest in
Brazil. Akin to other developing nations, concerns regarding civil unrest are heating up, spurred by income disparity,
inflation, corruption and lack of social safety net. Many low and middle class households continue to be left behind.
Unemployment currently stands at 12%. Although debt to GDP of 60% compares favorably to several developed
nations, Lula’s administration has run record deficits in the last few years. Like China, the Brazilian government is also
engineering a slowdown, by cutting stimulus and fiscal budget, and raising taxes. Forecasted GDP growth for 2011 may
fall as much as 300 bps from 7.5% in 2010.
As we've witness during periods of market turmoil, global credit markets and equity markets are integrally linked. When
European sovereign debt issues fomented in 2010, global credit markets began to tighten, and lending rates increased
for US and Asian companies. In 2011 and 2012, as emerging nations adopt tightening policies, growth estimates will
similarly be lowered for European and US companies.
Bias is STILL to the upside!
With little more than band aids to solve the world's structural problems, why has it been impossible to short stocks for
an extended period. Part of the reason for the continued uptrend has been the improving health of businesses. Other
may also argue that it’s been the "Invisible Hand" of government overtly supporting the market. I also believe there’s
been a psychological effect in play. The majority of market participants are positioned on the long-side, so the natural
desire is for stocks to go higher. Even the staunchest bulls consider this a fragile recovery. As such, I believe institutions
kept buying stocks to sustain momentum. If you lose the plot and allow markets to pull back, the fear is it will be
extremely difficult to reclaim the upward momentum. As long as the FED primes the pump and "Black Swan" events are
kept in check, money will continue to chase stocks higher. But the last few years have demonstrated that 100 year
events are more like 5 year events, so you need to be on your toes.
How do you navigate these choppy waters
I know most of you have heard the saying "There's No magic bullet". While that is true, it doesn't mean you shouldn't be
participating in the market. Since March 2009, there has been one simple axiom -- "tactically position your portfolio to
the long side; if there is a hint of a Macro rift, go neutral or raise cash." I don't think you can go wrong with that mantra.
HOWEVER, pay attention to the alarm bells: 1) coming June, the FED will end QE2, even though I believe QE3 is
inevitable, there will be protracted struggles to get it approved, and 2) in coming weeks we will hear about wide-spread
margin compression on earnings' conference calls.

7. Tactical investments --
Source: JP Morgan
Long bias commodities
• One thing we can all agree is that global populations will continue to grow -- benefitting commodities, in
particular, fertilizers and chemicals
• Gold (as well as ancillary plays such as silver and platinum), will continue to be a net beneficiary of a weak dollar
and global tumult. The likelihood of gold replacing the dollar as reserve currency is remote, but it will continue
to be relevant as an alternative safety play.
• Extreme care will be needed as commodities stocks can move 5% – 10% intraday, in either direction.
Neutral to short technology
• The technology replacement cycle has been in swing for a few quarters. However, what we've learned is that
the willingness of corporate IT managers to commit to build-outs is ephemeral, linked closely with business
climate/sentiment.
Long bias Financials medium term
• Housing has not bounced back in any meaningful way. In fact home sales have fallen to their lowest levels in
decades. However, driven by the FED's loose monetary policy, the steep yield curve has allowed net interest
margin to expand. As margins have improved, it helps to offset the bad loans that were sitting on their books.
Given that banks are still trading at 1x book and 9x earnings (vs. 2x book and 14x earnings historically), it may

8. confer an attractive entry point. Obviously, headline risk will continue to exist and housing inventory still needs
get written down.
• New proposals to limit the role of FNM and FRE could also provide opportunities for banks. Specifically, banks
and mortgage companies will provide guarantees for RMBS that met certain strict underwriting criteria. A
government entity would then provide reinsurance to the holders of the securities, which would only be paid if
shareholders were entirely wiped out.
• Don't underestimate the impact of mutual fund sector rotation and valuation, as financials are broadly
considered under-owned.
Immediate catalysts (positive & negative):
• Q1 earnings season will start shortly. My expectations will be somewhat softer results vs. Q4 due to: 1)
seasonality, 2) fallout from Japan, and 3) push-out of corporate purchases.
• Broker earnings may likely show some upside given stronger trading and flow activity (ex/ MS), improving asset
management business (rising stock market), solid equity/debt originations, strong M&A pipeline, and elevated
secondary activity. Boutique firms such as LAZ, GHL, EVR, JEF, KBW, etc have been gaining share, as there are
fewer bulge bracket firms to compete with, while Goldman and Morgan are under greater regulatory scrutiny
given their commercial banking structures.
In this initial report, I've chosen to take a broad approach to lay the foundation, as each topic discussed above may take
several pages to expound upon. Going forward, the focus will be specific thought pieces and timely highlights on current
market dynamics. Please send any comments or suggestions. I appreciate your support.
Andrew Lee
(646) 330-1663