Market Commentary First Quarter 2009

Zugswang

n central India, approximately I 1,500 years ago, there arose a unique game, called Chaturanga, or “four parts,” referring to the four divisions of an army (elephants, chariots, cavalry and infantry). In the painting above, the deity Krishna is seen playing the game with his consort Radha. Unlike the much older Chinese game of go, Chaturanga introduced two new grandmasters and world champions, came concepts to board games: that different pieces from the (ex-) . From Mikhail could have different functions, and victory/ Botvinnik, who won the world championship (defeat) was determined by the fate of a single in 1948, to Vladimir Kramnik, the 2000 cham- piece. pion, the Soviets/ dominated the A century or so later, the Persian Empire game.1 swept across India, and brought the game back Among the greatest Soviet grandmasters was home where it became immesely popular. Mark Taimanov, born in Ukraine in 1926. Tai- Over the subsequent centuries, the game was manov was unusual in a sport that requires carried by invading armies across North Africa intense study and concentration in that he was and into Europe, to China, Southeast Asia and simultaneously one of the world’s greatest pi- into Russia. Today, the game is played by mil- anists, featured in the 1960s collection, Greatest lions of people (and their computers), every Pianists of the 20th Century.2 To have been the hour of every day, in each country on all seven best player and the best pianist in the continents. Soviet Union, concurrently, is unimaginable. Chess, as the game is now known in English, is Between 1948 and 1976, Taimanov played in a enormously popular throughout the world, but record 23 USSR Championships, He won the it has a particularly passionate, near-religious, World Senior Championships in 1993 and devotion in Russia. For over fifty years, the full apparatus of the state promoted the game, 1 The current champion is Viwanathan Anand of India, seeking to nurture and develop, as a matter of who won the title from Kramnik in 2007. government policy, the very best players. For 2 Playing Suite for 2 pianos No. 2 ("Silhouettes"), Op. 23 Co- the past half-century, the greatest players, the quette by Anton Stepanovich Arensky

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Market Commentary First Quarter 2009

1

Capital Market Performance 3.1% 4.1% 10.0% 0.1%

0.0% -0.7% -4.6% -5.4% -10.0% -10.8%-10.7% -20.0% -22.1% -30.0%

-40.0% -38.2% -46.5% -50.0%

-60.0% -56.8% 1Q09 1-Year 5-Year “Bipolar US Equities Int'l. Equities US Bonds Global REITS describes the emotional state of the 2 markets...” S&P 500: Great Depression (daily, semi log, 0 16 20-100, though Sep 22)

104 Mini-Bull 1 104 4/10/1930: 81.36 Mini-Bull 2 2/24/1931: 57.03Mini-Bull 3 6/26/1931: 48.18 52 11/13/1929, 55.43 52 Mini-Bull 4 12/15/1930, 45.32 11/9/1931: 36.16 6/1/1931, 38.92 Mini-Bull 5 3/8/1932: 28.19 26 10/5/1931, 27.68 26 1/5/1932, 23.70

6/1/1932, 13.81 13 13 Mar-29 Jun-29 Sep-29 Dec-29 Mar-30 Jun-30 Sep-30 Dec-30 Mar-31 Jun-31 Sep-31 Dec-31 Mar-32 Jun-32 Sep-32

Courtesy: Laffer Associates

1994. Perhaps his most famous game occurred after. The 25% gain off of the 9 March low in the World Championships in 1971. Unfortu- was the best two-week performance since the nately, it was a match he would most like to 1930s. Indeed, strong, swift rallies in bear mar- forget. Upon his return to , Taimanov kets are common occurrences. In the 86% was jailed, thrown off of the Soviet team and drop from 1929-1932, there were 5 rallies forbidden even to play piano. That match was more than 20% (see Chart 2), 9 rallies greater one of the greatest of all time, a prelude to an than 15%, 43 over 5%. In the 60% decline even more famous contest, and in them are from 1937-1942, there were also 9 rallies in lessons for investors today. excess of 15%, 52 more than 5%. ipolar describes the emotional state of Our recent rally was sparked by word that the the markets in the first quarter: de- major banks were, at last, operationally profit- B pressive till early March, manic there- able (that is, they made money off of the free

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Market Commentary First Quarter 2009

3

Change in Private Inventories (CBI) 120 80 s) ar 40 l o D f 0 o s n -40 o li il -80 (B -120 Shaded areas indicated US recessions 2009 research.stlouisfed.org -160 1940 1950 1960 1970 1980 1990 2000 2010

Source: U.S. Department of Commerce: Bureau of Economic Analysis

4 money given to them by the government, ig- Net new borrowing by US households noring the massive write-downs of loans they have yet to acknowledge). The collapse of civi- Crisis begins 3 11 lization, better than even money at Ladbrokes 10 in January, has apparently been forestalled, or 9 8 at least postponed. Indeed, there is evidence 7 that the pace of economic decline has abated 6 5 (the infamous second derivative), albeit in the 4 3 context of continuing economic contraction. 2 1 US GDP fell more than 6% (annualized) for 0 -1 the second straight quarter. Nearly half the -2 1952 1960 1970 1980 1990 2000 Q4 2008 drop came from inventory reductions, the Includes households and nonprofits; negative figures indicate steepest drop on record (see Chart 3), but that that households paid back debt instead of borrowing more. was the only (relative) good news (good, be- Source: US Bureau of Economic Analysis; US Federal Reserve; Mckinsey Global Institute Analysis cause inventory restocking will provide a later boost to output). Commercial construction 5 dropped 44% (its largest quarterly decline since records began in the 1940s), and residential Conference Board Consumer construction fell another 38%. Capacity utiliza- Confidence Index tion fell to a record low of 69%, and consumer 140 credit contracted for the first time (see Chart 4). The national unemployment rate is ap- 120 proaching 9% (and is over 11% in California, a 100 post-war high). It is no wonder that consumer confidence fell to its lowest level ever (see 80 Chart 5). Mar-03, 60 Oct-82, 61.4 Dec-74, 54.3 43.2 40 May-80, Feb-92, Mar-09, 50.1 47.3 26.0 3 20 Ladbrokes plc is a publicly-traded, legal betting company 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 06 08 in the UK.

Graphs Courtesy of Morgan Stanley

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Market Commentary First Quarter 2009

The decline in home prices sparked some in- 6 terest among buyers, as both home sales and housing starts bounced higher in the past % Change in Price of Existing homes month. But the big picture for housing remains 20% gloomy, as prices continue to fall (see Chart 6), 15%

there is a record number of vacant homes (see 10% ge an Chart 7) and foreclosures spike higher (see h 5% c ce ri Chart 8). p 0% r ea y r/ (5)% The loss of wealth over the past year or so has ea y been staggering. Equities have dropped about %(10)% $30 trillion (55% of world GDP) and $11 tril- (15)%

(20)% 9 1 3 5 7 9 1 3 5 7 9 1 3 5 7 1 3 5 7 9 lion (20% of world GDP) of residential real -6 -7 -7 -7 -7 -7 -8 -8 -8 -8 -8 -9 -9 -9 -9 -0 -0 -0 -0 -0 n n n n n n n n n n n n n n n n n n n n estate has evaporated. The decline in global Ja Ja Ja Ja Ja Ja Ja Ja Ja Ja Ja Ja Ja Ja Ja Ja Ja Ja Ja Ja

wealth has been three times as severe, as a per- Courtesy: Goldman Sachs Source: National Association of Realtors centage of GDP, as at any time since the “Economic 1930s.4 Because stocks represent a much lar- pain is not ger share of wealth today, this decline has had 7 confined to the a bigger impact on wealth destruction than at Vacant Homes, 1965 to 2008 United any time in more than a century (see Chart 9, (Vacant homes per thousand households) 180 States.” pg. 5). Households have seen net worth

(relative to income) plunge by 23% (see Chart 160 10, pg. 5). The direct impact of this wealth destruction is 140 less spending, as consumers seek to rebuild 120 through savings. But the secondary effects can

be more significant as consumer retrenchment 100 puts pressure on businesses and their highly- geared lenders. The economy will regain its 0 lost output in a few years, but investors will 1965 1970 1975 1980 1985 1990 1995 2000 2005 Notes: Total number of vacant housing units. Data are quarterly and are plotted likely face a much longer recovery period as businesses restructure, raise capital and dilute Source: Congressional Budget Office: Dept of Commerce, Bureau of the Census; Haver Analystics current owners. The real economy rebounded to 1929 levels by 1937, but real profits didn’t 8 recover till 1949, and the stock market didn’t touch the 1929 peak in real terms until 1953. Mortgage Foreclosure Started (%)

conomic pain is not confined to the 1.20 United States. Indeed, this global con- 1.07 E traction is the deepest and most wide- 1.00 spread since the 1930s. The IMF estimates 0.80 global output will fall (-1.3%) for the first time, 0.69 with advanced (OECD) economies shrinking 0.60 4.3%. World trade is expected to decline more than 10%, also the first contraction in over 50 0.40 National

0.20 4 Peter Berezin and Swarnali Ahmed, Goldman US ex California and Florida 0.00 Sachs. 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006

Courtesy: Morgan Stanley;

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Market Commentary First Quarter 2009

9 years. This is also the most highly synchronous economic contraction Market Cap as % of GDP (see Chart 11). This synchrony is omi- 200% nous because it portends both a more 180% protracted and severe downturn as 160% well as a weaker recovery. 140% 120% Global imbalances, defined as the 100% absolute sum of each country’s cur- 80% rent account balance, have been cited 60% as a principal and precipitous cause of 40% the economic crisis. In the previous 20% decade, these imbalances nearly treb- 0% 1885 1905 1925 1945 1965 1985 2005 led, to around $1.5 trillion, or nearly

Source: Boyan Jovanovic and Peter Rousseau, GS Global ECS Research 6% of world GDP, with the US and China the largest (and complemen- “the most tary) contributors (see Chart 12, pg. highly 10 6). Excessive debt-driven consump- synchronous tion in the US fueled by a savings glut economic US Household Net Worth contraction” relative to disposable Income, % in Asia and the Middle East created 640 these enormous imbalances which 620 were an “integral part” (IMF) of 600 580 global low interest rates and a rise in 560 -23% leverage that fostered the creation of 540 riskier assets and housing price bub- 520 500 bles in the US and elsewhere. 480 460 These imbalances are narrowing in 440 the current retrenchment. The US 420 400 current account deficit is expected to 0 shrink from 6% of US GDP in 2006 1952 1960 1970 1980 1990 2000 Q4 2008 to just over 3% this year, but as one Source: US Bureau of Economic Analysis, US Federal Reserve, McKinsey Global Institute Research deficit shrinks, another, the fiscal deficit, expands. The federal budget deficit, which has never been worse 11 than 6% of GDP (1983), will be 13% % of Countries in Recession of GDP this year (see Chart 13, pg. 6). Across advanced (OECD) econo- Highly synchronized recessions are rare events that typically are 70 preceded by or coincide with a U.S. recession. mies, the combined fiscal deficits will (% of countries in recession; shaded areas denote U.S. recession) 60 be close to 9% this year. This explo- sion of public debt (see Chart 14, pg. 50 6) is a stop-gap, and the world will

Ten 40 eventually have to find a way to re- concurrent duce more sustainably these structural recessions 30 imbalances. And none of the above data address the looming entitlement 20 deficits, both public and corporate 10 (see Chart 15, pg. 6).

0 1960 70 80 90 2000 08:Q4

Source: IMF staff calculations

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Market Commentary First Quarter 2009

12

Current Account Balance in PPP Dollars: Since 1980

PPP $bn 2500 fc st

2000 Middle East 1500 BRICs ex. China Major western Europe 1000 Japan China 500 US

0 -500 -1000 -1500 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

Sources: IMF, GS Global ECS Research

13 14 Federal Budget Deficits or Surpluses, 1969 to Ratio of Debt to GDP Among Select 2019 (% of gross domestic product) Advanced Economies

4 350% (In percent, GDP-weighted, 1987=100) Actual Projected 2 CBO’s Baseline 300% Government 0 Projection Households 250% Financial Institutions -2 Nonfinancial corporates -4 200% -6 CBO’s 150% -8 Estimate of the President’s 100% -10 Budge -12 50% -14 0% 1969 1974 1979 1984 1989 1994 1999 2004 2009 2014 2019 Q1-87 Q1-90 Q1-93 Q1-96 Q1-99 Q1-02 Q1-05 Q1-08

Source: Congressional Budget Office Sources: Bank of Japan; Bureau of Economic Analysis; Federal Reserve; Office of National Statistics; and IMF staff estimates.

15 16

Pension Funds of Large U.S. and European CPI Inflation (yoy change) Companies: Estimated Funding levels 130 20% 10.9% 120 United Kingdom 15% 9.5% 1980 1974 110 5.6% -0.2% 10% 1933 Current 100 3.2% 5% 1999 90 0% 80 Euro area (5)% -2.9% 70 United States 1949 CPI Inflation 60 (10)% (yoy change) Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-08 Notes: The funding level for accounting purposes, as a percentage of the net present value of (15)% 7 1 5 9 3 7 1 5 9 3 7 1 5 9 3 7 1 5 9 3 7 1 2 3 3 3 4 4 5 5 5 6 6 7 7 7 8 8 9 9 9 0 0 1 liabilities. The calculations project forward the last publicly reported levels by using move- c- c- c- c- c- c- c- c- c- c- c- c- c- c- c- c- c- c- c- c- c- c- ments in market prices and interest rates since then. The U.S., euro area and U.K. companies e e e e e e e e e e e e e e e e e e e e e e comprises the constituent firms of the S&P 500, Eurostoxx 50 and FSE 350 Indices. D D D D D D D D D D D D D D D D D D D D D D

Source: Hewitt Associates Courtesy: Goldman Sachs

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Market Commentary First Quarter 2009

Accompanying growing fiscal deficits is a surge 17 in the money supply, and that has inflationary implications. There is no causal link between Countercyclical Policies and Output-Inflation Dynamics deficits and inflation, as inflation is driven ex- clusively by monetary (not fiscal) policies. Ris- United States: Money Stock (M1) (100 at t=0; business cycle peak 120 ing fiscal deficits in the early 1980s, for exam- at t=0; months on x-axis) 115 ple, occurred in the midst of falling inflation as 2007 monetary policy was tight. Monetary policy has been unleashed to combat the current eco- 110 nomic contraction: M2 is rising at 15% p.a. 105 and excess bank reserves have exploded from less than $3 billion a year ago to over $700 1929 100 billion today. Given the magnitude of the out- put gap (supply vs. demand), inflation is not an 95 immediate threat, but when growth does de- 90 velop, the Fed will have to withdraw these 0 4 812162024 “..worri- excess reserves or inflation will return. Of some paral- course, that can’t be done precipitously, as the United States: Industrial Production lels..” Fed did in 1936-37, thus aborting the recovery and Consumer Prices and prolonging the depression. Deflation de- (year-over-year percent change) 8 scribes the world today, but a longer view war- December 6 February 2007 4 rants at least a consideration of the alternative 2009 s 2 e (see Chart 16, pg. 6). c ri 0 P r The massive monetary response is perhaps the -2 e First wave of bank m July su biggest policy difference from the 1930s, and -4 n runs and failures 1929 o while the economic pain has been real enough, (October 30,1930) -6 C it isn’t anything close to what we saw 75 years -8 July ago (see Chart 17). Still, there are “worrisome 931 -10 parallels,” as the IMF notes: falling asset prices, -12 constraints on lending due to deleveraging, -30 -25 -20 -15 -10 -5 0 5 10 15 20 doubts about the solvency of the financial sec- Industrial production tor. Source: IMF Governments have gone to great lengths to ensure the viability of the financial system, from guaranteeing deposits to subsidizing 18 funds to outright ownership of banks and in- Commercial Bank Loan Charge-Offs (in percent of total loans) surers. These actions may prevent widespread 20% defaults, but have yet to relieve all of the pres- Estimates sures on financial institutions. Monetary poli- 15% United States cies have been effective in reducing liquidity 10% premia, as evidenced in the narrowing of the 5% Europe TED and LIBOR spreads, for example, but 0% there remains severe economic stress on finan- cial institutions. Corporate defaults are rising (5)% globally and recovery rates on defaulted bonds (10)% are falling. The IMF has doubled its estimates (15)% of expected write-downs in the US from $1.4 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 trillion as of October to $2.7 trillion most re- cently. Globally, the Fund sees potential losses Source: IMF staff estimates

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Market Commentary First Quarter 2009

of $4.1 trillion through next year. Since the lose his knight, but by moving his knight, he start of 2008, the market capitalization of allowed Fischer’s pawn to pass and be pro- global banks has fallen more than half, from moted, thus sealing his fate (see Board-Game $3.6 trillion to $1.6 trillion. Bank earnings, be- 2). fore loss provisions, are expected to fall 50% Game 2 and charge-offs are forecast to peak at over abcdefgh 4% of total loans, the most since the 1930s 8 8 (see Chart 18, pg. 7). 7 7 6 6 Perhaps the best news came from the OECD’s 5 5 annual update of Society at a Glance. Americans 4 4 (again) ranked among the most obese in the 3 3 developed world, and spent the least time eat- 2 2 ing (France and Japan appeared at the other 1 1 end of this measurement). But countries with abcdefgh expanding waistlines and fewer eating minutes had faster economic growth this decade than In the middle of the fourth game, Taimanov “..among the countries with slimmer, less hurried food pa- was similarly forced to move to an inferior most obese..” trons. There’s hope, after all. position. Fischer’s white king (a6) threatens one group of black pawns, and Fischer maneu- o open the Challengers’ Round of the vered his bishop to force Taimanov’s king to World Championships, Mark Tai- retreat, opening the way for the white king to T manov was well prepared. Former take the pawns (see Board-Game 4).5 world champion and three other grandmasters were appointed as his sec- onds. Taimanov was determined to win the Game 4 right to face the reigning world champion, Bo- abcdefgh ris Spassky. But in a sport that boasts a long 8 8 history of eccentric geniuses, Taimanov faced 7 7 the most eccentric, most brilliant player of all 6 6 time. 5 5 4 4 As a very young boy, he would travel alone by 3 3 subway from his home in Brooklyn to play 2 2 chess in Washington Square Park near NYU. 1 1 In 1957, he became US champion at the age of abcdefgh 14, the youngest ever, and won the title every subsequent year he competed. In 1963, he did 5 Play continued: not lose or draw a single match. By 1971, he, 57...Nc8 too, was determined to win the championship 58. Bd5 Ne7 59. Bc4! Nc6 from , a man he had never de- 60. Bf7 Ne7 feated in five previous attempts. 61. Be8

moving the knight would allow the bishop to capture the kingside In a sport of long tradition and convention, pawns. The black king must give way.

Bobby Fischer broke all the rules. His style of 61...Kd8 62. Bxg6! Nxg6 play was breathtakingly brilliant, daring and 63. Kxb6 Kd7 unpredictable. In his second game against Tai- 64. Kxc5 And White has a win position. Either one of the White’s queenside manov, who played as black, Taimanov had pawns will promote or the white king will attack and win the black two pieces remaining and he had the next kingside pawns and a kingside pawn will promote. Black resigned seven moves later. move, although he certainly would have pre- 6 I remember playing alongside, following the moves on TV and in the ferred to pass: if he moved his king he would newspaper.

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Market Commentary First Quarter 2009

Fischer went on to defeat Taimanov 6-0, and action. Fischer put Taimanov, twice, in a place then defeated another , Bent Lar- where his only choices worsened his position. sen, also 6-0. Fischer had won nineteen con- secutive matches without a loss or a draw, a ugswang is the German word meaning feat never accomplished before or since. And “compulsion to move.” In chess, the Fischer didn’t just win; he annihilated the Z word describes the rare experience of greatest players of the time. Thus was set up being forced into an inferior position, where the most famous match in history, against the each choice of move leads to a weakened state. back drop of the Cold War, Zugswang leads, inevitably, to defeat. There is versus Boris Spassky. a time for offensive parries, and a time for defensive steps, but a player should never be It seems hard to imagine today, but at the time, without options, never compelled to move the world was riveted to the live broadcast and unless it’s favorable. As with chess, as with move-by-move analysis of that match.6 investing. Fischer blundered, and lost, the first game, and refused to appear for the second, defaulting, and thus apparently sealing his fate, for no one had ever come back from a two-game deficit. All Spassky had to do was draw each game and he would retain his title. But Fischer, in some of the most brilliant games in the annals of chess, took seven games from Spassky, losing only once more, becoming the only American, the only non-Soviet, to be world champion in a span of 60 years. But let’s return to the opening match with Tai- manov, and games two and four, where Tai- Juan Gris manov was forced to move into an inferior position, and eventual defeat. This is a very unusual development, as most games end when either the defender cannot move except into mate, or mate is achieved with a specific

6 I remember playing alongside, following the moves on TV and in the newspaper.

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MICHAEL A. ROSEN PRINCIPAL & CHIEF INVESTMENT OFFICER MAY 2009 This report is not an offer to sell or a solicitation to buy any security. This is intended for the general information of the clients of Angeles Investment Advisors. It does not consider the investment objectives, financial situation or needs of individual investors. Before acting on any advice or recommendation in this material, a client must consider its suitability and seek professional advice, if necessary. The material contained herein is based on information we believe to be reliable, but we do not represent that it is complete or accurate, and it should not be relied on as such. Opinions expressed are our current opinions as of the date written only, and may change without notification. We, along with any affiliates, officers, directors or employees, may, from time to time, have positions, long or short, in, and buy and sell, any securities or derivatives mentioned herein. No part of this material may be copied or duplicated in any form by any means and may not be redistributed without the consent of Angeles Investment Advisors, LLC.

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