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THE D WORD

As of this week the Lehman emerging markets bond index was down over 28% for the year, with the Latin America and European sub indices each down by an even larger percentage. Pummeled by falling commodity prices and without the ability to borrow any more from external markets, the emerging economies are in dire straits and the potential for default by one or more of them has become very real.

Two countries that our customers have asked us about repeatedly this week are Argentina and Russia. The prospect of default by either is significant: after years of misguided policy Argentina’s government is genuinely broke, while Russia’s potential for reneging on its obligations may be motivated by politics as much as its balance sheet.

Argentina: Sinking Fast

Compared with the other major Latin American economies there are relatively few tranches of Argentine US dollar denominated debt, most of which was issued in the wake of the default through rolling existing bonds. Despite this, external debt still hovered at just under 50% of GDP in the first quarter.

Raising money in international markets has been difficult for Argentina’s leaders since they still have not fully settled with creditors in the 19 country Paris club –their primary new foreign creditor in recent years has been the Venezuela Government (with Comrade Chavez demanding yields as high as 15%). Early in September President Kirchner announced that she intended to attempt a settlement on the $6.7 billion remaining in defaulted debt at the expense of the nation’s foreign currency reserves, but by then the credit markets had already shut down completely. This leaves her with only the home market left to turn to as she seeks to salvage her ambitious public works programs.

The private pension funds that are currently being eyed for nationalization are among the primary holders of Peso denominated Argentine debt, as well as banks and other financial institutions. Many of the bonds held by domestic holders have yields linked to inflation, which has become a source of controversy since the present administration and its predecessor adopted a policy of publishing fake, artificially low CPI numbers to stave off additional interest obligations. This policy of lying contributed to additional tension between Argentina and the IMF, helping to make the chances of international aid even more remote.

In short, the policy restructuring of domestic debt and nationalization of pensions that the government has embarked on seem likely to undo all the progress made by the Argentine economy over the past 5 years within a few short months.

The Peso’s plunge and skyrocketing yields (see chart below) indicate that foreign traders have largely factored a restructuring of some type in already. At this stage, the impact of a default will for the most part only be felt by the Argentinians themselves and their immediate neighbors.

Russia: Wounded Bear

In comparison to Argentina, the Russian debt situation is infinitely more complex and greater in scope.

In recent years the Eurobond and other international markets were increasingly significant providers of liquidity for the Russian economy until the one two punch of the Georgia incursion and the banking crisis effectively closed those windows. As such, the current bailout plans being sponsored by the Russian government has been financed domestically –with domestic Ruble debt there up over 10% YTD as of the end of September. With the freefall of both the Ruble and oil continuing to pick up speed, the Kremlin has adopted a consistently more aggressive tone.

If you read our work regularly you know that we view the economic crisis facing Russia and its political allies as a very serious issue that could have a destabilizing impact on global politics. Putin & Co. have a record of seizing private assets whenever it suits them, this does not bode well for creditors –the current turmoil could prove to be an irresistible opportunity to take Russia back into bankruptcy and rebuild it according to their vision.

One clear loser in any Russian debt restructure would be EU unity. A passive response by large economies there with more skin in the game will be perceived as appeasement by their newer Eastern partners who retain a profound distrust of their former overlords.

We will be keeping our eye on Russia and Argentina closely for the foreseeable future. Unlike some well known market pundits however we will not be making any investments there; assets could not possibly be “cheap” enough for us to want to own them in a nation so poorly managed as either.

Andrew Barber
Director

NATURAL GAS

We've been bearish on natural gas since the late spring and our supply / demand model for natural gas is showing an inventory build in 2009E that will be greater than expected when we first turned bearish. Obviously, though, the price of natural gas has corrected rather dramatically and a good deal of bad news is priced into the equities and the commodity. That said, as we look into 2009, there is potential for real supply / demand imbalances.

On the supply side, YTD production is up y-o-y 8%. While we are starting to see producers cut back on drilling (Chesapeake's recent announcement for one), production will not stop on a dime. The production ramp we are on this year is well above trend line and any historical norm (the producers got greedy). The growth in production has not lead to a build in inventory, so far, because demand has averaged +4% y-o-y and imports (LNG and Canada) have been down y-o-y. Low LNG imports are finally lapped in November of this year, so in the last couple of months of this year and into next year comparisons favor a building of inventory.

Demand has been robust YTD at up +4%. Currently, the EIA is estimating growth of +1.9% in consumption in 2009E. We have a hard time seeing that happening given the current economic environment. In recent history, natural gas has rarely seen much more than GDP growth y-o-y and, in fact, in tough economic times has seen y-o-y declines, such as in 2001 when natural gas consumption was down more than -4% y-o-y. In 2001, this was primarily driven by an almost 10% y-o-y decline in industrial consumption, which is not an unlikely scenario for 2009 in our opinion.

In terms of inventory, as of October 10th, we are 3% above the 5-year average, which is certainly not overly bearish. That said, we will likely see continued building of inventory into year end and in early 2009, which could take the slightly above average inventory number to well above average.

So as we look out the next 6 - 12 months, we are fairly bearish on supply and demand and our model shows a more meaningful build than consensus. Obviously a good deal of bad news is priced in already and we wouldn't recommend shorting the equities down here. But in terms of the actual price of the commodity, it is hard for us to get bullish until we can rule our forecast for an inventory build.

On the positive side, we don't want to downplay Chesapeake and its peers cutting cap-ex budgets for drilling. This is a bullish sign, but we just need to see some evidence of production beginning to decline, as a result of these actions, before we can get bullish on the fundamentals.

Daryl G. Jones
Managing Director

CBRL – Changes to management’s compensation metrics in 2009

In the CBRL’s proxy filed last week, the compensation committee changed the key financial metrics for management’s compensation. According to the proxy “We seek to align the interests of the named executives Named Executive Officers with those of our shareholders by evaluating executive performance on the basis of key financial measurements which that we believe closely correlate to both near-term and long-term shareholder value, including increases in operating profit, revenue growth and operating margin.“ In 2008 the key metrics included operating profit, revenue growth and return on investment.

Why would management not want to include ROI in 2009? One thought would be to make it easier for management to get a bonus since they did not hit the key metrics in 2008

For management to get a bonus in 2009 total revenue are to increase approximately 4.5% to 5.5% over 2008 and operating income margin to be approximately 6.0% to 6.3% compared with 6.3% in 2008. All of this translates to operating income growth of approximately 6.4% in 2009.

Currently, the Reuters estimate for revenues growth is 3%, flat EBITDA and earnings declining slightly.

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US Market Performance: Week Ended 10/24/08...

Performance:

Week Ended 10/24/08:
Dow (5.4%), SP500 (6.8%), Nasdaq (9.3%), Russell2000 (10.5%)

October 08’ To Date:
Dow (22.8%), SP500 (24.8%), Nasdaq (25.8%), Russell2000 (30.7%)

2008 Year To Date:
Dow (36.8%), S&P (40.3%), Nasdaq (41.5%), Russell2000 (38.5%)

Eye On Our Network: The "Stockdale Paradox"

We have been hammering on our RE Investment Theme "Eye On Leadership" for most of this year. To some, say 9 months ago, that was a little too “soft” of a Theme … to those who get it now, leadership is going to be a driving factor in solving this financial crisis. Finally, we are seeing consensus fall onto our side of the moral compass balance sheet.

This is a very good thing, for both America, and the next generation of capitalists that this crisis will give opportunity to.

Below is an excerpt from one of our avid readers, who captures the "Stockdale Paradox" from the penmanship of Jim Collins:
KM
---------

Keith,
"The author is Jim Collins who wrote the book Good to Great. I thought it would be interesting reading for you at a time when great leaders and companies in the Business World are faltering , the economy is believed to be in a full Recession and FNM is no longer as we knew it."
Regards,
-RE Subscriber
---
The Forum
A man in his early 20s recently asked me, "So, what's a recession like?" It's an entirely alien concept to him; he'd grown up during the greatest economic boom in modern memory. His question drove home the fact that we haven't faced a severe, protracted economic setback for nearly 2 decades, leaving us terribly unpracticed at dealing with tough times.

With this recession -- long in coming, perhaps long to stay -- now officially upon us, it is imperative that corporate leaders relearn a key lesson about how great companies (and great people) deal with difficult times differently from how they deal with merely good ones. That lesson is the "Stockdale Paradox," a peculiar psychology shown by those who emerge from tough times not just intact, but stronger.
Adm. Jim Stockdale was the highest-ranking U.S. military officer in the Hanoi prison camp during the Vietnam War. Tortured many times during his 8-year imprisonment, Stockdale lived without any prisoner's rights, no set release date and no certainty as to whether he would ever again see his family.

He shouldered the burden of command while fighting an internal war against his captors and their attempts to use the prisoners for propaganda. At one point, he beat himself with a stool and cut himself with a razor, deliberately disfiguring himself so that he could not be put on video as an example of a "well-treated prisoner." He exchanged secret intelligence information with his wife through their letters, knowing that discovery would mean more torture and perhaps death. After his release, Stockdale became the first three- star officer in the history of the Navy to wear both aviator wings and the Congressional Medal of Honor.

You can understand, then, my anticipation at the prospect of spending part of an afternoon with Stockdale, who happened to be at the Hoover Institution across the street from my office when I taught at Stanford. In preparation, I read In Love and War, the book he and his wife wrote to chronicle their experiences those 8 years.

As I read the book, I found myself getting depressed. It just seemed so bleak -- the uncertainty of his fate, the brutality of his captors. And then it dawned on me: Here I am sitting in my warm and comfortable office, looking out over the Stanford campus on a beautiful Saturday afternoon. I'm getting depressed reading this, and I know that he gets out, reunites with his family and becomes a national hero. If it feels depressing for me, how on earth did he deal with it when he was actually there and did not know the end of the story?

"I never lost faith in the end of the story," Stockdale said when I asked him. "I never doubted not only that I would get out, but also that I would prevail in the end and turn the experience into the defining event of my life that, in retrospect, I would not trade."

I didn't say anything for many minutes, and we continued the slow walk toward the faculty club, Stockdale limping and arc-swinging his leg, still stiff from repeated torture. Finally, I asked, "Who didn't make it out?"

"Oh, that's easy," he said. "The optimists."
"The optimists? I don't understand," I said, completely confused.
"The optimists. Oh, they were the ones who said, 'We're going to be out by Christmas.' And Christmas would come, and Christmas would go. Then they'd say, 'We're going to be out by Easter.' And Easter would come, and Easter would go. And then Thanksgiving, and then it would be Christmas again. And they died of a broken heart."

After another long pause, he turned to me and said, "This is a very important lesson. You must never confuse faith that you will prevail in the end -- which you can never afford to lose -- with the need for discipline to confront the most brutal facts of your current reality, whatever they might be."

Volatility: Echoes of LTCM

"History Doesn't Repeat Itself, But It Rhymes"
-Mark Twain (attrib.)

The term “relative value” can at times be slippery. Distinct from directional investing and arbitrage, the term is loosely defined as an investment designed to capture a contraction or expansion between the market values of two instruments that are not directly related but which share common economic drivers.

Earlier this week we purchased the Canadian dollar (FXC), in part, because of the relative value play between it and the US dollar (i.e. Canada and the US are both stable North American democratic economies that share(d) a high degree of financial integrity by international standards). The deficit driven US economy is facing the grave consequences of exploding levels of debt and slowing personal consumption, while the smaller and surplus driven Canadian economy ‘s only major negative is slowing GDP growth spurred by declining commodity prices.

The massive spikes in volatility levels this week appeared to be driven by indiscriminate buyers willing to pay up no matter what the price. Recall that on Thursday that we speculated that some of this buying was due to a large player (or players) being forced to liquidate short volatility positions rather than investors trying to hedge risk.

Market chatter has been full of speculation that several large players (including one particularly large fund based in Chicago) have been whipsawed in a “relative value” volatility transaction. Details are sketchy but my guess, based on this frenzied buying, is that the trade in question was a play on the relative level of volatility of small caps vs. large caps. Whether making a straightforward wager on the VIX vs. the RVXK (the Russell 2000 equivalent) or a more complex dispersal transaction spanning individual names –anyone who was counting on large cap equity volatility to revert to its historical low levels relative to small caps has been in a world of pain.

This brings to mind the demise of Long Term Capital. This of course occurred only a decade ago when the masters of bond arbitrage gambled on an equity volatility mean reversion with disastrous results. Then, the LTCM traders were undone when the VIX levels held out at anomalous levels for much longer than they anticipated. This time around not only have volatility levels sustained at highs for a prolonged period, the relative spread between the VIX and the RVXK has swung wildly, providing stresses that exceed any historical comparison. As such, any model based approach is suffering for lack of context.

Simply put, I saw the wild action in the VIX this week as the capitulation of hedge funds who were betting on a mean reversion, rather than a broad market capitulation signaling a bottom.

Andrew Barber
Director

Early Look

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