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Our view on global investment markets:

December 2014 The Third Law


Keith Dicker, CFA
Chief Investment Officer
keithdicker@IceCapAssetManagement.com
www.IceCapAssetManagement.com

December 2014

The Third Law

Moves like Jagger


Three hundred years ago, physicist Isaac Newton, compiled the Third
Law of Motion. Ever since, people everywhere have noticed how
every action does indeed have an equal and opposite reaction.
This Third Law of Motion is certainly evident in the music world
where The Rolling Stones gathered a lot of moss. The hoodlums of
rock & roll seduced the world into sympathizing with the devil as well
embracing the emotion of never being satisfied. At the time, the
Rolling Stones represented the dark side of music and life.
The Beatles on the other hand represented the opposite reaction they wanted nothing more than to simply hold your hand. They
embraced the rising of the sun and were seemingly always twisting
and shouting about love. At the time, the Beatles represented the
bright side of music and life.
Of course, as time passed the social infatuation and rejection of each
band, swung dramatically and often in opposite directions, just as
Newtons Third Law of Motion predicted it would.
The pendulum of the money world also swings from side to side, yet
most of the time, most investors, mostly see what they want to see.
The good times are always just around the corner and any bad times
were simply the luck of the draw.
Astonishingly, Newtons Third Law seems to be either forgotten or
dismissed altogether, and this is a shame because the worlds

financial pendulum is the process of reaching that ever so brief


pause, after which it then begins to swing in the other direction.
To many thoughtful investors, it has become crystal clear that the
world is indeed on the cusp of a dramatic change in direction. There
will be extreme cases of financial, social, political and economic
losses. But there will also be extreme cases of financial gains the
secret is understanding how and where global capital will flow.
Applying Newtons Third Law of Motion will help you realise that for
every negative action, there will also be an equal positive reaction is
crucial to both preserving and growing your wealth.
Unfortunately, many investors make the mistake of taking a singular
stance without the thoughtful consideration of Newtons Third Law.
Of course, this one dimensional thinking is deeply rooted in our
recent past the one that dominates our investment expectations to
this day.
Weve written and presented before that practically everyone in the
investment business today earned their stars and stripes during the
famous 1982-1999 bull market (see Chart 2, page 4).
Weve experienced countless occasions and situations where
investment firms would use market data with 1982 as the starting
point to flog their newest mutual fund to the unsuspecting public.
Better still are the moments when a grey haired, industry veteran

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December 2014

The Third Law

Beware the starting the point


begins lecturing us with the all too predictable ...Ive been in this
business for 30 years, and .... And since 30 years is a long time, they
must be right.
But, and this is a pretty big BUT they are only right if you use the
early 1980s as the starting point. Otherwise, they are pathetically
wrong.
For those not in the know, both the stock market and the bond
market enjoyed their greatest runs ever when using 1982 as the
starting point.
In fact, almost every investment fund ever created produces
perfectly, perfect returns using the magical 1982 start date. Yet,
simply shifting the start date back to 1952 and counting forward 30
years will give you a not so rosy story - and most likely, fewer clients.
It appears that IceCap is not the only one to observe this seemingly
obvious point. Chart 1 on the next page perfectly illustrates this exact
same concept.
The point we make is that many investors in the world today are too
trustworthy of their local banks and advisors, and have swallowed the
industry sales pitch hook, line and sinker.
Instead, respecting and understanding that financial, economic, social
and political histories actually predate 1982, will provide you with a
different perspective on how the world is now shaped.

The belief and hope (theres that word again) that the world will
continue along a upward trend with a few bumps here and there has
been grossly miss-sold. Instead, the pendulum is changing direction
and this change in direction will create untold losses for the Euro
currency, government bonds, and banks & insurance companies
around the world.
Yet, the brighter side of the investment world will see untold gains for
the US Dollar and US stocks.
The key to understanding this paradigm shift is respecting Newton
and his Third Law of Motion. As Europe further disintegrates down its
rabbit hole, private sector money will seek safety. And, the only
market big enough in the world to absorb this kind of capital
movement is the US Dollar.

The Biggest Fallacy

The world is riddled with many untruths, and none compare to those
perpetuated by the investment industry and its staunch belief that
economic growth is the driver of stock market growth.
On the surface, it is a nice story after all, if a company makes
profits, pays out dividends and then makes more profits and pays out
even more dividends, it has to be good for the stock price.
Yet, if any half-respected investment analyst sharpened their pencil
just a little, and researched economic growth and stock market
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December 2014

The Third Law

Chart 1: Comparison of two different 30 year periods of investing

1954

1984
30 years
= 0% return

2014

30 years
= 400% return

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December 2014

The Third Law

Weird, but true

Chart 2

To demonstrate the truth about economic growth and the stock


market, consider the experience in the US since 1927. Over this 87
year period, the median annual profit growth has been 8%.
Yet, when companies grew their profits by more than 8%, their stock
performed less than periods in which their profits grew by less than
8%. In other words, less economic growth equaled higher stock prices
and vice-versa. Weird, but true. (Source Ned Davis Research).
From a different perspective, consider Chart 2 on this page which
details US Economic growth by decade, side by side with the growth
in the stock market during the same period. As you can see, there is
no consistent link whatsoever between economic growth and stock
market performance. Its still weird, but still true.
On a related note, compare the returns during the glorious 1980s and
1990s, to other decades. This illustrates our previous point about
how client and industry return expectations have been significantly
skewed due to most investment professionals and their mentors
gaining their experience from this specific time frame.

Source: Crestmont Research

movements, their objective conclusion would be a jaw-dropper to say


the least. Yes, there certainly are times when stock markets do well
when our economies are growing, but there are also times when the
exact opposite happens, and even more times when there is no
rhyme and reason to connect one with the other at all.

Now, there are always people who will say this 87 year time period is
too long WW1, the Great Depression, WW2, the baby boomer
years, the Vietnam War years, the Star Wars 80s years, the Tech
bubble years and the housing crash years shouldnt count. For those
market seers, we offer Chart 3 (next page) which shows economic
and stock market growth for the last 12 months.

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December 2014

The Third Law

Its still weird


Chart 3
Country

GDP Last 12
months

UK
France
USA
China

2.9%
0.4%
2.4%
8.4%

Stock Market
Last 12
months
2.5%
6.6%
17.3%
3.2%

Source: OECD, Market Watch

and youll find students analyzing GDP models and then allocating
their investment decision to the fastest growing economies.
This is wrong of course. Because if you think about it, this would
mean your investments should always be allocated to the Chinas and
Indias of the world. After all, these countries have consistently
created faster growth than any of the western world countries, yet
their stock markets have certainly not been the best performing.
Now, this isnt to say you cannot make money in faster growing
economies. Yes, you absolutely can but you have to be the business
owner. The one who earns and receives the profit. The distinction of
course, is that success in growing your business isnt necessarily
reflected in your stock price.

Again, there has been no correlation or pattern connecting economic


growth to stock market returns. If you can find a clear pattern let us
know.

This confusion between correlation and causation has stumped


the industry veterans for a long time. Some simply ignore it, while
most others have no idea the phenomena even exists.

Interestingly, a year ago we spoke with global managers based out of


London and they were absolutely positive that UK GDP would
accelerate and that it was a real nice time to buy UK stocks. In
hindsight, they were 100% correct about the UK economy, but the UK
stock market was nothing special at all.

Still not convinced? The next time your advisor tries to justify their
sales commission, ask them about correlation and causation and how
it relates to the stock market and economic growth. The most likely
response will be the one full of confusion and misdirection. In other
words, your question doesnt reconcile with what theyve been
taught and fed throughout their career, or worse still you are paying
a whole lot of fees for nothing.

Unsurprisingly, we also encounter this economic growth-stock market


fallacy in academia. Walk into practically any business school today

Weird, but it is true.


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December 2014

The Third Law

If a recession occurred in the forest would an economist hear it?


What should you believe?

If youre into numbers, this means that out of the last 7 recessions, this
un-eclectic group of big bank economists expected none of them to
occur. This is serious stuff even the worst teams in sports win a game
every now and then, but not the big bank economists.

What we mean by this is that there are times when yes, the economy
does strongly influence the stock market. But as we have already
demonstrated, there are also times when the economy can have the
complete opposite effect on the stock market.

In some ways, it should have you thinking - if a recession occurred in the


forest, would an economist hear it? In other ways, this shouldnt be a
surprise at all. When you think about, if your big bank investment
professionals believe that stock market success is driven by the growth
of the economy, and the big bank economist predicted a recession was
about to occur, it would mean that you should sell your stocks.

If economic growth doesnt drive stock prices then what does? A


whole host of things actually. Unfortunately, when you dig deeper
youll find that there are no constant drivers of the stock market.

To make matters even more confusing, there are periods when other
factors have a greater influence on stock prices. In fact, there are
many times inflation, interest rates, politics and military conflicts can
be the dominant driver of your wealth.
Now, when you think about it this way, perhaps it is no wonder the
global investment industry has steered investors into believing that a
singular, tunnel-visioned factor is the key to achieving stock market
success.
Yet, when we think of it this way, the industry fascination with the
belief that economic growth creates stock market wealth still doesnt
make sense. After all as Chart 4 on the next page shows, over the
past 44 years, professional economists as a group, employed by the
very same investment firms who proclaim that economic growth
produces stock market growth, have never, ever predicted that a
recession would occur.

And, we know for a fact that despite numerous stock market drops of
50% or more, most investment advisors have never recommended,
suggested or even hinted that you should make appropriate
adjustments to your portfolio.
Now, if the industry were on trial and they were sitting in the witness
stand, it is at this point their attorneys would be screaming objections anything to distract you from the truth.
We suggest you re-read this again, because as the worlds financial
pendulum begins to change direction, and all of the energized actions
create equal and opposite reactions do not expect the vast majority of
the investment industry to understand nor correctly communicate what
is happening. History shows they simply do not understand it, it isnt in
their DNA and you shouldnt expect this to change.

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December 2014

The Third Law

Chart 4: Economists track record vs actual economic growth


Professional
economists have
predicted 0 of the
last 7 recessions
Professional
economists have
NEVER expected a
recession to occur
Expansion
Recession

Since 2001
professional
economists have
been accurate
12.7% of the time

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December 2014

The Third Law

Stronger, higher, faster


The Next 12 Months

driven by investors always seeking the best return. This is true


sometimes but not all of the time. Remember that the world is
actually a dynamic place and linear thinking will give you onedimensional perspectives.

Currently, the entire Euro-zone is rolling into recession, China is


growing 47% slower than its 2007 peak, and commodity sensitive
economies such as Canada, Australia, and Brazil are all producing less
growth than expected. Meanwhile, we expect the United States will
continue to produce 2.5-3.5% economic growth during the next year.

A dynamic perspective shows there are also periods when investment


returns are driven by investors running away from certain losses, and
this is the environment that has been created in Europe today.

Over the next 12 months, the world will see a see-saw battle
between those believing and hoping that America can pull the rest of
the world out of its economic funk.

And during this period, we expect the US Dollar and US stock markets
to continue to march higher relative to practically every other
currency and stock market. However, do not attribute better currency
and stock market performance to better economic growth this will
be a mistake.
We have already demonstrated that economic growth has no bearing
on financial market performance, yet this show of US strength will
incorrectly be attributed to investors seeking to maximise their
investment returns. Instead, the strength in American markets should
be attributed to international capital seeking safety.
Note this distinction, because the end result will have booming
consequences that will be both unexpected and highly unusual.
The investment world has taught most people that that returns are

Although the economy is not a consistent contributor to stock market


growth, it is an enormous contributor to social and political change
and this is the key to following the decline of the Eurozone.
Enormous economic, political and social change is happening in
Europe and the smart money will not be sticking around to see what
happens.
Now, despite 6 years of increasingly stronger stimulus programs, 6
years of stronger worded communiqus, and 6 years of stronger
policy programs, IceCap fully expects Europes economy to become
even weaker as it heads into the 2nd half of 2015.
Investors, politicians and policy makers have to be reasonable here.
There is zero evidence that the subscribed economic policies are
working. Instead of targeting the disease of bad debt, decision
makers continue to target the symptoms of bad debt deteriorating
unemployment, deteriorating fiscal balances, and rising popularity of
extremists political parties.

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December 2014

The Third Law

It just isnt working


The critical point to understand is that deteriorating social and
political conditions are being caused by the chronic debt crisis. And as
the debt crisis continues, the social fabric begins to change
dramatically. And it is the dramatic social changes that is causing the
financial pendulum to begin swinging away from Europe and breaking
apart the Euro. As an example, consider the following:
Spain 80% of Catalonia voters support separation from Spain.
1st

France For the


time ever, the leader of the Euro sceptic party,
the Front National finished ahead of leaders from Frances main two
political parties.
Italy Five Star Movement has begun process of preparing the
country for a referendum on leaving the Euro.
Greece/Spain/Italy 40% to 50% of youths are unemployed.
The fact that the popularity of separatists parties is increasing
simultaneously with a deterioration in unemployment definitely has
every European government shaking in their boots. And when you
also consider that tax revenues are no where close to keeping pace
with spending, and therefore increasing the need to borrow even
more money, there should be little wonder that people, companies
and their wealth are leaving the Eurozone.
Since our last writing, economic conditions in Europe have

deteriorated even further and not just in southern Europe and


France, but in Germany as well.
While European government leaders have to remain positive in their
message those government leaders have everything to lose, the
message from the European Central Bank (ECB) remains LOUD and
CLEAR.
The ECB will continue to throw everything possible at the debt crisis,
hoping that it will disappear. Well, throw everything that is, except for
the only thing that will resolve the crisis losses for bond holders.
Its the losses to bond holders that is really scaring Europe, and the
one that will likely create snowball-like havoc around the financial
world.
Together with the European Commission, the ECB has supported and
launched over a dozen significant and meaningful stimulus programs
and strategies to yank the Euro-zone right out of its economic misery.
At the time, the ESM, ESFM and the ESFS were touted as being more
innovative than the invention of the wheel. Next, the world was
introduced to LTRO1, and then LTRO2, and then another strongly
worded pronouncement all of which were lauded as being more
innovative than the internet.
And of course, we shouldnt forget efforts to simply change the
definition of debt and the reclassification of illegal drugs and

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December 2014

The Third Law

FAILED
prostitution as strong contributors to the economy. While this move
didnt quite earn the label as being innovative, it did demonstrate
how the folks in Brussels can whip out new policy papers on a
moments notice.
Today of course, no-one is talking about any of these programs
anymore. Yes, they still exist but they have obviously been rendered
useless against this tsunami-wall of debt that continues to both
accumulate and cause people (and their money) to flee the Eurozone.
Two months ago, the ECB announced that interest rates will now be
NEGATIVE. Yes, negative. Americans, Canadians and the British
complain about getting next to nothing on their bank cash balances
and deposits. Imagine for a minute that you had to pay the bank to
hold your cash and deposits. Well, that is exactly where Europe is
headed.
The hope (theres that word again) of course, is that people and
companies will start to spend their savings, instead of hoarding their
savings. It is also hoped that European banks will lend money to
these same people and companies. The trouble is, these people and
companies have no interest in borrowing any money. As a result the
ECBs negative rate strategy is akin to pushing on a string or worse
still leading a horse to the water.
The fact that the ECB continues to create new and more aggressive
policy plans, validates our view that all previous plans have failed to

Chart 5

FAILED
FAILED
FAILED
FAILED

FAILED
IceCap Prediction: will FAIL

Source: ECB & IceCap Asset Management Limited

solve the debt crisis. Chart 5 above details previous strategies, our
grade as well as details for future plans.
Next up for the ECB, is the one plan every central banker has been
dreaming of since the entire debt crisis started money printing. It will
happen in Europe, and well have more comments and analysis as the
old world ventures down this path.
Meanwhile not to be outdone, the European Commission in Brussels
has also embarked on their latest stimulus program. As usual, it
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December 2014

The Third Law

More debt
sounds absolutely brilliant on the face of it. Yet, simply peel away a
few layers of the European onion and youll discover that once again
Europe is trying to solve its debt crisis by issuing more debt.
The European Fund for Strategic Investments is being promoted as
a EUR 315 billion fund which will create 1.3 million jobs over 3 years.
It sounds and reads great, yet the devil is once again in the details
which shows the Fund will receive EUR 5 Billion in cash and then, get
this, borrow an additional EUR 310 Billion.
This is the latest perfect example of how Europe is treating the
symptoms of their debt crisis. Once again, the strategy of using more
debt to fix a debt crisis seems a bit odd, but thats exactly what their
financial doctors have prescribed.
The situation in Europe has not occurred anywhere of this magnitude
over the last 100 years, let alone the past 30 years. IceCaps view
hasnt changed unless the Eurozone is willing to form a single
country, with a single government, with a single financial plan where
everyone is responsible for everyone elses debt, then it will fail.
This slow motion failure is happening before our eyes, with each
passing day seeing increasingly more Europeans moving their wealth
to safer markets. The good news is that there will be an equal and
opposite reaction in US markets this is where investors can benefit.
Of course, not everyone sees it this way. Case in point, consider the
worst investment idea ever.

The worst investment idea

The investment industry is full of a lot of things, and without looking


very hard you should not be surprised to see new mutual funds and
new investment ideas flogged on an almost daily basis.
Like all innovation theres some good and some bad. The really
good will stick around for a long time, while the not so good, loses
people a lot of money and then quietly sets with the sun.
We often like to comment on the ineffectiveness of the investment
industry, yet we rarely comment on a specific product until now.
Recently we were approached by a mutual fund company touting the
merits of their newest and greatest investment fund a European
bank mutual fund.
At first, we thought it was joke. But after a few minutes we quickly
realised these guys really were trying to sell us a mutual fund stuffed
to the brim with European bank stocks. The thesis behind the fund is
that European banks are intrinsically under valued. In other words,
the stocks are cheap and they should rise considerably faster than the
broad market over time.
We say fat chance. In fact, we believe European banks will become
the worst investment idea of the decade, let us explain why.
For generations, the surest, safest, most guaranteed events were
commonly referred to as money in the bank. And for good reason,
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December 2014

The Third Law

Save George Bailey


after all the last memory anyone had of a bank going under was the
one owned by George Bailey in Its a Wonderful Life. And since that
only happened in a movie surely the odds of a bank going belly up
were slim and none.
Yet, since 1980 there have been over 2,100 American banks that have
closed their doors or had to receive financial assistance (aka tax
payer bailouts) to get by. And thats just in the United States. During
the 1990s, Asia and Latin America saw 234 banks close its door. And
even in Canada 43 financial institutions have failed since 1967.
The point we make is that bank failures happen all the time. Yet, most
investors and their financial advisors only have a limited
understanding of how a bank is actually taped together and to give
you a hint, just know that banks use very little of their own money to
make money. In other words, they use your money to make money.
Now, as the European debt crisis re-escalates, this iconic phrase of
money in the bank will become an ironic phrase. To fully appreciate
the magnitude of risk emanating from Europes banks, you must first
understand how a bank is structured as a company. The most glaring
difference between a bank and a Wal-Mart, Microsoft, Johnson &
Johnson, or even your corner store is the amount of debt used to run
its business.
Banks are clearly not your typical company. They are aggressively
levered businesses. What we mean by this is the average bank has

borrowed money equal to 10-30 times what they own. For


comparison Wal-Mart has borrowed 1.7 times, Microsoft 0.9 times,
while Johnson & Johnson has borrowed 0.8 times of their own
money. These companies may struggle from time, but they are simply
not structured to go KA-BOOM in the middle of the night.
The easiest way to understand the inherent leverage within a bank is
to consider a bank that has $5,000 cash and then borrows another
$95,000 to give them a total of $100,000 cash to run their business.
Now, most banks are very conservative with their money and in this
example, they would invest the $100,000 in various things including
lending for mortgages and lending to companies and governments.
The problem arises when, despite prudent analysis and rigid
enterprise risk management procedures, the bank suddenly
experiences a loss. In the above example, imagine the bank losing
2.5% on their investments. This of course, would equal $2,500 which
would be half of the banks original cash holdings.
When this happens, the regulators rush in and demand the bank
replace the $2,500 loss of capital with new capital. Simple enough.
But look what happens if the bank loses 5% on their investment. This
$5,000 loss completely wipes out the banks original $5,000 cash
holdings. And that is just on a 5% loss.

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December 2014

The Third Law

Return of the Lira


Now, if the bank has a loss >5%, three different things can happen.
First, the bank can find new investors. Normally there is a high
probability of this happening. But only if the reason for the banks
losses is isolated to that specific bank. If these losses are rampant
throughout the economy, then no new investors will ride in to save
the day.
Next, the bank can be bailed out. Here, the government would walk
in using tax payer money to recapitalise the bank. This of course
happened in 2008 and although tax payers (and voters) accepted this
course of action back then, it is highly unlikely that tax payers will
accept it a second time.
Third, if no new investors can be found then the bank will go through
a normal bankruptcy/out of business process whereby all of its assets
are sold and then the proceeds are paid out to creditors who accept
losses on their loans to the bank.
Now, this is where it gets tricky for two reasons.
Reason 1: all creditors who leant money to the bank are usually other
banks, and insurance companies. Once these banks and insurance
companies take a loss on their investment, it has the potential of
causing them to lose capital and therefore run the risk of going under
as well. Again, this is what happened in 2008.

Reason 2: and this is the main concern for everyone involved with
European finance, the banks losses might actually be coming from
one of the European governments.
This is the scenario where one of the Eurozone countries decides to
leave the Eurozone. As for which country could leave, simply close
your eyes and pick. Any or all of Spain, Portugal, Italy, Greece, France
etc could leave on a moments notice.
To demonstrate the danger, assume for a minute that Italy decided to
leave the Eurozone and return to using the Italian Lira as their
currency. Immediately, Italy would announce that that all of the
money it owes will now be owed in Lira and not Euros. But there
would not be a fair market conversion. To make matters simple, Italy
owes investors over EUR 2.1 Trillion. If Italy left the Eurozone, it
would then tell investors they will be paid back LIRA 2.1 Billion which
would be significantly less than the original EUR 2.1 Trillion.
Anyone doubting the scenario of Italy leaving should really go back to
2012 when then Prime Minister, Silvio Berlusconi told French
President Sarkozy and German Chancellor Merkel that he was pulling
Italy out of the Eurozone. What happened next was the political
assassination of Berlusconi and therefore demonstrating the
seriousness of the situation in Europe.
So, this brings us back full circle to several important points. First of
all, banks are leveraged and small losses have the potential to
snowball throughout the entire industry.
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December 2014

The Third Law

Our portfolios continue to build up USD positions


Second, the most important issue in Europe is the financial health of
the countries unless this is fixed, the banking sector is exposed to
very serious things.
And third, why would anyone invest in a European Bank Fund?

Our Strategy

Currencies: Throughout the year, weve been adding more and more
exposure to the US Dollar within our currencies strategy. This has
been the correct call and although the US Dollar has recently
appreciated strongly relative to all other currencies, we believe this is
just the beginning of a major move upwards. As result, well likely be
adding even more money to USD as we enter 2015.
Equities: Since mid-year, weve also been increasing our exposure to
the stock market with a big emphasis on the US markets and
momentum strategies. This too has been value-added, and as long as
markets remain in the current uptrend, well continue with a focus on
momentum strategies, with specific allocations to the US.

Commodities: Our portfolios have small allocations to commodities,


and although we expect a near-term rally, our outlook remains
subdued for the sector as we enter 2015. Well likely be reducing
these positions completely at some point in the near future.
As always, wed be pleased to speak with anyone about our
investment views. We also encourage our readers to share our global
market outlook with those who they think may find it of interest.
Please feel to contact:
John Corney at johncorney@IceCapAssetManagement.com
Ariz David at arizdavid@IceCapAssetManagement.com or
Keith Dicker at keithdicker@IceCapAssetManagement.com.
Thank you for sharing your time with us.

Fixed Income: Weve previously communicated that we exited our


high yield bond strategies during the summer before the sell-off. The
sector has rallied off its recent lows, but we believe the sector is
priced to perfection with limited upside from its current yield. Well
continue to avoid this sector, and remain with higher quality fixed
income allocations.

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