Dear Investor,

In his early years, Warren Buffett managed a private investment partnership, a vehicle we would now call a hedge fund. In the early years of the fund, in the late 1950's and early 1960's, Buffett was very focused on his performance relative to the Dow Industrials. He made it clear that the goal of the partnership was to provide higher returns than the Dow, and that if he didn't achieve that goal then there was no real reason for the partnership to exist. After all, his opinion was that if an investment manager does not meet or beat the returns of the market itself then the investor could do better by just buying the market through a mutual fund.

However, as time passed he began to make a subtle shift away from his beat the market every year goal. As his fund grew he was no longer just buying stocks - he was buying controlling interests in the companies behind the stocks. He began to focus more on acquiring good businesses at attractive prices, with good people running those businesses, and letting the market assign a higher price to it later. In a 1965 letter to clients, he made the following comment:

"...our results, relative to the Dow and other common-stock-form media usually will be better in declining markets and may well have a difficult time just matching such media in very strong markets." - Warren Buffet, July 9 1965

While I do not have a window into Buffett's mind to know exactly what he meant, I have the feeling he was referring to his own methodology of finding investments and how that methodology performs in different market conditions. Forty seven years later, most of us who now know of Warren Buffett would say that the long-term performance of his specialized talent for acquiring good businesses at attractive prices is unrivaled. Buffett did very well for his investors while this early fund was in operation, as he continued to refine his skill of buying undervalued companies. In 1969 he decided to close his fund largely because he no longer saw any worthwhile investment opportunities and did not want to continue on just hoping to get lucky with other people's money (as he put it) with sub-par investment opportunities.

It's safe to say that these days he cares much less (if at all) about how the stock price of his current investment vehicle, Berkshire Hathaway, performs relative to the Dow Industrials in any particular year. He remains constantly focused on what generates long-term value for Berkshire shareholders.

One of the most important take-home lessons I have learned from Buffett, and from the short story above, is this: the ability to step back and use the market to achieve one's goals, rather that trying to follow and beat the market's every move, is key to long-term success in investing. With hindsight we now know that several years before Buffett closed his fund in 1969 the stock market had entered a long-term bear market, and it would take 16 years before the Dow Industrials surpassed its 1966 high for good. Investors during that time who stayed fully invested and myopically focused on matching or beating the returns of the major stock indexes (and the major bond indexes as well) every step of the way were handed huge losses on an inflation-adjusted basis by the end of the 1970's. That was the price for keeping the blinders on and ignoring the larger market forces at work.

In his own way, by 1969 Buffett knew the market environment had changed for the worse and decided to step back until the Bear had a chance to return value to the market. By avoiding the temptation of taking on unnecessary risk with other people's hard-earned money, he did the exact opposite of what 99% of Wall Street would ever do - dare to defy the herd in the name of preserving client's capital. Today, since mutual funds are required to stay fully invested according to their prospectus, they are actually prevented from even attempting to better manage risk. They can only go with what the market gives them and hope to squeeze out a few extra percent return over their rival funds.

At Sitka Pacific, we have the flexibility to take more meaningful actions to preserve capital, manage risk and volatility, and invest where the best opportunities are. Our goals are simple: to preserve capital first and generate an absolute positive return second. In order to achieve those goals we look at the market as a means to generate a return, not something that should be blindly followed. We use the market when it can be useful to us, and can look elsewhere (even to cash) when there is more risk than potential reward in the market. This flexibility to manage risk may prove critical over the next several years.

This is why in 2007, like in 2006, our performance will likely be similar to what Buffett described above, because we will not be taking on all the risk the general market is willing to sell us in an effort to insulate ourselves from some of the current risks. In this review we'll dig below the surface of the market and the economy a little and look at what happened in 2006 and how things appear as we start 2007. When we get through to the end, hopefully you'll have a clear idea of where I think the current risks and potential rewards are in the coming year, how we plan to move ahead, and how that will affect portfolio performance. We'll get started with a review of the current economic backdrop, and then take a bird's eye view of the current market.

The Economy

The main economic theme of 2006 was undoubtedly the slowdown in the housing market, and as 2006 drew to a close the central point of debate among economists was whether or not the slowdown in housing will come to affect the broader economy. The year-over-year price appreciation of many formerly hot housing markets turned negative at the end of 2006 for the fist time in a decade, and nationally home prices are now down ~3% from a year ago. Given that many of the hottest areas were showing over 30% y-o-y gains at the end of 2005, this was a huge shift; the image of a brick wall comes to mind.

Many discussions on the housing market these days seem to focus on what increases in delinquencies and foreclosures will mean and the possibility that housing prices could decline for some time. Such an outcome is certainly a concern at this point and it would clearly have a huge affect on the economy as a whole, but that is not where we stand today. Right now we have a housing market "stall" that has brought nationwide house appreciation to a standstill, below the rate of inflation. It's important to recognize that this alone will have a significant economic effect because over the past several years consumer spending has been supported by home equity withdrawal to the tune of hundreds of billions of dollars per year - which amounts to several percent of US GDP. If home prices fail to appreciate further, that source of extra cash and spending will no longer be available.

In light of that, it's no surprise that GDP growth slowed significantly in the third quarter of 2006 alongside clear data showing the housing market had softened - the changes in consumer spending and sentiment that came with the stalled housing market are starting to be seen in the statistics. And there is every reason to think this will continue into 2007. For instance, by some estimates there is over $1 Trillion (yes, Trillion) in variable rate mortgages that will reset to higher interest rates in 2007. So while the housing market had been a large net contributor to consumer spending over the past several years, the combined effects of higher interest rates on variable mortgages and the lack of price appreciation (thus dampening or removing entirely equity-withdrawal-based consumer spending) means housing will likely continue to be a drag on the economy in 2007.

As long as interest rates remain low, the housing market will probably continue on a track of slow deflation over the next few years. Some economists, most notably Alan Greenspan, have been saying over the past few months that there are signs of a turnaround and that the worst is over. Anyone familiar with market history or some of the current data recognize that kind of talk for what it is - cheerleading. As an example of the kind of data the housing market is giving us, the chart below (courtesy of Contrary Investor) shows Housing Permits over the past 46 years. Housing permits are a leading indicator of the housing market; they lead actual housing starts, construction employment and prices, and are an excellent barometer of how the homebuilding companies judge future market prospects. As you can see on the far right of the chart below, the number of permits being filed for new construction have been in a free fall since hitting a high about a year ago.

The last bottom in permits in 1992 occurred several years before the housing market itself started to gather steam for another sustained move higher, and given the shear momentum of the decline in the chart I don't think anyone could say we're there yet. The numbers for housing permits, starts, inventories, etc., will let us know when housing will cease to be a drag on the economy. Right now the evidence just isn't there.

This is not meant to be a housing update but the housing turn was the dominant change in the economic landscape in 2006, and despite what many pundits are saying it will be the dominant economic theme over the next few years - just as the bursting of the tech bubble was 5 years ago. Unlike the tech bubble which was largely a business event, the housing slowdown will be a consumer event that affects the economy more broadly. And while it's unlikely we will see an 85% drop in a major market index in the near future like the Nasdaq suffered in 2000-2002, there will be consequences for the economy and the markets in the coming years. Here are two examples already in the books from 2006.

Back in the August monthly update we looked at a chart of the Commodities Research Board (CRB) index which had just broken down through a 5-year trendline. Due to a recent rebalancing, the CRB index is now heavily influenced by oil and related commodities. In July crude oil had peaked at $79/barrel and in August it had become clear, by the action of oil and the CRB index, that the 5-year bull market in oil had ended and there was the possibility of a substantial decline. Since then oil has declined to below $55/barrel, falling more than $10/barrel just since the start of 2007. It seems the decline last summer was sparked by a washout of speculative money in the oil futures market, but since then oil has clearly been declining due to more than just hedge funds unwinding their oil positions. It's no coincidence that oil began its decline just when the effects of the slowing housing market started to show up in the statistics. So while the decline may have started from speculators selling, it has likely continued due to a slowing economy. The same is true for other commodities such as copper, which ended the year at $287 (down from a high in May at $394). Copper has continued its decline in January, recently hitting a low at $247 - 37% below its 2006 high.

The decline in oil and commodities like copper in mid-2006 represent a huge change in the investment landscape, because from 2001 to mid-2006 the commodity advance was more or less unstoppable. They also represent a change in the inflation landscape at the consumer price level. After rising from a low after the end of the last recession in late 2001/early 2002, the Consumer Price Index (the thick black line on the chart on the following page) chopped its way higher until taking a steep dive in 2006.

The CPI decline in 2006 is clearly energy related, as oil, retail gasoline, and natural gas prices fell dramatically. Seen in isolation, this could be considered a good thing for the economy - after all, aren't cheaper gas prices a positive thing for the economy? From an individual consumer level, certainly. But a steep drop in consumer prices can also be a sign that the economy as a whole is slowing and demand is slackening. Since the drop in the CPI coincides with a drop in GDP growth, and a similar drop in many housing statistics and commodity prices, this seems to be the case.

Last but certainly not least, the Treasury Yield Curve ended 2006 strongly inverted. As you can see on the chart below, the last time the yield curve was this far in the negative was in 2000 - just before the 2001 recession (shown by the light grey vertical bar). Prior to that, the last serious inversion was in 1989 before the recession in 1990. In the October monthly update we discussed the yield curve in detail and looked at a chart of average 1-year returns of the stock market following a yield curve inversion, so we won't dwell on it here. Suffice it to say the yield curve is in agreement with the current data from the housing market, commodities, and CPI inflation: the economy is slowing, and there is an elevated risk of recession in 2007.

From an economic perspective 2006 gave us ample reason to approach 2007 with caution, but we all know the markets don't always act in perfect sync with the economy. In fact, they are sometimes years apart in their reactions. The data above do provide some context to look at the markets as we start the year, because we also know the markets often play catch-up to a deteriorating economy far faster than most people can react. With that in mind let's see what trends changed in 2006 and what we can expect (if anything) in 2007.

The Markets

The stock market rallied modestly into the spring, had a sharp correction into the summer, and then rallied from the summer lows to the end of the year. The S&P ended up 16% for the year. Treasury bond yields rose to a peak in the summer, and declined from there leaving the yield on the 10-year Treasury bond at 4.7% at year's end from 4.4% at the beginning of 2006. Gold had a volatile year, but ended up over $120 (or 25%) higher at $638/oz. The US dollar index ended the year down 8%.

In 2006, the Dow Industrials made a new all-time high, as did many of the small-cap indexes. The S&P 500 rallied closer to its 2000 high at 1553, trading as high as 1431 in December. The tech-heavy indexes such as the Nasdaq Composite also rallied, but underperformed the Dow Industrials and S&P 500 in 2006 and remain more than 50% below their 2000 peaks.

As we have been discussing in the monthly updates, I have kept general market exposure hedged during the spring and early summer, and from August through the end of the year. Looking back at the rally from the summer lows it's tempting to conclude this was obviously a time to throw caution to the wind and jump into the market with both feet. After a choppy advance throughout 2004 and 2005 the rally from the July low has been a solid sprint to new all-time highs for some indexes. If this turns out to have been the start of a larger rally that carries stocks higher into 2008, then you can definitely fault me for staying hedged during the first part of it.

However, our goal at Sitka Pacific is to protect and preserve capital first and only then open ourselves up to capital gains. Not every rally carries the same risk/reward profile, and I'd most certainly classify the recent rally as high risk. Given the data we are seeing coming out of the economy and other US markets, some of which was detailed above in the economic summary, as well as simple market history tells us that we are very likely near the end of this cyclical bull market. We are surely not at the beginning.

Since the spring of 2003 the market has rallied uninterrupted for almost 4 years, with corrective phases never giving back more than more than 10% along the way. This graph (courtesy of Chart of the Day) shows all the significant market rallies since 1900, and you can see how the current rally from 2003 compares by the hollow blue dot marked by the You are here box. In short this is now the 4th longest rally without a 10% correction since 1900, and for a rally of this duration it's been one of the lowest returning.

At this late stage of the game the stock market appears driven by two factors: the decline in the price of oil, and the reduction of float. The S&P 500 has been tightly negatively correlated to the price of oil over the past 3 years, and the strong rally from the July low has coincided with a $25 decline in the price of a barrel of oil. Also, corporations and private equity firms bought back a record amount of stock in 2006 - shrinking the float of non-financial equity in the market by close to $600 Billion. This is around 8 times the annual average going back to 1975. In 2005 non-financial equity shrank by more than $350 Billion, bringing the 2005-2006 equity reduction total near $1 Trillion. This is part of the story behind the lack of volatility in the market, and the "constant bid" that seems to be there at every dip.

The question of course is whether these trends will continue. To be a buyer of the market at this point you have to hope that the data we're seeing from the housing market and the inverted yield curve do not foreshadow an economic slowdown or a recession (which together they always have in the past), and you have to hope that the 4th longest rally since 1900 continues a little while longer. You also have to hope that corporations continue to buy back their own stock at an off-the-charts record pace, and hope the price of oil and other industrial commodities continue their decline. These are a few of the reasons we maintained a cautious stance towards the general market late in 2006 and into 2007. History suggests the market has little to offer at this point except a high amount of risk for the potential return.

There are, however, other opportunities around - and the Treasury bond market is one of them. Yields on Treasury bonds peaked in 2006 near the time of the stock market lows, and in the process they re-confirmed a very long-term bear market in bond yields (a bull market in bond prices). The chart below shows the yield on the 30-year Treasury bond from 1980 through 2006; the green arrow points out the high near 5.25% this past year was at a long-term trendline that dates back to 1981.

After hitting a low in 2003, Treasury bond yields have consolidated and are in a technically attractive position. Although bond prices have rallied somewhat from the summer highs, Treasuries have yet to benefit from the full flow of funds that usually funnel into safe havens during an economic slowdown. Junk bond yield spreads remain at historic lows, and the stock market is still in rally mode. When/if these markets turn in 2007, the rally in Treasuries should accelerate. If not, there are clear lines in the sand that if crossed will let us know when to exit.

Gold hit a high near $730/oz in May, and has since then been locked in a volatile trading range. We carried gold-related positions from 2005 into early 2006, and then exited the sector until entering again in October. Although metals such as copper have come down fast from their 2006 highs, Gold has maintained its composure and as a sector remains in a unique position. Many things affect the price of gold, including the value of the dollar against other currencies, the money supply of the US and other countries (notably Japan), and real interest rates to name a few. In these categories there were some headwinds for gold in 2006, but it remains in its long-term uptrend and we will probably remain interested in this sector in 2007 both as a hedge against bond positions and as a pure speculative position.

The main foreign market of interest as we head into 2007 is Japan. While the US is still struggling with the aftermath of the tech bubble and the impending housing decline, Japan is just coming out of a long deflation where both stock and housing markets spent over a decade in decline. The Nikkei, the Japan equivalent of the S&P 500, continues to break through significant technical barriers and is continuing to "prove itself". We remained on the sidelines with Japan for the later half of 2006, but have recently entered a few positions just before year's end. While many markets outside the US look extended, Japan may be a standout in the next few years. As with Gold, we will likely remain interested in Japan in 2007.

Account Performance
	Hedged Growth	High-Yield Growth	S&P 500
2005*	11%	6%	5%
2006	9%	15%	16%
Total	21%	22%	22%
All account returns are after management fees. *July-December 2005

From inception in July 2005 through December 2006, both Hedged Growth accounts and High Yield Growth accounts have more or less matched the return of the S&P 500 on average after management fees. Roughly two-thirds of this time we have been partially or fully hedged against general US stock market exposure. With the exception of a small window in the summer, we were fully hedged against market exposure from early 2006 through the end of the year. As a result, Hedged Growth accounts, which maintain short positions in stocks along with market hedges, trailed the S&P in 2006. Returns during that time came from positions in specific market sectors as well as from foreign markets.

As we discussed at the beginning of this review, I expect the portfolios to match or slightly trail the market in the coming year if the strength in stock continues without a significant correction. If this rally from 2003 ends and the market begins its long-overdue correction, the portfolios will likely significantly out-perform the market. At this point the trade-off of some potential returns for insurance against a decline is reasonable given the condition of the market and the economy. Our portfolios will continue to maintain positions in attractive stocks, and we will maintain our exposure to specific sectors and markets that have a much higher probability to generate positive returns than the general US stock market. Our goal is for a positive return in 2007.

If you have any questions regarding your account, please feel free to contact me. I will be in touch with you personally within the next couple months with some additional updates if we don't talk before then.