Members received this update on Saturday

Friday, All-Star Legg Mason fund manager, Bill Miller's letter to shareholders got a lot of press due to his suggestion that the names getting beat up today are likely to be the best performers and new leaders of the next 5 years. While we don't wholly agree on all his ideas we do agree with the overall premise of the letter in that of the benefits to value- based contrarian investing.

Consider his notion:
"What has worked for the past 5 years continues to work, and what has worked is the high beta trade on global synchronized recovery. When everyone was panicked about deflation in 2002, the right thing to do was to bet on reflation. The winners have been commodities, especially energy, materials, industrials, non-US, non-dollar, and emerging markets."
And conclusion:

"What seems to have escaped notice is that all those winners bottomed with the peaking of junk bond spreads in the summer of 2002, and have risen concomitantly with the consistent narrowing of credit spreads that began to end in March of this year. If that was not just a spurious correlation, and I do not think it was, then there is trouble ahead for those crowded into all the popular favorites."

This is a "writing is on the wall" type statement and when going against the crowd these types of indications are what contrarians such as Bill Miller use to identify turns in the trend. One of the sectors he was increasing exposure to was financials. We can't get long term bullish on financials just yet, as we expect book values to continue to deteriorate and multiples to book continue to contract. Consider the back of the napkin math on Citigroup. Before its all said and done say worst case scenario they write off $40b (equal to 50% of their off balance sheet SIV exposure). The multiple goes to 1x book and the stock could ultimately be worth around $20 or another 45% downside. That is an extreme number but it's also the risk. That being said, these names are heavily shorted and there is a little whiff of capitulation in the air. We see potential for a big bounce in the banking sector which could also catapult the S&P to new highs.

The news flow on financials has been downright dreadful. Write downs, SIVs and commercial paper risk, dividend risk, capital ratio risk, balance sheet risk, CEOs resigning, etc. No one wants to touch banks because we fear what we can't quantify. When Dom told me he thought banks could be completing 5 down into support I thought he was crazy to be looking to get long. Then I kept reading these analysts' comments and downgrades due to what had already occurred. The financials are on their lows with these risks largely discounted and NOW they want to downgrade. The "writing was on the wall" that the credit cycle was peaking showed up as early as 2003. The unfolding of events reads like a timeline:

• First the Fed funds rate bottomed at 1% in 6/03 which peaked monetary stimulation as evidenced by the also peaking of yield curve (2s/10s) at around 250bps and indication that excess liquidity was also peaking.

• Months later GDP growth would also peak as did the spread to fed funds at just over 600bps indicating risk of peaking collateral values.

• The DXY would bottom in late 2004 rallying approximately 15% throughout 2005 confirming liquidity and credit was receding.

• In the summer of 2005 as the dollar was rallying and the curve was flattening, the public homebuilders were topping, confirming the peaking of collateral values.

• The regional banks stopped rallying and started to chop sideways for the remainder of 2006 while pundits and analysts were pounding the table on the "awash in liquidity" thesis after the market's impressive recovery from the summer lows.

• Greenspan calls the bottom in housing in 10/06 in the face of spiking defaults and foreclosures.

• The money centers continued to rally into 2/07 before they finally topped as it became clear underperforming assets were increasing and they were being forced to de-lever.

• Warehouse lines were being cut off and mortgage brokers were dropping like flies.

• The broker dealers, who trade and own much of this paper, followed by topping in June as the Bear Stearns hedge funds were blowing up and liquidating.

The recent earnings announcements from the financial sector gave us the first estimate to the extent of the losses and thus far they are substantial.

Now if we can easily point to a 4 year evolution of a peaking in the credit cycle and obvious affects on the provider of the credit, the financials, then the market has discounted it. The event has already occurred. These analysts have missed the story and are late to the game. We, however, had been anticipating this event since fall 2006 and are now looking forward. The question to determine long term performance is what will be the long term damage to these institution's balance sheets and the future multiple paid to book value. We think it eventually goes lower but not without first bouncing in the analysts faces.

Holding support below and rallying to the .50% or .618% retrace could produce as much as a 15% return and likely push the broader indices back to new highs. Of course, if they give way, it could get ugly for everybody and in that case we should be defensive.

Bottom Line:

We aren't getting bullish on banks but we aren't piling on late either. With a scared and bi-polar market we must be on top of the financials which are the main culprits in this volatile environment. As we demonstrated there was ample evidence of their imminent demise. However just as we got defensive on the S&P prior to recent volatility, as we saw financials lag since early 2007, we now must be cognizant of potential technical support, Wall Street analyst capitulation and oversold conditions and be prepared for a snapback rally. We do not want to be looking to aggressively sell a market if banks are rallying.

Notes:

• There are many potential patterns as we head into year end.
• SPX looks like it could collapse back to Aug lows or push to new highs on holding here.
• NDX shows no signs of weakening but could be close to finishing a pattern.
• Materials have slowed momo and may have finished 5 up
• BKX and XBD will make or break this last to months of the year.
• We don't know what they own or what it's worth.
• Dick Bove - financial bear notes C capital issues are relatively insignificant to overall size of balance sheet.
• Dollar has Fed on hold bullish for the curve a net positive for banks duration risk
• Money markets still edgy high yield accounts under stress
• Imagine XLF heavily shorted

Conclusion:

Follow the Bouncing Banks.......