P.O. Box 6643, Annapolis, MD 21401 410.224.

2037

Second Quarter

July 2011

This has not been a happy period for investors, with May and June seeing many markets and sectors collapse by 10% or more, wiping out first quarter gains. The reasons for this spring collapsewell rehearsed in the mediahave not gone away, and with valuations neither particularly compelling nor overly stretched, we are neither aggressive bulls nor bears for the next several months. We see a sideways market, with mini peaks and troughs along the way, for the next several months (or longer), in what the Financial Times columnist John Authers has called The Age of the Crab. We do, however, see some very solid companies selling at good prices, particularly (though not only) in the resource sector, on which we continue to be long-term bulls.

Sideways markets make stock selection key

Indeed, this sideways action is really what we have already experienced this year. It is similar to the pattern frequently seen after a major market decline; an impressive rally back towards old levels, followed by a long, broadly sideways movement (as per the Dow after 1929 or Tokyo after 1990). Of course, the peaks and troughs along the way seem significant at the time. In this kind of marketa trading market not an investment onethere will be two general ways to profit: attempting to time the ups and downsdifficult at bestor increasingly focused stock selection. Though ever-mindful of whether the market is overbought or oversold at any given time, we will emphasize the second strategy, buying good quality companies, preferably those with appreciable dividends, when they represent good value. Thus in June, after seven losing weeks that took the market to what appeared oversold levels, we bought fairly aggressively, topping up accounts with solid values in the broad U.S. and global markets as well as in resources. We will be seeking to capture some gains in coming weeks and months.

The markets giveth, the markets taketh away

Given the declines in May and June, however, it is not surprising that the quarter was a poor one for most markets and sectors, erasing most of the gains earlier in the year. The broad U.S. market fell (though the Dow was up, less than 1%), and the majority of overseas markets were also down. For the year to date, European stocks have been the strongest, Asia the weakest; the world index (ex-U.S.) is up just 1.1%. The reasons for the markets weakness are well known, but the rally of the last few weeks should not fool us. The problems have not been solved. The European debt issue remains and will eventually weigh on the Euro; the downgrade of Portuguese debt to junk exacerbates and will accelerate the decline. China continues to tighten in the face of a speculative real estate bubble. And here at home, Quantitative Easing 2 (QE2) has ended without a new stimulus program being announced, while the debt deadline looms, all amid a sputtering economic recovery. Despite all this, however, 2011 is not 2008; the excesses in the markets are not as great, and Mays declines were mild compared with 2008s. As for the commodities, their declines in the second quarter were worse than other sectors, driven by fears over Chinas economy, moving most into negative territory for the year. Though gold itself was up 6% for the first half, gold stocks (as per the XAU index) fell over 10%, and the juniors even more. The broad commodities index (Dow Jones UBS Index) was down 2.6%.

It was a disappointing period for us, with May and Junes declines wiping out all gains for the year. Though our gold accounts beat the index in the first half, losing only half as much, our resource accounts fell around 5%. Similarly, our global accounts lost some ground over the period, with the mid-risk growth account down, though less than 0.5%; our conservative accounts rose just 1.6%, while our aggressive accounts were down (though largely due to one anomalous account).* Although we mostly underperformed the indices in this period, we are comfortable with the value in what we own. The high allocation in our global accounts to resources, which were among the hardest hit sectors, is the primary reason for this relative performance, while the juniors, which dominate our gold and resource accounts, fell more than the big caps this quarter. Many of these juniors, however, are selling at compelling value and we expect them to rebound quickly when the resource sector recovers before the end of the year. Similarly, many of the other stocks that have fallen more than the broad market in the last couple of months also represent good value at these levels. I suspect that precisely these stocks will rebound the most.

Economy stumbling as easy money continues

Given the economy, its not surprising that the market fell in the last couple of months. QE2 clearly did not work. Ben Bernanke finally seems to comprehend this, though he has no idea why. So even as the economic recovery seems to be stalling, with jobs growth changing from tepid to abysmal and house prices down again, the Federal Reserve failed to announce a QE3 as the previous program came to an end. Although the Fed did not announce a new program to follow the end of QE2, it is clear that monetary policy remains loose. The Fed has stated that interest rates will stay low for an extended period and made clear that although it would not (for now) introduce a new stimulus program, it would make ongoing purchases from principal repayments. So there has been no exit, and the Feds balance sheet will remain large. Federal Reserve credit has grown at over 45% the past three months; that is not being withdrawn. And while its a political assessment as much as an economic one, I am guessing that, given Uncle Bens puzzlement as to why the Feds textbook prescriptions have not worked, and his obsession to avoid a depression, not to mention an election little more than a year away, the Fed will institute a QE3 at some point in the future (although perhaps called something different). Once economic reports deteriorate sufficiently, the Fed will try to stimulate again.

Banks, employment and housing: all hurting

Surprising to some on Main Street, the bank and financial sector is hurting, hit with staff layoffs and other expense cuts; Goldman Sachs expects to lay off almost 2,000 employees by the end of the year. No wonder sales at the Manhattan Maserati dealership have dropped by a third just in the last month! More importantly, the housing market remains in very poor shape in most parts of the country. Prices are down again, as are sales. Significantly, of the mortgages in default (two months or more in arrears), fully 30% have not made a payment in over two years. These are not people who are trying to keep up and with a
* Please note: Past performance is no guarantee of future results. For complete information on our past performance, including factors to be considered in viewing past performance and other disclosures, please contact our office. Specific stocks mentioned herein are intended solely as illustrative of strategies and types of stocks we are buying or selling, and are not intended as indicative of entire portfolios or of any individual clients portfolio. The numbers mentioned represent our composite averages. They represent all accounts that fall within the stated objectives which have the ability to buy and sell options; they exclude accounts under $200,000 and accounts with significant limitations or restrictions that would make them unrepresentative of the account type. Performance figures for composites referred to herein reflect the deduction of administrative fees, but may not take into account all performance fees attributable to the specific period. The performance of any individual stock or stocks does not take into account fees. Performance numbers include dividends; dividends are not reinvested. Commissions charged may vary depending on the brokerage firm at which an individual account is held. All accounts are managed individually and are therefore different, even within the same broad objective. Factors such as an individuals circumstances, the size of the portfolio, and the time the account opened can affect specific buy and sell decisions. Factors such as price movements and security liquidity can affect whether any trade is made for all accounts. Global Strategic Management, an SEC-registered investment advisor, does business as Adrian Day Asset Management.

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bit of luck will be able to. These are people who, for the most part, could not afford the house they bought and never will. So for all the houses currently in foreclosure, there are more lining up behind them ready for foreclosure if the backlog clears at all. Worse, there are eight million mortgages with a long-to-value of 95% or more, on top of the 12 million already under water. They may be current now, but if prices decline, they might think twice. This is why Fed and Administration policies are aimed at boosting housing prices, and why the Fed will keep interest rates low. But with the unemployment rate stubborn at over 9%, many people will find it increasingly difficult to keep their mortgage payments current, and a mortgage holder who gets behind, is underwater on his mortgage, and sees no near-term prospect of improvement, is more likely to stop making payments altogether. Despite the stalling economic recovery, inflation is inching up; the latest CPI report showed prices up 3.6% year-on-year, up from a CPI of 2% a year ago. Measures to restrain inflation growth will equally hurt the economy.

Europes debt and Chinas bubble hurt global prospects

The same concerns exist in global economies, with their well-publicized problems, especially the European debt crisis and economic slowdown in China. The recent downgrade of Portuguese bonds to junk clearly illustrates that the debt problem is by no means resolved. The debt problems in the periphery compared with the relative stability in the core makes European monetary policy all the more a juggling act. The European Central Bank has been tightening in order to stop inflation in its tracks, but only moderately. It may be enough to keep a bid under the Euro, but possibly not sufficient to stop inflation, yet enough to hamper the efforts of the peripheral countries to bring their debt under control. Despite these rate increases, in Europe as elsewhere, real interest rates remain negative.

Is Chinas tightening phase coming to an end?

Likewise, China has been tightening, with five rate hikes since last October, in a bid to dampen inflation and deflate a real estate bubble. There are certainly risks: higher rates are pushing up the yuan and thereby narrowing the cost differential between manufacturing in China and in home countries (including the U.S.), and leading to some reduction in outsourcing to China. Thus, manufacturing output is beginning to decline. There is also the ever-present risk that tightening gets out of control and social tensions increase, due to reduced work and higher prices. But inflation continues to move uplatest numbers show a consumer inflation rate of 6.4%--suggesting pressure to continue tight. Yet there is strong real growth, rising consumer spending, and, despite the latest numbers, signs that the monetary tightening is beginning to have an effect on inflation. Many local analysts expect the government to hold off additional rate hikes for the near term as inflation peaks and speculation is dampened. What happens in China is critical as it has been the engine of global growth for the last several years. Yet if there is a slowdown in growthon track for around 9.5% growth this yearthe economy will still grow at levels of which the U.S., Europe, and Japan can only dream. So we see a moderation in growth but not a collapse for the foreseeable future.

Emerging economies will rebound sooner

The U.S., China and Europe are not the only ones where inflation has picked up. Indeed, the emerging economies have imported inflation, primarily from the U.S., while many, particularly in Asia and the commodity exporters, have felt the brunt of Chinas tightening with lower imports. But as we have discussed before, by and large these countries have stronger balance sheets at the government and private level than the
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major OECD economies, solid banking systems, and undervalued currencies, so they are likely to withstand the problems in the major economies and resume growth sooner. Overall, most economies are seeing only moderate growth, sputtering in many countries, despite the easy money of the past few years, with negative real interest rates in most of the world. While rates will stay low for some time, they are beginning to go up; Europe, China, and Australia, as well as many emerging economies, have already increased rates this year. The major choice facing policy makers around the world will be how rapidly to increase rates to stem inflation against the risk of harming decidedly uneven recoveries.

Dollar rally over?

Higher rates have been one factor supporting various currencies, though there are other factors as well. The yen has been strong as money is repatriated to help the post-earthquake rebuilding, while the Swiss franc has been strong as a safe haven and the Canadian dollar has benefitted from sound economic policies. The Euro has been volatile but stronger on balance. Though the earlier rally has run out of steam the last couple of months, the fact that the dollar has been unable to rally in the face of the European debt crisis is quite telling. Clearly, the market is concerned about the U.S.s own debt problems. Fundamentally, we remain bearish on the dollar, as it continues to lose purchasing power. We favor Asian currencies (outside the yen) as well as gold as hedges on the dollar.

Stocks: A sideways market

Following the spectacular rally off post-crisis lows, the stock markets second legfrom last September was driven entirely by monetary stimulus. But most of this year, the market has meandered as the impact of monetary stimulus has diminished. Though corporate earnings remain positive and valuations not terribly stretched, theres not much firepower to drive stocks broadly higher and there is the need for massive new stimulus to reignite the rally. The public is largely not in the market, despite the lack of good alternatives, but the public is unlikely to pour into stocksnot yet, anywaywith economic indicators sputtering. As discussed above, we think a sideways market, neither the start of a new bull market nor a collapse, is most likely for the next several months or more. (Near term, with expectations high, disappointing corporate earnings could provoke a sell- off.) This makes stock selection more critical than ever, but also increases the need to be a little more active. Much the same comments could apply equally to global markets, whose post-crash rallies have equally run out of steam. In Europe, corporate earnings are weak across the board, on the back of higher costs and weak demand. That is weighing on markets. The emerging markets which started to underperform towards the end of last year, may well emerge from this period sooner, and are likely to see better returns in the year or two ahead, though it will still be a stock pickers market. Overseas markets generally offer far better valuations (with many major markets selling at just 10 times earnings) and present greater opportunities.
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 Commodities down, but will recover

As mentioned, the commodities generally were hit hard in the spring; in truth, they had begun a steady decline months earlier with many topping out early in the year. It was a perfect storm for the complex: the Japanese earthquake (which halted much manufacturing); China tightening, with a rundown in inventories; a slowing U.S. economy; a rally in the dollar; the end of QE2; and interest rate hikes in many countries (including major resource consumers, China and India). Commodities were arguably ahead of themselves, with some signs of speculation in the sector. All this combined to drive commodities down more than most. Yet this will change, and indeed is already changing. Japan, after the initial decline, is buying resources again for rebuilding. China appears ready to pause in its tightening program (as discussed above), and the economy remains on track for high growth. With inventories run down to multi-year lows, consumption will have to come from new purchases. And on the macro-economic level, we expect ongoing Federal Reserve stimulus, whatever it is called, and the dollar, as discussed, already appears to be turning down again. All of this means that the bull market in commodities will resume shortly, against a fundamental backdrop of higher demand from emerging economies and difficulty in increasing supplies sufficiently that will last for years. Thus, we have been buying aggressively the last couple of months amid the decline in prices, and already have been seeing some appreciable appreciation.

Inventories not a concern

One development that scared many investorsand set off the decline in the metalswas the huge build-up of inventories in China. As prices moved up, buyers Copper Inventories in China Decline started to build stockpiles; at a certain point in Chinas tightening, started to use those inventories instead of buying more. This, of course, made prices fall. But amid all the talk of high stockpiles, it was missed that this is a typical pattern, and certainly not unique to China, if perhaps more exaggerated. We saw the same thing in 2007 and 2008. And while the talking heads were frothing about high stockpiles of unused copper in China, these stockpiles were depleting rapidly. Copper inventories for example have fallen to two-year lows. Now end-users have to go to the market to buy afresh, and we will shortly see import numbers rise again, and with them, prices. (LME copper is already up sharply, from $8,700/tonne to over $9,700 since mid May, not that far from annual, and all-time highs.) Its far too late to be worrying about high stockpiles of unused copper in China.

Silver drop not unusual

A word on silver is also in order, since that was the poster boy of the speculative excess and the subsequent collapse. The silver price almost doubled this year to nearly $50 at the end of April, before a spectacular 30% collapse in just five days. Silver was overbought; we said so in many speeches to much
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horror. Of course, the rapid increase in margin requirements triggered the fall. But what has been lost by mostthough not by Ian McAvity to whom acknowledgements are dueis that silver has seen three other corrections of greater magnitude since 2004. Silver is, has been, and always will be volatile. People noticed this correction more because of the prior strong run up, and of course because it came from higher price levels, the absolute dollar drop was more. But 30% and more corrections in silver are nothing unusual, and (as we discussed last quarter), after a period of base building, we expect silver to resume its upward move. We dont necessarily expect significantly lower prices from here, but are prepared to have to wait just a little before it moves up again. So we have been accumulating slowly on dips. For the last two months, silver has traded in a fairly narrow range between the low $33s and the mid-$37s.

Emergency oil move supports higher prices

We are also bullish on oil, for long-term fundamental reasons. Quite simply, consumption is rising faster (about twice as fast) as production; and production is rising faster than new discoveries. With spare capacity among producers, particularly Saudi Arabia, falling, how long can this go on without significantly higher prices? The politically-inspired release of oil from the Strategic Reserves only reinforces this view. The amount of oil to be released represents just two-thirds of a single days consumption. (Total strategic reserves are just 18 days worth.) As for the price action, the oil price was already falling along with prices of other commodities from the peak in late April at $115, down to a low of $95. The furthert drop that followed the announcement of the release of oil from reserves has already been more than made up in the market. Other than a three-day psychological impact, the move has not lowered prices at all. So one can argue that the entire exercise was pointless. What it does show clearly, however, is just how desperate policy makers are becoming to stimulate economies. Emergency stockpiles are meant for just thatemergencies, to supply oil in case of physical shortages and not to lower prices.

Gold vs. the Fed: Gold winning

As for gold, there is little new to say. Gold is money, and people are buying gold because they do not trust their paper currencies. So long as interest rates around the world remain low (negative in most countries), and so long as the Federal Reserve and others continue with the deliberate efforts to debase their currencies, then gold will be the asset of choice. We are only seeing a pause, and a very mild one at that (less than 6% from top to bottom), before gold resumes its upward trajectory. As China pauses its tightening and the Fed continues to hold on to its massive balance sheet (not to mention the possibility of Europe coming unglued again), gold will move up. The gold stocks, despite strong rallies in the last few weeks, lagged severely throughout most of the second quarter, and remain undervalued relative to bullion, with some of the best value among the juniors and exploration companies. That is where we have been concentrating our buying in recent weeks. In sum, the circumstances of the last several months contrived to drive most markets and sectors down. But renewed easier monetary policy, in China as well as in the U.S., will see the dollar slide while boosting gold and other resources. The broad stock markets, here and overseas, will be supported by this easy money, though debt problems and stagnating recoveries in the U.S. and Europe will put a lid on any rally. Hence, we see a sideways stock market. We are, therefore, holding on to our high allocation to gold and resources, including oil, while in the broad market, we have been buying selectively, both in terms of individual companies and timing of buys, with an
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emphasis on value in Europe and growth in Asia, and always preferably companies with dividends. The next quarter or two is likely to see us trim some positions as markets move upwards.

Review of Individual Accounts

Global Accounts
We have been far more active in global accounts this year than is normal. This results from the wild swings in the market, going from overbought to oversold. Starting the year with about 10% in cash, we sold as markets moved up, raising the cash levels again, until, just in the last month, we topped up accounts as markets tumbled, bringing many of our favorite stocks into good buying ranges again. We are now more-or-less fully invested, with 8% in cash, but most of that either in foreign currencies or set aside for the exercise of puts. Several new buys, here and there We added to old favorites but also bought small positions in several new companies. These include some U.S. companies: American Capital Agency, which invests in government-guaranteed mortgage pools, and yields over 18%; and two depressed big caps, Microsoft, which has morphed from a growth story to a value stock, and Staples, selling at levels reached at the depth of the 2008 credit crisis, but fundamentally a good company. Overseas, we have three new companies: Fujicco, which produces processed food, selling at well under half book value, at prices not seen since 2003; Orkla, which manufactures branded grocery goods in Norway, trading at book with an almost 5% yield; and another Norwegian-based company, Cermaq, which produces fish feed and operates fish farms around the world, and has historically very high margins and returns. Looking to raise cash Though we like all these companies and they represent good value, we may sell on strong shortterm rallies. This trading is essential in the sideways market, especially where stocks do not pay significant dividends. Overall, we expect to be raising cash in coming months if the market or individual stocks rally. In truth, the cash levels in accounts were reduced only because markets were so oversold. We did sell two stocks this past quarter, both on valuation grounds: Unilever and Mapletree Logistics. Our global stocks are split between big-cap value companies in Europe and higher-growth stories in Asia, most of which pay reasonable dividends. In addition, we have a high allocation to incomeoriented companies in the U.S., adding on dips to two of the more conservative Business Development Companies, Ares Capital and Gladstone Capital, each yielding around 8%. Our global accounts also have a high weighting to the resource sector. Looking ahead, we expect to maintain those high weightings to resources and BDCs, while raising cash as opportunities present themselves from global stocks that are no longer good value. We certainly want to be positioned to take advantage of strong buying opportunities that will almost certainly arise in this uncertain world.

Gold accounts
As have the global accounts, our gold accounts have swung wildly this year, and we have gone from buyers to sellers and back again. We entered the quarter with an already-low cash position of under 5%. Then we started trimming positions in the usual spring rally which came promptly to an end at the beginning of May, taking gold stocks to well under the years lows. We had not sold as much as we wanted, before the crash caused us to switch and buy again. If that sounds wild, think of a stock that we like, has potential but pays no dividend and goes from $1.15 to $1.90 back to $1.12. To benefit, one has to sell a little on rallies, and lock in the gain. Now, after topping up accounts fairly aggressively in June, we are now fully invested, with less than 2% of accounts in cash, and most of that set aside for puts. This is among the lowest we have ever
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been in any type of account, and we are looking to raise a little cash in coming weeks and months. Two new buys, including one trade Among the stocks we bought were our top picks, including Franco Nevada, Allied Nevada, Lara, Yamana, and Vista. We added two new companies: European Goldfields, which is developing projects in Greece; and Solitario, a solid outfit with half a dozen projects in Latin America. The former is more of a trade; we have already sold some of our position after the long-awaited permit was issued. With cash so low, we will be looking for such trading opportunities. During the quarter, we exited only one company, and that is Radius Gold, taking advantage of a strong move in April, which seemed to us to put it above fair value. The stock today is lower than where we sold it, and we could rebuy it. So in the coming quarter, while very positive on gold and believing the gold stocks are still undervalued relative to bullion, and with many exploration stocks at depressed value levels, we want to maintain a fully invested posture. But because these stocks are inherently volatile, and to ensure we have funds for new opportunities which will doubtless come along, we will be looking to raise cash, perhaps by trimming positions.

(the old Magma Energy after its merger with Plutonic). The first, because we are bullish on copper for the next year or two, contrary to market opinion at that time; the second because of internal corporate developments; and the third because it is exceptionally oversold. Bought depressed uranium stocks Our new buys were concentrated on the uranium sector, which we believe is oversold following the Japan-induced selloff. Despite Japan, and the grandstanding in some other countries, such as Germany (perfectly happy to buy its power from French plants), nuclear power will clearly continue to be a significant part of the energy mix in the years ahead; China for one is not going backwards. We bought Cameco, the worlds leading uranium producer; Paladin, a growing Australian producer and possible takeover target; Mega Uranium, a highly depressed explorer; and the Uranium Participation Certificate, for direct exposure. We are looking to add to our oil holdings, buying more Canadian Oil Sands this past quarter as the stock tumbled from the mid-30s to the mid-20s. We would like to increase our exposure to oil, but in the right companies at the right price. Overall, we expect to remain reasonably fully invested, though always looking for opportunities to monetize holdings and redeploy the cash when better opportunities come along. Our focus remains on gold, copper, oil, silver, agriculture and uranium. In sum, this has been a difficult year so far, and we do not expect that to change significantly, though we do expect the resource sector to perform strongly in the second half of the year. The broader stock market, however, will be more of a sideways market, albeit with strong moves up and down. We will look to use this volatility to acquire strong companies at good prices, companies that we can hold for a long time and enjoy the dividends along the way. Given our low cash holdings across all accounts, we will be looking for opportunities to raise cash in coming months, so we are ready for any exceptional buying opportunities that come along.
Adrian Day, July 8th, 2011

Resource Accounts
Similarly, our resource accounts, after trimming positions, topped up in the May-June decline. We strongly believe that the long-term resource story remains intact, both because of supply/demand fundamentals and the macro-economic environment. So our overall bias, as with gold accounts, is bullish, looking to buy when opportunities are available, but selling when a particular company disappoints, or when a stock or the sector gets overbought, in order to ensure we have cash available for the next downturn. This quarter we sold only one stock, Abacus, a junior copper company that has disappointed. We are now pretty fully invested after Junes buying. Most of that buying was adding to existing holdings, particularly this past quarter Freeport Copper, Reservoir Minerals, and Aterra Power
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