In this newsletter we will attempt to describe our understanding of the markets and the economy, and the steps we take to position our portfolios to reflect our views. First, we are content with the performance of Vega Equity* during the Q-I, 2009. We have outperformed S&P 500 by several percentage points. At the moment of this writing, portfolios are more or less flat year-to-date.

The main question we are facing: "is the worst over for the world economy?" In recent weeks financial markets have latched on to the "green-shoots", "glimmers of hope" thesis, rising smartly as an array of statistics turned out to be less dire than expected.

We continue to believe, however, that the situation with the markets remains extremely volatile, and we are not out of the woods by any stretch of imagination. While during the several weeks in March market has shown some signs of life, we view that behavior as the bear market rally.

Most of the talking heads on TV, and the government officials are telling us that the economic indicators faintly hinting at a thaw, and with the stocks higher by 15-20%, we are definitely in the beginning of the recovery cycle. This is, of course, the biggest investor's quandary as banks submit to stressful inspection and the reports of likely lousy first quarter profits begin to arrive in daunting quantity. Is it indeed the case? Doubtful. The main issue remains the health of our banking system. Here we share the opinion of Nobel Prize Winner in Economics, Professor, Paul Krugman:

"So the market was greatly reassured when Tim Geithner declared that the "vast majority" of banks are well capitalized. Count me as baffled. I mean, maybe he was actually giving us a hint about the stress tests — but I took it as a remark that was uninformative at best, ominous at worst.

After all, there are a lot of banks in America. There are 1,722 institutions on the Fed's list of "large commercial banks". And I have no doubt that most of these banks — indeed, the vast majority — are in fine shape. That's because they're regional institutions that never got into the risky games played by the big guys.

But the big guys are where the money is. The top 10 institutions on that list have 58 percent of the assets. (If we looked at bank holding companies rather than only commercial banks, assets would be even more concentrated.) So it's perfectly possible that the "vast majority" of US banks are well-capitalized, but that banks with, say, a third of the system's assets are insolvent.

What Geithner said, then, was true but useless. If anything, his wording was cause for concern: Treasury knows the difference between raw numbers of banks and asset holdings, even if the press seemed to miss the distinction, and if he'd meant to say that the vast majority of assets are held by sound banks, he would have."

FOUR MAIN SCENARIOS

There are four possibly scenarios we are considering:

• Speedy Recovery: V-Shaped Recovery — Probability — 5%
  After slipping into recession in the third quarter of 2008, G3 growth resumes in mid 2009. This would be in line with an average duration of every recession in the post war period.

• Mild Recession: U-Shaped Recovery — Probability: 25%
  Aggressive central bank easing and a quick resolution to G3 banking sector problems leads to a recovery taking hold sometime in the second half of 2009.

• Severe Recession: W-Shaped Recovery — Probability: 45%
  Banking sector problems lead to a collapse in consumer and business confidence. Economic output contracts for throughout 2009 and a recovery only starts to emerge at the beginning of 2010 as the Process of bank de-leveraging runs it course.

• Depression: L-Shaped — Probability: 20%
  Banking failures spread around the G7 nations. Equity markets and house prices collapse further. Unemployment rises rapidly and deflation takes hold. World economic activity contracts for the next two to three years.

We think that the market is at a critical juncture, and we are positioning our portfolios to reflect the above scenarios.

MAIN INDICATORS

Our main premise is that we are still in a secular bear market. None of the three signposts we watch for the start of the next bull market has yet flashed green — the earnings and housing downturns have much further to go, we believe, and banks' balance sheets are not sufficiently repaired. Valuations could provide a trigger for a new bull market in the absence of fundamental drivers, if they got cheap enough.

However, at 10.9x Shiller P/E (or 14.9x in the US), we are far from such levels. In fact, we believe a major valuation undershoot in this cycle is still likely.

Will the bear market rally be long or short? A longer 'Japan in the 1990s' type of rally could be unfolding. Leading indicators are turning up and the second derivative is improving on many measures of growth. Bulls argue that positioning is short and the market can climb a wall of worry. We suspect the rally will end soon.

We are watching five areas to decide whether we are getting closer to end of the rally.

1. Credit markets — positive for now — as they currently show many signs of improvement.
2. Growth — positive for now as lead indicators bounce. However, such momentum will be difficult to sustain as expectations rise, providing a test for the market. Also, there are some interesting stats showing a further deterioration, not improvement, in the second derivative, such as April rail traffic in the US and Shanghai port volumes.
3. Bank bailout plans — this is harder to call, but more likely negative, in our judgment.
4. Employment — negative as there has been little improvement in job data.
5. Sentiment/positioning — more of a negative, we think, with bulls minus bears on the AAII survey going above zero; anecdotes of people being drawn in right now are consistent with being close to a peak in the market.

FEDERAL RESERVE

According to the March 12, 2009 Federal Reserve Statistical Release, the Fed holds as assets on its balance sheet approximately $456B in longer-duration US government notes and bonds with only $18B in the shorter-term bills. This is a major shift away from the historical focus of Fed activity being in shorter-term bills rather than longer-duration notes and bonds. Also on the balance sheet are: (i) ~$69B in mortgage securities (guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae!?) all carried at face value and all with duration in excess of 10 years; (ii) $240B in commercial paper with 90 day maximum maturity (Commercial Paper Funding Facility LLC); (iii) $26B in assets at "fair value" from Bear Stearns (Maiden Lane LLC); (iv) $18B in assets from AIG subsidiaries at "fair value" (Maiden Lane II); and (v) $27B in collateralized debt obligations on which the Financial Group of AIG wrote credit default swaps (CDS) contracts, estimated at "fair value" (Maiden Lane III). Chairman Bernanke's claim on February 18, 2009, at the National Press Club that "we expect to recover the credit we extended" seems quite a reach.

The Fed has inordinate power and will fight deflation at all costs. The Fed deliberately targets 2% annual inflation in order to provide cushion against their worst fear, deflation. Inflation hurts the purchasing power of the "Have-Nots", but is a great benefit to the "Haves" in that it increases their relative wealth via asset appreciation. It is the Haves who are in power, and ultimately they will get their way. The Fed must continue printing and spending to support additional bad asset purchases and in order to keep interest rates low and force liquidity through the system. Despite pushing on a rope right now, the flow of liquidity is inevitable and it will be a dam break when it does.

The Fed's balance sheet now stands at $1.9T, more than double six months ago. It is expected to grow materially from here as the Fed explicitly stated they will continue to do what is needed in terms of printing money and buying securities in the open market.

CONCLUSION

We remain cautious about the "market rally" and position our equity portfolio to reflect that utilizing a large number of protective options and having a substantial part of the portfolio in non-market correlated assets.

As always, please do not hesitate to call us to discuss the positioning of your portfolios.