Stock and Bond Market Outlook

February 6th, 2013

Can You Handle a 50% Drop in Stock Prices during 2013?

Warren Buffett, the famous multi-billionaire investor from Omaha, has for decades explained individuals should not
invest heavily in the stock market unless they can financially and emotionally withstand a 50% drop in stock prices
in their portfolio.  [Even this top investor saw his company’s Berkshire Hathaway stock price lose 50% in value
between late 2007 and early 2009.]

Mr. Buffett’s top quote and advice to all investors is:
“Rule #1 - Never Lose Money, Rule #2 - Never Forget Rule #1”

Mr. Buffett understands the power of compound interest and savings.  Mathematically, large losses can take many
years to regain.  A 50% loss requires a subsequent 100% gain just to get back to where you started.
Avoiding oversized losses is critical to wealth accumulation, as small regular gains compound
at an astonishing clip when viewed over time.

Considering the global and U.S. economies are the most out of “balance” in modern times during February 2013,
the new 5-year highs for American stocks should be taken with a grain of salt.  Massive debt-centric, fiscal stimulus,
government spending has combined with record interference in “free” market forces by central banks worldwide to
convince businesses and consumers the economy can be sustained at present levels.  With “unlimited money printing”
pledges by the Japanese central bank, the ECB in Europe and Federal Reserve in the U.S during late 2012 and
early 2013, and out-of-control (record “peace time”) sovereign deficits and debt levels in most every important nation
on the planet, PLENTY could go wrong for investors banking on strong equity returns this year.  In fact, economic and
trade friction between nations is INCREASING the likelihood of major “wars” on the ground in the Middle East,
between China and Japan, in a worst case scenario between European partners, and perhaps between China
and the U.S. over time.

We have been accumulating hard assets like energy, real estate and precious metals investments of late to prepare
for the effects of unlimited money printing in the real world.  You can read the January research report on our top gold
and silver buys here.

Statistically, the American stock market is EXTREMELY OVERVALUED.   When overlaying total U.S. stock market
worth vs. yearly economic GDP production, on top of stock prices vs. trailing 5-year earnings (a favorite long-term
valuation measure for many), early 2013 ranks in the 96th percentile for “overvaluation” during the last 100 years.
All other instances, 1929, 1999-2000 and 2006-2007 were GREAT times to SELL STOCKS, and get out of Dodge.

At the same time as January 2013’s near-record equity inflows into mutual funds by mom and pop investors,
and ultra-high sentiment readings of 50%-70% bulls in every investor survey,
company “insiders” have been dumping stocks at an alarming rate.

Based purely on the math, here are the equally-weighted odds we have devised in our work at Quantemonics,
from early February as a starting point, for the U.S. stock market’s direction the remainder of the year:  +10%, Flat,
-10%, -20%, -30%, -40%.  The midpoint is to expect a -15% drop from early February, for a -10% calendar
year performance.  Sound impossible?  Further understand that historically the year after a Presidential election
is one of the worst to hold stocks, much less buy at a multi-year top!  If you had a 6-sided die for gambling,
would you roll the dice with an equal chance of generating +10% returns vs. losing -40%?

Should you sit in cash the rest of your life because of these fears?  NO
Should you be fully 100% invested in stocks and ignore ALL COMMON SENSE?  NO

What CAN an investor do to prepare for a difficult market span, without selling all stock ownership?

The main reason we opened Quantemonics Investing was to give small investors an intelligent option to own
truly dynamic, diversified and “hedged” portfolios that can perform well in any market environment, not just a rising
bull trend.  This area of the financial world is usually reserved ONLY for the wealthy, but Covestor is today providing
such opportunities for investors.

During our first two years on Covestor, we have devised portfolios with little or no correlation to the stock market’s
direction.  All told, we have been net market neutral to slightly net short in overall design because of abnormally
high market “risk.”  This is the main reason the Quantemonics Investing, Relative Value portfolio performance has
been flat to somewhat negative vs. the market’s small gain since inception.

The flip side is we are well prepared for a sharply lower stock market, and may indeed outline GAINS for investors
in Relative Value (and our second portfolio under development at Covestor.com) on a large market decline.
That’s the smart advantage of holding a “hedged” portfolio.  If you believe, like Warren Buffett, big losses
can permanently damage your financial health, methodically designed, hedged portfolios may be something
worth looking into for your money, especially at this critical juncture in American history.

-Paul Franke, Director of Research

Quantemonics Investing, LLC
P.O. Box 2788
Mission, Kansas 66201
(913) 749-2628
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