January 12, 2011

Dear friends:
We wish you a Happy and Prosperous New Year!

REVIEW OF THE PROGRAMS

It has been a successful year for all our programs — Vega Equity*, Vega Safety, Vega Inevitable, Vega International, and Vega ETF. We have recovered most of the losses of 2008, and most of you (finally!) will see positive appreciation in the utmost-right column of the reports you are receiving with this newsletter. While we have exercised significant caution in all our programs, it has been a rollercoaster ride in equities all year long. It seems that we have been moving through a minefield.

Vega Equity* has been concentrating its portfolio in oil and oil-related stocks, diversifying into precious metals, international banking stocks, technology, and biotech.

Vega Safety has been gradually moving its portfolio into the shorter end of the yield curve (more on that in the Section below).

Vega Inevitable Program has enjoyed a huge run up in the prices of commodities and precious metals.

Vega International has been mostly invested in emerging markets, Brazil, India, and China; with the addition of some of the European countries which we consider "healthy."

Vega ETF has reflected our views of the sector performance with the addition of precious metals as well.

So where do we go from here?

OUR FORECAST

The internal political situation has clarified itself a bit, and the business climate is definitely improving. The extension of the Bush Tax Reform has definitely helped the markets to stabilize. As it is well known, the markets hate uncertainty.

There are, however, several main issues which remain unresolved, and they will impact the behavior of capital markets in 2011:

Government Deficit

Government deficit (and as a consequence, the strength of the dollar), and the behavior of interest rates remain very unclear. The Bipartisan Debt Reduction Commission has been created, but whether or not they will be able to accomplish anything constructive as yet to be seen. We all know how efficient the government commissions are.

Unemployment

The situation with unemployment is still very uncertain: will the business leaders be able to create more jobs? The unemployment remains very high, and by some estimates, it might take many years before the unemployment returns to an "acceptable" level. The impact of the high unemployment on the consumer's spending is unclear.

Finances of States

Most of the states (California is the most vivid example) are experiencing significant budget deficits. Of course, the main difference between the states and the Federal Government is that the states cannot print money. They cannot balance their budgets either. Many Governors of this state made promises to do that — and failed miserably. Will this one succeed? We wish him the best, but realistically, the chances are very slim. This means that the Federal Government will have to help the states (we do not consider the possibility of state bankruptcy as a serious threat), and then the Federal Reserve will have to print even more money, increasing the inflationary pressures, and thus raising the interest rates. At least that is how markets perceive it now, and will continue to act accordingly. Neither QEII, nor QEIII (if that happens) can control the market's attitude. The inevitable inflation is coming — it is just a matter of time.

Real Estate

Real Estate is still in a state of complete chaos. If you tried to refinance your existing mortgage at historically low interest rates, you know what we are talking about. The foreclosure process conducted by many banks seems to be semi-legal, without proper documentation. Banks are still holding a huge inventory of houses — there is no source of reliable data. While some areas of the country are definitely starting to recover, many areas are still significantly under water. Since housing construction is one of the drivers of our economy and the perceived wealth of the nation, many economists think that until the housing sector starts to feel "healthy," a robust economic recovery is not possible.

China

Does China have a real-estate bubble? Will their economy continue to grow at the same incredible rate — and thus fuelling the consumption of industrial commodities? From the beginning of the year to November, the consumer prices in China rose by 5.1%, the fastest increase for 28 months and a striking turnaround from the deflation of the year before. The People's Bank of China raised interest rates by a quarter of a percentage point over Christmas, following a similar move in October. It does not seem to create an immediate threat: banks cannot lend at less than 5.81%; but in an economy which is growing by 15% a year in nominal terms, that floor is unlikely to deter the borrowers. However, the attempts of the central bank (and the central government) to slow down the growth will have to be monitored very carefully.

EQUITIES

The current price/earnings ration for the S&P 500 is approximately 15.2, and the historical average is about 15. By that measure, the market is currently fairly priced. At the top of the market in 2007, the same average was about 17. The average return of large-cap stocks in the third year of a bull market has been 3%, and the market return when Congress is deadlocked has been as high as 41% and as low as –47%, with the average being 2%.

Given the uncertainties described in the previous chapter, and taking into account the historical average, we expect the market to appreciate this year, but not very significantly. While it is always a fruitless exercise to make these kinds of predictions, we would like your expectations from Vega Equity* portfolios to be in sync with our expectations.

The appetite for risk for most investors has diminished significantly (what a surprise!). Today only 34% of people under age 35 say they are willing to take substantial or above-average risks in their portfolios, down from 45% in 2005, according to the Investment Company Institute.

FIXED INCOME

This year, most economists (not all — but the "depression forecasters" are in the minority) believe that rates will rise — it seems that there are clear signs that the economy is recovering, Gross Domestic Product is expected to grow about 3.3% worldwide this year, and 3.7% in 2012, according to HIS Global Insight. Therefore, the central banks around the world will start raising interest rates (it is already happening in China, and Australia, for example), and thus preventing the global economy from sinking into Japanese style deflation. Of course, we all read about QEII — "Quantitative Easing II." In November of this year, the Federal Reserve announced that it would buy hundreds of billions of dollars of Treasuries to keep rates stable. Most fixed income experts agree that buying Treasuries now is similar to buying Internet stocks in 1999.

Therefore, in our fixed income portfolio, we will remain on the shorter end of the yield-curve with the hope of picking up the additional yield when the interest rates start to rise.

As always, we appreciate your business. Do not hesitate to call us with any questions you might have, and refer us to your friends.

Vega Capital Group Team.