Let s review some of the issues that have investors leaning over the edge in the last few weeks:

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1 Dec 4-18 Good Afternoon to all Clients: What a week for the markets.the FED does an apparent 180 degree turn on future rate hikes and Trump boasts prematurely about the great deal with China!! Both of these announcements rattled the markets resulting in a huge -3.1% drop (800 points) on the DOW Tuesday and a whopping -3.8% drop on the Nasdaq over ambiguity and uncertainty around these two issues and how they will play out in 2019! Let s review some of the issues that have investors leaning over the edge in the last few weeks: #1 More Fed Rate Hikes Is it Yes or No? -over a matter of one month Jay Powell went from likely 4 hikes in the next 12 months to 1-2 hikes which is a massive change or flip in expectations and confidence on the economy by the very cerebral Federal Reserve.markets HATE uncertainty and sudden changes -from yes- the market and economy can absorb 4 more rate hikes --to the economy is now too weak to take these extra hikes in and this DESPITE the fact that the REAL funds rate is still only at ZERO (as inflation is the same as the Fed Fund rates)!!! This back tracking or fear on the Feds part has investors on edge -the exact Fed language went from the rates were a long way from neutral (in early Oct) to the rates remain just below the broad range of estimates that would be neutral for the economy (Nov 28 th ) that is a big flip in opinion and has investors appropriately worried about 2019 growth -most importantly for a macro guy like me is what history says about a sudden Fed flip like this. when the FED finally hits pause after a long hike cycle it is because there is trouble ahead in the form of significant economic weakness and history tells me that a recession often follows within 12 months of this flip/pause. -either way, this flip has put investors on edge and although we all still expect the Dec 18 rate hike, what happens after this is now unknown but let s have a look at the Bond market message post flip. #2 Bond Market Message Post Fed Flip!! -the bond markets are screaming CAUTION for those who care to listen -the bond market is much larger and more sophisticated than the equity markets (as there are more safety orientated pension fund folks who really have to preserve the wad) and they are telling me to be VERY careful with my equity exposure right now

2 -the bond market Yield Curve (YC) JUST inverted for the first time since 2007 and this is a major red flag!! - it is the short end of the curve that has inverted (the 2year/ 3 year and 5 year) but even the 2s/10s are down sharply from the Oct high of 35 bp to 11 bp today!! -recall that the 10 year yield was 3.23% Nov 8 (a 7 year high over expectations of future growth) BUT today it has plunged to 2.92%...this tells me that money is now piling into the 10 year bond (which pushes yields down) as a flight to safety action!! -I will remind readers that an inverted YC is one of the best indicators of a pending recession and the lead time to recession ranges from 6-20 months my guess is mid-late 2019??? -so the bond market message is for very weak economic growth in 2019 with low inflation and forward equity markets do not like low growth especially if the P/E is priced for continued high growth.this tells me equity markets are flat to negative for 2019 and this low reward and high risk is not my cup of tea Where Will Earnings Be in 2019? -to keep the markets trending north we need higher earnings and revenues in 2019 that will be a challenge if the economy slows and margins get squeezed -analysts are now rolling back their Earnings expectations for 2019 which will soon make the P/E ratios look very expensive and this is starting to worry equity investors -Morgan Stanley Chief Strategist Mike Wilson says there is greater than a 50% chance that we experience a modest earnings recession in 2019 (that is two quarters of negative yoy growth) so again this low reward and high risk environment equates to defensive investing in my humble opinion The TIPPING POINT on the Liquidity Squeeze is Near? -I have been harping on this for the last year -over the last 10 years the avg annual GDP growth has been a paltry 2.1% vs 3.7% in the prior decade (from ) yet in both periods the S&P 500 rose about the same (330% last decade vs 350% in 90s) -the major influence behind this market growth DESPITE such anemic GDP growth was the fact that the FED, the ECB, the B of Japan and China were all massively stimulating with QEs which pushed liquidity into equity markets (this resulted in TINA there is no alternative but stocks) -the stock market has zoomed over the last decade in part because of the massive global stimulus re Quantitative Easing (QE) and record low rates but this market enabler is now finally in REVERSE (i.e. QT) and has resulted in shrinking liquidity which is a shortage or reluctance of money flow and lending and that is never good for equity markets

3 -famed investor Stan Drukenmiller has always stated that it is not earnings but liquidity that moves the markets and of particular note is that he recently said he is on triple red alert over liquidity shrinkage -pressure on liquidity is coming from several fronts--the most influential are the large Central Banks who are all reversing QE programs into QT (Quantitative tightening) e.g. the ECB finally stops its massive QE in December and the US is actively into QT and is reducing its balance sheet by $ 600 Billion in 2019 which removes $600 bill dollars from circulation so that is less dollars that goes towards equities, construction, art, condos etc. -on top of this QT liquidity squeeze we also have the FED raising rates which is another hit to liquidity as more dollars must now be spent on servicing the massive debt accumulated over the last decade -finally we have the new TRUMP Trillion dollar deficit program in the US which will require massive issuance of bonds to fund this deficit for years to come which will take even more cash out of circulation and away from equities..yes Houston we have a le-a-nding problem. -the bottom line is that prior to 2017 there was massive amounts of $ chasing all assets such as equities, real estate, art etc. BUT that is now in reverse and the evidence of how harmful this liquidity shrinkage has been already is to simply look at 2018 where almost all global markets have seen flat to negative returns as have all asset classes -until recently we had the three exceptions to this down ward pressure from the liquidity shrinkage with the FAANG, Bitcoin and WEED stocks dodging the bullet but that has all changed in the last few months and boy are they ever taking it on the chin like all other assets. -my fear is that the side effects of this liquidity shrinkage is just getting started. A Recap on DEBT The 2019 Nail in the Coffin?? -global debt has gone from 200% of GDP in 2007 to 318% in 2018 and my bet is that this will FINALLY become a problem in 2019 and at many levels. -total US Corporate debt has gone from $4.9T in 2007 to $9.1 T in 2018 and the two areas of massive growth have been in junk bonds and investment grade BBB rated bonds -there is $6T of investment grade corp debt and a whopping 50% is rated BBB (just one notch above junk fyi) and some estimates are that 33% of these BBB are really junk (but the credit rating agencies are tailgating once again on fixing this).this is a big risk in 2019 as these bonds roll over at higher rates especially if the economy softens -at the corporate level this implies lots of ZOMBIE companies have been allowed to survive because of cheap-easy to get debt but when the lag of higher rates kick in plus slower revenues/sales these zombie companies will start defaulting as they always do at the end of the cycle

4 -another area of risk is Emerg market debt which is already under great strain and especially China where its debt:gdp has gone from 140% to 260% over the last 10 yrs. this is a big risk going forward -at the household level debt is now at $13.3T which is higher than The risk in 2019 will be rising defaults in either EM debt, EU debt esp. Italy or US Corp debt. The Global Economy and the EU are a 2019 Risk -I have already pointed out previously that the global economy is slowing but it is the EU in particular that has many headwinds to deal with in the EU has to deal with #1. The stoppage of QE Dec 2018 #2. The Brexit March #3. Italy and its debt and the possible fall out on the EU banks #4. Its main German engine is now in decline and #5. Social unrest in places like France and #6 a slowing Asian market. Some Leading Indicators Flashing RED -housing is plunging on all fronts and is a very early leading indicator on the economy and the effects of rising rates consequently home building stocks are in a serious bear market -other leading sectors (that are also sensitive to rising rates) include autos and restaurant activity and point to a consumer who is both tapped out and priced out and this is confirmed with the weak 3 rd quarter retail store results from Target and Best Buys Initial Jobless Claims-Firings are Rising -we have seen 3 weeks in a row of rising jobless claims (i.e. firings) which is a BIG red flag if this trend continues as we ALWAYS see this (companies laying off workers) at the end of the cycle and on average about 8-10 months before a recession hits. -I will be watching this very closely over the next few weeks What are Smart Money Managers Doing I see my favorite Canadian investor Prem Watsa is at 50% cash ($17 bill) on the investment side he is jaw boning that the US is ok but I will follow his actions same story with Buffett who continues to hold massive cash reserves.

5 CONCLUSION There are just too many RED FLAGS for me to be aggressively positioned in equities right now! The extreme volatility that we are seeing is a warning sign that investors are on edge and nervous about rates and trade with China and ultimately how slow the economy will be in The much smarter bond market is telling me with its inverted YC that volatility is set to rise and that 2019 growth will be very weak! This implies lots of risk and very little reward!! I will therefore stay the course with a focus on DEFENSE and WAD PROTECTION for all clients. On an optimistic note--my sense is that an excellent buying opportunity is near and we will soon get to execute on the BUY LIST I sent to all clients last week (and more will be added I suspect if we see more volatility and declines) I will send out the usual additional interesting readings in a separate attachment later today or tomorrow If you have any questions please fire away...and again very happy to be safe and sitting on dry powder at this time!!! Terry