In addition, the sample portfolio ended the quarter with 100% invested in cash equivalent and fixed income investments.

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3 Review: Sample Income Portfolio In the past quarter, the portfolio s value was impacted by the following changes in market values Bonds and preferred shares increased by $ Deposits of interest and dividend income added $ Accrued Discount Bond interest added $31.22 In addition, the sample portfolio ended the quarter with 100% invested in cash equivalent and fixed income investments. Portfolio Thoughts: As mentioned in the June quarter review, we continue to monitor the investment portfolio s overall exposure to risk corporate bond and stock markets. During the most recent quarter the market prices for the General Electric (GE) and Bank of Nova Scotia appeared to return to a more normal leave. Both experienced price gains, but the GE bond gained more suggesting the market is not as concerned with corporate bond risk, which the pricing in the 1 st and 2 nd quarters appeared to suggest. We believe interest rates will remain low, for the foreseeable future, due to the o Current credit contraction cycle, o Ongoing world central bank policy and o Canada s position as a safe haven for investors. Overall, we continue to be comfortable with the sample portfolio s current investment allocation and continue to look for opportunities to reinvest the portfolio s cash balances. Thoughts and Concerns: Short-Term (next 3 to 6 months) European Financial Crisis has not improved despite open-ended promises of unlimited liquidity made by the European Central Bank (ECB). o One of the biggest problems facing the ECB and Sovereigns is the continued flow of deposits out of banking systems in weak and weakening economies (Ireland, Greece, Portugal, Italy and Spain) and into the stronger banking systems (Germany, France, Britain, Switzerland). Depositors, individuals and institutions, continue to withdraw hundreds of billions of Euros from weak economies and move it to strong economies. This natural flow of money continues to force the ECB into unnatural bond buying and bailout activities, further eroding saver/investor confidence. o The Euro currency continues to hamstring governments. In the absence of individual currencies, governments are limited in their

4 ability to manage the affects of the deleveraging inherent in a credit contraction cycle. Unable to depreciate the currency, governments are left with austerity as the only means to devalue their economies, which appears to only add to the depressive nature of rising unemployment, falling asset prices and lower consumption. o The financial crisis in Europe has reached a phase where, without any indication the austerity is working, citizens are beginning to voice their pain. This past quarter witnessed a substantial increase in civilian protests, marches and violence in countries such as Greece, Portugal and Spain. This increase in hostile civil actions cannot be viewed as a positive for Europe s administrators, European economies and stock/bond markets. o During the most recent quarter the European economies continued to slow and this slowing is evident in the Purchasing Managers Index, declining GDP numbers, lower shipping traffic (Baltic Dry Index is down 64% so far in 2012), increasing unemployment levels, small business closure data, etc. The slow down in Europe is now showing in the economic data in rest of the world and, in particular, in China. o If we stop and think about the state of affairs in Europe one year ago, two years ago, three years ago, we quickly see Europe continues to deteriorate economically, financially and socially, despite all of the announced measures by the ECB, IMF and governments. Europe is not better today than it was last year, the year before or the year before that! Central Bank Actions: Over the past three months, central banks in Britain, Japan, China, Europe and the United States have launched liquidity programs that total in the trillions of dollars not because things are improving, but rather in another desperate attempt to halt the continued deterioration within the financial and economic systems. o The central banks continue to borrow more and more money to then purchase Mortgage Backed Securities (MBS), sovereign bonds, bailout banks and governments. These actions continue to distort the nature of markets. For example, the Federal Reserves recently announced plan to purchase $40 billion of MBS, each month, translates into them buying over 70% of all MBS created each month. In addition, the ECB s recently announced unlimited bond buying program would see the central bank buying almost 40% of all upcoming sovereign bond sales for the foreseeable future. These high levels of government buying will distort markets and the investment decisions of individual/institutional investors. How will these distorting activities play out? Once begun, how and when do they cease? In their efforts to create certainty and

5 minimize volatility, we fear central banks are actually increasing both. (As an aside: We often wonder how the central banks activities are any different from the activities of individual banks when they illegally manipulated LIBOR? To our way of thinking the two are the same.) Commodity Prices should continue to benefit from the actions of central banks. As the government money reaches the financial system and individual banks look for ways to enhance their profits, money should flow into commodities gold, oil, etc. As a result, commodity markets will continue to diverge from their underlying supply/demand fundamentals. This distortion may increase the danger that commodities enter a bubble phase, dependent upon investors to push prices higher. (For a brief discussion on the impact on the gold price, read Gold: Should You or Shouldn t You?) U.S. Fiscal Cliff: This is the same problem facing Europe Greece, Portugal, Spain, Italy, France, Germany, and even Canada. All of these governments are spending more than they take in. The only difference between each is how much more they can borrow from lenders. Countries like Canada and Germany still have lots of room on their lines of credit. Countries like Greece and Portugal are Maxed out - they have hit their credit limits. When looking at the United States and the upcoming deadlines, if the past is any indication, then investors can expect no concrete action other than to simply kick the can further down the road. No agreement on spending cuts - No new tax increases the U.S. will simply post-pone making tough decisions until some future date. This is probably the best outcome for stock markets in the short-term. If they do decide to deal with their operating deficit and ballooning debt levels the results will not be a positive for investors increase in taxation (corporate and individual) and spending cuts both negatives for economic growth, as we have witnessed in Europe. New CMHC Mortgage Rules: Short-term indicators appear to suggest the government s rule revisions are having their desired affect upon the mortgage and real estate markets in Canada. We will continue to watch this story and its impact on the Canadian economy in the coming months. Longer-Term Credit Contraction: We continue to view the current investing environment as one within a continuing credit contraction cycle and, as

6 such, it will be difficult for most corporations and governments to return to the grow rates experienced prior to Headwinds for Corporate Profits: The follow are a few of the longerterm head winds that corporations and their profits face. o Growing Pension Expense: As company pension funding deficits remain high and more boomers retire, corporations will be required to make larger and larger funding contributions to their pension plans. Their pension contributions come directly out of profits, making profit growth difficult. During the September quarter, Canada refused to follow the example of other countries (U.S., Britain, etc) and adjust the rules companies must follow when funding and accounting for pension expenses/deficits. Canada s break from this trend is good for employees, but does not help investors as pension expenses remain current and cannot be pushed into future periods. o Income Tax Trend: The long-term income tax trends (corporate and personal) have shifted. Governments around the world are finding it increasingly difficult to implement lower income tax rates and some have actually begun to raise rates. Prior to 2008, the developed world chanted for lower and lower income tax rates and governments willingly obliged. This enabled corporations to increase their net profits with very little effort on their part. (Note: Britain and France have announced income tax increases for highincome individuals and the EC is moving forward with it s plan to impose taxes on financial transactions.) o Rising Unemployment: As unemployment continues to rise for most of the world, economies and corporate revenues are feeling the negative impact from declining consumption. In the United States, the monthly unemployment numbers appear, at first glance, to be improving. Unfortunately once we look below the surface we see the numbers are improving because the employment participation rate is declining dramatically, reaching 31 year lows. (The participation rate indicates the percentage of eligible workers that are actual seeking work. A declining percentage indicates workers are giving up, discouraged by their inability to find employment.) Global Economic Slowdown: Economies, China, Asia, Europe and the United States, are all contracting as indicated by the most recent Markit Purchasing Manager s Indices and announced GDP numbers. Such an overwhelming slowdown has not occurred since the financial crisis of What is more discouraging is the current global slowdown is occurring after governments have pumped trillions into banks, individual

7 financial systems and newly created bailout funds. Even Central Bank coordinated policy initiatives seem powerless to reverse the slowdown. Disinflation/Deflation: Bond yields continue to decline, with the exception of those issuers faced with credit issues corporate and sovereign. We continue to believe bond market yields, especially those represented by the yield curve, continue to be good indicators for future inflation expectations. With this in mind, bond markets continue to indicate inflation is not a concern. We think it could be successfully argued current bond yields continue to worry about deflation, especially when one considers the zero-interest rate policies and trillions pumped into the financial systems by the Central banks. We continue to believe that the trillions injected has artificially supported commodity prices and without these injections commodity prices would be lower and the official inflation data would display deflationary signs. Recently, we have begun to think the central banks are attempting to manage deflation - a major shift from their policy of the past 30 years. Prior to 2008, central banks made managing inflation a priority and we are beginning to believe that central bankers, through endless programs of Quantitative Easing, are actually trying to manage the rate of deflation. Our explanation: The credit contraction cycle is usually accompanied by deflation, which history shows often leads to economic depressions. By injecting tremendous liquidity into financial systems (which is inflationary by nature), central banks are trying manage the deflation/inflation balance. If this is true, then it might help to explain why trillions and trillions of dollars of new liquidity has not resulted in rapid total inflation around the world. Instead, we see prices increasing in some areas (commodities (food, oil, gold) and financial (stock/bond/mortgage) markets), but not other areas (wages, real estate, manufactured goods). (Note: This argument might give too much credit to central bankers. Are they really smart and powerful enough to figure this out and manage it successfully? Probably not.) Individual Investors: One of the most worrisome trends continues be the exit of individual investors from stock markets. This exodus is confirmed by fund flow reports that show individual investors selling stocks, buying bonds and simply increasing their cash asset allocations. Trading volume on North American and European stock exchanges continues to decline at a frightening pace. For example, daily trading volume has declined 44% since 2008, despite the indices being up more than 100%. The financial crisis, more importantly, the uncertainty surrounding financial markets, unprecedented government actions, regulatory changes, the seemingly never ending scandals and overall stock market volatility continue to raise investor skepticism causing many to swear off stock market investments altogether. In addition, the increasing domination of daily trading activity by Dark Pools and High-Frequency Trading (HFT) has added to investor

8 cynicism. For example in the United States HFT now accounts for approximately 70% of daily trading volumes and almost 50% in Europe. This reversal of a decades old love affair with stocks is creating a longterm trend that is a negative for stock market investments. Central Bank Intervention: As mentioned above, Central Bank and Government intervention has permanently altered the investing landscape. Initially, the trillions injected into financial systems and bailout funds were slated to be temporary. No longer. Governments will be hard pressed to reverse any of their initiatives. We find government intervention in capital markets, financial systems, regulatory systems, etc. fraught with irony. Free market proponents and capitalists constantly preach how governments need to leave them all alone. Government regulation is bad. Governments have no place in the free-market economy. Etc. etc. But yet when they blow themselves up to whom do they turn for aid? Maybe, it is not irony. Maybe, it is hypocrisy. In any event, investors will have a difficult time understanding the new investing landscape and what to base their investment decisions upon until the government intervention has solved all of the problems or it has been exhausted. Until then the landscape will continue to shift. Each week we seem to read about some new crisis and some new cure. Investors should remain cautious when it comes to investing their savings. All of the short and long-term concerns outlined above are important in their own individual right, but collectively they create an environment that is hostile for investors. In the 1980s, 1990s and up until 2008, all were trending in a direction supportive of investors and, in particular, stock market investments. Investment Actions: No changes were made to the sample portfolio during the quarter. At present, we continue to watch the developments out of Europe and the progressive economic slowdown with a defensive view. At present no changes are contemplated.