Thoughts and Concerns: 1) During the July to September quarter the financial turmoil surrounding Greece and Europe increased in its intensity.

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2 Thoughts and Concerns: 1) During the July to September quarter the financial turmoil surrounding Greece and Europe increased in its intensity. In an effort to support the European banking system (and indirectly banking in North America and the United Kingdom), the European Union embarked upon a number of reactionary financial initiatives. Namely increasing the bailout for Greece in July and the purchase of Italian and Spanish government bonds through the European Central Bank (ECB). The European Union member countries are currently in the process of ratifying significant changes to the rules that govern another funding vehicle, the 440 billion euro European Financial Stability Facility (EFSF), so that it may now be used to purchase additional sovereign bonds in the secondary market and to provide lines of credit to European banks and businesses. The EFSF is intended to supplement the European Central Bank s bond buying efforts and to add support to the extended U.S. Dollar-liquidity Swaps facilities, which provides emergency short-term funding to European Central Banks and, thus, funding of European banks and business. Once the rule changes for the EFSF have been passed the focus will shift toward increasing the size of this fund to the estimated 2 trillion Euros needed to deal with the European financial crisis. The EFSF fund will most likely follow the American model by once again borrowing the additional funds. These initiatives signal a deteriorating situation within the world s financial system, not an improvement. We view the increasing turmoil in Europe as one of the greatest risks investors face today. 2) Last quarter we observed that bond markets appeared to have classified sovereign bonds into two separate groups Secure countries and everyone else. This continues to be the case and is reflected in the recent 10-year bond yields. Currently yields are - Canada (2.20%), The United States (1.93%), Germany (1.89%), France (2.60%), United Kingdom (2.43%) and Japan (1.03%). While the 10-Year bond yields for Italy (5.65%), Spain (5.14%), Ireland (7.82%), Portugal (11.29%) and Greece (22.66%) are considerably higher. 3) In the strongest economies, persistently low interest rates may help borrowers, but they are beginning to negatively affect the profits of lenders and insurance companies, they are increasing the funding deficits for pension plans and continue to hurt savers

3 and those heading into retirement. With mortgage and lending rates at historic lows, (in the United States, now reaching 4.01%,) the financial incentive for lenders continues to decline (Why would a lender take on the risks of a 30-year loan that only has gross revenue of 4.0%?). At the same time, pension plans are experiencing increasing deficits in pension funding. Most pension plans require investment a rate of return above 5.0% in order to achieve their funding requirements and with long-term interest rates at current levels pension plans are being squeezed. Finally, if you are a saver or are in retirement, you know first hand how your investment income continues to suffer in this declining interest rate environment. 4) The economic weakness initially witnessed at the end of the first quarter and through the second quarter of 2011 intensified during the third quarter. It now appears that most of the western economies are heading back into a recession. If this is so, then this is very worrisome as these economies are entering the recession from a very weak starting point. When compared with the last recession, going into a recession at this time when government revenues are weaker, government deficits are higher, unemployment is higher, consumer and government debt levels are higher and real estate values are considerably lower (outside of Canada.) could make any recession a long drawn out affair. In addition, this time it will be difficult to look to China as an economic savior, as we did last time. China is currently struggling with its own economic and credit issues and is not as well positioned to drive world economic growth. 5) The recent economic weakness has been accompanied by a decline in commodity prices. This decline is both good and bad. Good because it gives each consumer an instant after-tax cash injection, as they pay less for gas and groceries, and it helps each business increase their profit margins as operating expenses decline. But it is also bad because the declining commodity prices may cause the economic data to move toward a disinflationary trend, possibly even deflationary. This would motivate the U.S. Federal Reserve and other central banks to embark upon another monetary stimulus program (Quantitative Easing) adding further to the distortions in the capital and investment markets. The central banks fear deflation, as they feel that once consumers and investors begin to accept deflation as a future condition, they will adjust their spending and

4 investing decisions accordingly. The central banks believe that deflation would be a disaster for economies built upon rising asset prices and debt. Note: As stated in previous quarters, we believe that inflation has been declining for over 3o years and this trend will continue into the future. We believe if the governments had not injected trillions into the world s financial system the inflation data would actually show a continuation of the 30-year trend and could possible show a deflationary trend exists. 6) We believe that investors may need to reconsider a few of their long held investment assumptions when making investment decisions. For example, a. Investors may need to begin looking at their investment income and rates of returns by referencing real interest yields. So when looking at a 10-year Government of Canada bond yield of 2.20%, investors should do so in the context of the inflation rate. If the inflation rate is 0%, then 2.20% is a good real rate of return. In fact, it is the same as a few years ago when the bond rate was 4.40% and inflation was 2.20%. Note: So if the Canadian 10-year bond yield falls to 1.03% (as it currently sits in Japan) is this horrible? Well, if inflation is 1.0% then yes this is bad. But if inflation is actually negative 1.2%, then, in theory, it is no worse than it is today because the real interest yield would be 2.23%. b. Bond yields are now lower than dividend yields. This is a new dynamic for this generation of investors. Prior to 1958, bond yields were typically below the dividend yields paid by stocks, but in 1958 this relationship changed as investors began to believe in capital gains as an investment reward. From 1958 until recently investors were willing to accept a lower and lower dividend yield from their stock market investments as they focused more and more upon capital gains as the true reward. Now investors are more focused upon regular, reliable and consistent investment incomes as the motivation for their investment decision. For this generation of investors this is a new shift in the investing dynamic. c. Dividend worries. Another possible change for this generation of investors is the assumption that stock dividends are safe and dependable and they never go

5 down. Now, we all know that when companies get into financial trouble they will reduce and even eliminate their dividend payments (Yellow Media), but this generation views these events as isolated cases and not normal. In some cases, we have even been conditioned to view dividend cuts as a buying opportunity (TransCanada, Telus, etc). This view may need to change as dividend payments could possibly be at risk as the economy moves into recession and corporate profits come under pressure. 7) There continues to be a shift by regulators and government agencies toward greater market regulation and taxation. This trend will eventually reduce the flow of capital between investment markets and countries reversing a 40-year trend toward globalization. Investment markets that will be affected are currencies, commodities and derivatives. In addition, should world stock markets begin to deteriorate substantially, investors can expect governments and regulators to intervene. 8) We continue to believe the world is experiencing the second phase of a Credit Cycle (Credit Contraction) where asset prices struggle to move higher and borrowers (consumers, businesses and governments) continue to focus their efforts on deficit and debt reduction. These conditions support anemic economic growth, declining asset prices, declining inflation (possibly deflation), and declining interest rates. For investors, these conditions should raise a number of questions about the future of corporate profits, dividend payments, the direction of future inflation/interest rates and the future values of asset such as stocks and real estate. The conditions that exist during the second phase of a Credit Cycle (Credit Contraction) are considerably different than during the first phase of a Credit Cycle (Credit Expansion). Can investors continue to use the same investing framework in the future as they did in the past? Investment Actions: a) During the past quarter we added to the Balanced Sample Portfolio s stock market hedge position by purchasing additional units of the Horizon BetaPro S&P/TSX 60 Inverse Exchange- Traded Fund (ETF). This purchase was made in an effort to increase the portfolio s defenses against possible stock market weakness. Note: As previously stated, this ETF is not a perfect match for our portfolio as it is tied to the TSX 60 index, which

6 holds a large number of stocks not currently held in our portfolio. So it is not a perfect hedge for the portfolio, but it is the simplest and it should achieve our desired results. b) During the 12-month period ending June 30 th the portfolio received deposits of interest and dividend income from the investments held. A portion of this income was reinvested in the additional units of the ETF described in a) above and the balance was added to the portfolio s current holding of the Province of Ontario Bond, maturing on December 2, c) Going forward, we are hopeful that investment opportunities will develop within the corporate bond and preferred share markets in the coming months so that we can allocate some of the portfolio s shorter-term investments to earn a higher investment rate of return. At present, we are comfortable with our sample portfolio s asset allocation and the individual investments held.

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