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1 Client Advisory Memorandum Commodity Markets Commentary J U LY Home Ofc: 560 White Plains RD, Tarrytown, NY P n F n

2 Client Advisory Memorandum Commodity Markets Commentary JULY 2008 A Strategic and Tactical Examination of Today s Commodity Markets Commodities continue to be a staple of the financial headlines as their exceptional performance has attracted a deluge of investor attention while the U.S. economy continues to struggle through a difficult period. The recent performance of individual commodities is remarkable given how fast prices have shot up, particularly for crude oil. There are some very legitimate reasons for commodity outperformance, and the long-term story supporting commodities remains strong. Supply and demand dynamics throughout the developing world support higher commodity prices over the long term as a burgeoning middle class demands more energy, food, and metals. As a principle, we believe that commodities are an asset class and represent an excellent way to diversify a portfolio of both stocks and bonds given their negative correlation to both asset classes. Commodities have also proven to be an effective hedge against a declining U.S. dollar and inflation over the past few years. However, we also see some short-term risk to the commodity outlook on the horizon Given the extreme interest and rapid rise to prominence of this important asset class, we wanted to take this opportunity to outline our short-term and long-term views on commodities, and how we view them as a part of your overall portfolio allocation DJ-AIG Commodity Index Year-to-Date Component Performance as of June % Natural Gas Corn Heating Oil Crude Oil Gasoline Soybean Oil Soybeans Copper Aluminum Silver Gold Coffee Lean Hogs Live Cattle Sugar Cotton Wheat S&P 500 Nickel Zinc

3 Page Two The Perfect Storm Monoline insurers, auction-rate securities, variable-rate demand notes, tender-option The Nature of Today s Commodities Market and Ways to Invest bond programs, and hedge fund de-levering have all contributed to the precipitous re-pricing In of short, municipal commodities bonds over are the raw past materials few months. used for We food, will energy, attempt and to the examine production each of of these finished goods. a little The more commodities detail shortly. market But, is how mainly did divided these into complex seven and sub-sectors. mostly unheard These sectors of issues include: and energy, security livestock, structures grains, become industrial negative metals, factors precious in the normally metals, high food/fiber, quality, and and vegetable some might oil. say, As investors, boring, municipal there are bond a number market? of different Well, as ways has been to invest the case in commodities: in many other areas of the fixed income markets, subprime mortgages are an indirect, but primary culprit. 1. Ownership of Actual Commodities Not practical due to storage and management The considerations. municipal bond market has been increasingly reliant on bond insurance over the past few years. Insured municipal bond issues have represented approximately 50% of the municipal 2. Own Commodity Producer Equities Not a pure exposure to commodities and tend to be sector. The benefit of bond insurance for issuing municipalities is that it serves the purpose more correlated with equity markets than they are to commodities. of effectively decreasing their borrowing costs by increasing their credit ratings. For example, a city/town rated A by the ratings agencies could transform their rating to AAA by 3. Invest with a Commodity Trading Adviser Actively managed commodity futures. Betting purchasing insurance on their issuance, as monoline bond insurers essentially offer to make on the skill of the manager. investors whole in the event that their securities should default for any reason. The business 4. model Systematic of the monoline Investment insurers Through is predicated a Commodity on their Index strong - Exposure balance to the sheets, inherent capital return ratios, on and the their asset own class AAA as driven ratings. by Without economic the factors. AAA imprimatur for the bond insurers, municipalities with underlying ratings below AAA would not be able to claim that rating. For many years, We believe that the most efficient means of investing in commodities is through index investing. the municipal insurance business model was rock solid, as municipal securities rarely default. Systematic investing in a commodity index represents the most pure and inexpensive way to However, more recently many bond insurers began to diversify away from their bread and gain exposure to the asset class. The two primary commodity indices in today s market are butter municipal business and delved deeply into to the supposedly safe structured product the DJ-AIG Commodity Index and the Goldman Sachs Commodity Index. Both of these indices markets (ABS, CDO s). invest in a wide range of long-only commodity futures contracts that are fully collateralized, typically by short-term, high quality Unfortunately for the bond insurers, fixed income we learned instruments. that not all ratings are created equal. Many of these structured securities, which were collateralized by toxic subprime mortgages Example: A crude oil contract that trades at $100 a barrel multiplied by 1,000 loans, but still given a high quality stamp of approval, began to lose value rapidly in the latter barrels is worth $100,000 worth of crude. To maintain this level of exposure, the half of 2007 as mortgage delinquencies spiked. The massive issues in the structured product index rolls into the most current outstanding contract. From the March contract, markets began to call in to question the adequacy of the monoline bond insurers capital it would roll into the April contract. This exposure is backed by $100,000 worth reserves needed to pay claims and hence jeopardized the status of their AAA ratings. Fears of collateral. that the bond insurers would not be able to maintain their ratings lowered the value of their insurance Total and Return sent = municipal Return on yields Collateral skyward +/- and Net prices Change down. on the The Crude anxiety Oil Contract surrounding the bond for insurers the Period has lingered in the municipal markets for months as the ratings agencies have re-evaluated the strength of their balance sheets and the viability of their ongoing business model. To date, a number of the big players in the bond insurance market have been outright CLARFELD FINANCIAL ADVISORS, Inc. Home Home Ofc: Ofc: White White Plains Plains RD, RD, Tarrytown, NY NY P P F

4 Page THREE DJ-AIG Commodity Index Broad Sector Components Agriculture 30% Livestock 7% Energy 33% Industrial Metals 20% Precious Metals 10% Our preferred fund for commodity investment is the PIMCO Commodity Real Return Fund. The index that PIMCO replicates is the DJ-AIG index. They actively manage the underlying collateral by investing in TIPS, a further hedge against the deleterious long-term effects of inflation. The PIMCO Commodity Real Return Fund has outperformed the DJ-AIG Index significantly due to its management of Treasury Inflation-Protected Securities as the collateral to back the purchase of commodity futures. Long-Term Strategic Benefits of Commodities As you know, we are devoted followers of modern portfolio theory in which the prudent diversification of asset classes allows investors to create optimal portfolios by combining multiple uncorrelated return and volatility streams. By doing this, one can create a portfolio that produces a combination of higher returns and less risk than any individual asset class could on its own. As we follow this recent period of stagnant equity performance, we are comforted to know that commodities are somewhat serving the purpose of hedging the current equity market decline and reducing overall portfolio volatility. This would certainly make Harry Markowitz proud. The reasons for establishing and maintaining a long-term allocation to commodities are many: 1. Low Correlation Historically, commodities have exhibited a low/negative correlation to both stocks and bonds, with returns and volatility similar to that of stocks. In simpler terms, when stocks and bonds zig, commodities tend to zag. The primary reason for the lack of

5 Page FOUR correlation stems from the fact that unexpected supply/demand events (i.e. droughts, frosts, floods, political risks) that occur in commodity markets have little to do with events that impact stocks or bonds. Asset Class Correlations - Past 15 Years - Quarterly S&P 500 LB Aggregate DJ-AIG CPI S&P Equity LB Aggregate - Bond DJ-AIG - Commodity CPI - Inflation Bloomberg and Clarfeld Analysis 2. Inflation Hedge Commodities are positively correlated to the inflation rate. As inflation has increasingly become a concern given high energy and food prices, along with the Federal Reserve that has been pumping billions of dollars into the economy, a strategic long-term commodity exposure helps to hedge some of the inflation risk inherent to today s market. 3. Hedge Against Declining Dollar Commodities are also an effective hedge against a steadily declining U.S. Dollar. Higher dollar-denominated commodity prices can be expected as non-dollar denominated commodity producers are forced to raise prices to compensate for the declining value of the greenback. 4. Rebalancing Benefit One additional benefit of commodity investing is that the seven primary sectors have very little correlation with one another. Therefore, there is a rebalancing benefit to the index as appreciated commodities are sold and depreciated commodities are purchased. Demographic Trends and Geopolitical Events Also Support a Long-Term Allocation One can also make a strong case that evolving global demographic and economic trends favor higher commodity prices over time. The large emerging economies around the world such as Brazil, Russia, India, and China are demanding an increasing amount of raw materials in the form of energy, metals, and food in order to support a massively growing middle class. The International Energy Agency warned that demand for oil imports by China and India will nearly quadruple by The same problems hold for other commodities as well. Another area

6 Page Five to watch closely is the impact of electricity demand on energy prices. Many large electricity plants around the world, and particularly in China, use coal as their primary source of power. The growing middle class in China is demanding an ever-increasing amount of electricity as they strive for a higher standard of living. Although there is plenty of coal around the world, China is having problems getting it to their plants quickly enough due to a lack of rail lines. In order to keep their populace content and stable, they may need to import ever-increasing amounts of crude oil as a substitute for coal. Unfortunately, on the supply side of the equation, many commodity industries have underinvested in infrastructure for years, and are having a difficult time increasing their production capacity to match the increase in global demand. The most blatant example of underinvestment has occurred in the crude oil refinery space. Global refineries are currently running at about 90-95% capacity, and refineries in the United States are extremely old and vulnerable to extreme weather and accidents. These supply bottlenecks will take many years of infrastructure investment to overcome. Finally, due to increased geopolitical tensions and the tendency towards resource nationalization, particularly as they relate to crude oil production in Russia, the Middle East, Africa, and South America, energy prices would expect to experience many more upside surprises as opposed to events that would serve to lower prices. Short-Term Threats to the Commodity Rally We currently feel that commodities and energy could face some significant near-term headwinds. Among the reasons that commodities may retreat include: 1. U.S. Dollar If the FOMC winds down its interest rate easing campaign due to inflationary concerns, and the interest rate differential between the U.S. and other regions around the world narrows, the dollar will strengthen from its record low levels relative to other developed currencies. This could lead to an unwinding of many of the short-dollar/ long-commodity positions in today s market. Commodities, particularly crude oil, have benefited from a steadily declining U.S. Dollar. We believe that if the dollar reverses course, commodities may sell-off. 2. Speculators We believe that although current prices can be partially justified by supply/ demand dynamics and the acceptance of commodities as a strategic asset class over the past decade, the current market is partly driven by speculators who are chasing higher returns in light of recent equity market stagnation. Additionally, any sustained positive traction in the

7 Page SIX more fairly valued equity markets may lead asset allocators to make wholesale shifts out of commodities and back into equities. 3. High Prices May Finally Break Demand There is increasing evidence that consumers are beginning to reduce their energy demand as prices continue to rise and the global economy continues to decelerate. These reasons lead us to be strategically (long-term) bullish and somewhat tactically (shortterm) bearish on commodities. Conclusion There are many reasons to maintain a steady allocation to commodities in the context of your overall investment picture. Commodities are a fantastic, diversifying exposure in environments like the one we are facing today, and worldwide supply/demand trends support higher commodity prices over long periods of time. The benefits of commodities to your portfolio lead us to believe that the best time to invest in this important asset class is always. We have been mindful of the fact the commodities can be very volatile at times, and like equities, they can exhibit sustained periods of underperformance. As a result, they have represented a fairly conservative allocation in our client portfolios. However, in order to reap the full diversification benefits of the asset class and expand the efficient frontier, we are moving our long-term targets for commodities to the 4-5% range from our current allocation of approximately 2% of portfolios, depending on individual risk tolerance. Although we believe that the long-term thesis for commodities remains intact, the recent rally in commodities may be a little too-much, too-soon. As a result, we are standing pat at the current allocations. This leaves most portfolios 2-3% underweight commodities relative to our updated long-term targets. We would view any significant short-term pullback in the asset class as a potential opportunity to dollar cost average into our higher long-term target. If the commodities market continues to rally, the portfolios will naturally drift toward their higher targets. CLARFELD FINANCIAL ADVISORS Home Ofc: 560 White Plains RD, Tarrytown, NY P F