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John Paulson, fund manager of the Paulson Funds, was one of the few managers to navigate the 2008 bear market well.  He recently released his 2008 year end letter and it’s very insightful.  I’ve included some of the more relevant parts as well as the direct link here:

“Until we see signs of a turnaround in the economy, we will maintain our conservative strategy: hedge market exposure; focus on corporate spread deals; target competitive bid situations to enhance returns; and focus on the occasional short opportunity.

2009 Outlook

While we remain bearish on the economy, we are bullish on our investment portfolio which is structured as follows:

1. Slight Short Exposure to Equity Markets

2. Remain Short Financials

3. Focus on Long Distressed Opportunity

4. Mortgages

5. Bankrupt Debt

6. Distressed

7. Capital Restructurings

Focus on Strategic Merger Deals

We are maintaining our short focus on financials, as we don’t believe we are through the financial crisis.  Goldman Sachs recently estimated total U.S. credit losses in this cycle of $2.1 trillion as compared to realized losses to date of $1 trillion, indicating we are only half way through the crisis.

While we maintain a slight short bias on the equity market and believe there are additional gains to be made on the short side in financial equities, the biggest driver for the Advantage Funds in 2009 and 2010 will be in long distressed opportunities.  We estimate the potential size of the distressed debt market to approach $10 trillion including mortgages, corporates, financials and sovereigns.  We are targeting an allocation of up to 50% in distressed debt for the Advantage Funds.  As the types of investments will be very similar to the Credit Funds (which target ~100% allocations to distressed debt) we refer Advantage investors to the report on the Credit Funds for a discussion of our strategy in this area.

We still believe it is too early to commit capital to public equities on the long side.  Currently, credit costs are rising across almost every credit category. We will need to see stabilization on credit costs and a higher realization of anticipated credit losses before we will commit capital to the long side.

In the meantime, we decided to focus on selective short opportunities to achieve positive returns for the fund while we wait for the long opportunities to arrive.  As of mid-January we have long positions of 13% and short positions of 31% for a net short exposure of 18% in the Recovery Funds.  While we believe the strategy has the potential to produce high returns, it is very company specific and research intensive.  We don’t believe an index approach will work as one can as easily lose money in financial stocks as make money, as indicated by the figure below.

We remain bearish on the outlook for the U.S. economy and believe that the recession will extend into late 2009 and likely into 2010. The sharp contraction in the global economy, the instability of the global financial system and the ongoing credit contraction are unlikely to be resolved in the first half of 2009. While the U.S. stimulus package will likely cushion the decline we don’t think it can halt the downturn and will likely have longer term negative consequences.”

Good stuff.