The Aspiring Analyst Vol. 1 Iss.

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Sell In May And Go Away theaspiringanalyst@gmail.com

This month’s newsletter will be our shortest yet. It is unbelievable how an overheating China, a
deflationary Japan, an exploding Middle East and an imploding Europe has been met with little more
than a shrug by the equity markets as the major indices continue to plod higher. If Jan Hatzius of
Goldman Sachs, who forecasted (and continues to maintain) a 1,500 year-end target for the S&P500,
was given a crystal ball in January that foretold the devastating Japanese earthquake, the Jasmine
Revolution in the Middle East and the inevitable path to default for Greek/Irish/Portuguese government
debt, what would his forecast be?

We are not perma-bears by nature. In fact, if the Shiller PE ratio was less than 10x right now, we would
pile into S&P ETFs and spend our free time reading books or listening to music. But the Shiller PE ratio is
24x and therefore, we preach caution.

We think there are lots of things that could go wrong. Chief amongst our worries at the moment is
Europe. Specifically, when the Greek 2-year yield is above 25%, it means the country is facing default,
irrespective of what the officials say. We are also worried about inflation. We are worried that when
central bankers focus purely on core inflation, they miss the bigger picture that expectations may be
ratcheting up to a permanently higher level.

With so much uncertainty, we prefer to keep a large portion our portfolio in cash. Yes, it’s painful to see
the purchasing power of cash depreciate by 3, 4, 5% a year. But we think it is a better alternative than
being forced to chase risk and face 30, 40, 50% haircuts.

The Aspiring Analyst will not be publishing in June, as your analyst is getting married. We will resume
our writing in July, when hopefully, we will have better clarity on the path of the economy post the Fed’s
QE2.

Jason Chen
The Aspiring Analyst

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 The Aspiring Analyst Vol. 1 Iss. 5
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Bulls Vs. Bears

Not sure if a lot of people caught this interview of Robert Shiller of Yale University (Bearish) and Jeremy
Seigel of Wharton University (Bullish), but it is definitely worth 7 minutes of your time:

http://pragcap.com/are-stocks-cheap-bull-vs-bear

Readers should note that we are in the Shiller camp. As we have noted in our March newsletter, we
firmly believe equity markets are overvalued with a cyclically adjusted Shiller PE ratio above 24, implying
average 10 year forward returns of less than 5% per annum.

The biggest issues we have with the Bullish case, as presented by Professor Seigel, is that bulls believe
‘this time is different’ and we should not weigh the great recession of 2008 as heavily in normalized
earnings. They believe earnings cannot be considered high only two years after the deepest recession
since the 1930s. They believe that stocks are cheap on a relative basis to record low interest rates, with
a P/E ratio of 13 to 14 times.

But as Professor Shiller pointed out, the Shiller PE is a simple model that has been back-tested to the
1870s; on the grand scheme of things, ‘this time is not different’. Why should we weigh this recent
recession any differently than all of recessions in the past? Second, a lot of the rebound in earnings in
2009/10 was due to cost cutting; profit margins are at historical highs while total employment in the
U.S. is still short 8 MM jobs. With rising commodity prices pressuring margins, how sustainable are
earnings? Finally, precisely because interest rates are at historical lows, the only way for interest rates to
go is up.

Nothing To See Here, Move Along

‘Nothing to see here, move along’ is essentially what European government and central bank officials
are telling us, in regards to rumours that Greece may restructure its sovereign debt or leave the Euro-
area altogether1,2,3. Somehow, we do not believe them. Where have we heard this before? Oh right, we
heard this denial when Greece was rumoured to require a bailout in 20104; when Ireland denied it was
getting bailed out in late 20105; and as recently as late April when Portugal denied it was being bailed
out6. At this point, if European government officials were to start denying rumours that Elvis is alive

1
Reuters, retrieved Sunday, May 8, 2011, http://www.reuters.com/article/2011/05/08/us-eurozone-greece-
germany-idUSTRE7461QJ20110508
2
Reuters, retrieved Sunday, May 8, 2011, http://www.reuters.com/article/2011/05/07/greece-eurozone-
idUSLDE7460A820110507
3
Reuters, retrieved Sunday, May 8, 2011, http://www.reuters.com/article/2011/05/07/ecb-liikanen-
idUSHEL01014820110507
4
The Australian, retrieved Sunday, May 8, 2011, http://www.theaustralian.com.au/news/world/merkel-denies-
bailout-for-greece/story-e6frg6so-1225828917782
5
Reuters, retrieved Sunday, May 8, 2011, http://www.reuters.com/article/2010/11/12/ireland-bailout-
idINWLA789520101112
6
Reuters, retrieved Sunday, May 8, 2011, http://www.reuters.com/article/2011/04/27/portugal-bailout-
idUSLDE73Q29F20110427

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 The Aspiring Analyst Vol. 1 Iss. 5
Sell In May And Go Away theaspiringanalyst@gmail.com

(even though he has been officially dead for decades), we may be inclined to bet against those officials,
based purely on their record for telling the truth.

Does Mr. Bernanke Wear Jeans?

Does he fly commercial? Does he eat out? If so, he will find that inflation is becoming much more
widespread than just volatile food and energy prices7. Clearly, he is failing at his job of “maintain[ing]
low and stable inflation by our definition of price stability by maintaining the purchasing value of the
dollar, keeping inflation low.” He also needs to work harder at “try[ing] to keep higher gas prices from
passing into other prices and wages throughout the economy and creating a broader inflation, which
would be much more difficult to extinguish.” Quotes are from the farcical press conference Mr.
Bernanke held after the latest FOMC meeting.

As we have written about in the past, inflation expectations take time to percolate through the
economy. While businesses may be willing to suffer lower margins in the short-term from volatile
energy and commodity prices, in the long-run, if those prices persist, businesses will increase their own
prices, creating an upward spiral of inflation expectation. Reversing such a spiral will be difficult. The
sooner Mr. Bernanke realizes this, the better.

We Hate To Be Right

Last month, we pointed out that one of the consequences of the Japanese earthquake will be a
disruption to global supply chains. Well, we were right. While the direct impact of the earthquake
pushed down Japanese exports by 2.2%8 in March, it was more surprising to see countries as far away as
Brazil and India impacted: Toyota recently suspended production in Brazil because of parts9 while Honda
cut production in India10. Texas Instruments also blamed its recent miss of analyst estimates on the
Japanese earthquake11. We suspect supply chains will have to get a lot longer and inventories kept a lot
higher in the near future as companies continue to react to the disaster. Do not be surprised if
manufacturers of all stripes and colours continue to blame the earthquake for lower margins in the
coming months.

Sell In May And Go Away

7
Bloomberg, retrieved Sunday, May 8, 2011, http://www.bloomberg.com/news/2011-05-06/restaurants-raising-
prices-in-trend-inflation-hawks-cite-to-criticize-fed.html
8
WSJ, retrieved Sunday, May 8, 2011,
http://online.wsj.com/article/SB10001424052748703922504576273632350582312.html
9
AFP, retrieved Sunday, May 8, 2011,
http://www.google.com/hostednews/afp/article/ALeqM5iaT5Y13VFTNJZW8eMT2RD06U3A1A?docId=CNG.f95ffd6
909cd3a22bdbaf23323c5cbae.341
10
Economic Times, retrieved Sunday, May 8, 2011, http://articles.economictimes.indiatimes.com/2011-05-
04/news/29509246_1_car-production-hsci-parts-suppliers
11
Reuters, retrieved Sunday, May 8, 2011, http://uk.reuters.com/article/2011/04/18/uk-texasinstruments-
idUKTRE73H7CC20110418

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 The Aspiring Analyst Vol. 1 Iss. 5
Sell In May And Go Away theaspiringanalyst@gmail.com

We are following the old adage, ‘sell in May and go away’ by maintaining our near-40% cash position in
our portfolio at this time. Investors who are deploying capital into equities at this time should be
comfortable with three near-term risks:

• The Federal Reserve’s ending of QE2 in June – when the Fed’s QE1 program ended in 2010, the
economy and equity markets promptly rolled over. Might the same happen this time?
• U.S. Austerity – furthermore, how much austerity will Republicans demand before they agree to
raise the U.S. government’s debt ceiling? We have no doubt the debt ceiling will be raised. The
only question is what kind of concessions will be wrung out of the process.
• A Greek debt restructuring – although the authorities keep denying that Greek sovereign debt
will be restructured, we do not believe their denial is credible. Will a restructuring lead to
contagion in the Euro-region?

We think these risks are too great, especially considering the U.S. economy is growing at a sub-2% rate.
It would not take much to tip it back into a recession. Even if you are comfortable with these risks, we
highly encourage investors to invest with a healthy margin-of-safety. Consider how the investment will
perform if your estimates are off by 15%. Is the investment priced for perfection, and are you priced for
perfection (too much leverage)?

We Are Not Goldbugs

We do not like physical gold (not to be confused with gold mining companies, which we view as
producers of a commodity product, where low cost producers, or a producers with undervalued and
unrecognized assets can have intrinsic value). The same applies for silver as well. As a value investor, we
cannot justify investing in an asset class, precious metals bullion, that has no intrinsic value. Let us
explain.

When we invest in a company under a value investing framework, we are either investing because of the
asset value (i.e., the assets of the company is worth more than what you pay for them) or the earnings
power (i.e. the stream of earnings is worth more than what you pay for them). With bullion, you get
neither. The price you pay for bullion is the price of bullion, if not more, since you need to add
brokerage expenses. It also does not provide any stream of earnings. In fact, owning bullion requires
storage and insurance costs.

Goldbugs claim gold is a hedge against inflation – unlike fiat currencies, central banks cannot simply
print more gold. There may be some truth to this; we also worry about the inflation caused by the
Federal Reserve’s quantitative easing programs. However, we need much higher rates of inflation to
justify the rise in the price of gold.

Consider this: the price of gold was less than $300 in 2000 while the price of gold is now roughly $1,500.
So in 10 years, the price of gold has gone up five-fold. Inflation in the U.S. would have to be at least 18%
per annum for 10 years, to justify the five-fold increase in gold in 10 years. A $2.50 Big Mac in 2000

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 The Aspiring Analyst Vol. 1 Iss. 5
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should be selling for $12.50, according to the price of gold. We went through the Economist’s historical
Big Mac Index12, and here is what we found:

4.80

4.30

3.80

3.30

2.80

2.30

1.80

1.30

0.80
Apr-98 Apr-99 Apr-00 Apr-01 Apr-02 Apr-03 Apr-04 Apr-05 Apr-06 Apr-07 Apr-08 Apr-09 Apr-10

Big Mac (US$) CPI-U Gold (London PM)

Figure 1: Price of Big Mac vs. U.S. CPI vs. London PM Gold Price, scaled to April 1998.
Source: The Economist, U.S. BLS, www.onlygold.com

While the price of Big Macs indicates that official CPI is indeed understated by about 10% cumulatively,
the discrepancy is not nearly the same degree as implied by gold. A Big Mac retailed for $2.56 in April
1998 and $3.71 in October 2010. It did not increase in price five-fold. Investors who believe the price of
gold will continue to go up is really speculating in the price of a bubble and not investing.

Disclaimer: Our goal through this blog is to provide analysis and ideas that you, the reader, might find useful in forming your
own investment decisions and hopefully improve our analytical skills in the process. We are not soliciting for the management
of your investments nor seeking to provide financial advice. The Aspiring Analyst blog and letters will not take responsibility for
any investment losses incurred by readers through the trading of securities and strategies mentioned in this blog or its
accompanying letters. The views expressed in this blog and its accompanying letters reflect the author(s) personal views about
the subject company(ies) and its (their) securities. The author(s) certify that they have not been, and will not be receiving direct
or indirect compensation in exchange for expressing the specific recommendation(s). Readers are cautioned to seek financial
advice from qualified persons such as a Certified Financial Planner prior to taking any action in regards to the securities and
strategies mentioned in this blog or its accompanying letters.

12
The Economist, retrieved Sunday, May 8, 2011, http://www.economist.com/markets/bigmac/