Global T ti l Gl b l Tactical Asset All ti A t Allocation

GTAA
Equities
First Quarter
January 9th , 2010 Damien Cleusix damien@clue6.com d i @ l 6

Clue6

First Quarter 2010

Executive Summary
Stocks

1

Valuations are now above levels where performance going forward will not please the buy & hold crowd, even if we go p g g p y , g back to the good old days, the credit bubble stops deflating, growth reaches pre-2007 level in a sustainable manner ,.... At 1200 on the S&P 500 will be priced more expensively than all of the structural tops pre-2000 (well 1997-2000) except the final tail of the 1929 move... This does not imply that the market will fall in the short or even the medium term but that a further rise will only have speculative and no investment merit if bought. Our base assumption remains that we will fall to significantly undervalued levels before a new secular bull market can start (in the developed world as you know we believe that we are in a secular bull market in emerging markets). This currently implies a sub-530 level on the S&P 500 going up by 5-6% a year. Option activity, insiders and most of the smart-money we follow are in a configuration where markets have struggled in the past But even if sentiment is once again too greedy it has to be put in the context of the recent advance and market past. greedy, trend (higher highs and higher lows). This does not imply that the market can not continue to rise in the medium-term but more that it should at least consolidate in the short-term. Small investors optimism has finally started to rise and is now deep in overconfident territory… Most of the breadth divergence we noted in November and December are now gone… Uniformity remains high... On the liquidity side, inflows into US equity domestic funds remain low while the money is pouring into emerging market equity fund. This has historically been followed by underperforming EM markets… We have seen a slight pick up in buybacks but h b they remain very l i low while IPO’s and Secondaries h hil d d i have b been plentiful with b bbl reminiscent l l i Hong Kong and l if l i h bubble i i level in d China…Monetary aggregate momentum is turning down and this could prove to offer some headwind to risk assets… Pension funds’ funding status is deteriorating despite the rising equity markets courtesy of the rising present value of liabilities. liabilities

Clue6

First Quarter 2010

Executive Summary

2

Seasonals are supportive even if one has to remember that the equities have relatively important (>5%) correction intra-month in January, especially after strong starts…. Cycles are still supportive but the 20 weeks cycles should be topping in the very near future… Intermarket relationships have improved from the numerous divergences witnessed in November and December. The relative good performance of defensive around the world is a worry as is the fed funds futures/equities co-movement but so far so good. We W are more worried about th medium-term momentum of b d and commodities which i i a configuration where equity i d b t the di t t f bonds d diti hi h is in fi ti h it market productivity has been poor historically…Sovereign CDS will continue to need your attention… The trend is up almost everywhere but we are at or near the top of the new rising channel. Correction to at least the bottom of the channel expected before a potential resumption of the up move but the rest of the analysis points out to something potentially bigger than the correction we had since March…

Clue6

First Quarter 2010

Equities: Valuations – A Repeat
Valuations are not useful f short-term market projections b t are essential i f V l ti t f l for h t t k t j ti but ti l in forecasting ti long-term returns. They become informative in the shorter term when they reach extremes. When they are very high one should not allow the other indicators in one’s arsenal to deteriorate too much before pushing the exit button, the reverse is true when they reach very low levels. The perpetual question is what constitutes high and low and which valuation ratios to look at We at. look at normalized price to earning ratios (normalized using an trailing reported earnings moving average, average margins or peak earnings) and price to book value. We like to look at a historical dataset as long as possible. It is also important to consider the quality of the data. One often hears that valuations should be higher because the markets are less risky. We disagree. Main Street has clearly been less volatile in the past 30 years (well up to now), as has inflation. The consequence is that companies have increased their leverage dramatically (cf. A. Greenspan s Paradox A Greenspan’s “Paradox of Credibility” or H Minsky’s “Unstable Stability” . In the Credibility H. Minsky s Unstable Stability process earnings volatility has increased rapidly in the past 10 years (Chart 1). From the mid 50’s to the mid 80’s, real annual earnings were rising or falling by 3.8% for every percent change in annual real GDP growth. In the past 10 years if was 22%... This has been aggravated by a substantial deterioration of the assets where: 1. intangibles have become legion in some countries (Table 1) (ask a bondholder of a bankrupt high intangibles company what intangibles are worth...),. Goldman Sachs has calculated that the S&P 500 constituents asset/equity ex-goodwill has risen from 2.5 in the 80s to 4.4 today. 2. 2 Financial asset have proportionally increased increased. 3. Assets' mark to market which increase their pro-cyclicality. In brief, as often repeated in the past, we think market should be valued at lower levels, not higher levels than historically. This is thus not surprising that AAA and AA bonds represented almost 60% of the Barclays Capital Investment Grade Index at the end of the 70s while they only represent 25% today.
Clue6 Chart 1 US Earnings Volatility

3

Source: R. Shill Clue6 S Shiller, Cl 6

Table 1

Tangible Book Value

Source: Bloomberg, Clue6

First Quarter 2010

Equities: Valuations – A Repeat
Investors attach a lots of importance to what happen to earnings on the very short term while they have a very negligible influence on the intrinsic value of the markets. Indeed even if earnings were to be 0 in the next 2 years, this would not affect by more than a few percentage points the intrinsic market value derived by a dividends or cash flows discount model. Remember that markets are a claim on a very long-term stream of cash flows. What moves market valuation around fair value in the short-term is investors’ risk appetite. This is what we analyze extensively in the Sentiment, Breadth, Liquidity, Seasonality and Cycle section of our presentations. In the long-term, we believe that the main driver of long-term generational fluctuation in valuation ratios from very undervalued to very overvalued, is the reallocation of the stock of wealth (as demonstrated by J. Tobin more than 40 years ago). One can see this phenomenon in action l ki at the S i looking h Saver/Spender ratio or Middle to Young cohort (Ch 2) /S d i iddl h (Chart 2). This is the ratio of the population aged 40-49 years to 20-29 years (we will show graphs for other markets later). For the US we think the time for the next structural bull market to start will be the low made between 2014-2016 (with a preference for 2014). As we have said in the past 10 years, this does not mean that there won’t be cyclical bull markets in between. In the past we have showed that during structural bull markets the market rises around 85% of th ti f the time while i structural b hil in t t l bear market it rises approximately 65% of th ti k t i i t l f the time… So where do we stand now…
Source: Census Bureau, Clue6

4

Chart 2

S&P 500 and Middle to Young Cohort

Clue6

First Quarter 2010

Equities: Valuations
For longer-term return projections (7 years), we use a methodology similar to Grantham, Mayo, Van Otterlo & Co so let’s use their graphs (Chart 3 and 4). What is the performance of the various categories if in 7 years they trade at the average valuation normalized to average margin. Another indicator we look at is the Value Line Median Appreciation Potential (VLMAP) which P.Bernstein used in his valuation estimation of the market. It is the median price appreciation potential estimated by Value Line of the all of the 1700 stocks they cover for the following 3 to 5 years. It fell below 60% which is at the bottom end of its history… One should start accumulating stocks when it rises above 100%... High quality stocks expected return has declined by more than 2% to 9.6%. This is where we still would be greatly overweight (and as an aside valuation our macro scenario favor "bunker-like" balance sheets). As we will show in the next few pages, we think there is a non-negligible risk (it is a risk identified and not a prediction…) that the market will make “THE” bottom at levels up to 50% below where the markets are now. In 2000 we said that the S&P 500 would fall below 500 before the next structural bull market starts, we still believe that this is a potential outcome (but we would add 5-6% a year to this objective going f bj i i forward ( d (would b a combination of extension and time f the correction I.E the ld be bi i f i d i for h i h longer it takes the lower the required decline…) But we also know that timing the exact bottom is impossible so we will automatically increase our recommended allocation on declines once we fall below 700-750 on the S&P 500 and we see b dth extremes without regard t th t d Th allocation will b i breadth t ith t d to the trend. The ll ti ill be increase along l price declines exactly as we did in March this year. One need a plan to stick to in such environment and this is ours. We will also limit the extent to which we take net short positions the closer we are to what we consider rock bottom valuations. l ti
Chart 4 Chart 3 GMO 7 Years Return Forecast

5
August 2009

Source: Grantham, Mayo, Van Otterlo & Co

November 2009

Clue6

First Quarter 2010

Equities: Valuations
We have shown that the concept of book value has changed in the last 15 years (Table 1 earlier). This is especially true for the US and Europe. In 2007, in our effort to convince clients of the overvaluation of the market, we presented data demonstrating that balance sheets had experienced a radical mutation in the past 25 years. N only did we see a d li Not l decline of the f h importance of the tangible assets, those were now dominated by financial assets whose procyclicality was masking the potential problems and over-leveraging.
Source: Bloomberg, Clue6 S l b Cl 6 Source: Bloomberg, Clue6 S l b Cl 6

6
Chart 5 US PB Chart 6 Europe PB

We understand that in a service economy tangible assets are not as important as when manufacturing dominated (see the proportion of tangible assets in emerging economies on table 3), but once more, ask yourself what i t k lf h t intangibles are worth i a ibl th in bankruptcy… On the various charts the semi-transparent area represent time when the market was cheaper than today on a book value per share basis. A cursory look at the graphs confirm that valuations are not as attractive as they were just 6 months ago ago…

Chart 7

Japan PB

Chart 8

Japan Small Caps PB

Source: Bloomberg, Clue6 Bloomberg

Source: Bloomberg, Clue6 Bloomberg

Clue6

First Quarter 2010

Equities: Valuations
Chart 9 Asia ex Japan PB Chart 10 Latin America PB

7

The picture is less flattening if one looks at price to normalized earnings or price to replacement value (Tobin Q) All in all we would estimate the US and European markets to be overvalued by 30-40% with a fair value between 750-800 (and do not forget that we will undershoot) Seems outrageous to many but we undershoot). feel comfortable (and in good company…J. Grantham, A. Smithers, J. Hussman,…) Japan remains undervalued and as said, the low historical ROE should be seen as a potential to

Source: Bloomberg, Clue6 S l b Cl 6

Source: Bloomberg, Clue6 S l b Cl 6

mean revert to other countries standard now that Japan is slowly, but surely, becoming more shareholder friendly. Emerging markets are getting increasingly expensive here They are profiting most from the here...They excess liquidity pumped by central banks around the world and from the cheap USD but... The USD won't fall forever and once you reach a certain level of valuation you are only counting on finding a bigger fool. Trend change should definitely be acted upon from here on... Eastern Europe is slowly getting more expensive and we would now be careful given the macro background... Buy aggressively on a return to 0.5-0.6 PB.

Chart 11

Eastern Europe PB

Source: Bloomberg, Clue6 Bloomberg

Clue6

First Quarter 2010

Equities: Valuation
Chart 12 USA and Europe Return on Equity Chart 13 S&P 500 Selling General and Selling, Administrative Expenses YoY

8

Source: Morgan Stanley

Source: Goldman Sachs

Return on Equity is probably near a bottom in the US and there is still some work to be done in Europe which tends to lag by 12-18 months, as do earnings (Chart 12). Return on equity analysts projection which we qualified as overoptimistic earlier might come to pass for 2010 (well the one g ( ) q y y p j q p g p ( they add a couple of months ago not the current ones. At least US companies have been firing a lot of workers. The decline in nonfarm payrolls at more than 5% surpasses the decline in GDP... In Europe we have only seen 1% decline... The consequence has been that the annualized Q2/Q3 growth of the business sector GDP has been 1% while profit have increased by 46% (thanks to financials which represents again more than 35% of total profits…)
Clue6 First Quarter 2010

Equities: Valuation
Chart 14 US Profit/GDP Chart 15 US Private Compensation/GDP

9

Source: Bloomberg, Clue6

Source: BEA, Clue6

The reliance of margins in the US has been in good part due to the foreign profits margin (Chart 14) (more on this later) … Note also that the effective tax rate was 22% (it was 30% in 2007 ) 2007…) Longer-term we are expecting to see a mean-reversion in the Private compensation to GDP (Chart 15) which will weight on margins which might stay lower for longer and not reach the 2007 and even 2000 high for quite some time. This should be associated by a reduction in inequalities,... But more on this very important and under discussed problematic later in 2010…

Clue6

First Quarter 2010

Equities: Valuation – US Earnings
Chart 16 US NIPA and S&P 500 Operating Profits Chart 17 S&P 500 as Reported Earings and Margin Direction Model

10

Source: Clue6

Source: Clue6

We have used the Chart 16 a couple of times in the past (2000, 2002 and 2007) to forecast a turn in the S&P 500 operating earning cycle. NIPA Profit leads by 2 to more quarters. This bodes well for at least the coming 2 quarters (at the top of the cycle accountants tries to mask the earning y q g q ( p y g deterioration while at bottoms they do the reverse…) A few remarks… First the big increase in the last quarters NIPA profit was mainly due to financials. Profits in the sector rebounded strongly because of a decline in both charge offs… One has also to see that the current ratio of as reported (according to GAAP) to operating earning at 14% is the lowest in history (last low was 60% during the 2000-2002 bear market). Accountant are working hard… Finally our basic margin model is has recently turned negative… If earnings grow beyond Q2 2010 it will have to be supported by top line growth.

Clue6

First Quarter 2010

Equities: Valuation – Style
Chart 18 Valuation Factor Dispersion Table 2 Speculative vs. Defensive

11

Source: Morgan Stanley

Source: Zeelotes

There are many analysis one can use to time styles. One we use and have advised to use for many years, is factors dispersion. There are many ways to calculate it… On Chart 18 you can see the calculation for both Europe and the US of the value factor dispersion… When dispersion is spiking higher, buy junk t k (we have d hi h b j k stocks ( h demonstrated i th past th t th b t stocks t b after a b tt t t d in the t that the best t k to buy ft bottom ( d it can also b an i t (and l be intermediate b tt di t bottom i an in on-going bull markets) were the stocks appearing in short screens) when it is low, buy quality… The messages are… the outperformance of simply buying low PB stocks vs. high PB stocks is likely to be much below average going forward (until dispersion increase again but dispersion could decrease further before we would short them), speculative factors are likely to underperform until we get the next bout of increasing dispersion BUY QUALITY STOCKS with stable growth rock solid balance sheet steadily increasing dispersion, growth, sheet, dividends and book value per share and a moat…
Clue6 First Quarter 2010

Equities: Valuation – US Future GDP Growth

12

Source: CBO,Clue6 Idea: J.Hussman

As said in the past, in the long run, earnings tend to grow slightly less than GDP. The above concept to estimate forward growth was first proposed by J.Hussman. For the US real GDP to reach the CBO potential real GDP forecast in 10 years, the growth should be 2.7% which is one of the lowest in history. If one add that there is a non-negligible risk of deleveraging and overcapacity related deflation (if Central Banks and Government do not go all-in g g g g p y ( g where inflation might become a problem) this does not bode well for nominal growth which is what people and companies use for they investment and consumption decisions…
Clue6 First Quarter 2010

Equities: Sentiment – Surveys
Chart 19 Investor Intelligence Bull/Bear Ratio Chart 20 NAAIM Survey and S&P 500

13

Source: Investor Intelligence, Clue6

Source: NAAIM, Clue6

For the first time in a while, almost all of the Surveys we follow are indicating a very high level of confidence that the market will continue to rise… On Chart 19 one can see the the Investor Intelligence Bull ratio which has recently reached its highest level in many, many years (with the Bearish percentage at its lowest level since 1987, and thus 3 weeks in a row now…) The same configuration is starting to emerge when looking at the American Association of Individual Investors survey with the bearish percentage at 23% (but it went below 10 a couple of times in the past)… The National Association of A ti I Th N ti l A i ti f Active Investment M t t Managers allocation survey (Ch t 20) i also not f ll ti (Chart is l t fare away f from past hi h d i th past 8 t highs during the t weeks… Markets have tended to struggle after such a long stretch of bullishness…
Clue6 First Quarter 2010

Equities: Sentiment – Surveys
Chart 21 Greenwich Macro Managers Bearish% Chart 22 TSP Survey and S&P 500

14

Source: Greenwich Alternative Investments, Clue6

Source: TSP, Clue6

On Chart 21 one can see that the Macro Managers bearishness has abated but remains relatively highs (and we would not use it as a contrarian signal at this j hi juncture) ) Finally the TSP Bull/Bear Survey (Chart 22) has recently moved sharply higher and has given a sell signal according to the methodology they use…

Clue6

First Quarter 2010

Equities: Sentiment – Surveys
Chart 23 ML Fund Managers Survey Percentage Net Overweight Japan Chart 24 ML Fund Managers Survey Percentage Net Overweight Emerging markets

15

Source: Merrill Lynch

Source: Merrill Lynch

On a Country/Region basis there are 2 stand outs… Everybody hates Japanese stocks (Chart 23) while the sky seems to be the limit for Emerging markets (Chart 24)… 2 potential surprises for 2010? Probably but the timing will have to be right with probably 3-4 phases during the year but with the Topix beating EM by the end of the year….

Clue6

First Quarter 2010

Equities: Sentiment – Put Call Ratios
Chart 25 S&P 500 and OEX PC Ratio Chart 26 S&P 500 and Equity PC Ratio

16

Source: Clue6

Source: Clue6

Looking at option activity the picture is similar… On Chart 25 one can see that the OEX put call ratio rose above 2 4 times in the past few weeks… this is something very worrying. At the same time the Equity put call ratio is hovering at a low level (Chart 26). If b th were combined on a single graph, one would see th “J P tt ” we h both bi d i l h ld the “Jaw Pattern” have di discussed i th past… d in the t

Clue6

First Quarter 2010

Equities: Sentiment – Put Call Ratios
Chart 27 S&P 500 and Small Traders Option Activity Chart 28 S&P 500 and Small Traders Buy to Open Put/Call Ratio

17

Source: OCC, Clue6

Source: OCC, Clue6

In the meantime digging further into the data one can see that small traders (up to 10 contracts traded) puts buy to open activity represents less than meantime, data, 16% of their total activity which is near an historic high while their call buy to open activity represents 36% of their transaction… not far from the 40-42% extremes reached in the past (Chart 27 and 28)…

Clue6

First Quarter 2010

Equities: Sentiment – Insiders
Chart 29 S&P 500 and Russell 3000 Insiders Chart 30 Footsie and Insiders

18

Source: Bloomberg, Clue6

Source: ML, Clue6

The number of sell transactions in the US is reaching a high level (especially given the fact that at year end activity usually abate somehow…) while buying b i remains l (Ch 29) i low (Chart 29). The same is true in the UK where the buy to sell ratio is historically low (Chart 30)… But remember, insiders activity is especially useful in 2 configurations: lots of relative buying or increased selling when the market decline…

Clue6

First Quarter 2010

Equities: Sentiment – Insiders
Chart 31 Europe Directors’ Buying (in eur mio.) (transactions capped at eur 1 mio.) Chart 32 Europe Directors’ Selling (in eur mio.) (transactions capped at eur 1 mio.)

19

Source: D t h B k S Deutsche Bank

Source: Deutsche Bank h k

In Europe we have seen a big increase in selling during the past 8 weeks consolidation (Chart 32) while buying has remained low (Chart 31)…

Clue6

First Quarter 2010

Equities: Sentiment – Insiders
Table 3 Global Insiders Activity Table 4 Global Insiders Activity

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Source: Bloomberg, Clue6

Source: Bloomberg, Clue6

Looking at other markets around the world, one can see that insiders have become increasingly bearish in Hong Kong notably (Table 3-4)… Note that the last quarterly ratios where already much higher than the very bullish (lots of insiders buying) that we witnessed at the end of 2008 and the start of 2009…

Clue6

First Quarter 2010

Equities: Sentiment – Smart Money
Chart 33 S&P 500 and Hussman Strategic Growth Beta Exposure Chart 34 S&P 500 and Leuthold Core Beta Exposure

21

Source: Clue6

Source: Clue6

J. Hussman strategy here is clear. He buys small on weakness and re-hedge completely on strength. According to our calculation he is currently fully hedged d he has been out recently saying that a >20% correction i lik l (b not certain…) to start i the next 8 12 weeks… h d d and h h b l i h 20% i is likely (but i ) in h 8-12 k S. Leuthold, who has been bullish and right since early in 2009, has started to sound more cautious, at least for the short-term… His exposure is still high though (Chart 34)…

Clue6

First Quarter 2010

Equities: Sentiment – Smart/Dumb Money
Chart 35 Nasdaq 100 and Non-Commerical Net Long Future Position Chart 36 S&P 500 and Strategists Stock Allocation

22

Source: Bloomberg, Clue6

Source: Bloomberg, Clue6

Non-Commercial have dramatically diminished their Nasdaq 100 futures net long positions from an all-time high to approximately 2000 contracts (Chart 35). (Ch 35) Wall Street Strategists have dramatically increased their equity allocation recommendation in the past few weeks (Chart 36) and while it remains lower than average if one look at the past 12 years history this would probably not be the case if a longer history was available…

Clue6

First Quarter 2010

Equities: Sentiment – Dumb Money
Chart 37 Analysts US Stock Recommendations 3 Months Change Chart 38 Topix and Percentage Analysts Sell Recommendations Japan

23

Source: Bloomberg, Clue6

Source: Bloomberg, Clue6

Analysts recommendation momentum is not very informative here with both buy and sell recommendations being lower than 3 months ago (Chart 37) In Japan after a pick up in sell recommendations at the end of 2008 we are seeing continuing decrease in the momentum of buy recommendations (Chart 38).

Clue6

First Quarter 2010

Equities: Sentiment – Dumb Money
Chart 39 Topix and Shares Bought on Margin Profit/Loss Ratio Chart 40 Topix and Shares Sold on Margin Profit/Loss Ratio

24

Source: Bloomberg, Clue6

Source: Bloomberg, Clue6

In Japan analysts have access to the performance of the margin buyers and sellers. On Chart O Ch t 39 one can see th t when i that h investors are starting t make money on th stocks b t t ti to k the t k bought on margin ( even l i l ht i (or losing less th 5%) th rally i than 5%), the ll is usually very near a reversal… The same is true on stocks sold short on margin (Chart 40)… when they start to make a profit, a reversal to the upside is not very far… we had a good example in December… Margin traders are currently losing both way…
Clue6 First Quarter 2010

Equities: Sentiment – Volatility
Chart 41 S&P 500 and Vix Time-Spread Chart 42 S&P 500 and CFTC VIX Large Speculator Net Position

25

Source: Bloomberg, Clue6

Source: Bloomberg, Clue6

Our VIX Indicators are giving conflicting signals… The time-spread is at levels where market volatility has increased and markets have struggle to make sustain advances (Chart 41) while noncommercials have an important net short position indicating that they believe the VIX will continue to decline in the near-term (Chart 42). Remember that they are the smart-money here (but note that they were dead wrong with their highest net long position in December so… Looking only at the VIX, the recent highs have not been confirmed by a VIX new low which is a negative while on the positive side it is still making lower lows and lower highs… A break above 23.5 followed by a higher low would be needed to change the trend…

Clue6

First Quarter 2010

Equities: Breadth

26

Why breadth and volume can help us gauge the future prospective risk/reward ratio of the market. We have tried for 10 years to explain it… Well J.Hussman explains it brilliantly… as always “A good way t thi k about prices and t di volume i t abandon th id th t money goes i or out, and t thi k i t d about th market as d to think b t i d trading l is to b d the idea that in t d to think instead b t the k t a collection of various groups. Imagine there being fundamental investors, who are interested primarily in value (buying on weakness and selling on strength), and technical investors, who are interested primarily in trends (selling on weakness and buying on strength). These people also trade on different horizons and base their trading on different extent of movement. In this sort of equilibrium trading volume is a measure of strong views and disagreement As the market turns weaker trend following investors equilibrium, disagreement. weaker, trend-following typically abandon stocks, while fundamental investors accumulate. The reverse is true on significant strength. So spikes in trading volume tend to occur primarily at extremes relative to the target prices of fundamental investors. Volume spikes also tend to be correlated with a series of positive or negative shocks that then abate. In contrast, dull volume is a measure of low sponsorship, strong agreement, and lack of external shocks. Equally important is that net incipient buying from both technical and fundamental investors cannot exist so large price movements are typically exist, required to relieve the disequilibrium. If you've got an overvalued market which then loses technical support, the outcome can be extremely negative, because technical investors are prompted to sell, but fundamental investors have weak sponsorship at that point, so large price declines are required to induce the fundamental investors to absorb the supply. In contrast if you've got an undervalued market where fundamental investors raise their outlook the demand from fundamental investors is not contrast, you ve outlook, typically provided by technical investors (who would tend instead to buy on advances in price), so the price must increase enough to induce fundamental investors with shorter horizons to supply the stock. All of these dynamics have been active in the market over the past two years, but the most significant outlier has clearly been the past few months, where volume behavior has demonstrated much weaker sponsorship than we would have expected for an advance of this size Normally the volume size. Normally, characteristics we've seen have been much more typical of short-squeezes and less durable advances.” J.Hussman

Clue6

First Quarter 2010

Equities: Breadth
Chart 43 S&P 1500 and its AD Line Chart 44 Nasdaq 100 and the New High New Low Model

27

Source: Clue6

Source: Clue6

After having showed sign of potential divergence in November and December, breadth is back in sync with the market… The S&P 1500 Composite Index cumulative advance decline line has now confirmed the market recent highs (Chart 43). The divergence was due to the poor showing of small caps stocks which have performed extremely well since mid-December. We will have to see if the rebound is simply the traditional small caps rebound during this time of the year or is a sustainable move (breadth-wise) in the weeks to come… The Nasdaq New High-Low Model is still on buy (Chart 44). But one has also to keep in mind that volume remains anemic and that the up-down volume stats are not showing real buying behind the recent move (real accumulation has been absent since October…)
Clue6 First Quarter 2010

Equities: Breadth
Chart 45 Topix and Normalized Advance-Decline Ratio Chart 46 MSCI Asia Ex Japan and Normalized Advance-Decline Ratio

28

Source: Clue6

Source: Clue6

Our Japanese normalized advance-decline ratio moved to an extreme oversold level (<-40) in early December and has since moved back to positive (Chart 45). You (Ch 45) Y usually needs a move above 20 f the market to stale after such oversold readings… ll d b for h k l f h ld di In Asia, we did not have any breadth thrust in the past 3 months (Chart 46) and are slowly approaching the >5 levels where the market tend at least to consolidate (if we expect the move out of extremely oversold level where it usually indicates continuation…)

Clue6

First Quarter 2010

Equities: Breadth
Chart 47 S&P500 and Fosback High Low Index Chart 48 S&P 500 and Hindenburg Omens

29

Source: Clue6

Source: Clue6

Since we have started to write those presentations, many years ago, we have used the following 2 studies to warn of impeding cyclical trend change. On chart 47, one can see the Fosback High Low Index remains very low, indicating a lack of distribution. It is likely to remain low until mid-March as many stocks plunged into March 2009 making a big rise in new lows unlikely. We have yet to see any Hindenburg Omen triggered on any of the Major index (Chart 48)…

Clue6

First Quarter 2010

Equities: Liquidity
Chart 49 Equity mutual fund assets and net cash Chart 50 Flows to Emerging Markets Mutual Funds and Future Relative performance

30

Source: Nomura

Source: ICI, Clue6

Net inflows into equity mutual flows continue to be negative (Chart 49) in the US while we are continuing to see huge inflows into emerging market oriented f d ( d while US i i d funds (and hil investors h have b been net sellers of equity mutual f d they h ll f i l funds h have b been net b buyers of emerging market equity f d ) f i k i funds…) Such important inflows have been historically followed by a substantial underperformance of Emerging markets (Chart 50).. The NYSE margin debts has now exceeded the 2000 levels on a % of market cap basis…

Clue6

First Quarter 2010

Equities: Liquidity
Chart 51 Number of Buybacks Announced per Month in the US Chart 52 Number of Buybacks Announced per Month in Japan

31

Source: Bloomberg, Clue6

Source: Bloomberg, Clue6

Buybacks have picked up slightly in the US in the past 2 months but remains at a very depressed level (Chart 51)… In Japan, we have seen a slightly more robust pick up (Chart 52) but we would like to see more to be convinced that management is more confident on their company prospect and more interested in the well-being of their shareholders… Note that we remain wary of too much buybacks which, in aggregate, still remains a sign of management “short-terminism”… and in Japan we would prefer t see stocks b ld f to t k bought b k th new unproductive capital expenditure… ht back than d ti it l dit

Clue6

First Quarter 2010

Equities: Liquidity
Chart 53 US IPOs and Secondaries (US mio.) Chart 54 China + Hong Kong IPOs and Secondaries (US mio.)

32

Source: Bloomberg, Clue6

Source: Bloomberg, Clue6

The Banks TARP repayment have caused a big jump in the amount of secondaries in December (Chart 53). The market digested them surprisingly well with b k shares only underperforming slightly (b still f f ll i h banks h l d f i li h l (but ill far from their S h i September hi h ) b highs) In China and Hong Kong, management are taking advantage of the current rebound to flood the market with new shares (Chart 54)… Remember that management sell stocks mainly for 2 reasons. First when they have to in order for the company to survive (what happened in the US during the first d i th fi t 4 months of 2009) or when th would b stupid not t (lik Bl k t th f h they ld be t id t to (like Blackstone i J l 2007 Chi and H in July 2007, China d Hong K Kong at th end of 2007 and t the d f d potentially now…)
Clue6 First Quarter 2010

Equities: Liquidity
Chart 55 US Middle to Young Cohort and Equity Funds Assets Chart 56 Japanese Middle to Young Cohort and Equity Funds Assets

33

Source: ICI, Census Bureau, Clue6

Source: BOJ, Japanese National Institute of Population and Social Security Research, Clue6

The above 2 graphs are well-known for those who have been reading our research for a long-time. We believe that the long-term flows into and out of assets (the relative buying/selling urgency to be more precise as they are no money getting in or out of the market… for each buyer there is a seller and vice-versa) have a demographic cause… It affects the assets relative value and can be best seen on the secular trends in normalized valuation ratio. In the US, one should not be surprised by the net outflows from equities into bonds, this is what should happen (Chart 55) while in Japan we should see the reverse (Ch 56) h (Chart56)…

Clue6

First Quarter 2010

Equities: Liquidity
Chart 57 Most Bullish Middle to Young Cohort for the Next 5 Years Chart 58 Middle Age Population Growth Forecast

34

Source: Census Bureau, Clue6

Source: Census Bureau, Clue6

On chart 57 you can see the countries which have the most positve demographic dynamic according to the Middle to Young Cohort hypothesis… But should not only the “Middle to Young Cohort” but the absolute growth of the middle age population (Chart 58). Combining both, one see that the picture is somewhat less bullish than it seems for Japan, Spain, Poland, Portugal and Greece

Clue6

First Quarter 2010

Equities: Liquidity
Chart 59 Most Bearish Middle to Young Cohort for the Next 5 Years Chart 60 Middle Age Population Growth Forecast

35

Source: Census Bureau, Clue6

Source: Census Bureau, Clue6

On chart 59 one can see the countries with the most bearish demographic configuration according to the Middle to Young Cohort hypothesis… The middle age dynamic of those countries is presented on Chart 60…

Clue6

First Quarter 2010

Equities: Liquidity

36

Liquidity momentum has a slight tendency to lead markets, and this should be especially true given in the current environment… M2 momentum is not supportive going forward…

Clue6

First Quarter 2010

Equities: Seasonality – President Cycle and Monthly Seasonality
Chart 63

37

US Four Year Presidential Cycle (S&P 500 Total
Return since 1927)

Chart 64

US Monthly Return

(S&P 500 Total Return since 1944)

Source: Clue6

Source: Clue6

The four year Presidential cycle has been distorted by the huge fiscal and monetary stimuli of last year. The rational behind the presidential cycle theory is that public money is spend to optimize the chance of the incumbent (s) to be reelected and that is followed by some pay back for the market… The market has a tendency to perform slightly better in January (Chart 64) but in the past 10-15 years we have witnessed a good start followed by a nasty correction intra-month so…

Clue6

First Quarter 2010

Equities: Seasonality – Sell in May and …
Chart 65

38
Average Return MSCI EM Indices 1970-1998

Average Return MSCI Indices 1970-1998

Chart 66

Source: The Halloween Indicator, S. Bouman

Source: The Halloween Indicator, S. Bouman

We are now in the positive half of the year (Chart 65 and 66) and our “sell in may” seasonal quant models (where the switch is not based solely on sell may a date but we want a technical confirmation during a given time-window) are also on buy…

Clue6

First Quarter 2010

Equities: Seasonality – End of Month Anomaly
Chart 67

39

US Day of the Month (S&P 500 Total Return since
1944

Chart 68

Japan Day of the Month (Topix Total Return since 1979

Source: Clue6

Source: Clue6

The day of the month continue to exhibit its historical pattern in the US and Japan (Chart 67-68) (the same is true for most markets as showed previously)… previously)

Clue6

First Quarter 2010

Equities: Seasonality – Cycles
Chart 69

40
Chart 70 Super Cycle Economic Seasons

NYSE Composite and the 20 and 40 Weeks Cycles

Source: Clue6

Source: Bronson Capital Market Research

The next 20 weeks cycle low is expected for the middle to end of March (Chart 69). Chart 70, courtesy of B. Bronson, has been used in the past to depict the relative assets movement during the Long Cycle (Kondratiev wave). Many analysts have tried to define this cycle by applying a fixed number of years but, as we have long said, we think that this is more of a generational cycle of leveraging and deleveraging (was visible on price up to the creation of the Fed and on money velocity since then…). People who were young in the 30’s were allergic to borrowing during all their life, organizing parties to celebrate their final mortgage payment… The same is slowly happening now in the developed world (it will likely accelerate in the coming years when the weak foundation of the current upswing will become clear to all…) The Autumn Season is the harbor of the biggest bubbles (1929 and 2007) stocks valuation are rising while interest rates falls from a high level What could we 2007), level. ask for more… It is followed by the Winter where interest rates and stocks valuations become highly correlated, both falling…

Clue6

First Quarter 2010

Equities: Intermarket
Chart 71 S&P 500 and World Defensive Relative Performance Chart 72 S&P 500 and Nasdaq Composite Relative Performance

41

Source: Clue6

Source: Clue6

Defensive have been performing relatively well in the past3-4 months (Chart 71). To follow attentively in the next few weeks to see if they manage to b k out… Thi would b a negative f the market… break This ld be i for h k After having struggled, along with small caps in the past 5 months, the Nasdaq Composite has finally made a 52 weeks relative high against the broader market (Chart 72). This is positive has the market tend to be most productive when the Nasdaq relative performance trends higher along with the market as we have showed with various models in the past…

Clue6

First Quarter 2010

Equities: Intermarket
Chart 73 S&P 500 and the KBW Bank Index Relative Performance Chart 74 S&P 500 and iShares iBoxx $ High Yield Corporate Bond Fund Net Asset Value

42

Source: Clue6

Source: Clue6

Banks shares continued underperformance is worrying (Chart 73) as it is a logical consequence of our macro scenario but one could still say that they performed relatively well given the h h f d l i l ll i h huge amount of dil i they h f dilution h have to suffer i the recent past… and l ’ not f ff in h d let’s forget that they are i the h h in h portfolio of quite a lot of the smart money managers we follow so… High yield spreads are continuing to decline and junk bonds are making new price highs (Chart 74) despite the rapidly rising 10 years treasuries which is impressive…

Clue6

First Quarter 2010

Equities: Intermarket
Chart 75 S&P 500 and US 2 Years Treasury Bonds Chart 76 S&P 500 and Eurodollar Model

43

Source: Clue6

Source: Clue6

Two years treasuries have spiked higher recently (Chart 75) and this should be associated with struggling market in the current environment… The Th same i t is true f i fl ti expectation… for inflation t ti We also like to look at the relative behavior of the equity markets and the Eurodollar future. On chart 76 you can see what happen to the market when the eurodollar falls (higher rate expected) 2 days in a row and the market falls at the same time… We had an episode mid October… Another one could mark an peak of significance… One of our most effective intermarket “consolidation forecaster” which simply looks at the combined medium-term momentum of bonds and commodities is also flashing a warning signal…
Clue6 First Quarter 2010

Equities: Intermarket – US10 Years Govies against Stocks
Chart 77 S&P 500 and US 10 Years Treasury Bonds Chart 78 S&P 500 and US 10 Years Treasury Bonds

44

Blue area indicates when the momentum in 10 years government bond yield is positive. In this period, stocks performed when the momentum was negative.

Blue area indicates when the momentum in 10 years government bond yield is positive. In this period, stocks performed when the momentum was positive. p

Source: Clue6

Source: Clue6

We have long argued that one the characteristics of the current structural bear market (and we are talking US, Europe and Japan here...) was the positive correlation between stocks and government bond yields yields. But one has also to take into account the fact that while they are positively correlated, when yields have risen too much too quickly the stocks will struggle. The sequence is usually rising rate, acceleration to the upside, yield starting to fall just before stocks do it to…

Clue6

First Quarter 2010

Equities: Intermarket
Chart 79 MSCI Emerging Markets and Dollar Index Chart 80 S&P 500 and Sovereign CDS

45

Source: Clue6

Source: Bloomberg, Clue6

We already identified potential headwinds for emerging markets (Valuation, investor bullishness,…) Don’t forget to look at the USD… A rising USD has rarely been a positive for emerging markets (Chart 79)… 2010 or 2011 could be years of major sovereign negative surprises… on the next page one will find the countries to have especially an eye on… On Chart 80 you will find the usual suspects We could have put Austria in the mix suspects… mix…

Clue6

First Quarter 2010

Equities: Intermarket

46

Source: RBS

Canaries in the coal mine candidates… To observe attentively in the coming months… Candidates have been selected using the methodology of “Rules of Thumb' for Sovereign Debt Crises” by P. Manasse and N. Roubini, 2005

Clue6

First Quarter 2010

Equities: Graphs
S&P 500

47

Shoulder

Shoulder Head

The S&P 500 continues its march upward inside a well-defined up channel. We continue to see higher highs and higher lows. The inversed head & shoulders and June-July flag targets are still above us at 1200-1250 while the descending 2007-2008 channel should offer resistance at the 1100-1130 levels. A series of narrow range day has usually been a warning of an impending correction in the past 12 month… Had the first on Wednesday this week…
Clue6 First Quarter 2010

Equities: Graphs
DJ Euro Stoxx 50 E S

48

Shoulder Shoulder

Head

Europe has been slightly underperforming recently but has now managed to make new cyclical highs. The head & shoulders target is at around 3300. We would continue our strategy of selling strength (top of channel) and buying weakness (bottom of channel) until our tactical model becomes a seller… We would now move from selling upside volatilities to outright reduction of the equity exposure and even a small net short positions when reaching the top of the channel…
Clue6 First Quarter 2010

Equities: Graphs
Topix T i

49

Shoulder

Head Shoulder
Shoulder Shoulder

Head

The Topix reacted strongly by rebounding from its December oversold level… It has now formed an inversed head and shoulder with a 1000 target…

Clue6

First Quarter 2010

Equities: Graphs
MSCI A i ex-Japan Asia J

50

Asia rose strongly at the in the past 2 weeks has everything which is associated with risk… As everywhere the gain have been made on low volume… Yet one has to respect a market making a new 12 months high after having consolidated during 4 months… To be honest it smells a bull trap but…

Clue6

First Quarter 2010

Equities: Graphs
MSCI EM L i A Latin America i

51

Similar as in Asia but with less impetus…

Clue6

First Quarter 2010

Equities: Graphs
MSCI E Eastern E Europe

52

Eastern Europe still remains one of the least discounted "unavoidable accident" in the market today (it is was mostly discounted in the Eastern European markets last year but the second round effects to ward other part of the world are not…… The stronger IMF has voided the "end of their world" scenario, but… We repeat what we said last time Do not forget to pick some of the dominoes falling by contagion there are plenty of good time… contagion… things in the Czech Republic for example…
Clue6 First Quarter 2010

Equities: Conclusion

53

Valuations are now above levels where performance going forward will not please the buy & hold crowd, even if we go back to the good old days, the credit bubble stops deflating, growth reaches pre-2007 level in a sustainable manner ,.... At 1200 on the S&P 500 will be priced more expensively than all of the structural tops pre-2000 (well 1997-2000) except the final tail of the 1929 move... This does not imply that the market will fall in the short or even the medium term but that a further rise will only have speculative and no investment merit if bought. Our base assumption remains that we will f ll to significantly undervalued l l b f i i h ill fall i ifi l d l d levels before a new secular b ll market can start (i the d l d world as you l bull k (in h developed ld know we believe that we are in a secular bull market in emerging markets). This currently imply a sub-530 level on the S&P 500 going up by 5-6% a year. Option activity, insiders and most of the smart-money we follow are in a configuration where markets have struggled in the past. But even if sentiment i once again t greedy, it h t b put i th context of th recent advance and market t d (hi h hi h and hi h l ti t is i too d has to be t in the t t f the t d d k t trend (higher highs d higher lows). Thi ) This does not imply that the market can not continue to rise in the medium-term but more that it should at least consolidate in the short-term. Small investors optimism has finally started to rise and is now deep in overconfident territory… Most of the breadth divergence we noted in November and December are now gone… Uniformity remains high... On the liquidity side, inflows into US equity domestic funds remain low while the money is pouring into emerging market equity fund. This has historically been followed by underperforming EM markets… We have seen a slight pick up in buybacks but they remain very low while IPO’s and Secondaries have been plentiful with bubble reminiscent level in Hong Kong and China…Monetary aggregate momentum is turning down and this could prove to offer some headwind to risk assets… Pension funds’ funding status is deteriorating despite the rising equity markets courtesy of the rising present value of liabilities... Seasonals are supportive even if one has to remember that the equities have relatively important (>5%) correction intra-month in January, especially after strong starts…. Cycles are still supportive but the 20 weeks cycles should be topping in the very near future… Intermarket relationships have improved from the numerous divergences witnessed in November and December. The relative good performance of defensive around the world is a worry as is the fed funds futures/equities co-movement but so far so good. We are more worried about the mediumterm momentum of bonds and commodities which is in a configuration where equity market productivity has been poor historically…Sovereign CDS will continue to need your attention…

Clue6

First Quarter 2010

Equities: Conclusion

54

The trend is up almost everywhere but we are at or near the top of the new rising channel. Correction to at least the bottom of the channel expected before a potential resumption of the up move but the rest of the analysis points out to something potentially bigger than the correction we had since March…

Clue6

First Quarter 2010