Smithers & Co. Ltd.

World Market Update

1st March, 2010.
Summary.

● According to both q and CAPE, US equities are around 50% overvalued.1

However, it seems that Japan is cheap and that the world and European
markets are not much overvalued.

● We expect bank lending in the US and other G5 countries to remain

constrained. With the ending of inventory destocking, demand for credit
should rise. This combination should cause liquidity to tighten.

● It is therefore likely that corporate issues of bonds and equity issues will be
large and, in the absence of further asset purchases by the Federal Reserve,
household liquidity will continue to fall.2

● US equities will therefore tend to fall back unless liquidity preference

continues to fall. The odds seem to be against this, as profit margins are high
and nonetheless need to improve to meet expectations. Falling liquidity
preference also goes with market momentum, which gives signs of having
stalled this year.

● We prefer the Tokyo market to Wall Street. (i) It is cheaper, (ii) Japanese
companies have better profit prospects than US ones and (iii) it is much less
favoured by investors.

● We remain optimistic that the world economy will recover slowly, and
rebalance through a combination of good growth in China and other
developing economies and moderate growth in the developed world.

● We note that inflation rose to 5% in 1934 with economic recovery despite the
huge output gap. This conflicts sharply with those who believe that there is no
danger of inflation picking up sharply in the near future, should the recovery
prove robust.

● We see no reason for most investors to hold bonds.3

● We do not expect any marked change in exchange rates for the next few
months but, looking further ahead, we think that both the yen and sterling are
more likely to weaken than strengthen against the dollar.

1
New data are due on 11th March with the publication of the Flow of Funds for the year
end 2009.
2
See Charts 1 & 2 of the World Market Update for 28th January for details of recent falls
in US household liquidity.
3
See Report No. 349 “Bonds – Government and Corporate, Nominal and Real – Why
Should Anyone Hold them?” 24th November, 2009 and Report No. 353 “Why Hold Bonds (2)?”
20th January, 2010.
© 2010 Smithers & Co. Ltd.

This research is for the use of named recipients only. If you are not the intended recipient, please notify us immediately; please do not copy or
disclose its contents to any person or body, as this will be unlawful.

Information and opinions contained herein have been compiled or arrived at from sources believed to be reliable, but Smithers & Co. Ltd. does not
accept liability for any loss arising from the use hereof or make any representation as to its accuracy or completeness. Any information to which no
source has been attributed should be taken as an estimate by Smithers & Co. Ltd. This document is not to be relied upon as such or used in
substitution for the exercise of independent judgment.

Page 1 of 5 1st March, 2010.

FDIC Q4 2009.

The FDIC report for 2009 showed that the US banking industry was
continuing to shrink, with total assets falling by 5.3% over the year, which was the
largest fall in the history of the FDIC. Loans and leases have fallen for six quarters in
a row.

The quality of earnings seems poor as the coverage ratio fell to 58.1%, its
lowest level since mid-1991, i.e. during the “thrift crisis”.

Economic recovery probably requires banks to expand their balance sheets. It

is generally acknowledged that current equity ratios are woefully inadequate; large
levels of retained earnings are therefore in the public interest. But, as Table 1 below
shows, retained profits have now been negative for three years in a row. We think that
bankers are misleading themselves and their shareholders about their future capital
requirements and therefore expect large amounts of new equity issues to be required
over the next few years.4

Table 1. Data on All FDIC-Insured Institutions. $ bn.

(Source: FDIC.)

2006 2007 2008 2009

Cash dividends 93.4 110.3 51.1 47.2
Retained earnings 51.8 -10.4 -46.5 -34.6
Profits after tax 145.2 100.0 4.5 12.5
Increase in equity 129.5 99.2 -56.4 176.9
Changes in goodwill 68.8 48.3 -40.1 6.8
Apparent external equity 8.9 61.3 30.3 204.7
Total assets $ bn. 11,860 13,034 13,841 13,109
Total equity $ bn. 1,248 1,347 1,291 1,468
Total goodwill $bn. 413 462 423 428
Equity ex goodwill $ bn. 835 886 869 1,040
Equity ex goodwill as % of 7.0% 6.8% 6.3% 7.9%
assets
Coverage ratio5 137% 93% 75% 58%

Money and Growth.

Money supply is unlikely to grow, if bank balance sheets do not; so the

unwillingness of banks to expand their balance sheets may inhibit the growth of the
economy through restricting the growth of credit and money.

4
See Report No. 351 “Bank Regulation – Commercial vs Central Banks.” 11th January,
2010.
5
This is the ratio of loans on which interest has been due but unpaid for 90 days or more,
to provisions for loan losses.

© 2010 Smithers & Co. Ltd. Page 2 of 5 1st March, 2010.

 As Chart 1 illustrates, the recent recession was not preceded by any apparent
weakness in the growth of money and the sharp year-on-year decline in bank balance
sheets has not prevented GDP at constant prices being higher in Q4 2009 than a year
earlier. However, it may be that monetary growth is a necessary condition, even if not
a sufficient one, for economic expansion and that the recent weakness in the growth of
M2 should be a matter of concern.

Chart 1. US: M2 January 2007 - January 2010.

20 20

12 Months
15 15
3 Months
% change p.a.

10 10

5 5

0 0

-5 -5
Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10
Source: Federal Reserve via Ecowin.

Looking Back to 1928.

Chart 2. US: Money and GDP 1928 - 1939.

120 120
Indices of money and GDP 1928 = 100.

Money Stock
110 110
GDP at Current Prices
100 GDP at Constant Prices 100

90 90

80 80

70 70

60 60

50 50
1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939
Sources: Friedman and Schwartz (Money Stock) & NIPA (GDP).

© 2010 Smithers & Co. Ltd. Page 3 of 5 1st March, 2010.

 One reason for concern is that from 1928 to 1933 money and output fell
together, as Chart 2, shows and many commentators have since attributed the fall in
US output to this decline in the money stock.

The differences between recent events and those after 1929 are so great that
they have, so far at least, provided little guidance to recent developments. A longer
term comparison indicates, however, that growth is likely to be slow if money and
credit are constrained.6 While the exceptional nature of the recent recession means
that economic forecasts are more than usually uncertain, we think that a mild recovery
in 2010 for the US is both likely and desirable, with banks’ unwillingness to expand
their balance sheets being likely to constrain but not prevent recovery.

Chart 3. US: Inflation 1929 - 1935.

6

4 CPI Change over 12 Months

% change in CPI over 12 months.

-2

-4

-6

-8

-10

-12
1929 1930 1931 1932 1933 1934 1935
Source: Bureau of Labor Statistics (BLS).

1934 does, however, provide a warning with regard to inflation. As Chart 3

shows, consumer prices rose sharply as the economy recovered vigorously, being
5.5% higher in June than 12 months earlier, despite the fact that output was 27%
lower in 1933 than it had been in 1929. No fears of future inflation were, however,
engendered by the rise in prices, after the massive deflation that had occurred earlier.

As Chart 4 shows, inflation in recent years has followed an extremely different

path from that of the 1920s and early 1930s, being strongly positive almost all the
time. The probable existence today of a significant output gap does not therefore
ensure that inflation will not rise sharply and, if it were to do so, that inflationary
expectations would not then pick up quickly.

While the likely growth in US and world output is always hard to forecast and
this is exceptionally so today, we think that the most likely outcome is the desirable
one of a slow rather than rapid recovery in the developed world, combined with a
much more rapid pick up elsewhere.

6
See Report No. 311 “US: Slow Credit Growth – A threat to the Economy and the Stock
Market.” 17th June, 2008.

© 2010 Smithers & Co. Ltd. Page 4 of 5 1st March, 2010.

 Chrt 4. US: Inflation 2004 - 2010.

5
% change in CPI over 12 months.

-1

-2 Change in CPI over 12 Months

-3
2004 2005 2006 2007 2008 2009 2010
Source: BLS.

© 2010 Smithers & Co. Ltd.

This research is for the use of named recipients only. If you are not the intended recipient, please notify us immediately; please
do not copy or disclose its contents to any person or body, as this will be unlawful.

Information and opinions contained herein have been compiled or arrived at from sources believed to be reliable, but Smithers &
Co. Ltd. does not accept liability for any loss arising from the use hereof or make any representation as to its accuracy or
completeness. Any information to which no source has been attributed should be taken as an estimate by Smithers & Co. Ltd.
This document is not to be relied upon as such or used in substitution for the exercise of independent judgment.

© 2010 Smithers & Co. Ltd. Page 5 of 5 1st March, 2010.