World
Global Strategy
Mind Matters
Where is the consensus?
James Montier
(44) 20 7762 5872
james.montier@sgcib.com
Albert Edwards
(44) 20 7762 UUU
Albert.edwards@sgcib.com
IMPORTANT: PLEASE READ
DISCLOSURES AND DISCLAIMERS
BEGINNING ON PAGE 8
www.sgresearch.socgen.com
19 January 2008
As Keynes opined long ago “The central principle of investment is to go contrary to the
general opinion”. Of course, this requires a measure of the “general opinion”. At a
(disturbingly) well-attended client conference last week, Albert and I asked attendees to share
their views on a number of topics. We found the consensus to be more depressed than we
imagined. For instance, our respondents thought there was a 30% probability of the US going
into a depression. Unsurprisingly, they weren’t optimistic on the outlook for equities. But
government bonds were the most disliked assets, and corporate bonds the most favoured!
Q To be a contrarian requires knowledge of where the consensus currently is. More often
than not, I prefer to infer this from market prices/valuations. After all valuations and prices
aren’t tempted to tell you where they would like to be allocated, rather than actually were
they are. Just as House, the eponymous anti-hero of the US TV drama, refuses to talk to
patients because they lie, I am generally mistrustful of survey responses.
Q However, placing my general misanthropy aside, at our recent London conference Albert
and I asked clients to share their views on a number of subjects in order to gauge where the
consensus might be.
Q On the economic outlook, we found the clients to be surprisingly downbeat (and that was
before listening to us!). The vast majority thought that any economic recovery would be
delayed until 2010. This stands in marked contrast to the view expressed by the consensus
of economists who are ever hopeful of a recovery in H2 2009. Less than 10% of our
respondents shared this faith.
Q Analysts are also finally becoming more bearish (in terms of their growth forecasts). If one
excludes financials, US analysts expect over a 10% fall in EPS over the next 12 months. The
markets are generally more pessimistic still. Outside the US, the market’s implied view of
earnings declines suggests drops of around 30% (less in the US).
Q We also asked our respondents what probability they placed on the US entering a
depression in 2009 (defined as peak to trough GDP contraction of 10%). The response once
again surprised us: the average probability was 30%. It should be noted the range of
answers was wide, some going with a zero probability, others saying it was a certainty.
However, it looks as if investors are cognizant of the risks of an extremely poor economic
outturn.
Q Given this expressed caution, it isn’t surprising there are so few optimists on equities.
Only 28% of our respondents were optimistic on equities. Government bonds were the most
disliked asset class, with 58% saying they were pessimistic on the outlook for govies, 10%
optimistic. Corporate bonds were the most favoured asset, with 62% optimistic on the
outlook for this asset class – distinctly at odds with the current market pricing.
Q One final observation, the conference was exceptionally well attended, never a good sign
from a contrarian perspective. Time to short Edwards and Montier?
 Mind Matters

Where is the consensus?

As Keynes long ago opined “The central principle of investment is to go contrary to the
general opinion, on the grounds that if everyone agreed about its merit, the investment is
inevitably too dear and therefore unattractive”.

To pursue such a strategy obviously requires an understanding of the “general opinion”. From
my perspective (James), this can often be inferred via valuation – i.e. the expensive assets are
the ones where the general opinion thinks the outlook is good, and the cheap ones are the
ones where no one wants to invest.

An alternative approach is to look at surveys. Albert and I recently asked clients at our London
conference to answer three questions to assess the current state of expectations on a couple
of issues. As an aside, I have long held that well attended conferences are often a sign of the
peak of a bubble (witness the attendance numbers at tech conferences in 2000), the bad news
for Albert and I was that the conference was very well attended! Short Edwards and Montier?

Question 1: the economic outlook

I think that most clients expect H1 2009 will be tough. But after that, do you think….

1) The global economy will start recovering in the second half of 2009 (and the recovery will be
sustained), or

2) The global economy will start recovering in the second half of 2009 (and the recovery will
quickly peter out), or

3) A sustainable recovery is delayed until 2010, or

4) We are in for a multi-year economic decline, or

5) Other…

Question 1: Distribution of answers (%)

80

70

60

50

40

30

20

10

0
1 2 3 4 5

Source: SG Equity Research

2 19 January 2008
 Mind Matters

As the chart above shows, our survey of fund managers shows them to be relatively
depressed about the economic outlook. Nearly 70% don’t expect to see an economic
recovery until 2010. The next most popular answer was 15% saying that we were in for a
multi-year economic decline.

According to the Blue Chip Economic Indicator’s survey of 50 professional forecasters (surely
an oxymoron) the consensus from economists is option 1. As the New York Times reported for
the Blue Chip Survey “many professional forecasters are optimistically heading into the New
Year declaring that the worst may soon be over…the economy should bottom out and start
growing again in small steps by July”.

Of course, these guys are as good as useless at forecasting. The table below demonstrates
the classic behavioural pattern of anchoring and slow adjustment. Just cast an eye over the
way in which a return to trend growth is slowly shuffled further out into the future, quarter by
quarter.

The economists’ shuffle: US GDP growth forecasts (%)

Forecast date
May-08 Aug-08 Dec-08
Q3 08 1.7 1.2 --
Q4 08 1.8 0.7 -2.9
Q1 09 2.3 1.6 -1.1
Q2 09 2.5 2.1 0.8
Q3 09 n/a 2.5 0.9
Q4 09 n/a n/a 2.3
Source: Survey of Professional forecasters

What of the analysts? The chart below shows the expectations of bottom-up analysts as
compiled by our data guru, Rui Antunes, of the global quant team. He finds US analysts
expecting around zero growth over the next 12 months. If we exclude financials (where the
analysts are expecting a 300% bounce-back from write-offs), analysts are looking for only a
10% decline in earnings over the next 12 months.

US 12m forward EPS growth (%)

20

15

10

-5
Index
Index ex Financials
-10

-15
Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08

Source: SG Equity Research

19 January 2008 3
 Mind Matters

Corporate managements are still deluded about the outlook for their own firms. They have
become increasingly pessimistic about the outlook for the overall economy, but the
expectations gap between their thoughts on the overall economy and the outlook for their
individual firms is as wide as it has ever been!

Duke University CFO survey: How optimistic are you on… (0-100%)

80
Economy Own Firm
75

70

65

60

55

50

45

40
Q2-02

Q2-03

Q2-04

Q2-05

Q2-06

Q2-07

Q2-08
Source: SG Equity Research

Of course, everyone we meet tells us that no one believes the analysts or the managers.
Indeed a rise in the use of non-earnings (or at least cyclically adjusted earnings) measures of
valuation is already underway.

This raises the question of what is priced in by the market? As regular readers will know I use
a simple method to assess the degree of scepticism with which the market is treating analysts
views. I look at the current forward PE relative to the average past forward PE (excluding the
bubble years). The chart below shows the implied earnings decline the markets have currently
priced in. As is often the case in our valuation work, we find that Europe, the UK and Asia all
have a greater margin for error than the US.

Market implied earnings decline

US Europe UK Asia
0

-5

-10

-15

-20

-25

-30

-35

Source: SG Equity Research

4 19 January 2008
 Mind Matters

Question 2: depression risk

What do you think are the odds of a US depression (defined here as a peak to trough decline
in GDP of 10% or more)?

Mean, median and standard deviation on the probability of a US depression

30

25

20

15

10

0
Prob of Depression Median St. dev

Source: SG Equity Research

As the chart above shows our survey revealed that the average probability of a US depression
was just under 30%. The range of outcomes was exceptionally high, with some responding
with a zero probability, and others at the other extreme saying a 100%!

This struck us as surprisingly high. In other words, the likelihood of an exceptionally poor
economic outturn is seriously being factored into investors’ thinking (and perhaps actions?)
This echoes the pricing on the Intrade Depression contract 1.

When I first came across this it was showing a 10% probability of a US depression – which I
thought was relatively high. However, as the chart below shows, this was certainly not high in
the context of recent pricing! According to the latest contract pricing, there is over a 50%
probability of the US encountering a depression. Could the bad news already be out there?

1
For expiry purposes a depression is defined as a cumulative decline in GDP of more than 10.0% over
four consecutive quarters. This is calculated by adding together the published (annualized) GDP figures
(as we detail here). If these annualised figures add up to more than -10.0% over four consecutive quarters
then the contract will expire at 100. Expiry will be based on official quarterly GDP figures reported by the
U.S. Department of Commerce (Bureau of Economic Analysis, Table 1.1.1, "Percent Change From
Preceding Period in Real Gross Domestic Product") as reported by the BEA. The final quarterly GDP
figures will be used for expiry - not the advance or preliminary numbers. Any revision of the final figures
will not affect the original expiry. Negative quarters in the preceding year will count towards the total GDP
decline for expiration purposes. For example, if the total decline in GDP from Q3 2008 to Q2 2009
exceeds 10.0% then the contract will expire at 100.

19 January 2008 5
 Mind Matters

Probability of a US depression in 2009: Intrade depression contract

Source: INtrade

Question 3: asset class preference

Are you optimistic, neutral or pessimistic on equities, government bonds and corporate
bonds?

This question did manage to produce my favourite additional comment, which was someone
remarking that without a benchmark or reference rate they found it hard to know whether they
were optimistic or not! The relative performance derby is alive and well!

O
pAre optimistic, neutral or pessimistic on…
t
i 70 Optimistic
m 60 Neutral
i Pessimistic
50
s
t 40
s 30

20
o
n 10

0
t Equities Government Bonds Corporate Bonds
h
eSource: SG Equity Research

e
Optimists on the equity front were a rare breed, with only 28% of respondents saying they
liked equities. This is good news from a contrarian perspective for me in light of my remarks
towards the end of last year on the availability of deep value opportunities. In fact, investors’
stances are roughly equally distributed when it came to equities. This is the most balanced
outcome across the three asset classes under consideration.

6 19 January 2008
 Mind Matters

In contrast, lots of respondents disliked government bonds (in line with my recent Mind
Matters, 6 January 2009). Some 57% said they were pessimistic with respect to government
bonds. I am not used to people agreeing with me, and one of the more disconcerting aspects
on my expressed caution on government bonds is the number of emails I had saying they
agreed with me!

However, I take some succour from the fact that over one-third of respondents were neutral
on government bonds (even at these low yields). Slightly under 10% of the audience shared
Albert’s optimism on the prospects for government paper.

In contrast to the widespread dislike for govies, the short government/long corporate bond
strategy was popular with respondents. Some 62% said they were optimistic on the outlook
for corporate bonds – the most popular asset class by far in our survey. This is clearly at odds
with the pricing in the market which shows that corporate bonds remain at exceptionally high
spreads to government paper. Perhaps this is where investors see the biggest opportunity,
but so far there is little evidence of anyone actually following their words with actions.

BAA spread over treasuries (%)

0
Jan-25
Jan-28
Jan-31
Jan-34
Jan-37
Jan-40
Jan-43
Jan-46
Jan-49
Jan-52
Jan-55
Jan-58
Jan-61
Jan-64
Jan-67
Jan-70
Jan-73
Jan-76
Jan-79
Jan-82
Jan-85
Jan-88
Jan-91
Jan-94
Jan-97
Jan-00
Jan-03
Jan-06
Jan-09
Source: SG Equity Research

Conclusions
Both Albert and I were surprised by the downbeat nature of the response we received. It
appears as if the buy side (as represented by our survey and we must acknowledge there may
be a degree of self-selection amongst those choosing to come to a conference to hear us
speak) has a more depressed outlook than the ever-optimistic, rose-tinted view offered by the
average sell-sider.

Our survey finds few willing to buy equities at this stage despite their cheap (ex US)
valuations. Despite the downbeat views expressed most are negative on government bonds,
and have a favourable outlook for corporate bonds.

It may well be worth remembering Ben Graham’s words: “The fact that other people agree or
disagree with you makes you neither right nor wrong. You will be right if your facts and
reasoning are correct”.

19 January 2008 7
 Mind Matters

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8 19 January 2008