July 2011

With the S&P 500 Index up over 30% in relative terms over the past 12 months, one would think the world is firing on all cylinders. In contrast over the same period the supposed safe asset class Gold which is a harbour against economic, political or social fiat currency crises is also up over 30%. Historically, Gold has been non-correlated to equity market returns but this relationship has now broken down. One would have to ask why? On each side of the trade, there is a view that one is right and the other is wrong. The global stock market has been acting like a pendulum of an old grandfather clock with any positive or negative economic update moving the pendulum one way or another. Within this review, we will explain the many causes of this volatility at present and outline how we incorporate these leading economic indicators into our value investment process prior to advising our investors to allocate capital to specific opportunities with the global universe of the stock market.

Fig1 The Investment Cog

Leading Economic Indicators

Investorsmake rationaland irrationaldecisions basedonthese leadingEconomic Indicatorsinthe shortterm

DriveGlobal StockMarket Returns

The first key theme that is central to equity market volatility at present is:1. European Sovereign Debt Crisis it is not just liquidity but more about solvency of the periphery(Greece,Italy,SpainPortugalandIreland).

Last week the Greek parliament voted in favour of further austerity plans in order to receive the next instalment (12bn) from its original rescue package. The implications for the overall Euro hinge on the outcome in Greece. If Greece defaults on its debt, contagion will spread to other periphery countries like, Portugal, Spain, Italy and Ireland. Greece requires funds prior to July 15th. The financial sector would experience a Lehmans 2 type of event due to French and German banks owning a large portion of Greek short-term debt. Current accounting rules allow you hold these investments at par value on your balance sheet as it is assumed you will receive your initial capital back upon maturity. If a default was to happen, holders of these Greek bonds would be required to value to mark-to-market these assets at their true value and such take losses. Fresh capital would be required to shore up the balance sheets. Furthermore, within Greece, The Economist reported recently- assuming a 50% haircut on exposures to marketable Greek sovereign debt, four Greek banks below would wipe out shareholders and require a significantly larger bail-out to recapitalise the banks. Fig 2 Impact to Greek Banks

The European member states are working on a plan that will allow Greece restructure its debt to stave off a Greek default on its debt. The French Banking Federation (FBF) issued a proposal which outlines how investors would take losses on bonds held but would not be a default which would enable French and German banks to maintain their core Tier1 capital ratios without any further requirement for capital. This proposal (Fig 4 below) highlights that bond holders through a series of complex transactions will receive 100% of their capital and then immediately invest 70% into Greek 30 year bonds. Greece receives 50% of this and the balance will be lodged to a Special Purpose Vehicle (SPV) and guaranteed. This, in my opinion, is Collateralized Debt Vehicle (CDO) which is one of the main instruments that caused the Financial Crisis. Essentially, the ECB would be prolonging the inevitable. The S&P ratings agency dealt a blow to this proposal yesterday, saying the plan would likely put Greece in selective default. This proposal is unlikely to get off the ground but markets have responded well to the proposal due to not looking deeper in mechanics. Until European members realise this is not all about liquidity but solvency, the likelihood of breakup of the Euro is high. Fig 4 French Bank Federation rollover proposal

Now to the question of how the bailout is financed and the risks it carries.
2. EFSFFundandfinancing

In May 2010, the Euro member states created the European Financial Stability Facility (EFSF) which is able to issue bonds guaranteed by European Member States up to 440 billion for on-lending to European member states in difficulty. Greece, Portugal and Ireland have availed of this fund to date. If we were to assume that other countries on the periphery require access to this fund, the EFSF will run out of capital. In March 2011 it was agreed to increase the size of the fund to 700 billion but this will not occur until 2013 with Germany contributing a third of the increase. Germany has a lot at stake at present as its four largest trade partners are Portugal, Greece, Italy and Spain. Currently it is running a trade surplus but the consequences of these periphery countries defaulting would severely impact Germany. In conjunction with the EFSF fund, the ECB (European Central Bank) has of late used its rediscount window to put more than 350bn at risk to the periphery. Ireland for instance has received more than 180bn of ECB money through their banks or equivalent to 100 per cent of our countrys GDP. According to the IMF estimates, European banks exposure to the periphery constitutes about 10 per cent of Europes GDP and 80 per cent of European banks capital. These large rediscount operations have remained well below the public radar whilst exposing the ECB. The ECB capital cushion is no more than 10bn, so you can see it exposes the European taxpayer to considerable risk should the peripheral debt be subject to a large haircut.
3. EurozonemanufacturingGrowthat18monthlow

Growth in the Eurozones manufacturing sector lost steam in June as both exports and domestic demand slowed, falling to an 18-month low as shown in the Markit Manufacturing Purchasing Managers Index (PMI) survey. The report highlighted that the PMI index fell to 52 from 54.6 in May, its lowest reading since December 2009. A contraction is indicated with a level below 50. Italys manufacturing sector shrank for the first time in 20 months, while Spains contracted for a second month in a row. Growth in the German and French sectors slowed considerably, while the UKS manufacturing expansion fell to a 21-month low.
4. Europeanbankstresstestresultsdueinseveralweeks

An exclusive report from Reuters indicated that up to one in 6 European banks is set to fail an EU-wide financial health check. Euro zone sources said the European Banking Authority was set to announce within weeks that 10-15 of 91 banks being scrutinised had failed.
5. InterbanklendingandLiquidity

Interbank lending using European government bonds has reached record levels. Lending between banks without the backing of collateral for any loans has become limited. Last week, lending using European bonds as collateral surpassed records seen during the financial crisis in August 2007( See Fig 3 Short term repurchase lending repo volumes) as highlighted within an article by the FT on Monday. The previous daily peak was recorded in July 2007 a month before the onset of the credit crunch.

Fig 3 Short term repurchase lending repo volumes

*Source FT July 4th 2011* We can infer that lending conditions have not improved and in order to keep economic growth moving alone, liquidity plays an important role. This I believe confirms that whilst market commentaries create a market place to indicate all is well. Well looking at this graph all is not well at present.
6. U.SDebtLevels

Across the Atlantic, the U.S. has been printing money and supporting its economy through Quantitative Easing I and II. This has pushed the national debt to over $13 trillion. President Barack Obama is trying to reach a compromise with Republicans lawmakers who are seeking spending cuts before they agree to raise the nations borrowing limit, currently capped at$14.3 trillion. The treasury has said it has until August 2nd before its ability to pay the U.S debt expires. If the U.S is not successful is raising the borrowing limit, the S&P credit rating agency has indicated that it will cut the U.S credit raring to its lowest level. In the past 55 years, the debt ceiling limit has been raised 78 times, often at the last minute.
7. U.SconsumersentimentdeclinesinJune

Consumer sentiment declined in June as expectations about the economy fell, according to the Thompson Reuters / University of Michigan survey released last Friday. The consumer sentiment gauge fell to 71.5 at the end of June from 74.3 in May, The sentiment reading, which covers how consumers view their personal finances as well as business and buying conditions averaged about 87 in the year before the start of the recession. These indicators still show the rocky environment that prevails. It is also important to note that consumers make up 2/3 of the US GDP. If consumers are cautious in spending, economic growth is bound to slow.

8. Institutefor rSupplyManagement(I ISM)DATAr releasedFridayJuly1 d

The pac of growth in manufa ce h acturing picked up for the first tim in four m t me month, with an index a of natio factory activity ris onal sing to 55.3 in June from 53.5 in M The su May. urvey beat forecasts f and equ uity marke gained on the bac ets ckdrop of this. Diggi ing into th figures the key he compon nent that dr rove the gro owth in the data was build up on inventorie This com e b n es. mponent rose to 54.1 in June from 48.7 in May. e 7 We beli ieve this is in anticipat tion of an e expected pic up in ord going f ck ders forward. In order to review the ISM data, you need to graph t data to show the im d the s mpact of the ISM ex inv ventories ISM Data e Inventori ex ies). Here yo will be a to see th the New Orders ou able hat w (See below Fig 5- I less Inv ventories sp pread (Red L Line), whic leads the broader ind by 3 m ch dex months, has tumbled and the divergence between it and the IS compos is not a near recor wide lev e e SM site at rd vels. The last tim this sprea closed w back in 2010, when QEI and II were ann me ad was n nounced to prop up the econ nomy artificially. We n now do not have this economic to availabl to help ou going t e ool le ut forward We feel the short te d. erm pick u in marke will quickly abate assuming the ISM up ets t figure disappoints going for s rward. Su ustainable economic g e growth is concurrent with a consiste growth in the ISM Data coup ent M pled with a falling une employment rate with the U.S. t t This is not the curr case. rent SM x es Fig 5 IS Data ex inventorie

9. CorporateProfitsasa%ofGDPNextEarningsQuarter

Corporate profits as % of GDP is 8.3% at present. John Hussmann illustrates the use of Corporate Profits as % of GDP and shows the negative correlation between current profit growthandfurthergrowthwithinthefollowinggraphs. Graph 1 below indicates that over time the relationship between corporate profits and futuregrowthratesincorporateprofits.ThisispredictingthatCorporateProfitswillfalloff from todays levels. Graph 2 below also highlights that corporate profit as a % of GDP is currentlythesixthhighestlevelsince1947puttingitinthe98thpercentile. Graph3showsaregressionthatshowstheaverageCompoundAnnualGrowthRateintothe futuretobe0%afteraseriesoflargeperiodsofcorporateprofitgrowth. Companysearningsquarterahead; Forthesecondquarter,S&P500companiesareexpectedtopostearningsgrowthof13.7%, downfromanestimatefora19.8%gainmadelastyear.Webelieveearningsestimatesmay needtobefurtherdowngraded. Graph1

Graph2 2

3 Graph3

10. Conclusion

Leading indicators that Cedar Capital follow highlighted and continue to highlight a consistent slowdown both in Europe and U.S. We believe that the deleveraging of both personal and corporate balance sheets in conjunction with sovereign debt risks is impacting demand, consumption and investors risk appetite. As the world is consumer driven, disposable income is in short supply at present. Companies have embarked on cost cutting and laying off staff in order to become more competitive. From here, consumers will play an important role in the continued return to sustainable economic growth. Stock markets seem inherently to ignore these leading indicators to eek out further returns. Eventually something will have to give and we prefer to monitor the siutation before allocating further capital into the markets. Just today European private sector activity was weaker than forecast in June, hitting a 20-month low level with recoveries slowing in Germany and France. Over the past two months, the region has seen the sharpest slowing in growth since just after the collaspse of Lehmans in late 2008. As you can see, there are a lot of headwinds globally which can or could impact equity market returns in the short term. It is during these periods of speed bumps, I expect to gain opportunities to allocate capital. Patience and disicipline is required in order to chart our way through the pending issues ahead. Fig 6 below outlines how Cedar Capital incorporates all relevant information in order to select available opportunities. Fig 6- The Cedar Value Based approach to Investing Leading economic indicators

Investment Decision

Bottomup Stock fundamental analysis

Macro environment conclusion

Markey Physcology