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Strategic ResearchMARK O. LAPOLLA, CFA
WWW.KNIGHT.COM
FebRuARy 11, 2011404.736.2431 | [email protected]
Refer to important disclosures at the end of this document. Knight Capital Americas, L.P.
The Final Chapter of The Old Story
Nevertheless, like me in 1958, investors refused to see the ground shifting beneaththem, even though the environment was no longer what they knew and thoughtthey understood. Like me, they were walking into a trap where the responses werenot what they had anticipated. Like me, they were headed toward big surprises forwhich they had no preparation.
It has been said that good forecasters have a good sense of history. I suppose that istrue. But the best lesson from the past is to forget it before it shoves you into trouble
and remember that surprises and ruptures surely lurk ahead.Peter L. Bernstein, (1919-2009) on the Financial Crisis
To Botch A Forecast, Rely on Past Experience
The New York Times; December 30, 2007
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We believe that the credit crash of 20072008 ended a 75-year Consumer
Credit Super Cycle in the developed world, and that government policy actions
particularly in China and the United Statesand the market responses to them,
have pushed the cyclical and structural terms of global trade past their tipping
points.
Thus, we believe that the consensus global growth story is ending, and so too,
the gilded age of the Emerging Markets.
The global economy will fully enter into a generational transformationrequiring the painful maturation of the developing world, the end of
entitlements based democracy in the developed world, and the hopeful
renaissance of U.S. economic and geopolitical leadership.
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Say It Aint So
Surely the endgame is upon us. Higher commodity prices will fuel inflation and materially higher interest rates. And necessarily,
this will precipitate a collapse in the dollar and threaten the fiscal sustainability of the United States. Moreover, if prevailing
economic and financial theory are to be believed, then all these statements are true and the implications quite troubling. But,
the prevailing orthodoxy is NOT to be believed, nor the de facto conclusions which they imply.
With the presumption of a broadening economic
recovery around the world, the global financial
markets are once again focused on rising
commodity prices, the global growth story and the
present risk that economic and foreign exchange
imbalances will trigger the end game of theSovereign Debt Crisis leading to higher interest
rates, currency debasement, and the possibility of
hyper-inflation.
And such is the nearly uniform consensus around the
world. The storyline goes something like this:
Profligate developed world nationsmost
particularly the United Stateshave recklessly and
irresponsibly adhered to expansive monetary policies
and regulatory regimes to support undisciplined
fiscal spending and gross excess consumption by
the household sector.
In turn, as a matter of accounting identity, domestic
dis-savings had to be balanced by foreign savings;
namely, the purchases of Government debt
obligations by rich nations flush with trade
surpluses and excess foreign exchange reserves.
This dynamic led to an ever-widening current account
deficit which drove the exchange rate of the dollar
down and should have resulted in higher interest
rates; but in a startling divergence from economic
theory, it did not.
In his now famous speech given in April 2005, Ben
Bernanke offered an explanation for why long-term
interest rates stayed low. It wasnt excess consumption
that fueled the current account imbalance; rather,it was a global savings glutprimarily in Asia
which by extension (we are being facetious here)
forced the United States to consume more in order
to absorb the excess savings of our trading partners.
But causal clarity is not important to the story line.
What is, however, is the entrenched belief that we
are dependent upon them for economic balance
and survival.
And nothing has changed. Today, the Federal Reserve
is proceeding apace with QE2, U.S. budget deficits
ensure an ongoing ramp-up of accumulated debt,
and stock and commodity prices have skyrocketed.
Inflation is breaking out across the emerging world,
the December UK Retail Price Index of inflation (4.8%)
doubled wage growth, and German unionsciting
rising inflationare pushed for higher wages at the
European Union Summit.
Surely the endgame is upon us. Higher commodity
prices will fuel inflation and materially higher interestrates. And necessarily, wont this precipitate a collapse
in the dollar and threaten the fiscal sustainability of
the United States? And if so, wasnt the leader of
the Communist Party of China, Hu Jintao, correct
when he declared at the G20 summit this past
November, We are the masters now.?
If prevailing economic and financial theory are tobe believed, the resounding answer to all these
questions is, yes. But the prevailing orthodoxy is
NOT to be believed, nor the de facto conclusions
which they imply.
And this is the ruband the ambitious
(foolhardy?) challenge of this publication: to
present our views in a simple and approachable
form that efficiently challenges the orthodox
consensus, and at a minimum, will serve as
the foundation for spirited dialogue going
forward.
To accomplish this, we have chosen to minimize
verbiage and maximize illustrations; and on
balance, to keep the logical flow going without
succumbing to tediousand in all likelihood
unconvincing detail. Ultimately, our objective
with this publicationas with all our workis to
apply experience, common sense, and intuition to
uncover powerful investment themes obscured bythe fallacies of conventional thinking.
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The Gist
To understand reality is not the same as to know about
outward events. It is to perceive the essential nature ofthings. The best-informed man is not necessarily the wisest.
Indeed there is a danger that precisely in the multiplicity of
his knowledge he will lose sight of what is essential. But on
the other hand, knowledge of an apparently trivial detail
quite often makes it possible to see into the depth of things.
And so the wise man will seek to acquire the best possible
knowledge about events, but always without becoming
dependent upon this knowledge.
Dietrich Bonhoeffer, Lutheran Minister
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Executive Summary
It is our contention that the current levels of
unemployment are structural, and likely understatethe magnitude of dislocation across the workforce.
It was Keynes who first wrote of technological
unemployment back in the days when machine was
replacing man at a furious rate.
Today, we believe the U.S. economy is suffering
from the cumulative effect of a different type of
technological unemployment; in this case, the rapidly
diminishing value of average human capital within
a society where IP (intellectual property) is the driver
of marginal productivity and profit.As a result, labor has been steadily losing its power,
and with it, wage growth. Thus, we view the housing
boom and bust in the context of a society desperately
trying to extend lifestyle gains to a workforce desiring
to live far above what their economic value justifies.
Needless to say, this was an outcome broadly
supported and cheered by the political establishment
(who have historically retained power through theextension of benefit,) as well as the financial sector
whose power and sway upon the affairs of the world
crested at unimaginable heights.
At the same time, the world was growing fond
of the rising emerging markets; in some cases
laden with resources, in most cases laden with
inexpensive labor, and in all cases, laden with
large populations hungry for higher standards
of living. This of course implied an insatiable
demand for commodities and all the elementsnecessary for massive infrastructure development;
and ultimately, of course, explosive demand for
branded goods from the developed world.
It is our contention that the emerging market
storywhich has now blossomed into the
global growth thesishas matured and come
to its cyclical end. Moreover, we believe that the
consensus view on U.S. monetary policy and theimpact that accumulated debt, persistent budget
and trade deficits will have on interest rates,
inflation, and the dollar, is wrong.
Our view remains that stable/growing cash flow
streams denominated in U.S. dollars are the most
attractive assets in the world. We believe that
unlevered cash on cash returns will once again
become the measure of value.
By design, this publication does not delve into
tactical concerns, sector weights, or securityselection. It is our hope that by providing clarity on
pivotal macro issues, this work will be applicable
to all investors and those concerned with the
allocation of assets over the coming decade.
Listed below are some key takeaways from our
work.
B The U.S. Labor Market Is Structurally Broken
B Consumer Credit Is Dead
B The Recovery Is Just a Stabilization
B Nominal GDP Will Remain Anemic for Years
B Corporate Profitability and Main Street Economics Are Uncoupled
B Corporate Margins Will Not Revert Back to Their Long-Term Mean
B Rising Commodity Prices Are Deflationary in the Developed World
B Sustaining Inflation in the U.S. Will Not Be Possible for Years
B The Global Terms of Trade Are Past Their Tipping Point
B Monetary Policy Cannot Create Inflation
B The U.S. Current Account Deficit Is a Non-Issue
B The Fed Anchors and Controls Rates
B The U.S. Is Fiscally Sustainable
B Interest Rates Will Remain Low
B The Euro Will Survive, but the Dollar Standard Will Grow Stronger
B Nominal Is All That Really Matters
B The Global Growth Story Is Over: and China Is the Linchpin
B Food Is More Important than Oil
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For the moment the very rapidity of these changes is hurtingus and bringing difficult problems to solve. Those countries aresuffering relatively which are not in the vanguard of progress. Weare being afflicted with a new disease of which some readers maynot yet have heard the name, but of which they will hear a greatdeal in the years to come--namely, technological unemployment.This means unemployment due to our discovery of means of
economising the use of labour outrunning the pace at which wecan find new uses for labour.
John Maynard Keynes
Economic Possibilities for our Grandchildren (1930)
The Fall of Labor
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The transformation of laborand the steadily
declining EVA (economic value added) of its core
lies at the root of todays economic crises and is
the singular challenge of this generation.
Two hundred years ago, some 92 percent of
Americans worked in agriculture, 5 percent inmanufacturing, and 3 percent in the service sector
(i.e.household servants.)
By 1890 less than 100 years latermachines had
already grown to dominate the economic landscape.
But rapid industrialization into the new century
brought with it serious abuses and unacceptable
business practices which needed major reform.
And through this period, the American Federation
of Labor (A.F.L.) was the dominant organizationrepresenting unionized labor.
Founded in 1886 by Samuel Gompers, the A.F.L.
was the culmination of labors long struggle to
create a super union of all crafts. From its launch
until the early 20s, the A.F.L. had great success.
As membership grew (peaking at 5.1 million in
1920), their powerful political influence resulted in
reducing the work week, dramatically increasing
real wages, improving working rights for women
and children, and restrictive immigration policy.On a relative basis, this was labors best time. It
was the period of Upton Sinclairs The Jungle; the
nation was sympathetic, and the politicians were
falling in line. Times were good.
But unfortunately for laborthanks to the Roaring
Twenties and the attendant explosion in stock
prices and debttimes got too good; and laborlost its power. Until, that is, The Great Depression.
Immediately following the Crash, President Hoover
adopted a tough love policy based upon his belief
that a strong, dependable wage for those employed
would carry the nation through the storm. And
although less than ten percent of big corporations
actually cut wages in 1930, collapsing demand and
the crush of debt service forced smaller and weaker
companies to slash both wages and jobs; and sothe cycle of deflation accelerated. By November of
1932, it is estimated that some 33 percent of all
wage earners were unemployed. Between 1929
and 1933, labor income had declined a staggering
48 percent.
But then, Franklin D. Roosevelt emerged as the
Democratic candidate for the Presidency and
immediately won labors strong support. Rightfully
so, the nation was tired of Hoovers mantra of
rugged individualism, and devastated by his refusalto use Federal money to relieve unemployment.
Moreover, Hoovers belief that Federal support
would undermine the character of the American
worker, was all labor needed to galvanize its
support around FDR.
And with these words, spoken in April of 1938,
FDR firmly established Governments heavyhand in the free markets: Not only our future
economic soundness but the very soundness
of our democratic institutions depends on
the determination of our government to give
employment to idle men.
And with that proclamation, and as furthered
by Lyndon Johnsons Great Society pledge, the
United States plunged forward with a growing
belief that it was governments role to guaranteeprosperity.
And it is our contention, that from this base of
expectationreinforced time and again by those
governing the landmany workers in America
allowed their economic value to grow stale; even
as the world was changing and their indebtedness
grew.
So today, without the benefit of massive credit
subsidies and the elixir of rising home prices,
much of the economy and far too many of itsworkers are struggling.
And it is our contention, that from this base of expectationreinforced time and again by those governing the landmany
workers in America allowed their economic value to grow stale; even as the world was changing and their indebtedness grew.
So today, without the benefit of massive credit subsidies and the elixir of rising home prices, both the economy and far too
many of its workers are struggling.
Prosperity Cannot Be Guaranteed
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Productivity Explosion: Exponential Output Growth and Steady Labor Decline
y = 50e0.6931x
R = 1
y = -33x + 133R = 1
0
100
200
300
400
500
600
700
800
900
1950 1980 2010
US Manufacturing Output Growth vs.Manufacturing Labor Decline 1950-2010
"US Manufacturing Output (1950=100) "US Manufacturing Workers (1950=100)
Expon. ("US Manufacturing Output (1950=100)) Linear ("US Manufacturing Workers (1950=100))
Source: Federal Reserve, Bureau of Labor Statistics, KSR
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X Marks the Spot
5%
10%
15%
20%
25%
30%
35%
40%
40%
45%
50%
55%
60%
65%
70%
1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
Non-Farm Payroll Components as Percent of Total Non-Farm Payroll
Private Service as Percent of Total (LS) Govt as Percent of Total (RS)
Manufacturing as Percent of Total (RS)
Source: Bureau of Labor Statistics, KSR
Despite perceptions to the contrary, by output, the United States is still the leading
manufacturer in the world. By value-added, the gap is 3X China. Yet, as shown below,the government employs twice as many people as manufacturers.
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In times of heavy leverage and deflationary pressure;NOMINAL dollars are everything.
Reflects services growing to 70% of the employedlabor base.
This divergence between government and privatesector payroll growth is a VERY big deal.
Despite the housing boomor perhaps because ofit, transfer payments grew twice as fast as personalincome.
As Manufacturing Intensity Declined, So Did Wage and Output Growth
-6.37%
-350%
-300%
-250%
-200%
-150%
-100%
-50%
0%
50%
100%
19 52 195 7 1 962 19 67 19 72 197 7 1 982 19 87 199 2 1 99 7 2 002 20 07
Acceleration (second derivative) in Household Debt
US Recession Household Debt YoY % Change
Source:Federal Reserve,KSR
10-Year Payroll Growth
-10%
0%
10%
20%
30%
40%
50%
60%
1959 1962 1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010
US Employees on Nonfarm Payrolls Total SA 120-Month % Change
US Employees On Nonfarm Payrolls Total Government SA 120-Month % Change
US Employees on Nonfarm Payrolls Total Private SA 120-Month % Change
Source:Bure au of LaborStatistics, KSR
100
120
140
160
180
200
220
240
J an- 99 J an- 00 J an- 01 J an- 02 J an- 03 J an- 04 J an- 0 5 J an -0 6 J an -0 7 J an -0 8 J an -0 9 J an -1 0
US Personal Income versus Transfer PaymentsSAAR (Indexed 100=1-31-1999)
US Personal Income SAAR Indexed 100=1-31-1999
Personal Income Transfer Payments to Persons SA Indexed 100=1-31-19 99
Source: Bureau of Economic Analysis, KSR
-4 Stdev
-3 Stdev
-2 Stdev
-1 Stdev
Median
+1 Stdev
+2 Stdev
+3 Stdev
+4 Stdev
-9.00%
-4.00%
1.00%
6.00%
11.00%
16.00%
1 94 9 1 95 4 1 95 9 1 96 4 1 96 9 1 97 4 1 97 9 1 98 4 1 98 9 1 99 4 1 99 9 2 00 4 2 00 9
US Nominal GDP Per Capita YoY % Change
Source: Bloomberg, KSR
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As IP has followed Moores law, innovative
competition has pushed most workers EVA below
their compensation costs.
This, in conjunction with rising benefit and regulatory
expense, has kept wage growth anemic and job
insecurity high. Thus, credit has been the necessary
lifeblood to keep most workers lifestyles moving
higher.
For the past twenty years, the global economy
has been rapidly bifurcating between Intellectual
Property (IP) and Scale.
Commonly known as the global labor arbitrage,
Ricardos theory of comparative advantage has been
playing out in dramatic fashion.
COMPENSATION
LIFESTYLE /CREDIT SQUEEZE
WEALTH WEALTH
IP SCALERICARDIAN ADVANTAGE
ACCELERATING ECONOMIC
BIFURCATION
LABOR DENSITY
ECONOMIC VALUE ADD
COMPETITION
Source: Knight Strategic Research
The Global Economy Has Rapidly Bifurcated Between IP and Scale
POLITICAL PRESSURE
WEALTH WEALTH
IP SCALERICARDIAN ADVANTAGE
INNOVATION
ACCELERATING ECONOMIC
BIFURCATION
LABOR DENSITY
ECONOMIC VALUE ADD
Source: Knight Strategic Research
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IP Versus Scale
The disparity of wealth and income is easily
understood from this chart. IP is accelerating at the
highest levels, while debt deflation is crushing the
vast majority of workers down the chain.
So too, those who own Scale production are the
robber barons of this day, but rising input costs have
triggered a wage-price spiral that will likely end their
era of exponential growth.
So as wage pressures and the modern form of Keynes
technological unemployment have accelerated,
aggregate nominal earnings and demand have been
falling in the IP world.
Conversely, demand for low-cost manufacturing
and assembly to feed this disinflationary trend
has accelerated. This has markedly increased wage
pressures in the Scale world.
LABOR DENSITY
ECONOMIC VALUE ADD
COMPENSATION
WAGE PRESSURE
IP & MATURE CREDIT = DEFLATION RISK
SCALE & ACCELERATING CREDIT = INFLATION
RISING DEMAND
WEALTH
IP SCALERICARDIAN ADVANTAGE
WAGE PRESSURE
FALLING DEMAND
WEALTH
.
Source: Knight Strategic Research
LABOR DENSITY
ECONOMIC VALUE ADD
COMPENSATION
IP & MATURE CREDIT = DEFLATION RISK
SCALE & ACCELERATING CREDIT = INFLATION
DEFLATION
INFLATION
DISINFLATION
WEALTH
IP SCALERICARDIAN ADVANTAGE
COMMODITIESTECHNOLOGY
WEALTH
.
Source: Knight Strategic Research
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The Necessary Rise of Credit
Keeping up with the Joneses. The phrase was popularized when a comicstrip of the same name was created bycartoonist Arthur R. "Pop" Momandwhich first appeared in The New YorkWorld in 1916.
It offered a sad parody of abjectconsumerism; the title of which, is stilla widely used colloquial expression forneedless consumption.
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And as financial innovation and capital formation accelerated, the competitive dynamics and speed of commerce intensified.
Moreover, the development of technology and transportation systems unleashed an enormous productivity wave and the now
fabled Ricardo global labor arbitrage. But no matter. The aggressive subsidization of mortgage credit and home ownership, and
all forms of seductive consumer lending, bridged the gap between labors falling economic value add and its desire for an ever
increasing standard of living.
Since our founding, the United States has been
generally committed to the pursuit of two seemingly
opposite agendas: free-market capitalism and social
welfare. Without the benefit of experience, planning,
or continuity, the course of economic developmentwas charted by politicians, bureaucrats, and the
rising influence of special interests. Money was
the lubricant for the inherently sordid affair; as power
desired wealth, and wealth desired power.
Naturally, avaricious political promises often collided
with prudence and reality; thus, forward progress
required ever-increasing indebtedness. Our nation
moved forwardeven through the Great Depres-
sionbut with each economic cycle, government
intervention and social assistance grew more impor-tant, and so did our dependence upon debt.
So, after the devastating inflation of the 1970s, the
US Government and all its monetary and regulatory
authorities, committed to leveraging the American
dream of homeownership to launch the greatest
consumer credit boom in history.
With an economy duly tied to credit growth and
politicians duly tied to the extension of social benefit,
it shouldnt be surprising that housing became theUniversal Good.
Although our financial markets were always
forward leaning, it wasnt until the end of The
Great Inflation and the Volker era that the
democratization of capital exploded full force. The
stage was set with the signing of the EmploymentRetirement Income Security Act of 1974 (ERISA)
and the subsequent control of pension portfolios
by consultants; the explosion of mutual funds and
defined contribution retirement plans; the Interstate
Banking and Branch Efficiency Act of 1994, and
the 1999 repeal of the Glass-Steagall Act of 1934;
and of course, the nearly 20-year reign of laissez-
faire capitalism under Ayn Rand devotee, Federal
Reserve Chairman Alan Greenspan.
It was these factors that fueled an unprecedentedexplosion in financial innovation, but it was the
politically-mandated expansion of home ownership
which laid the foundation and drove the trend.
Under the auspices of the US Department of Housing
& Urban Development (HUD) and as executed by the
quasi-governmental Fannie Mae and Freddie Mac,
politicians transferred wealth to the private sector,
whileas we now knowirresponsibly allowing the
socialization of risk.
Culturally, we made a wholesale shift from debt aversion
to credit dependency; and from saving to consumption.
From a societal perspective, we progressed from Hey
Buddy, can you spare a dime?to Hey Buddy, do you
want to borrow a dime?from A chicken in every pot
to A home for every household.This virtuous cycle of rising asset values and expanding
leverage fostered an unprecedented period of capital
gains and economic expansion.
And as financial innovation and capital formation
accelerated, the competitive dynamics and speed of
commerce intensified. Moreover, the development
of technology and transportation systems unleashed
an enormous productivity wave and the now fabled
Ricardo global labor arbitrage.
As a result, labor lost its power rather quickly, and
the earnings gap between those who produced
and those who supported began to widen
dramatically; and metaphorically, having previously
sold their inheritance for free health care coverage,
rising benefits costs soon eclipsed wage gains.
But, no matter. The aggressive subsidization of
mortgage credit and home ownership, and all forms
of seductive consumer lending, bridged the gap
between labors falling economic value add and itsdesire for an ever increasing standard of living.
A Home for Every Household
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Debt Growth Plateaued After the Baby Boom
3%
5%
7%
9%
11%
13%
1946 1951 1956 1961 1966 1971 1976
US Consumer Credit Outstandingas a % of Nominal GDP (1946-1980)
Source: Federal Reserve, Bureau of Economic Analysis, KSR
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Productivity Growth and Declining EVA Caught Up With Labor
0%
2%
4%
6%
8%
10%
12%
14%
16%
40%
42%
44%
46%
48%
50%
52%
54%
56%
1949 1954 1959 1964 1969 1974 1979 1984 1989 1994 1999 2004 2009
Nominal Wage & Salary and Corporate Profitsas a % of Congressional Budget Potential Nominal GDP
Wage & Salary From The GDP Report US Nominal Dollars SAAR / Congressional Budget Office PotentialNominal GDPUS Corp Profits With IVA Total SA / Congressional Budget Office Potential Nominal GDP (RS)
Source: Bureau of Economic Analysis, #N/A N/A, KSRKSR
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DECLINING MANUFACTURING RISING IP
THE CONSUMPTION BUBBLE
CONSUMER CREDIT / LEVERAGE
EVA
WAGES
LIFESTYLE
Source: Knight Strategic Research
Massive Amounts of Credit Was Needed to Facilitate Lifestyle Growth
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The Housing Bubble Marked the End of a 75-year Credit Super Cycle
Asset price boom
Stronger
Balance sheets
Target leverage
Increase
B/S size
Source: Federal Reserve Bank of New York
The pro-cyclicality of the credit cycle was immenselypowerful. As leverage increased and balancesheets grew larger, direct flows into assets droveprices higher. This in turn, strengthened creditorsand induced more lending.
When mega cycles end, they are usually thecompletion of many convergent trends. In the caseof the housing boom, it capped the transition fromthe totally debt averse post-Depression cultureto the credit dependent sense of entitlement sovisible at the peak.
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And no one cared until they had to.
Hall of Fame Metrics
Deregulation and gross regulatory failure facilitatedthe disintermediation of the banking system.
The Most Pronounced Debt Cycle Ever
YoY % Change in Household Credit Growth
2.24
0.8
0.45
1.7
2.6
1.75
5.5
0
1
2
3
4
5
6
2 Q5 8 - 1Q60 1 Q6 1 - 3Q69 4 Q7 0 - 3Q73 1 Q7 5 - 4Q79 4 Q8 2 - 2Q90 1 Q9 1 - 4Q00 4 Q0 1 - Cu rren t
AnnualPercentageChange
Source:FederalReserve,Bloomberg,KSR
-1,000,000
-500,000
0
500,000
1,000,000
1,500,000
2,000,000
2,500,000
3,000,000
1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008
Commercial Banks versus Shadow BankingCredit Creation (Billion $ SAAR)
Shadow Banking Credit Creation Commercial Bank Credit Creation
Source:Federal Reserve,KSR
-1,500
-500
500
1,500
2,500
3,500
4,500
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09
$Billions
Debt Intensity of US Economy(Annual Debt Growth / GDP Growth)
US Total Domestic Debt YoY Change GDP US Nominal Dollars SAAR YoY Change
Source:Federal Reserve,Bureau of Economic Analysis, KSR
20%
25%
30%
35%
40%
45%
50%
55%
60%
65%
1978 1981 1984 1987 1990 1993 1996 1999 2002 2005
Total Consumer Debt Including
Mortgages Relative to Personal Income
Source: Bloomberg, KSR
2007
The prevailing belief was that home prices couldntfall.
And whats worse, job creation during the boomwas the weakest of any modern expansion.
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Certainly the origination machine believed in thespeculative value of residential real estate.
As shown here, the cost of capital actually
fellmateriallyin relation to the rate of priceacceleration in local markets.
Wow.
So lets be honest: who really thought aboutanything other than how much house they could
buy?
Both House Prices and the Allocation of Credit Were Unhinged from Reality
PEAK HOME VALUE CALCULUS
EQUIVALENT RENT
+
TAX BENEFITS
-
PROPERTY TAXES
+
PROXIMITY PREMIUM (Jobs, Schools, Community, Climate)-
COST OF CAPITAL (Required Equity + API)
+
SPECULATIVE PREMIUM
Source: Knight Strategic Research
PERVERSE SELECTION
HOUSE PRICE APPRECIATION
MO
RTGAGERATES
5% 30%
6%
10% 15% 20% 25%
3%
4%
5%
Source: Knight Strategic Research
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We calculated this ratio by applying the average amount of leverage in the housing
market (Fed data, adjusted for the multi-decade 30% of homeowners with nomortgage), the Case-Shiller 20-market index, and the 5-yr treasury bond yield as the
risk-free rate.
How Can There Be Any Risk When Prices Never Fall?
-4
-2
0
2
4
6
8
10
12
14
Dec-94 Apr-96 Aug-97 Dec-98 Apr-00 Aug-01 Dec-02 Apr-04 Aug-05 Dec-06 Apr-08 Aug-09
Sharpe Ratio for Residential Real Estate
Source: Blooomberg; Case-Shiller; Federal Reserve, KSRSource: Bloomberg, Case-Shiller, Federal Reserve, KSR
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Mortgage equity withdrawals (MEW) playedan enormous role in fueling consumption from
20032007.
Remember the Bank of America ads? I bet youdidnt know your home was your own personal
ATM!
Incredible.
By 1998, households were liquidating financialassets in earnesteven as their savings rate
diminished.
Asset Rich and Cash Poor
-4%
-2%
0%
2%
4%
6%
-400
-300
-200
-100
0
100
200
300
400
500
600
1 99 5-Q2 1 99 6-Q4 1 99 8-Q2 1 99 9-Q4 2 00 1-Q2 2 00 2-Q4 2 00 4-Q2 2 00 5-Q4 2 00 7-Q2 2 00 8-Q4
PCE Quarterly Change vs. Quarterly MEW and
MEW as a Percent of Nominal GDP
Quarterly Change PCE $ Bil lions SAAR MEW Annuali zed $ Bill ioins
MEW as Percentage of Nominal GDP (RS)Source: Bureau of Economic Analysis, Federal Reserve, Bloomberg, KSR
-15
-10
-5
0
5
10
15
-15%
-10%
-5%
0%
5%
10%
15%
20%
1 96 9 1 97 2 1 97 5 1 97 8 1 98 1 1 98 4 1 98 7 1 99 0 1 99 3 1 99 6 1 99 9 2 00 2 2 00 5 2 00 8
Net financial investment /
Personal Income vs. Personal Savings Rate
Net financial investment / Disposable Personal Income
US Personal Saving as a % of Disposable Income (RS)
Source: Federal Reserve, KSR
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A sound banker, alas, is not one who foresees danger and avoidsit, but one who, when he is ruined, is ruined in a conventionaland orthodox way along with his fellows, so that no one canreally blame him.
John Maynard Keynes
The Consequences to the Banks of the Collapse of Money Values
(1931)
The Crash
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As with most every asset market; volume follows
price. However, as seen in 2010, price did notfollow spiking volumes. And why would it? A very
large part of the transactions were foreclosureliquidations.
What we find most amazing, is how the most
sophisticated financial analysts around the worldfailed to account for the inevitable reversion
of HPA (house price appreciation) in their riskmodels.
But then again, the OFHEO told us in 2002 thatHPA was not part of their risk models because
the price series isnt volatile enough and nevergoes negative. Really?
500
700
900
1,100
1,300
1,500
1,700
3.5
4.0
4.5
5.0
5.5
6.0
6.5
7.0
7.5
Jan-00 Nov-00 Sep-01 Jul-02 May-03 Mar-04 Jan-05 Nov-05 Sep-06 Jul-07 May-08 Mar-09 Jan-10 Nov-10
$Billions
SAAR
Home Sales vs. Transaction Dollar Volume
US Existing Homes Sales Millions SAAR Existing Home Sales Transaction Value (Sales * Median Price) (RS)
Source: National Assoc. of Realtors, KSR
Q2 2006
Q4 2008
Q4 2009
Q2 2010 Q3 2010
Q4 2010
$0
$50,000
$100,000
$150,000
$200,000
$250,000
$300,000
0 50 100 150 200 250 300 350 400 450 500
Existin
gOneFamilyHomeSalesAveragePrice
Diaposable Income / 10-Treasury
Over Valued Homes
Source: National Assoc. of Realtors, Federal Reserve, Bureau of Economic Analysis, Bloomberg, KSR
The Failure to Incorporate Stress Tests for HPA in Risk Models Set Up the Crash
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Now thats deceleration; kind of like a test car
hitting a wall.
The rise in delinquencies across the consumer
credit markets has been unprecedented. But suchare the conditions when 75% of the debt is tied
to deflating collateral.
Moreover, with the now ingrained sense of
what we will call debt entitlement, as well asthe credit markets eagerness to bring bankrupt
households back into the fold, delinquency,default, and foreclosure, dont carry the same
penalty or societal stigma as they used to.
Delinquencies As % Of Total Loans
3.5
4.0
4.5
5.0
5.5
6.0
6.5
7.0
7.5
8.0
8.5
9.0
9.5
10.0
Mar-79 Mar-83 Mar-87 Mar-91 Mar-95 Mar-99 Mar-03 Mar-07
Source: Mortgage Bankers Association
-6.37%
-350%
-300%
-250%
-200%
-150%
-100%
-50%
0%
50%
100%
1952 1957 1962 1967 1972 1977 1982 1987 1992 1997 2002 2007
Acceleration (second derivative) in Household Debt
US Recession Household Debt YoY % Change
Source: Federal Reserve, KSR
The Magnitude of this Shock Has Definitely Increased the Propensity to Save
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Were it not for massive government interventionand regulatory forbearance, there is no questionin our minds that the credit crash would have
resulted in a global depression.
As shown, the deleveraging cycle is as reflexiveand procyclical as its twin.
Federal Reserve Disintermediation
Credit Created By Shadow Banking System (Trillions $ SAAR)
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
3.0
1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008
Source: Federal Reserve, KSR
Reflexivity Works Both Ways; Aggressive Policy Action Prevented a Depression
Asset price decline
Weaker
Balance sheets
Target leverage
ReduceB/S size
Source: Federal Reserve Bank of New York
The ugly unwind works the same way as theexpansion did; only in reverse. Weaker balance
sheets force deleveraging which cuts off the flowof capital supporting asset values. In turn, this
makes smaller, more conservative balance sheetsweaker still, which drives further deleveraging.
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The Crash Exposed a Labor Market That Was Already Broken
Similarly, the duration of unemployment has beenon the rise for the past several decades.
The crash in nominal GDP accelerated the
elimination of excess capacity and the maturationof web-based IP services, systems, and processes
has massively increased business productivity.
The collapse of the credit market slammednominal economic activity. And nominal is what
matters in a deflating economy.
Thus, even as the IP vs. Scale dynamic was
permanently eliminating a rising percentageof jobs, the blow to marginal consumption and
intensifying competition has accelerated what iscommonly called creative destruction.
6
11
16
21
26
31
36
41
1949 1954 1959 1964 1969 1974 1979 1984 1989 1994 1999 2004 2009
US Unemployment Duration Average Num Weeks SA
US Recession US Unemployment Durat ion Average Number of Weeks SA
Source: NBER, Bureau of Labor Statistics, KSR
21%
26%
31%
36%
41%
46%
51%
56%
1 96 7 1 97 0 1 97 3 1 97 6 1 97 9 1 98 2 1 98 5 1 98 8 1 99 1 1 99 4 1 99 7 2 00 0 2 00 3 2 00 6 2 00 9
Permanent Job Loss as Pct of Total Unemployment
Source: Bureau of Labor Statistics, KSR
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Markets are amazing. They will just move from one game to the next regardless of the
underlying thesis. But then again, the incentive structures around the world guaranteeit.
But Amidst the Crash, Wall Street Invented De-Coupling
80
90
100
110
120
130
140
150
2-Jul 24-Jul 15-Aug 6-Sep 28-Sep 20-Oct 11-Nov 3-Dec 25-Dec 16-Jan 7-Feb 29-Feb 22-Mar
MSCI BRIC, GSCI Commodity TR, SPX, FTSE 100Indexed 100=7-2-2007
MSCI BRIC Indexed 100=7-2-2007
S&P GSCI Enhanced Commodity (Total Return) Indexed 100=7-2-2007
S&P 500 INDEX Indexed 100=7-2-2007
FTSE EUROTOP 100 INDEX Indexed 100=7-2-2007
Source: Bloomberg, Goldman Sachs Commodity Index, KSR
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And although some seemed to understand that
within a deflating economy, increases in moneyspent on non-discretionary items directly reducedthe funds available for discretionary use; the
world was focused on the inflationary impacts of$100/bbl oil. Amazing.
Rule of Thumb: 10% $/bbl oil 2.5% GDP
In 2008, we were among the few who warned
that: 1. The commodity markets were beingoverrun by speculators, and 2. That risingcommodity prices were not inflationarybut
would actually accelerate deflation in the cash-strapped developed world.
Thus, we warned that every .01/gal increase ingasoline was the equivalent of a $1.5b (annualized)
tax to consumption.
The De-coupling Fueled a Commodity Boom... and Deflation
10
30
50
70
90
110
130
-3.0
-1.0
1.0
3.0
5.0
7.0
Mar-91 Nov-92 Jul-94 Mar-96 Nov-97 Jul-99 Mar-01 Nov-02 Jul-04 Mar-06 Nov-07 Jul-09
US GDP Nominal Dollars YoY %
versus Crude Oil (Inverted)
US GDP Nominal Dollars YoY SA WTI CRUDE FUTURE (RS Inverted $/bbl)
Source: Bureau of Economic Analysis, New York Mercantile Exchange, KSR
-250
-200
-150
-100
-50
0
50
100
150
200
250
$1.50
$1.75
$2.00
$2.25
$2.50
$2.75
$3.00
$3.25
$3.50
$3.75
$4.00
$4.25
Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10
AnnualizedBillions$ofConsumerSpending
GasPricePerGallon
Impact of Gas Price Change on Consumer Spending
(Billions $ Annualized)
Consumer Spending Hit when above $2.75 (RS) Daily National Avg $/ Gal Unleaded
Cumulative Consumer Spending Hit (RS)
Source: American Automobile Associatio, Federal Highway Administration, KSR
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And the Fear Was Inflation
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
4.5%
5.0%
Jan-02 Aug-02 Mar-03 Oct-03 May-04 Dec-04 Jul-05 Feb-06 Sep-06 Apr-07 Nov-07 Jun-08 Jan-09 Aug-09
Global Aggregates Core InflationYoY % Change
Core Inflation World Core Inflation Industrial Economies
Core Inflation Emerging Economies
Source: IMF Publ ications, KSR
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The more I see, the more I find reason for those who love thiscountry to weep over its blindness. The inquiry constantly is whatwill please, not what will benefit the people. In such a governmentthere can be nothing but temporary expedient, fickleness, andfolly.
Alexander Hamilton
All the Kings Horses andAll the Kings Men
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We will keep making the point. NOMINAL is what matters in a deflating/deleveraging
economy. Debt is a cruel taskmaster; it requires what it requiresregardless of assetprice and monetary velocity deltas.
The Government Faced an Unprecedented Post-War Collapse in Nominal GDP
-150
-100
-50
0
50
100
150
200
250
-500
-300
-100
100
300
500
700
900
19 51 1 95 5 19 59 1 96 3 19 67 1 97 1 19 75 1 97 9 19 83 1 98 7 19 91 1 99 5 19 99 2 00 3 20 07
YoY Chg Consumer Credit vs. YoY Chg Nominal GDP
YoY Chg Nominal GDP ($ Billion) YoY Nominal Chg Consumer Credit (RS $ Billions)
Source: Bureau of Economic Analysis, Federal Reserve, KSR
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Although most agree with our positionnamely that the multiplier of fiscal spending is
at best 1X; in our minds the spending was absolutely necessary to help forestall a completecollapse in confidence. The debate on how it was spent is another matter entirely.
So the Legislative Branch Blew Out the Budget and Spent
-3,000
-2,000
-1,000
0
1,000
2,000
3,000
4,000
5,000
6,000
-3,000
-2,000
-1,000
0
1,000
2,000
3,000
4,000
5,000
6,000
Mar-05 Aug-05 Jan-06 Jun-06 Nov-06 Apr-07 Sep-07 Feb-08 Jul-08 Dec-08 May-09 Oct-09 Mar-10 Aug-10
Borrowing by Sector (Billions SAAR)
Non-Financial Domestic Private Sector Financial Sector
Total Federal & Local Govt Total Domestic + Financial Sector (RS)
Source: Federal Reserve, KSR
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The Collapse in Both Stocks and Home Prices Crushed Household Net Worth
-30%
-20%
-10%
0%
10%
20%
30%
40%
50%
60%
1954 1958 1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006
Nominal US Household Net Worth12-Quarter % Change
Source: Federal Reserve, KSR
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The simple story is that the Fed stood underneath the collapsing shadow banking
system and caught the junk so the banks could recapitalize by milking the steep yieldcurve. Then, the Fed bought up the mortgage market to accelerate deleveraging and
to lower rates to stimulate refis and encourage origination.
-2,500
-2,000
-1,500
-1,000
-500
0
500
1,000
1,500
2,000
2,500
Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10
$
Billions
Fed Balance Sheet
Treasury Securities Held Fed Agency Securities Held MBS HeldEmergency Facilities & Other Assets Currency in Circulation Balances with Reserve Banks
All Other LiabilitiesSource: Federal Reserve, , KSR
Extraordinary Balance
Sheet Growth
Extraordinary Reserve
Growth
Treasury Holdings
Now Just Above
Normal
The Fed Became the Lymph Node of the Credit System; Then It Was Mortgage Time
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Credit creation requires collateral; it cannot beextended substantively without it. And since
75+% of consumer credit balances are residentialmortgages, we see reignition of the credit
machine as impossible.
The game is over. The speculative premium isgone, and now the market is returning to a
sustainable model for home prices.
And the foundation, community level cash flows,
is nothing more or less than the proximity toincome. Its all about the prospect of jobs and
economic vitality .
The Housing Market Is Structurally Broken; and Therefore, So Is Credit Creation
SUSTAINABLE HOME PRICE MODEL
COMMUNITY LEVEL
SUSTAINABLE CASH FLOWS
LOCATION PREMIUM -(PROPERTY TAXES)
COST OF
CAPITAL
EQUIV.
RENT
TAX INCENTIVESTAX INCENTIVES
Source: Knight Strategic Research
LENDER BORROWER
SHOW ME THE COLLATERAL!
COLLATERAL
DEBT SERVICE
EQUITY
Source: Knight Strategic Research
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1/31/2011
0
5
10
15
20
25
30
35
40
0 1 2 3 4 5 6 7 8 9 10 11 12
AvgDurationofUneploymentNumberofWeeks
Unemployment Rate (%)
Unemployment Rate (%) vsDuration of Unemployment Number of Weeks SA
1948 to Nov 2007 Dec 2007 -P resent Linear (1948 to Nov 2007)
Source: Bureau of Labor Statistics, KSR
Financial System Stability but No Improvements In Employment
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Now this chart is REAL. It doesnt depict a theory.There is a certain rate of job creationcurrently
somewhere around 140,000/monththat isneeded to satisfy population growth.
But as most are aware, shockingly weak jobgrowth isnt new. The last recession was also the
weakest in history.
The concept of NAIRU (the rate of unemploymentbelow which inflation would accelerate) is really
a theoretical compromise since the data neversupported the natural rate of full employment
concept. Lets just say, we dont buy ANY of it.
Economists regress past data with the assumption
that all environments trend toward someamorphous state of equilibrium, and then they
call it a theory. Unfortunately, their theories dontaccount for changes in the underlying structural
conditions.
So the Fed Reinforced Its Politically Inspired Dual-Mandate
125
130
135
140
145
150
J an -0 5 Nov-0 5 Sep -0 6 J ul-0 7 M ay-0 8 M ar -0 9 J an -1 0 Nov-1 0 Sep -1 1 J ul-1 2 M ay-1 3
Millions
Full Employment Gap
US Nonfarm Payrolls Total SA
Source: Bureau of Labor Statistics, KSR
11,000,000 JOBS SHORTOFMATCHINGPOPULATION GROWTH
:// . . / / / / / / - - - . / x- - - - . . / / : :
Source: Knight Strategic Research
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Source: Ahead of the Curve by Joseph H. Ellis, KSR
So Without Credit Growth and No Job Creation, What Lever Could the Fed Pull?
No collateral, no cash
flow, no credit.
Note to Self:
Inflation? Really???
IP vs. Scale andmassive slack
IP needs smartNOT numbers.
And the winner is?
The stock market.
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No matter how often we look at this chart, we arestunnedbut not surprisedat the condition of
the job market.
And some would like to argue that highunemployment rates and duration arent
structural?
Small business operators are facing the mostchallengingand potentially rewardingtime in
modern history. With the nominal demand andcredit likely to remain weak, and with technology
continuing to accelerate, this is the time to takeshare or die.
Rising Stock Prices Havent Inspired Small Business and It Creates the Jobs
01/31/2011
-7%
-6%
-5%
-4%
-3%
-2%
-1%
0%
1%
(28)(26)(24)(22) (20)(18)(16)(14) (12) (10) (8) (6) (4) (2) 0 2 4 6 8 10 12 14 16 18 20 22
Non-FarmP
ayrollasaPercentofPeakNFP
Number of Months Before to After Maximum Job Loss
US Jobs Lost and Months to Recover Peak
Aligned at Maximum Loss
1948
23
1953
24
1957
25
1960
21
1970
19
1974
20
1980
11
1981
29
1990
33
2001
49
2007
31
Source: Bureau of Labor Statistics, KSR
5
10
15
20
25
30
35
4080
85
90
95
100
105
110
1983 1986 1989 1992 1995 1998 2001 2004 2007 2010
NFIB Optimism Index vs.
Average Duration of Unemployment(Inverted Lagged 16-Months RS)
NFIB Small Business Optimism Index Unemployment Duration Avg Weeks Lagged 16-Months Inverted (RS)
Source: Nat'l Fed. of Ind. Business, Bureau of Labor Statistics, KSR
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Income Expectations Are Shockingly Weak So Deleveraging Continues
Love does make the
world go round....
but VAR and FICO hold
it together Son
-17
-12
-7
-2
3
8
13
18
23
28
1 98 0 1 98 2 1 98 4 1 98 6 1 98 8 1 99 0 1 99 2 1 99 4 1 99 6 1 99 8 2 00 0 2 00 2 2 00 4 2 00 6 2 00 8 2 01 0
6 Month Forward Consumer Expectations:Spread between Higher Income - Lower Income
Source: Conference Board, KSR
-12%
-8%
-4%
0%
4%
8%
12%
16%
20%
24%
Jan-90 Sep-91 May-93 Jan-95 Sep-96 May-98 Jan-00 Sep-01 May-03 Jan-05 Sep-06 May-08 Jan-10
Revolving Consumer Credit YoY % Change
Source: Federal Reserve, KSR
One thing IS certain; ongoing deleveraging
is consistent with income expectations andunemployment trends.
This chart truly reflects deep seated
pessimism because mathematically, the
consumer income expectations shown here
cannot be true given recent data releases.
Some suggest the recent upturn in spending,
which is unconfirmed by employment andwage growth, implies the data is wrong
because tax receipts are strong. We wouldemphasize this series more heavily than
that nuanced approach.
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The economic recovery has really just been a stabilization. Inappropriately in our
view, the market continues to focus on real growth, when in fact, nominal iswhat matters. And from that perspective, nominal GDP growth under 5% should be
considered recessionary.
And This Is All We Get With All That Stimulus?
-4%
-3%
-2%
-1%
0%
1%
2%
3%
4%
5%
-80%
-60%
-40%
-20%
0%
20%
40%
60%
80%
100%
Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10
Composition of US Nominal GDP Growth
PCE Inventories Government
Res Invest Non-Res Invest Net Exports
Nominal GDP YoY % (RS)
Source: Bureau of Economic Analysis, Bloomberg, KSR
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It Aint Mew, but Look What the Cat Dragged In
We havent heard anyone else talking about this. So, we got to wondering: How much
money was being saved/spent by squatters? The chart below is self-explanatory. Wedont have anyway of knowing how/if these funds are accounted for in the national
accounts data, but we would guess they arent. Windfall?
-400
-300
-200
-100
0
100
200
300
Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10
Monthly Change in Nominal PCE (SAAR) vs.Annualized Monthly "Savings" of Non-Performing Mortgages*
(Assumes $1250/mo as imputed "Squatters" benefit)
Annualized Non-Performing Mortgages @$1250 Monthly Change in Nominal PCE (SAAR)
Source: Bloomberg; BEA; * Lender Processing Services (2007 montly data imputed from industry trend), KSR
$
Billions
St t i R h
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Again, real doesnt tell the story. Whenreported inflation is collapsing, aggregate data
paints a flawed pictureparticularly whendisinflation turns into deflation. (No, the economy
is not IN deflation, but the primary collateral stock(real estate) is.
Inflation? Really?
This data is shocking. Biblical wisdom says Thepoor will always be with you, but almost 15% of
the population of the most powerful nation onearth???
The Recent Spending Rise Doesnt Jive
0
5
10
15
20
25
30
35
40
45
1969 1973 1977 1981 1985 1989 1993 1997 2001 2005 2009
Millions
US Food Stamp Participants
Source: USDA, Food and Nutrition Service, KSR
-4 Stdev
-3 Stdev
-2 Stdev
-1 Stdev
Median
+1 Stdev
+2 Stdev
+3 Stdev
-4
0
4
8
12
16
1961 1964 1966 1969 1972 1975 1978 1981 1983 1986 1989 1992 1995 1998 2000 2003 2006 2009
US Nominal PCE YoY % Change SA
Source: Bureau of Economic Analysis, KSR
%
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5
7
9
11
13
15
17
19
21
23
25
600
700
800
900
1,000
1,100
1,200
1,300
1,400
Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11
S&P 500 Index vs S&P 500 P/E Ratio
S&P 500 Price Index S&P 500 P/E Ratio (RS)
Source: Bloomberg, KSR
But What About the Stock Market? Doesnt THAT Indicate Recovery?
The amazing run in stocks from the July lows has actually seen the S&P 500s P/E Ratiofall. This is consistent with a move considered cyclical rather than secular, and we are
fast approaching an inflection where valuations will need to expand or stocks will fail.
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The expectation that margin expansion wasprimarily being fueled by payroll cuts and working
capital reductions, was misguided.
We believed then (March 09) what we believenow; namely that the IP deployments made
over the past decade got the full attention of
management teams trying to drive profitabilitygiven weak demand prospects.
The collapse in nominal economic activity aroundthe world in Q4 2008, established a base of
pessimistic expectation for operating companiesthat was discontinuous from their ability to
manage fixed and variable cost.
So, once demand recovered, incremental margins
exploded, and so did cash flow.
Productivity and Scale
6%
7%
8%
9%
10%
11%
12%
1959 1962 1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007
Relative Strength of US Corporate Net Cash FlowSA versus US Nominal GDP (SAAR)
US Corporate Profits With IVA and CCA Net Cash Flow SA / Gdp Us Nominal Dollars Saar
Source: Bureau of Economic Analysis, KSR
90
95
100
105
110
115
120
125
130
135
140
Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Jan-11
Standard & Poor's 500 Index Positive SurprisesIndexed 100=1-31-2007
Source: Bloomberg Indices, KSR
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Incremental Corporate Profitability Is Growing Exponentially
Another way of looking at the same productivitydata; this chart shows that the last $400MM of
corporate profit was made with only 5 millionincremental jobs.
Thats an incremental profit per employee of
$80,000 versus average profitability $14,000.
Stunning.
The acceleration of profitability per employee hasgone exponential.
This supports our IP-Scale construct, and certainly
explains the intensifying weakness of labor.
$0
$200
$400
$600
$800
$1,000
$1,200
50, 000 60, 000 70, 000 80, 000 90, 000 100,000 110,000 120,000 130,000 140,000 150,000
NIPA Profits (billions) vs.Number Employed (thousands)
Source: Bureau of Economic Analysis, Bureau of Labor Statistics, KSR
0
100
200
300
400
500
600
700
800
900
1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008
Growth of NIPA US Non-Financial Profitsper Employed Person
Source: Bureau of Economic Analysis, Bureau of Labor Statistics, KSR
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And Bigger Is Better
We believe that scale has been an enormous benefit in this recession. As weaker/
poorly capitalized operations have suffered or closed; stronger competition has beenable to take market share and utilize its flexibility to shift capacity based upon market
conditions.
ANEMIC
NOMINALGDP
CREDITCONTRACTION
MAIN STREET LOSSES ARE PUBLIC CO. GAINS
CAPACITY SHRINK
WEAK COMPETITION; POORLY FINANCED;
OVER-LEVERAGED; NON-
COMPETITIVE
WELL FINANCED; STABLE/GROWING
MARKET SHARE; COMPETITIVE
ADVANTAGE
SHARE GAINS
FLAT REVENUE
Source: Knight Strategic Research
WEAK COMPETITION; POORLY FINANCED;OVER-LEVERAGED; NON-COMPETITIVE
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Unquestionably, Corporate America Is Thriving Relative to Main Street
$0
$10,000
$20,000
$30,000
$40,000
$50,000
$60,000
$70,000
$0
$200
$400
$600
$800
$1,000
$1,200
$1,400
$1,600
$1,800
1951 1955 1959 1963 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003 2007
Billions
Billions
Corporate Cash Flow vs. Household Net WorthThe Growing Chasm
US Corporate Profits With IVA and CCA Net Cash Flow SA Household Net worth (RS)
Source: Bureau of Economic Analysis, Federal Reserve, KSR
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If investors all get caught in a 1914-style crisis, they will all godown together and nobody will underperform the benchmark,he says.But if they become pessimistic too early and are wrong,they will underperform. Therefore its better to consign a majorgeopolitical crisis to the realm of uncertainty, and treat it like therisk of an asteroid hitting the earth. Common sense tells us thata major war is much more likely than an asteroid, or indeed the
melting of the polar ice caps. But there are incentives for investorsand financial professionals to ignore the risk of crises.
Niall Ferguson
Barrons: March 12, 2007
The Game Is Over
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The Commodity Markets Are Overrun and Present a Major Risk to Global Stability
60
100
140
180
220
260
300
340
Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10 Jan-11
Crude vs Copper vs CRB Raw Industrials
Indexed to 100 1/2/09
WTI CRUDE FUTURE Indexed 100=1-2-2009
COPPER FUTURE Indexed 100=1-2-2009
Commodity Research Bureau/Reuters US Spot Raw Industrials Indexed 100=1-2-2009
Source: Bloomberg, Commodity Research Bureau, KSR
80
100
120
140
160
180
200
220
Jan -9 1 S ep -9 2 May-9 4 Jan -9 6 S ep -9 7 May-9 9 Jan -0 1 S ep -0 2 May-0 4 Jan -0 6 S ep -0 7 May-0 9
UN Food and Agriculture World Food Price Index
Source: Food and Agriculture Organizat, KSR
It is incredible to us that the debate regarding thedeleterious and destabilizing impact that speculators
have on the commodity markets still rages on. We fullyappreciate the necessary role that true speculators bring
to the markets, but we are aghast that more isnt doneto rationalize access. How can it possibly not distort
price and, therefore, the operations of real businessesand the functioning of the global economy, when
investment banks are caught stockpiling? And how canthe profusion of ETFs which are heavily marketed to
individuals not be a negative?
Quite obviously, controlling food price inflation iscritical to the well-being of the world. We cannot
understand why the United States agricultural belt isstill being used to produce corn for ethanol rather than
being markedly expanded to increase production fortrade around the world. Perhaps an enlightened client
will inform us?
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The economic value of manufacturing labor is inextricably linked to finished goods pricing. If for
example, you worked the factory floor making lawn mowers and your gross annual wage could buy100 machines, if input prices rose 20% and finished goods prices rose 10%, your value in the chain
declined by 9%; because now you could only buy 91 machines. Moreover, if we assume that yourproductivity increases by 10%/year, your compensated value would decline even further.
Manufacturing Labor Has a Call on Finished Goods Pricing
MARGI
N
INPUT COSTS
LABOR
MARGI
N
Source: Knight Strategic Research
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Thus Commodities Can Drive Wage/Price Spirals When Manufacturing Density Is High
But that is NOT the case for IP-centric economies like the United States. Because wages are NOT tiedto commodity prices, rising finished goods prices will face stiff elasticities of demandor outright
substitution. So if commodity price increases persist, the manufacturing intensive emerging worldwill either:
1. Have to hold margins and sell less
2. Hold prices and earn less, or
3. Hold wages flat.
The latter promises revolt, and either of the first two risk the deflationary collapse of marginalcapacity.
WEAKER DEMAND
WEAK DEMAND FLAT PRICES CFLO CREDIT PROBLEMS
INCREASED PRICES WAGES INFLATION
DEVELOPED WORLD
DEFLATIONARYPRESSURE
RISING
COMMODITY PRICES
CHINA
INFLATIONARY/
STAGFLATIONARYPRESSURE
FOREIGN EXCHANGE
RESERVES FALL
Source: Knight Strategic Research
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This schematic (borrowed from the government of New Zealand!) shows the flow of
prices across a balanced economy. As you will note, rising commodity producer priceinputs MUST be passed along to export markets, or domestically, through imports or
direct to consumer price increases.
So Really, Commodity Price Increases Will NOT Lead to Inflation Here
Inflation Flows in the Economy
ProducersPrice Index
(outputs)Import Price Index
Export Price Index
Labor Cost IndexProducers Price
Index (inputs)
Capital Goods
Price Index
Consumers
Price Index
Expenditure by production/government sector Expenditure by household SectorProduction
Sector
outputs
Labor
costs
Current
costs
Capital
costs
Source: Government of New Zealand, KSR
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Because in the Aggregate, Nominal Consumer Demand Is Structurally Impaired
COLLATERAL?
EQUITY?
EXCESS CASH FLOW?
RISING ASSET VALUES?
ANEMIC WAGES
JOB SECURITY?
CUSHION?
NEW RETIREMENT CALCULUS
DEMOGRAPHICS
COMPETITIVE IN IP MODEL?
DRIVE VALUE IN IP CHAIN?
INVESTMENT/EQUITY RETURNS?
RISING PROPENSITY TO SAVE
NO CREDIT/DELEVERAGING
BLEAK WAGE & ROI EXPECTATIONS
Inflation Flows in the Economy
Producers
Price Index
(outputs)Import Price Index
Export Price Index
Labor Cost IndexProducers Price
Index (inputs)
Capital Goods
Price Index
Consumers
Price Index
Expendi ture by product ion/government sector Expendi ture by household SectorProduction
Sector
outputs
Labor
costs
Current
costs
Capital
costs
Source: Government of New Zealand, KSR
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ECONOMIC SECURITY
GOVERNMENT POLICY
RESOURCE & INDUSTRY
TERMS OF TRADE
Source: Knight Strategic Research
We Therefore Believe The Game Is Over
We first made our Game Over call back in November; andsince then, our conviction level has increased. What we aresaying is that structurally, per this chart, the global terms oftrade have been pushed past their tipping point. And it is ourhope that the elements of this publication will all come togetherin support of our position.
In essence, we believe the disparity between the prevailingeconomic and financial structures around the world, inconjunction with the policies being effected by governments
(particularly China) are in the process of pushing the marketstowards a significant dislocation.
Specifically, as we will cover later in this report, China iscaught in a double-bind of its own making. We believethat the price/wage spiral that has commenced will not becontained by policy initiatives. Attempts to do so, will onlykeep the upward pressure on commodities and input pricesfirm, making the inevitable breakdown of past trend thatmuch worse.
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We Believe the BRIC and Commodity Rally Is An Echo Bubble
0
50
100
150
200
250
300
350
400
450
500
500
1,000
1,500
2,000
2,500
3,000
3,500
4,000
4,500
5,000
MSCI BRIC (12/10) vs DOW 1929 vs NDX 2000
NDX Index 2000 Peak MSCI BRIC 2007 Peak DOW Index 1929 Peak (RS)
Source: Bloomberg, KSR
5 YEARS
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With all the hoopla about an extended cycle for commodities; is it possible that ALL related
things are coming to an end? This chart depicts the 10-year average growth rate of commoditiessince 1800; the importance is that it has reached a well defined trend line.
Which Is More Plausible Looking At This Chart
-8%
-6%
-4%
-2%
0%
2%
4%
6%
8%
10%
12%
1805 1835 1865 1895 1925 1955 1985 2015
Commodity Prices in the US 10-Year Average Growth Rate
Source: U.S. Census Bureau, BLS, KSR
-8%
-6%
-4%
-2%
0%
2%
4%
6%
8%
10%
12%
1805 1835 1865 1895 1925 1955 1985 2015
Commodity Prices in the US 10-Year Average Growth Rate
Source: U.S. Census Bureau, BLS, KSR
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Calling long-term cycles on the basis of charts
alone is foolhardy, but the evidence is starting to
build.
Stocks have underperformed commodities in
four distinct periods since 1900. The difference
now, and the argument against the prior 10-yearaverage growth chart? This cycle has only lasted
about two-thirds as long.
So are the bulls right and the trend lines wrong?
We dont think so, because the structural condi-
tions in the developed world cant tolerate a dif-ferent outcome.
And As Confirmed By These
200%
300%
400%
500%
600%
700%
800%
900%
1000%
1100%
Jan-95 May-96 Sep-97 Jan-99 May-00 Sep-01 Jan-03 May-04 Sep-05 Jan-07 May-08 Sep-09 Jan-11
S&P 500 INDEX / ThomReuters/JefferiesCRB
Source: Bloomberg, KSR
0.4
0.8
1.6
3.2
6.4
12.8
25.6
51.2
102.4
1 87 1 1 88 1 1 89 1 1 90 1 1 91 1 1 92 1 1 93 1 1 94 1 1 95 1 1 96 1 1 97 1 1 98 1 1 99 1 2 00 1 2 01 1
LogarithmicScale
US Stock Prices Relative to Commodity PricesFour Periods of Commodity Outperformance
Source: Shiller, US Census Bureau, Bloomberg, KSR
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It would be foolish, in forming our expectations, to attach greatweight to matters which are very uncertain...[since] investmentbased on genuine long-term expectation is...scarcely practicable[because] capital investment [is controlled] by persons [withoutspecial knowledge or perspective] seeking to outwit the crowd,and pass the bad, or depreciating, half-crown to the other fellow.
John Maynard Keynes,
The General Theory of Employment, Interest and Money (1935)
We Are the Masters Now
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China Is Caught in Its Own Trap
China circa 2011 shares many similarities with the United
States in both 1929 and 2007, as well as Japan in the1980s:
1. Massive disparity of wealth, income, andeducation.
2. Rapid industrialization and displacement oflabor.
3. Opaque and misleading economic and financialdata.
4. Massive build-up of leverage across the rising
class.5. Bubbles in both residential real estate and fixed
asset/infrastructure development.
6. Accelerating and uncontrolled growth indisintermediated credit.
7. Expected transference of economic growth todomestic demand.
8. Accelerating price/wage spiral.
The clearest investment case against China is also themost fundamental. It is trapped in a double bind of its
own making. For despite the CPCs own hubrisandthe ubiquity of the worlds confidence in itChina
appears to have lost control. And in an ironic twist, ithas done so by doing everything it can not to. For in its
own zeal to placate the masses through rapid growth,
China has created a tide of inflation that threatenswidespread social unrest. And what is its option? To
crush speculation and the extension of credit and risk adeflationary collapse?
China no longer controls its own destiny; the freemarkets do.
Source: IMF
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R = 0.9988 R = 0.9506
0
20
40
60
80
100
120
140
160
0
2,000
4,000
6,000
8,000
10,000
12,000
14,000
May-99 Apr-00 Mar-01 Feb-02 Jan-03 Dec-03 Nov-04 Oct-05 Sep-06 Aug-07 Jul-08 Jun-09 May-10
$Billions
CNY
Billions
China Fixed Assets Investment versusChina Export Trade (Projected 6 Months)
1 2M Av g. Ch ina Fi xed As se ts Inv es tment Ch in a E xp or t Tr ad e (RS ) $ Bi ll ion s
Poly. (12M Avg. China Fixed Assets Investment) Poly. (China Export Trade (RS) $ Billions)Source: China Economic Information Net, KSR
-20%
0%
20%
40%
60%
80%
100%
1 99 5 1 99 6 1 99 7 1 99 8 1 99 9 2 00 0 2 00 1 2 00 2 2 00 3 2 00 4 2 00 5 2 00 6 2 00 7 2 00 8 2 00 9 2 01 0
China GDP; Composition of Growth
Net Exports, Capital Formation, Final Consumption
China Yearly GDP by Expenditure -Net Exports of Goods & Serv
China Yearly GDP by Expenditure -Gross Capital Formation
China Yearly GDP by Expenditure -Final Consumption
Source: CEIC Data, KSR
Much like Japan in the 1980s, Chinas culture ofthrift has prevented the hand-off of economic
growth to domestic consumption. The bull caseis that this impediment (household savings rate
runs between 30% - 50%) will vanish when theCPC establishes a social security system. We dont
agree. If the U.S. populace does not trust ourgovernments management of a similar system,
will the trust of the Chinese populace be so strongas to transform its own culture?
Fixed Asset Investment Is Now 70% of GDP
Plain and simple, the physics of finance and
economicsand all that makes for good commonsense and practical experiencesays that theexponential expansion of fixed assets supported
by a pyramid of debt always ends in tears.
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Does It Have to End? This Chart Speaks Volumes
This IMF chart has been widely published by analysts struggling to put Chinas capex boom into context.
But now that we have 2010 data we have updated the illustration. Hmmm.
Japan (68-74)
Singapore (91-99)Korea (90-97)
Thailand (89-97)
Maylaysia (90-97)
China ('96-2009)
CHINA (2010)
35%
40%
45%
50%
55%
60%
65%
70%
5 6 7 8 9 10 11 12 13 14
Number of Sequential years of Capex Boom
Intensity and Duration of Capex Booms(Fixed Asset Investment/GDP and Years)
Source: IMF, KSR
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0%
10%
20%
30%
40%
50%
60%
70%
"Official"Government Bonds
Policy Bank Bonds NPLs on state-owned AMC
LGFV Bonds LGFV InfrastructureLoans
LGFV "Other"Loans
China's Debt to GDP Is At Least 70%
versus the "Official" 17.5%
Fitch Ratings has done groundbreaking work onuncovering the disintermediation of domestic credit
in China. According to its research, some 3 trillionyuan of credit has been created within Chinas trust
banking system, in 2010. This is a 40% increase over thegovernments stated numbers. The primary purpose
is to create yield-enhanced, short-term instruments.Moreover, Fitch recently reported that Chinese banks
are broadly utilizing undiscounted acceptances tounderstate leverage to regulators.
Chinas arcane system of laws and therequirement that local governments fund the
bulk of infrastructure development, has givenrise to an opaque network of over 8,000 LGFVs
(local government funding vehicles). Essentiallythese are Chinas form of public sector SIVs, and
its massive build-up of debt isnt included inofficial estimates of national debt, as we see it.
Banking System Leverage and Government Debt Are Grossly Understated
0
2,000
4,000
6,000
8,000
10,000
12,000
2007 2008 2 009 H109 H110 9M09 9M10
Net New Credit Flows (CNY Billions)
CNY and FX Loans Undiscounted Acceptances
CWMPs and CTPs (Credit-Related Wealth Management/Trust products) Claims of Hong Kong Banks on China
Source: Wind, Fitch, KSR
Source: Merrill Lynch
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The Incremental Productivity of Chinas Runaway Credit Growth Is Collapsing
0
2,000
4,000
6,000
8,000
10,000
12,000
Mar-00 Feb-01 Jan-02 Dec-02 Nov-03 Oct-04 Sep-05 Aug-06 Jul-07 Jun-08 May-09 Apr-10
China Total Loans YoY Change vs. GDP YoY Change (CNY)
China Total Loans of Financial Institutions YoY Change (CNY Billions)
China GDP 4Q Sum YoY Change (CNY Billions)
Source: China Economic Information Net, Bloomberg, KSR
As Adjusted Per Fitch Findings
Chinas economic growth appears increasingly dependent upon a system of Ponzi finance. And given the
price/wage spiral that its own zeal for growth has unleashed, it is most certainly caught in a double bind.
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The trend of economic surprise in Asia is already
perilous.
The Hong Kong Monetary Authority published
this data. It shows the CoVAR between Asiannations as measured by CDS volatility.
If China catches a cold....
And This Is a Great Risk for Asia
-140
-90
-40
10
60
Jan -0 7 M ay -0 7 S ep -0 7 Jan -0 8 M ay -0 8 S ep -0 8 Jan -0 9 M ay -0 9 S ep -0 9 Jan -1 0 M ay -1 0 S ep -1 0 Jan -1
Citigroup Economic Asia Pacific Surprise
Citigroup Economic Surprise Index - Asia Pacific
Source: Citigroup, KSRSource: Hong Kong Monetary Authority
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This chart is striking. As we entered 2011, the
imbalance between US companies raising andlowering guidance was almost 4 standarddeviations above normal.
And although we cannot gauge just how muchguidance would soften in the event of a China
breakdown, given such acute sentiment, a majordisruption seems reasonable.
It looks to us like the global equity markets
have done a very thorough job of pricing in therecovery of G7 leading indicators.
-4 Stdev
-3 Stdev
-2 Stdev
-1 Stdev
Median
+1 Stdev
+2 Stdev
+3 Stdev
+4 Stdev
-0.4
-0.2
0.0
0.2
0.4
0.6
0.8
1.0
1.2
1.4
1.6
Jan-00 Dec-00 Nov-01 Oct-02 Sep-03 Aug-04 Jul-05 Jun-06 May-07 Apr-08 Mar-09 Feb-10 Jan-11
Number of US Cos Issuing Financial Outlooks Up /Number of US Cos Issuing Financial Outlooks Down
Source: Bloomberg Indices, Bloomberg, KSR
And for the Developed World
-75%
-50%
-25%
0%
25%
50%
75%
-14
-10
-6
-2
2
6
10
14
1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009
G7 Composite Leading Index YOY %vs. MSCI World Index YoY
OECD G7 Composite Leading Ind. Total Trend Restored YOY % MSCI WORLD YoY % Change
Source: Organization for Economic Coop, KSR
%
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Dont Trust the Orthodoxy
Too large a proportion of recent mathematical economics aremere concoctions, as imprecise as the initial assumptions theyrest on, which allow the author to lose sight of the complexitiesand interdependencies of the real world in a maze of pretentiousand unhelpful symbols.
John Maynard Keynes,
The