Global

Gl b l Tactical
T ti l
A t Allocation
Asset All ti
GTAA
Equities Valuation

Third Quarter
June 14th , 2010

Damien Cleusix
d i @ l 6
damien@clue6.com

Clue6 Third Quarter 2010

 Executive Summary 1

Stocks
Valuations have improved slightly after the recent correction but remain way above fair value in most regions. Buy &
hold is not an option one should consider.
consider The US markets is currently priced at or above all the major structural tops with the
exception of the last few months of 1929 and the 1997-2000 absurdity (but at least then there was a huge style dispersion with
small caps and value stocks undervalued). And one has to keep in mind that assets and earnings quality is not what it was in the
past adding uncertainties to the mix.

Analysts and strategists are starting to use cash flows and free cash flows ratios extensively to demonstrate markets
undervaluation. It is true that markets look less expensive using those measures. The main reason is that companies are not
investing and have capital expenditures which are below their amortizations & depreciations. This is a rationale decision when
your WACC is lower than your expected return. Nominal growth is likely to be low in this new environment of deleveraging,
reduction
d i off overcapacity, i rising
i i taxes and d regulatory
l uncertainties.
i i The Th same cash
h flows
fl ratios
i where
h used d in
i Japan
J i the
in h early
l
90s.

All of this does not imply that the markets will fall in the short or even the medium term but that a further rise will only
have speculative and no investment merits if bought and that if one buy today to hold for the long-term,
long-term negative capital
gains are to be expected in the next 7-10 years (even 17 years).

Our base assumption remains that we will fall to significantly undervalued levels before a new secular bull market can
start ((in the developed
p world as, as y
you know, y
you know we believe that we are in a secular bull market in emerging
g g markets).
)
This currently imply a sub-530 level on the S&P 500 going up by 5-6% (could be higher if inflation picks up significantly)
a year.

Emerging markets are too expensive even if one consider that they are in a structural bull market (structural as we think that the
2003 andd 2009 low
l will
ill hold).
h ld)

Clue6 Third Quarter 2010

 Equities: Valuations 2

Valuations are not useful for short-term market projections but are essential in forecasting Chart 1 US Earnings Volatility
long-term returns. They become informative in the shorter term when they reach extremes
in combination with technical deterioration, sentiment extreme, internal or intermarket
divergences. When they are very high one should not allow the other indicators in one
oness arsenal
to deteriorate too much before pushing the exit button, the reverse is true when they reach very
low levels.

The perpetual question is what constitutes high and low valuation and which valuation ratios to
consider. We look at normalized pprice to earningg ratios ((normalized usingg a trailingg reported
p
earnings moving average (R. Shiller method), trend earnings, average margins or peak earnings
(J. Hussman method)), price to book value and the Tobin Q. We like to look at a historical dataset
as long as possible.

One often hears that valuations should be higher

g because the markets are less risky.
y
S
Source: R. Shill
Shiller, Clue6
Cl 6

We disagree, strongly and the past few years have strengthen this conviction. Chart 2 US Earnings Quality

Main Street cycles have clearly been less volatile in the past 30 years (well up to now), as has
inflation. The consequence
q is that companies
p have increased their leverageg dramatically y (cf.
A. Greenspans Paradox of Credibility or H. Minskys Unstable Stability) . In the
process earnings volatility has increased rapidly in the past 10 years (Chart 1). From the mid
50s to the mid 80s, real annual earnings were rising or falling by 3.8% for every percent change
in annual real GDP growth. In the past 10 years if was 22%...

Furthermore the quality of those earnings has decreased dramatically (Chart 2). Dont be
fooled Reported earnings (GAAP not operating which are even worse) have grown much
faster than what W. Buffett calls owners earnings which are the increase in book value and the
dividends paid. The difference between the 2 are mainly due to stock option programs true price
never being charged to earnings and indicates that earnings are not what they used to be.
So rce: Clue6
Source: Cl e6

Clue6 Third Quarter 2010

 Equities: Valuations 3

US Tangible Assets to Europe Tangible Assets

Chart 3 Total Assets Chart 4 to Total Assets
This has been aggravated by a substantial
deterioration of assets where:

1. intangibles have dramatically gained in

importance in some regions (Charts 3-6) (ask
a bondholder of a bankrupt high intangibles
company what intangibles are worth...),.
G ld
Goldman S h has
Sachs h calculated
l l t d that
th t the
th S&P
500 constituents asset/equity ex-goodwill has
risen from 2.5 in the 80s to 4.4 today.
2. Financial asset have proportionally increased.
3. Assets' mark to market which increase their
pro cyclicality
pro-cyclicality. S
Source: Bloomberg,
l b Clue6
Cl 6 S
Source: Bloomberg,
l b Clue6
Cl 6
Japan Tangible Assets to Emerging Markets Tangible
In brief, as often repeated in the past, we think Chart 5 Total Assets Chart 6 Assets to Total Assets
market should be valued at lower levels, not
higher levels than historically.

This is thus not surprising that AAA and AA

bonds represented almost 60% of the Barclays
Capital Investment Grade Index at the end of
the 70s while they only represent 25% today.

Source: Bloomberg,
Bloomberg Clue6 Source: Bloomberg,
Bloomberg Clue6

Clue6 Third Quarter 2010

 Equities: Valuations What Drives the Long Cycles 4

S&P 500 and Middle to Young

Chart 7 Cohort
Investors attach a lots of importance to what happen to earnings on the very short term
while theyy have a veryy negligible
g g influence on the intrinsic value of the markets. Indeed even
if earnings were to be 0 in the next 2 years, this would not affect by more than a few percentage
points the intrinsic market value derived by a dividends or cash flows discount model.
Remember that markets are a claim on a very long-term stream of cash flows.

What moves market valuation around fair value in the short-term is investors risk appetite.
pp
This is what we analyze extensively in the sentiment, breadth, liquidity, seasonality and cycle
section of our presentations.

In the long-term, we believe that the main driver of long-term generational fluctuation in
valuation ratios from very undervalued to very overvalued, is the reallocation of the stock of
wealth (as demonstrated by J. Tobin more than 40 years ago). One can see this phenomenon in Source: Census Bureau, Clue6
action looking at the Saver/Spender ratio or Middle to Young cohort (Chart 7).

This is the ratio of the population aged 40-49 years to 20-29 years. For the US we think the time
for the next structural bull market to start will be the low made between 2014-2016 (with a
preference for 2014). This is not a forecast but something to keep in the back of her/his mind.

As we have been saying during the past 10 years, this does not mean that there wont be cyclical
bull markets to take advantage from in between.

During structural bull markets the market rises around 85% of the time while in structural
bear market it rises approximately 65% of the time

Clue6 Third Quarter 2010

 Equities: Valuations 5
For longer-term
F l t return
t projections
j ti (7 years),
) we use a methodology
th d l similar
i il tot Grantham,
G th M
Mayo, GMO 7 Years
Van Otterlo & Co so lets use their graphs (Chart 8 and 9) showing their estimated 7 years Chart 8 Return Forecast
forward performance for the various categories if they trade at the average valuation normalized February 2010
to average margin in 7 years .

Another indicator we look at is the Value Line Median Appreciation Potential (VLMAP) which
P. Bernstein used in his valuation estimation of the market. It is the median price appreciation
potential estimated by Value Line of the all of the 1700 stocks they cover for the following 3 to 5
years. It fell below 50% which is at the bottom end of its history One should start
accumulating stocks when it rises above 100%... After having fallen to 45% in April it has now
risen to 70%.
70%

High quality stocks expected return has declined by 2.3% to 7.6%. This is where we still
Source: Grantham, Mayo, Van Otterlo & Co
would be greatly overweight (and as an aside valuation our macro scenario favor "bunker-
like" balance sheets).

As we will show in the next few pages, we think there is a non-negligible risk (it is a risk
identified and not a prediction) that the markets will make THE bottom at levels up to
50% below where the markets are now. Chart 9 April 2010

In 2000 we said that the S&P 500 would fall below 500 before the next structural bull market
could start, we still believe that this is a potential outcome (but we would add 5-6% a year to this
objective going forward (would be a combination of extension and time to determine the final low
target I.e. the longer it takes the lower the required decline)

But we also know that timing the exact bottom is impossible so we will automatically increase
our recommended allocation on declines once we fall below 700-750 on the S&P 500 and we
see breadth extremes without regard to the trend. The allocation will be increase as price
declines exactly as we did in March 2009.

One need a plan to stick to in such environment and this is ours. We will also limit the extent
to which we take net short positions the closer we are to what we consider rock bottom
valuations.

Clue6 Third Quarter 2010

 Equities: Valuation 6
US NIPA Tax Rate

Source: Clue6 Idea: J Early

y

This graph is another attempt to demonstrate the importance of starting valuation for longer-term returns.

According to this model, the real 17 years total return should be negative. In 2027 you will not have made any real profit.

Impossible, right,
Impossible right impossible
impossible We will see,
see low real growth and surprisingly high inflation later (as you know we think deflation is the real
problem in the medium-term) might produce this surprisingly low return.

Clue6 Third Quarter 2010

 Equities: Valuation 7
US NIPA Tax Rate

Source: Clue6 Idea: J Early

y

A graph
h we have
h usedd in
i the
h past. We
W assign
i a 100% probability
b bilit that
th t the
th S&P 500 reall index
i d willill fall
f ll below
b l the
th broadest
b d t black
bl k line
li before
b f we can
embark into a new structural bull market. We assign a 85% probability (but think we should say 100%) that it will fall below the middle black line
and we would say that there is a 25% risk (for those invested) chance (for those who have been able to preserve capital) that we will fall below the
bottom, light black line.

As an aside,
aside we are currently just below the valuation levels that made A.Greenspan
A Greenspan (after a discussion with R.Shiller)
R Shiller) talk about irrational
irrational exuberance
exuberance
in 1996. At that time the markets were as expansive as during all the major recent market tops (29, 66). So please, dont be anchored to the valuation
of the past 15 years, they are likely to be seen as an aberration by future markets historians.

Clue6 Third Quarter 2010

 Equities: Valuation 8
Chart 10 Normalized PE Ratio and Forward Returns Chart 11 Current Normalized PE Ratio

Source: MS

Source: MS

Note the correlation between starting normalized price earning ratio and markets performance (Chart 10).

It is important to keep in mind that we do not believe that a market priced a 20 time normalized earning will produce positive returns as Chart 10
imply but we believe that cheaper markets will outperform more expansive ones.

Where do markets stand now? Chart 11 give you the answer.

In the future we will give you a table with the market we except to outperform in the long-term vs the one we think will underperform, the results
will not be similar to chart 11.

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 Equities: Valuations 9

Chart 12 PE using NIPA Tables Chart 13 PS using NIPA Tables

Chart 12 and 13 are constructed using the Bureau
of Economic Analysis NIPA tables. The data is
less likely to be impacted by the CFO
prouesses. We have not normalized them but the
message is clear. Markets are OVERVALUED.

The message is similar if one look at the Tobin

Q (Chart
(Ch 14).
14) We are at the
h same levels
l l off all
ll the
h
major tops ex 98-2000 folly.

The price to book ratio gives a more flattening

picture (Chart 15) even if we are far from the
l l where
levels h the
h market
k bottomed
b d in
i the
h past. But
B S
Source: BEA,
A Clue6
Cl 6 S
Source: BEA,
A Cl
Clue6
6

remember the book value is not what it used to

Chart 14 US Tobin Q Chart 15 US PB
be.

Source: Federal Reserve,

Reserve Clue6 Source: Bloomberg,
Bloomberg Clue6

Clue6 Third Quarter 2010

 Equities: Valuation Earnings vs. Cash Flows 10

As one as probably
A b bl already
l d started
t t d tot hear,
h stocks
t k are cheaper
h th average on a cash
than h flows
fl and
d free
f cash
h flows
fl b i while
basis hil they
th are much
h more expensive
i (probably
( b bl
not hearing this part much) on all other metrics.

Cash flows are good, better than earnings which are simply an accounting construct. We agree on this and always look at Sloanes accruals when analyzing a stock but what we
have now are large cash flows which are the results of net disinvestments (amortizations & depreciations higher than investments as demonstrated in our January macro note).
The end results is lower expected long-term growth.

Note that we understand companies not investing as for many the WACC is higher than the expected return. Welcome to a low nominal growth world where overcapacity and
over-leverage have to be worked out, slowly but surely.

Clue6 Third Quarter 2010

 Equities: Valuations 11

Chart 16 Europe PB Chart 17 Japan PB

Europe is cheaper than the US but this is justified
(Chart 16).

It is still trading at more than 1.5 times the book

value.

Japan is cheap based on book value, especially at

the small cap levels which are trading 70% of
book value (Chart 17-18). The reason why Japan
is cheap on a book value basis but expensive on an
earning basis is that they have very low return on
equity. The low historical ROE should be seen
as a potential to mean revert to other countries S
Source: Bloomberg,
l b Clue6
Cl 6 S
Source: Bloomberg,
l b Clue6
Cl 6
standard now that Japan is slowly, but surely,
becoming more shareholder friendly. Chart 18 Japanese Small Caps PB Chart 19 Asia ex Japan PB

In our last report we said that

Emerging markets are getting increasingly expensive.They

are profiting most from the excess liquidity pumped by
central banks around the world and from the cheap USD
but... The USD won't fall forever and once you reach a
certain level of valuation you are only counting on finding a
bigger
gg ffool. Trend change g should definitely
f y be acted upon
p
from here on...

Markets are now cheaper but not by much.

Asia is trading at almost 2 times book (Chart 19).

Source: Bloomberg,
Bloomberg Clue6 Source: Bloomberg,
Bloomberg Clue6

Clue6 Third Quarter 2010

 Equities: Valuations 12

Chart 20 Latin America PB Chart 21 Eastern Europe PB

Latin America is more expensive than 80% of the

time in the past 20 years (Chart 20).

We remain careful on Eastern Europe. Buy

aggressively
gg y on a return to 0.5-0.6 PB,, especially
p y
in the sound countries suffering the domino effect
(Czech Republic,)

S
Source: Bloomberg,
l b Clue6
Cl 6 S
Source: Bloomberg,
l b Clue6
Cl 6

Chart 22 Global Tobin Q (Median

EV/Total Assets)

The global Tobin Q is historically high as the chart 22 demonstrate.

Source: ML

Clue6 Third Quarter 2010

 Equities: Valuation 13
Chart 23 US Median Vs Mean PE Chart 24 UK Median Vs Mean PE

Source: Clue6 Source: MS

In 2007 we said that the coming bear markets would be very different that the one we experienced in 2000 because the overvaluation was almost
universal. In 2000-2003 value and small cap managers did very well but they lost a lots of money in the 2007-2009 decline.

We did those forecasts using ,among other, something similar as the Chart 23 and 24. The later is not up to date.

When the average valuation is much higher than the median, the overvaluation is concentrated and astute stock pickers (and you know we
are value investor at heart) tends to navigate the decline relatively well. This was the case in 2000 for example. When, on the contrary, median
g
valuation are higher than mean valuation,, stock ppickingg is almost meaningless.
g

Chart 23 indicates that there is some margin for stock selection but not much.

Clue6 Third Quarter 2010

 Equities: Valuations 14

Analysts are expecting peak earnings to be

Chart 25 S&P 1500 Earning Estimates Chart 26 S&P 1500 Margin Estimates
reached next year and much more in 2012 and
2013 (Chart 25). As shown on the next page their
record do not speak
p for them and theyy are
expected to be even wrongerthan they have been
in the past.

Margins are expected only to reach the 2007

level in 2012 (Chart 26). Lets be clear on this. We
strongly doubt that we will see the 2007
margins in our life time (and for those who
wonder we are still quite young and in good
health).
S
Source: Bloomberg,
l b Clue6
Cl 6 S
Source: Bloomberg,
l b Clue6
Cl 6
On Chart 27 one can see the margin before tax for
the overall US economy. They are rapidly S&P 1500 Long-Term Earning
Chart 27 US Domestic Margins Chart 28 Growth Estimates
approaching the 2007 highs and are not likely to
reach them. But might reach them in our life-time,
maybe The big difference with the Chart 26 is
that they are BEFORE TAXES and taxes have
only one way to go.

Finally long term earning growth expectation

have ticked higher recently (Chart 28). Even if
the economy was to grow at its fastest 20 years
pace of the century it would not be able to produce
such earning growth. Earnings grow more slowly
than nominal GDP, everywhere. This is set in
stone. Why? Dilution as we will show later in this
Source: Federal Reserve,
Reserve Clue6 Source: Bloomberg,
Bloomberg Clue6
report.

Clue6 Third Quarter 2010

 Equities: Valuation 15

S&P 500

Source: McKinsey

If you want to be the most accurate analyst on the street, the only skill required is some mental calculus capabilities or a calculator. Take
the consensus and remove a certain percentage which is linear to the time period since the last recession. The longer we are from a recession the
higher the percentage you subtract. You can also had the Wrights yield curve recession model to the mix if you want to work hard. When it flashes
a probable recession you can remove at least 50% from the consensus and then take a 12 months vacation.

You can then write reports with a lots of complicated equations and graphs that nobody can understand but as they cant they believe that you are
superiorly intelligent and this would do the trick. Never tell them how you do it they could not handle the truth.

Clue6 Third Quarter 2010

 Equities: Valuation 16
Chart 29 US NIPA Tax Rate Chart 30 US NIPA Margin with Constant Tax Rate

Source: MS

Source: BEA, Clue6

We said that we doubted that after-tax margin would reach 2007 level in our life time and the main reason, beside the fact that financial profits will
collapse
p to more normal level as a % of total pprofits, are taxes. Taxes will be raised and qquite aggressively,
gg y sometime in the future.

As you can see taxes have declined steadily since the 50s (Chart 29). An if taxes had remained the same, margins today would not be this
impressive (Chart 30). The same is true for ROE.

Not only taxes will be risen but tax evasion, legal or illegal will be an area of intense official scrutiny. Big US companies will have to pay much
more taxes in the US and wont be able to book their profits in fiscal paradises has they have done in the past.

Clue6 Third Quarter 2010

 Equities: Valuation 17
Chart 31 Constituents of Real Stocks Return Chart 32 Market Cap vs. Price Index

Source: Earning Growth: The2 Percent Dilution, R. Arnott, W. Bernstein, FAJ

Source: BEA, Clue6

Why are not broad market indices earnings not growing as fast as nominal GDP? Because investors are diluted through net new issuance. issuance One
way to look at this is looking at the ratio of market cap to price (cf. Earning Growth: The2 Percent Dilution, R. Arnott, W. Bernstein, FAJ).

Real Earnings have grown by 1.4% and dividends by 1.1% since 1871 based on professor Shiller data. So one can only laugh or cry at
analysts long-term growth estimates.

Clue6 Third Quarter 2010

 Equities: Valuation 18
Chart 33 US NIPA and S&P 500 Operating Profits Chart 34 US NIPA Profit Composition

Source: BEA, Bloomberg, Clue6 Source: BEA, Clue6

US NIPA profit have yet to turn down which they have historically done a couple of quarters before S&P 500 GAAP earnings (Chart 33).

But one has to take into account the financial sector contribution to those earnings. Financial earnings represent 55% of total domestic
earnings (Chart 34). This is simply absurd. Financial earnings have historically been more resilient during recession (well except the last one)
which explain some of the historical spike in the ratio but now the financial sector is earning as much as it was in 2007 (some investment banks
even had perfect trading quarter during the first 3 months of the year, not loosing money a single day).

In 10 years we do not expect financial profit to be more than 25% of total and 25% is likely to be optimistic. This will be the result of a
mixture of greater regulations and higher taxes.

Clue6 Third Quarter 2010

 Equities: Valuation 19
Chart 35 US Private Compensation/GDP Chart 36 Hours of Work to Buy the S&P 500

Source: Bloomberg, Clue6 Source: Thechartstore.com

Longer-term we are expecting to see a mean-reversion in the Private compensation to GDP (Chart 35) which will weight on margins which
might
g stayy lower for longer
g and not reach the 2007 and even 2000 high
g for qquite some time if ever. Workers will ask for their fair share of
profits.

This should be associated with a reduction in inequalities,... And lower economic growth

On Chart 36, one can see another reason of the increase in wealth inequalityFinancial assets price have risen much more than average income
This will also mean revert (and not as a consequence of rapidly rising average income)

Clue6 Third Quarter 2010

 Equities: Valuation The Price has to be Right 20
Chart 37 Real GDP Growth Vs Real Stock Chart 38 Emerging Markets Real GDP Vs Real
Return 1899-2008) Stock Return (1988-2007)

Source: Smithers & Co Source: Societe Generale

Do not confound good potential secular macro growth with good investment . As W. Buffet said Price is what you pay, value is what you get.

As you can see on Chart 37, even if you knew in hindsight which countries would grow the fastest, you would not have outperformed. One has to
take into account that the 2 World War have had a significant impact (some of the less directly impacted lands have had the best performance) but
the same is true for the past 25 years in emerging markets (Chart 38)

The price you pay (in term of valuation) is determinant Countries with high expected growth are expensive to buy Only buy them on
panic

Clue6 Third Quarter 2010

 Equities: Valuation Price Stability 21
Chart 39 Average PE Ratio By Range of Chart 40 PE Ratio and Inflation
Inflation

Source: Crestmont Research

Source: Crestmont Research

PE ratio are higher in low inflation environment than when inflation is high as is commonly known, but PE are also lower when low
i fl i become
inflation b d fl i
deflation.

Note that we have always been puzzled by analyst using the low inflation high PE argument as what really matter is how the market perform going
forward. And market perform better (on a 5-10 years basis) when PE are low and inflation high.

Clue6 Third Quarter 2010

 Equities: Valuation US Future GDP Growth 22

Source: CBO,Clue6 Idea: J.Hussman

As said in the past, in the long run, earnings tend to grow slightly less than GDP. The above concept to estimate forward growth was first
proposed by J.Hussman. For the US real GDP to reach the CBO potential real GDP forecast in 10 years, the growth should be 2.7% which is one of
the lowest in history.

If one add that there is a non-negligible

g g risk of deleveraging
g g and overcapacity
p y related deflation ((if Central Banks and Government do not ggo all-in
where inflation might become a problem) this does not bode well for nominal growth which is what people and companies use for they
investment and consumption decisions

Clue6 Third Quarter 2010

 Equities: Conclusion 23

Valuations have improved slightly after the recent correction but remain way above fair value in most regions. Buy & hold is not an option
one should consider. The US markets is currently priced at or above all the major structural tops with the exception of the last few months of 1929
and the 1997-2000 absurdity (but at least then there was a huge style dispersion with small caps and value stocks undervalued). And one has to keep
in mind that assets and earnings quality is not what it was in the past adding uncertainties to the mix.

Analysts and strategists are starting to use cash flows and free cash flows ratios extensively to demonstrate markets undervaluation. It is true that
markets
e s look
oo less
ess eexpensive
pe s ve us
usingg those
ose measures.
e su es. Thee main reason
e so iss that co
companies
p es aree not
o investing
ves g andd have
ve ccapital
p eexpenditures
pe d u es wwhich
c aree
below their amortizations & depreciations. This is a rationale decision when your WACC is lower than your expected return. Nominal growth is
likely to be low in this new environment of deleveraging, reduction of overcapacity, rising taxes and regulatory uncertainties. The same cash flows
ratios where used in Japan in the early 90s.

p y that the markets will fall in the short or even the medium term but that a further rise will onlyy have speculative
All of this does not imply p and
no investment merits if bought and that if one buy today to hold for the long-term, negative capital gains are to be expected in the next 7-10
years (even 17 years).

Our base assumption remains that we will fall to significantly undervalued levels before a new secular bull market can start (in the developed
world as,, as yyou know,, yyou know we believe that we are in a secular bull market in emerging
g g markets).
) This currentlyy imply
p y a sub-530 level on the
S&P 500 going up by 5-6% (could be higher if inflation picks up significantly) a year.

Emerging markets are too expensive even if one consider that they are in a structural bull market (structural as we think that the 2003 and 2009 low
will hold).

Clue6 Third Quarter 2010