26 August 2010

Global Strategy
Alternative view
www.sgresearch.com

Global Strategy Weekly

They laughed. Oh how they laughed.

Albert Edwards Investors cannot move for the weight of broker research comparing the current conjuncture in
(44) 20 7762 5890 the US with Japan a decade ago. While bond markets at least, move to discount deflation,
albert.edwards@sgcib.com
most sell-side analysts still say the current situation is unlike Japan a decade ago. They are
right. Things now in the US are much, much worse than Japan a decade ago.

Q Equity investors are in for a rude shock. The global economy is sliding back into
recession and they are still not even aware that these events will trigger another leg down in
valuations, the third major bear market since the equity valuation bubble burst.
Q This lack of awareness reminds me of reports this week that a 35 year old Polish man
hadn’t noticed for five years that he had a bullet lodged in his head. Like the equity market
in 2000, the Polish man had been partying too hard to notice that he had been shot. The
Global asset allocation BBC report the police as saying "He told us he remembered having a sore head, but that he
Index SG
% Index wasn't really one for going to the doctor." – Link.
neutral Weight
Equities 30-80 60 35 Q As the equity bloodbath of the last decade enters its final, even bloodier phase, investors
Bonds 20-50 35 50 continued optimism also reminds me of the Black Knight in Monty Python & the Holy Grail -
Cash 0-30 5 15
link. Despite being grievously wounded by King Arthur, the Black Knight makes light of his
Source: SG Cross Asset Research
injuries which he dismisses as a flesh wound. The vast bulk of the investment industry fails
to appreciate that we are locked in a structural bear market and about to enter Act III.
Q There is still too much hope about. Until the mantra changes from “Equities for the long
term” to “Bonds at any price”, we will not have completed our Ice Age journey. It has been a
difficult road for me personally for the last 14 years during which I have been laughed at and
my ideas dismissed as the attention-seeking ravings of a lunatic. But as we complete the
path set out below over year (see chart), the Japanese template of supposedly ‘expensive’
bonds outperforming supposedly ‘cheap’ equities; this will feel nothing like a flesh wound.

My vision of the next year: world bonds (10y+) and equities

375 375

350 350

300 300

250 250

Bonds
Global Strategy Team 200 200
Albert Edwards
(44) 20 7762 5890
albert.edwards@sgcib.com 150 150

Cash
Dylan Grice
100 100
(44) 20 7762 5872 Equities
dylan.grice@sgcib.com 75 75
97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12

Source: Datastream

Macro Commodities Forex Rates Equity Credit Derivatives

Please see important disclaimer and disclosures at the end of the document
 Global Strategy Weekly

The front cover chart shows outperformance of global government bonds against equities has
been in the order of 100% even before equities begin yet another cyclical slide. My colleague
Dylan Grice asked me if there was similar outperformance if we exclude Japan over the last 14
years. There is.

This year has already seen a dramatic flip-flop in sentiment as the market has begun to
acknowledge it is sinking into the deflationary quicksand. For this year outperformance in the
US, for example, is over 20 percentage points (see chart below).

Total return of US long bonds (10y+) and S&P composite (1 Jan 2010=100)
120 120

115 115

bonds 10y+
110 110

105 105

100 100

95 95

Equity
90 90
JAN FEB MAR APR MAY JUN JUL AUG

Source: Datastream, SG Cross Asset Research

The structural bear market has not reached the end. We have long said that the de-bubbling
process would end only when equities became very cheap and revulsion in equities as an
asset class hangs in the air like a fog.

The problem remains more of excess valuation within the US rather than Europe, but that will
not prevent the bear market hurting other cheaper markets as much. We will return to the
valuation nadir last seen in 1982 with the S&P bottoming around 450 (see chart below).

Cyclically adjusted PE (using trendline for trend earnings)

45 45

40 40

US
35 35

30 30

25 25

20 20

15 15

10 Europe 10

5 5
73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09

Source: Datastream, SG Cross Asset Research

2 26 August 2010
 Global Strategy Weekly

We still like to keep it simple. Drawing straight lines is about as simple as it gets and hence a
ruler is one of the most important investment tools to have in one’s armory (they never tell you
that on a MBA program!). The bond market is still locked in a technically perfect bull market
(see left-hand chart below). The next move down is clear to me. Global cyclical failure will take
US 10 year yields down to the 1½ -2% range. In our world, 10y German bunds will break
below 1½% and even UK Gilts will break below 2%.

And we may be closer to outright deflation than many suppose. The Cleveland Fed produces
an alternative measure of core CPI, namely trimmed mean and median CPI. Among other
things these reduce the dominance of imputed owner-occupier rent in the core measure. On
these measures core inflation is evaporating far faster than the official measure suggests –
(see right-hand chart below and link). The slide in median CPI from a 2008 peak of 3% to only
0.5% has been precipitate, especially after 10 years of relative stability centering on a 2½%
rate. We are sliding closer to deflation faster than the official core data suggests.

US 10y bond yield Cleveland Fed trimmed CPI (Median) and core CPI inflation
10 10 6 6

9 9
5 5

8 8

7 7 4 4
median trimmed
6 6

3 3
5 5

4 4 2 2

3 3
1 1

2 2
core CPI
1 1 0 0
86 88 90 92 94 96 98 00 02 04 06 08 10 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

Source: Datastream, SG Cross Asset Research

So far the equity market has shrugged off much of the weaker data that abounds, and has not
joined the bond market in a perceptive move. The equity market will though crumble like the
house of cards it is, when the nationwide manufacturing ISM slides below 50 into recession
territory in coming months. Indeed the new orders data for August, already reported in
regional ISM’s suggests the equity market is going to get some sentiment crushing data in the
very near term. But never mind the last standing optimist will tell us – it is only a flesh wound!

Philadelphia and New York Fed ISM new orders (average) and national ISM headline measure
40 65
new orders
30
(av of philly and NY Fed)
60

20

55
10

0 50

-10
45

-20
40

-30

headline ISM 35
-40
(rhscale)
-50 30
2002 2003 2004 2005 2006 2007 2008 2009

Source: Datastream, SG Cross Asset Research

26 August 2010 3
 Global Strategy Weekly

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4 26 August 2010