02.11.2011 The Final Chapter of The Old Story

Strategic Research
FebRuARy 11, 2011

WWW.KNIGHT.COM
MARK O. LAPOLLA, CFA

404.736.2431 | MLAPOLLA@KNIGHT.COM
The Final Chapter of The Old Story

Nevertheless, like me in 1958, investors refused to see the ground shifting beneath them, even though the environment was no longer what they knew and thought they understood. Like me, they were walking into a trap where the responses were not what they had anticipated. Like me, they were headed toward big surprises for which they had no preparation. It has been said that good forecasters have a good sense of history. I suppose that is true. 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
Refer to important disclosures at the end of this document.
Knight Capital Americas, L.P.
Strategic Research
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 transformation requiring 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.
Strategic Research
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 the Sovereign 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 interest rates. 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 to be 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 by the fallacies of conventional thinking.
Strategic Research The Gist

To understand reality is not the same as to know about outward events. It is to perceive the essential nature of things. 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
Strategic Research
Executive Summary
It is our contention that the current levels of unemployment are structural, and likely understate the 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 the extension 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 elements necessary 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 the impact 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 security selection. 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.
BBThe U.S. Labor Market Is Structurally Broken BBConsumer Credit Is Dead BBThe Recovery Is Just a Stabilization BBNominal GDP Will Remain Anemic for Years BBCorporate Profitability and Main Street Economics Are Uncoupled BB Corporate Margins Will Not Revert Back to Their Long-Term Mean BBRising Commodity Prices Are Deflationary in the Developed World BBSustaining Inflation in the U.S. Will Not Be Possible for Years BBThe Global Terms of Trade Are Past Their Tipping Point
BBMonetary Policy Cannot Create Inflation BBThe U.S. Current Account Deficit Is a Non-Issue BBThe Fed Anchors and Controls Rates BBThe U.S. Is Fiscally Sustainable BBInterest Rates Will Remain Low BBThe Euro Will Survive, but the Dollar Standard Will Grow Stronger BBNominal Is All That Really Matters BBThe Global Growth Story Is Over: and China Is the Linchpin BBFood Is More Important than Oil
Strategic Research The Fall of Labor
For the moment the very rapidity of these changes is hurting us and bringing difficult problems to solve. Those countries are suffering relatively which are not in the vanguard of progress. We are being afflicted with a new disease of which some readers may not yet have heard the name, but of which they will hear a great deal 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 we can find new uses for labour. John Maynard Keynes Economic Possibilities for our Grandchildren (1930)
Strategic Research
Prosperity Cannot Be Guaranteed
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.
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 in manufacturing, 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 organization representing 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 labor lost 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 so the 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 refusal to 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 heavy hand 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 guarantee prosperity. 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 its workers are struggling.
Strategic Research
Productivity Explosion: Exponential Output Growth and Steady Labor Decline
US Manufacturing Output Growth vs. Manufacturing Labor Decline 1950-2010
900 800 700 600 500 400 300 200 100 0 1950 1980 2010
"US Manufacturing Workers (1950=100) Linear ("US Manufacturing Workers (1950=100)) "US Manufacturing Output (1950=100) Expon. ("US Manufacturing Output (1950=100))
y = 50e0.6931x R = 1
y = -33x + 133 R = 1
Source: Federal Reserve, Bureau of Labor Statistics, KSR
Strategic Research
X Marks the Spot
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.
Non-Farm Payroll Components as Percent of Total Non-Farm Payroll
70% 40%
65%
35%
30% 60%
25%
55% 20% 50% 15% 45%
10%
40% 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Private Service as Percent of Total (LS) Manufacturing as Percent of Total (RS)
Source: Bureau of Labor Statistics, KSR
5% Govt as Percent of Total (RS)
Strategic Research
As Manufacturing Intensity Declined, So Did Wage and Output Growth
US Nominal GDP Per Capita YoY % Change
+4 Stdev 240
US Personal Income versus Transfer Payments SAAR (Indexed 100=1-31-1999)
16.00%
+3 Stdev
220
+2 Stdev 11.00% +1 Stdev 6.00%
200
180
Median
160
1.00%
-1 Stdev
140
-2 Stdev -4.00%
120
-3 Stdev
100 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 US Personal Income SAAR Indexed 100=1-31-1999 Personal Income Transfer Payments to Persons SA Indexed 100=1-31-1999
Source: Bureau of Economic Analysis, KSR
-9.00% 1949 1954 1959 1964 1969 1974 1979 1984 1989 1994 1999 2004 2009
Source: Bloomberg, KSR
-4 Stdev
Reflects services growing to 70% of the employed labor base.
Despite the housing boomor perhaps because of it, transfer payments grew twice as fast as personal income.
Acceleration (second derivative) in Household Debt
100% 50% 0% -50% -100% -150%
10-Year Payroll Growth

60% 50% 40% 30% 20%
-6.37%
-200%
10%
-250%
0%
-300%
-10% 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
-350% 1952 1957 1962 1967 1972 1977 1982 1987 1992 1997 2002 2007
US Recession
Source: Federal Reserve, KSR
Household Debt YoY % Change
This divergence between government and private sector payroll growth is a VERY big deal.
In times of heavy leverage and deflationary pressure; NOMINAL dollars are everything.
10
Strategic Research
The Global Economy Has Rapidly Bifurcated Between IP and Scale
WEALTH
ACCELERATING ECONOMIC BIFURCATION

LABOR DENSITY ECONOMIC VALUE ADD
WEALTH
WEALTH
ACCELERATING ECONOMIC BIFURCATION
WEALTH
COMPETITION
LIFESTYLE /CREDIT SQUEEZE
INNOVATION
POLITICAL PRESSURE
IP
RICARDIAN ADVANTAGE
LABOR DENSITY ECONOMIC VALUE ADD COMPENSATION
SCALE
Source: Knight Strategic Research
IP
RICARDIAN ADVANTAGE
SCALE
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.
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.
11
Strategic Research
IP Versus Scale
IP & MATURE CREDIT = DEFLATION RISK SCALE & ACCELERATING CREDIT = INFLATION .
WEALTH
IP & MATURE CREDIT = DEFLATION RISK SCALE & ACCELERATING CREDIT = INFLATION .
WEALTH
WEALTH DISINFLATION
WEALTH
WAGE PRESSURE RISING DEMAND
DEFLATION INFLATION
FALLING DEMAND
WAGE PRESSURE SCALE
TECHNOLOGY IP RICARDIAN ADVANTAGE
COMMODITIES SCALE
IP
RICARDIAN ADVANTAGE
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.
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.
12
Strategic Research The Necessary Rise of Credit
Keeping up with the Joneses. The phrase was popularized when a comic strip of the same name was created by cartoonist Arthur R. "Pop" Momand which first appeared in The New York World in 1916. It offered a sad parody of abject consumerism; the title of which, is still a widely used colloquial expression for needless consumption.
Strategic Research
A Home for Every Household
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 development was 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 Depressionbut with each economic cycle, government intervention and social assistance grew more important, 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 the Universal 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 Employment Retirement 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 laissezfaire capitalism under Ayn Rand devotee, Federal Reserve Chairman Alan Greenspan. It was these factors that fueled an unprecedented explosion 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 its desire for an ever increasing standard of living.
14
Strategic Research
Debt Growth Plateaued After the Baby Boom
US Consumer Credit Outstanding as a % of Nominal GDP (1946-1980)
13%
11%
9%
7%
5%
3% 1946 1951 1956 1961 1966 1971 1976

Source: Federal Reserve, Bureau of Economic Analysis, KSR
15
Strategic Research
Productivity Growth and Declining EVA Caught Up With Labor
Nominal Wage & Salary and Corporate Profits as a % of Congressional Budget Potential Nominal GDP
56% 54% 52% 50% 48% 46% 44% 42% 40% 16% 14% 12% 10% 8% 6% 4% 2% 0%
1949 1954 1959 1964 1969 1974 1979 1984 1989 1994 1999 2004 2009 Wage & Salary From The GDP Report US Nominal Dollars SAAR / Congressional Budget Office Potential Nominal GDP US Corp Profits With IVA Total SA / Congressional Budget Office Potential Nominal GDP (RS)
Source: Bureau of Economic Analysis, KSR N/A, KSR #N/A
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Strategic Research
Massive Amounts of Credit Was Needed to Facilitate Lifestyle Growth
THE CONSUMPTION BUBBLE
LIFESTYLE
CONSUMER CREDIT / LEVERAGE WAGES
EVA
DECLINING MANUFACTURING RISING IP

17
Strategic Research
The Housing Bubble Marked the End of a 75-year Credit Super Cycle
Target leverage
Stronger Balance sheets Increase B/S size
Asset price boom

Source: Federal Reserve Bank of New York
The pro-cyclicality of the credit cycle was immensely powerful. As leverage increased and balance sheets grew larger, direct flows into assets drove prices higher. This in turn, strengthened creditors and induced more lending.
When mega cycles end, they are usually the completion of many convergent trends. In the case of the housing boom, it capped the transition from the totally debt averse post-Depression culture to the credit dependent sense of entitlement so visible at the peak.
18
Strategic Research
Hall of Fame Metrics
Total Consumer Debt Including Mortgages Relative to Personal Income
60% 55% 50% 45% 40%
$ Billions
Debt Intensity of US Economy (Annual Debt Growth / GDP Growth)

4,500
65%
3,500
2,500
1,500
500
35% 30% 25% 20% 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005
-500
-1,500 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09
US Total Domestic Debt YoY Change

Source: Federal Reserve, Bureau of Economic Analysis, KSR
GDP US Nominal Dollars SAAR YoY Change
The prevailing belief was that home prices couldnt fall.

Commercial Banks versus Shadow Banking Credit Creation (Billion $ SAAR)
3,000,000 2,500,000
And no one cared until they had to.
The Most Pronounced Debt Cycle Ever YoY % Change in Household Credit Growth
6
5.5
Annual Percentage Change
2,000,000 1,500,000 1,000,000 500,000 0 -500,000 -1,000,000 1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008
Shadow Banking Credit Creation
2.6 2.24 1.7 0.8 0.45 1.75
0 2Q58 - 1Q60 1Q61 - 3Q69 4Q70 - 3Q73 1Q75 - 4Q79 4Q82 - 2Q90 1Q91 - 4Q00 4Q01 - 2007 Current
Source: Federal Reserve, Bloomberg, KSR
Commercial Bank Credit Creation
Deregulation and gross regulatory failure facilitated the disintermediation of the banking system.
And whats worse, job creation during the boom was the weakest of any modern expansion.
19
Strategic Research
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
PERVERSE SELECTION
MORTGAGE RATES
6% 5% 4% 3%
5%
10%
15%
20%
25%
30%
HOUSE PRICE APPRECIATION

So lets be honest: who really thought about anything other than how much house they could buy?
Certainly the origination machine believed in the speculative value of residential real estate. As shown here, the cost of capital actually fellmateriallyin relation to the rate of price acceleration in local markets. Wow.
20
Strategic Research
How Can There Be Any Risk When Prices Never Fall?
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 no mortgage), the Case-Shiller 20-market index, and the 5-yr treasury bond yield as the risk-free rate.
Sharpe Ratio for Residential Real Estate

14 12 10 8 6 4 2 0 -2 -4 Dec-94 Apr-96 Aug-97 Dec-98 Apr-00 Aug-01 Source: Bloomberg, Case-Shiller, Federal Reserve, KSR Source:Blooomberg; Case-Shiller; Federal Reserve, KSR
Dec-02
Apr-04
Aug-05
Dec-06
Apr-08
Aug-09
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Strategic Research
Asset Rich and Cash Poor
20%
Net financial investment / Personal Income vs. Personal Savings Rate
15 600
PCE Quarterly Change vs. Quarterly MEW and MEW as a Percent of Nominal GDP
6% 500 400 4%
15%
10
10% 5 5% 0 0% 0 -5 -5% -10 -100 0% 300 200 100 2%
-200
-300
-2%
-10%
-15%
1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008
-15 Net financial investment / Disposable Personal Income

US Personal Saving as a % of Disposable Income (RS)
-400 1995-Q2 1996-Q4 1998-Q2 1999-Q4 2001-Q2 2002-Q4 2004-Q2 2005-Q4 2007-Q2 Quarterly Change PCE $ Billions SAAR MEW as Percentage of Nominal GDP (RS)
Source: Bureau of Economic Analysis, Federal Reserve, Bloomberg, KSR
-4% 2008-Q4 MEW Annualized $ Billioins
By 1998, households were liquidating financial assets in earnesteven as their savings rate diminished.
Mortgage equity withdrawals (MEW) played an enormous role in fueling consumption from 20032007. Remember the Bank of America ads? I bet you didnt know your home was your own personal ATM! Incredible.
22
Strategic Research
And the Party Was Without End
100% 95%
Growth in Real PCE as Pct of Growth in Real GDP (7-Year Rolling Period)
8.0 7.0
Contribution to Real GDP Growth (Volatility by Component)

Gross domestic product Personal consumption expenditures Gross private domestic investment Net exports of goods and services Government consumption expenditures and gross investment State and local
90% 85%
6.0
Percent Volatility
80% 75% 70% 65%
5.0 4.0 3.0 2.0
60%
1.0
55% 50% 1955 1958 1961 1964 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 US Recession
Source: NBER, Bloomberg, KSR
0.0 Post-War Boom 1946-1968

High Inflation 1969-1984
Stability 1985-1995
Post CRA/GS 1996-2007
Growth in Real PCE as Pct of Growth in Real GDP (7-Year Rolling Period)
The incremental GDP growth coming from personal consumption was not unprecedented; although it was clearly unsustainable. But the question remains: What will take its place?
This chart depicts the Great Moderation; the low volatility economic environment (aka the Minsky equilibrium) which fostered the gross misallocation of capital and the collapse of risk premiums around the world.
23
Strategic Research The Crash
A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional and orthodox way along with his fellows, so that no one can really blame him. John Maynard Keynes The Consequences to the Banks of the Collapse of Money Values (1931)
Strategic Research
Price Momentum Does Not Justify Capital Commitment
The highly reflexive and procyclial expansion of leverage ran amuck; and contrary to popular and politically correct opinion, it was ultimately made possible by the gross misallocation of capital by the globes largest institutional investors who allowed relative performance and momentum to substitute for the prudent allocation of credit.
Like all nations throughout recorded history, the extension of credit has been central to the economic affairs of America; and so too, the dangers of over-indebtedness have been central to our cultures shared wisdom. Unfortunately, the fact remains that the history of financial crises in the United States is all too robust for a supposedly enlightened country of such short life; notably, the Panics of 1837, 1857, 1873, and 1907; the Great Depression of 1929-1933, and the Credit Crash of 2007 2008. Surprising? Hardly. In his book, The New Paradigm For Financial Markets, George Soros makes the case that the global financial order has been developed on the basis of a flawed paradigm. Central to his argument is the notion that market prices do not randomly deviate from a theoretical equilibrium; but rather, that there is a two-way reflexive connection between perception and reality
which can give rise to initially self-reinforcing but eventually self-defeating boom-bust processes, or bubbles. He continued, I came to realize that market participants cannot base their decisions on knowledge alone, and their biased perceptions [incentive driven] (our comment)] have ways of influencing not only market prices but also the fundamentals those prices are supposed to reflect. We agree with Mr. Soros on virtually all counts. There is a great conundrum that arisesmost particularly as a result of suboptimal incentive structuresbetween truth and price; wisdom and value. Post hoc, ergo proctor hoc, as translated: after it, therefore because of it, is undoubtedly the most common and destructive fallacy present in the financial markets. If P=>Q; Q=>P; pure circularity. The insatiable desire to ascribe and act on causalityno matter how specious
or unsustainable the relationshipis at the heart of reckless momentum. And through transference, it is the very momentum of belief which clouds judgment, suspends common sense, and alters the perspective of current circumstance to sustain and reinforce itself. Precisely in this way, the highly reflexive and procyclial expansion of leverage ran amuck; and contrary to popular and politically correct opinion, it was ultimately made possible by the gross misallocation of capital by the globes largest institutional investors who allowed relative performance and momentum to substitute for the prudent allocation of credit.
25
Strategic Research
The Failure to Incorporate Stress Tests for HPA in Risk Models Set Up the Crash
Over Valued Homes
$300,000
Q2 2006
Home Sales vs. Transaction Dollar Volume

7.5 1,700
Existing One Family Home Sales Average Price
7.0 $250,000
Q2 2010 Q4 2010 Q3 2010 Q4 2008
1,500 6.5 1,300 6.0
$200,000
Q4 2009
$150,000
5.5
1,100
$100,000
5.0 900 4.5
$50,000 4.0 $0 0 50 100 150 200 250 300 350 400 450 500
700
3.5 US Existing Homes Sales Millions SAAR

Source: National Assoc. of Realtors, KSR
500 Existing Home Sales Transaction Value (Sales * Median Price) (RS)
Diaposable Income / 10-Treasury

Source: National Assoc. of Realtors, Federal Reserve, Bureau of Economic Analysis, Bloomberg, KSR
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
What we find most amazing, is how the most sophisticated financial analysts around the world failed to account for the inevitable reversion of HPA (house price appreciation) in their risk models. But then again, the OFHEO told us in 2002 that HPA was not part of their risk models because the price series isnt volatile enough and never goes negative. Really?
As with most every asset market; volume follows price. However, as seen in 2010, price did not follow spiking volumes. And why would it? A very large part of the transactions were foreclosure liquidations.
$ Billions SAAR
26
Strategic Research
The Magnitude of this Shock Has Definitely Increased the Propensity to Save
Delinquencies As % Of Total Loans
10.0 9.5 9.0 8.5 8.0 7.5 7.0 6.5 6.0 5.5 5.0 4.5 4.0 3.5 Mar-79 Mar-83 Mar-87 Mar-91 Mar-95 Mar-99 Mar-03 Mar-07
Acceleration (second derivative) in Household Debt

100% 50% 0% -50% -100% -150% -200% -250% -300% -350% 1952 1957 1962 1967 1972 1977 1982 1987 1992 1997 2002 2007
US Recession Household Debt YoY % Change
-6.37%
Source: Mortgage Bankers Association
The rise in delinquencies across the consumer credit markets has been unprecedented. But such are 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 as the 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.
Now thats deceleration; kind of like a test car hitting a wall.
27
Strategic Research
Reflexivity Works Both Ways; Aggressive Policy Action Prevented a Depression
Target leverage
3.0
Federal Reserve Disintermediation Credit Created By Shadow Banking System (Trillions $ SAAR)
2.5
Weaker Balance sheets Reduce B/S size
2.0
1.5
1.0
0.5
0.0
-0.5 1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008
Asset price decline

Source: Federal Reserve Bank of New York
The ugly unwind works the same way as the expansion did; only in reverse. Weaker balance sheets force deleveraging which cuts off the flow of capital supporting asset values. In turn, this makes smaller, more conservative balance sheets weaker still, which drives further deleveraging.
Were it not for massive government intervention and regulatory forbearance, there is no question in our minds that the credit crash would have resulted in a global depression. As shown, the deleveraging cycle is as reflexive and procyclical as its twin.
28
Strategic Research
The Crash Exposed a Labor Market That Was Already Broken
Permanent Job Loss as Pct of Total Unemployment
56% 41
US Unemployment Duration Average Num Weeks SA
51%
36
46%
31
41%
26
36%
21
16 31% 11 26% 6 21% 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009
1949
1954
1959
1964
1969
1974
1979
1984
1989
1994
1999
2004
2009
US Recession
Source: NBER, Bureau of Labor Statistics, KSR
US Unemployment Duration Average Number of Weeks SA
The collapse of the credit market slammed nominal economic activity. And nominal is what matters in a deflating economy. Thus, even as the IP vs. Scale dynamic was permanently eliminating a rising percentage of jobs, the blow to marginal consumption and intensifying competition has accelerated what is commonly called creative destruction.
Similarly, the duration of unemployment has been on the rise for the past several decades. The crash in nominal GDP accelerated the elimination of excess capacity and the maturation of web-based IP services, systems, and processes has massively increased business productivity.
29
Strategic Research
But Amidst the Crash, Wall Street Invented De-Coupling
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 guarantee it.
150
MSCI BRIC, GSCI Commodity TR, SPX, FTSE 100 Indexed 100=7-2-2007
140
130
120
110
100
90
80 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 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
30
Strategic Research
The De-coupling Fueled a Commodity Boom... and Deflation
$4.25 $4.00 $3.75 $3.50
Impact of Gas Price Change on Consumer Spending (Billions $ Annualized)
250 200
US GDP Nominal Dollars YoY % versus Crude Oil (Inverted)

10
7.0
Annualized Billions $ of Consumer Spending
150 100 50 0
30
5.0 50 3.0
Gas Price Per Gallon
$3.25 $3.00 $2.75 $2.50 $2.25 $2.00 $1.75 $1.50 Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Consumer Spending Hit when above $2.75 (RS) Cumulative Consumer Spending Hit (RS)
Source: American Automobile Associatio, Federal Highway Administration, KSR
70
-50
-100 -150 -200 -250
1.0
90
110 -1.0 130 -3.0 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 SA
Source: Bureau of Economic Analysis, New York Mercantile Exchange, KSR
Daily National Avg $/ Gal Unleaded
WTI CRUDE FUTURE (RS Inverted $/bbl)
In 2008, we were among the few who warned that: 1. The commodity markets were being overrun by speculators, and 2. That rising commodity prices were not inflationarybut would actually accelerate deflation in the cashstrapped developed world. Thus, we warned that every .01/gal increase in gasoline was the equivalent of a $1.5b (annualized) tax to consumption.
And although some seemed to understand that within a deflating economy, increases in money spent on non-discretionary items directly reduced the 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
31
Strategic Research
And the Fear Was Inflation
Global Aggregates Core Inflation YoY % Change

5.0% 4.5% 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% 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
Core Inflation World Core Inflation Emerging Economies

Source: IMF Publications, KSR
Core Inflation Industrial Economies
32
Strategic Research All the Kings Horses and All the Kings Men
The more I see, the more I find reason for those who love this country to weep over its blindness. The inquiry constantly is what will please, not what will benefit the people. In such a government there can be nothing but temporary expedient, fickleness, and folly. Alexander Hamilton
Strategic Research
The Government Faced an Unprecedented Post-War Collapse in Nominal GDP
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 asset price and monetary velocity deltas.
YoY Chg Consumer Credit vs. YoY Chg Nominal GDP

900 250
700
200
500
150
100 300 50 100 0 -100
-50
-300
-100
-500
-150 YoY Chg Nominal GDP ($ Billion)

Source: Bureau of Economic Analysis, Federal Reserve, KSR
1951 1955 1959 1963 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003 2007
YoY Nominal Chg Consumer Credit (RS $ Billions)
34
Strategic Research
So the Legislative Branch Blew Out the Budget and Spent
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 complete collapse in confidence. The debate on how it was spent is another matter entirely.
Borrowing by Sector (Billions SAAR)

6,000 5,000 4,000 3,000 2,000 1,000 0 -1,000 -2,000 -3,000 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
Non-Financial Domestic Private Sector Total Federal & Local Govt Source: Federal Reserve, KSR Financial Sector Total Domestic + Financial Sector (RS)
6,000 5,000 4,000 3,000 2,000 1,000 0 -1,000 -2,000 -3,000
35
Strategic Research
The Collapse in Both Stocks and Home Prices Crushed Household Net Worth
Nominal US Household Net Worth 12-Quarter % Change
60% 50% 40% 30% 20% 10% 0% -10% -20% -30% 1954 1958 1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006
36
Strategic Research
The Fed Became the Lymph Node of the Credit System; Then It Was Mortgage Time
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 yield curve. Then, the Fed bought up the mortgage market to accelerate deleveraging and to lower rates to stimulate refis and encourage origination.
Fed Balance Sheet

Extraordinary Balance Sheet Growth
2,000
1,500
1,000
Treasury Holdings Now Just Above Normal
500 0 -500 -1,000
Extraordinary Reserve Growth
-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
Treasury Securities Held Emergency Facilities & Other Assets All Other Liabilities Source: Federal Reserve, , KSR
Fed Agency Securities Held Currency in Circulation
MBS Held Balances with Reserve Banks
$ Billions
2,500
37
Strategic Research
The Housing Market Is Structurally Broken; and Therefore, So Is Credit Creation
SUSTAINABLE HOME PRICE MODEL
EQUIV. RENT COST OF CAPITAL
SHOW ME THE COLLATERAL!
EQUITY
TAX INCENTIVES LOCATION PREMIUM (PROPERTY TAXES)
LENDER
COLLATERAL
BORROWER
DEBT SERVICE
COMMUNITY LEVEL SUSTAINABLE CASH FLOWS

Source: Knight Strategic Research Source: Knight Strategic Research
The game is over. The speculative premium is gone, 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 to income. Its all about the prospect of jobs and economic vitality .
Credit creation requires collateral; it cannot be extended substantively without it. And since 75+% of consumer credit balances are residential mortgages, we see reignition of the credit machine as impossible.
38
Strategic Research
Financial System Stability but No Improvements In Employment
Unemployment Rate (%) vs Duration of Unemployment Number of Weeks SA
40
1/31/2011
35
Avg Duration of Uneployment Number of Weeks
30 25 20 15 10 5 0 0 1 2 3 4 5 6 7 8 9 10 11 12
Unemployment Rate (%)
1948 to Nov 2007

Dec 2007 - Present
Linear (1948 to Nov 2007)
39
Strategic Research
So the Fed Reinforced Its Politically Inspired Dual-Mandate
Full Employment Gap
Millions
150
145
140
11,000,000 JOBS SHORT OF MATCHING POPULATION GROWTH
135
130
125 Jan-05 Nov-05 Sep-06 Jul-07 May-08 Mar-09 Jan-10 Nov-10 Sep-11 Jul-12 May-13 US Nonfarm Payrolls Total SA
http://upload.wikimedia.org/wikipedia/commons/thumb/e/e3/NAIRU-SR-and-LR.svg/2000px-NAIRU-SR-and-LR.svg.png[2/3/2011 4:15:58 AM]
The concept of NAIRU (the rate of unemployment below which inflation would accelerate) is really a theoretical compromise since the data never supported 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 some amorphous state of equilibrium, and then they call it a theory. Unfortunately, their theories dont account for changes in the underlying structural conditions.
Now this chart is REAL. It doesnt depict a theory. There is a certain rate of job creationcurrently somewhere around 140,000/monththat is needed to satisfy population growth. But as most are aware, shockingly weak job growth isnt new. The last recession was also the weakest in history.
40
Strategic Research
So Without Credit Growth and No Job Creation, What Lever Could the Fed Pull?
Note to Self: Inflation? Really??? No collateral, no cash flow, no credit. And the winner is? The stock market.
IP vs. Scale and massive slack

Source: Ahead of the Curve by Joseph H. Ellis, KSR
IP needs smart NOT numbers.
41
Strategic Research
Rising Stock Prices Havent Inspired Small Business and It Creates the Jobs
NFIB Optimism Index vs. Average Duration of Unemployment
110
US Jobs Lost and Months to Recover Peak Aligned at Maximum Loss

1%
5
(Inverted Lagged 16-Months RS)
0%
105
Non-Farm Payroll as a Percent of Peak NFP
10
-1% -2% -3% -4% -5% -6%
15 100 20 95 25 90 30 85
01/31/2011
35
-7%
80 40
(28) (26) (24) (22) (20) (18) (16) (14) (12) (10) (8) (6) (4) (2) 0
1948 23 1953 24 1957 25 1960 21 1970 19 1974 20
6
1981 29
10 12 14 16 18 20 22
1990 33 2001 49 2007 31
1983
1986
1989
1992
1995
1998
2001
2004
2007
2010
Number of Months Before to After Maximum Job Loss
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
1980 11
Small business operators are facing the most challengingand potentially rewardingtime in modern history. With the nominal demand and credit likely to remain weak, and with technology continuing to accelerate, this is the time to take share or die.
No matter how often we look at this chart, we are stunnedbut not surprisedat the condition of the job market. And some would like to argue that high unemployment rates and duration arent structural?
42
Strategic Research
Income Expectations Are Shockingly Weak So Deleveraging Continues
6 Month Forward Consumer Expectations: Spread between Higher Income - Lower Income
28
20%
Revolving Consumer Credit YoY % Change

24%
23
16%
18
12%
13 8 3 -2 -7 -12 -17
Fusion
As covered in our Mosaics this week, the broker reports and subsequent earnings calls were.....well,a joke.No,I dont have access to the data nor the forensic accounting skills This chart truly reflects deep seated to uncover the dirty secrets that werent dispessimism because mathematically, the cussed, but I will say, as is in keeping with consumer income expectations shown here cannot bethe literary quality of my work, there is true given recent data releases. something rotten in Denmark. Some suggest the recent upturn in spending, From Goldmans implied characterization which is unconfirmed by employment and of the implies the data is wrong wage growth,overall environment as status quoor because tax english great; to Lehmans projection in receipts are strong. We would emphasize thisyears stock marketheavilyI am in of this series more returns, than that nuanced approach.
1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008
Source: Conference Board, KSR
8% 4% 0%
March 12-18, 2007 March 12-18, 2007
Goldman, Lehman & Bear Stearns, Oh My!

-4% -8%
1980
2010
Love does make the world go round.... but VAR and FICO hold it together Son
-12%
awe of these firms transcendent powers. Of particular humor (quote published in Mosaic) was GS CFOs answer to the performance of their models. One thing IS certain; ongoing deleveraging As the cartoon (my new hobbie) to the left sugis consistent with income expectations and gests, there is whole lot riding on VAR models unemployment trends. and the calculation and application of consumer credit scores.--not to mention the third leg of the stool; the rating agencies. What I am setting up here, is future discourse on what I believe will be the key players in the next and deeper saga of this unwinding credit cycle.
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
Asset Correlation is A Major Issue
43
Strategic Research
And This Is All We Get With All That Stimulus?
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 is what matters. And from that perspective, nominal GDP growth under 5% should be considered recessionary.
Composition of US Nominal GDP Growth

100% 80% 60% 40% 20% 0% -20% -40% -60% -80% Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 5% 4% 3% 2% 1% 0% -1% -2% -3% -4%
PCE
Res Invest Nominal GDP YoY % (RS)
Source: Bureau of Economic Analysis, Bloomberg, KSR
Inventories
Non-Res Invest
Government
Net Exports
44
Strategic Research
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. We dont have anyway of knowing how/if these funds are accounted for in the national accounts data, but we would guess they arent. Windfall?
Monthly Change in Nominal PCE (SAAR) vs. Annualized Monthly "Savings" of Non-Performing Mortgages* (Assumes $1250/mo as imputed "Squatters" benefit)
300
200
100
$ Billions
-100
-200
-300
-400 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 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
45
Strategic Research
The Recent Spending Rise Doesnt Jive
US Food Stamp Participants
Millions
US Nominal PCE YoY % Change SA

%
16
45 40 35 30 25 20 15 10
+3 Stdev
12
+2 Stdev
+1 Stdev
8
Median
-1 Stdev
-2 Stdev 0
5 0 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005 2009
-3 Stdev
-4 1961 1964 1966 1969 1972 1975 1978 1981 1983 1986 1989 1992 1995 1998 2000 2003 2006 2009
-4 Stdev
Source: USDA, Food and Nutrition Service, KSR
This data is shocking. Biblical wisdom says The poor will always be with you, but almost 15% of the population of the most powerful nation on earth???
Again, real doesnt tell the story. When reported inflation is collapsing, aggregate data paints a flawed pictureparticularly when disinflation turns into deflation. (No, the economy is not IN deflation, but the primary collateral stock (real estate) is. Inflation? Really?
46
Strategic Research
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 Ratio fall. 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.
S&P 500 Index vs S&P 500 P/E Ratio

1,400 25 23 21 1,200 19 1,100 17 15 13 11 800 9 700 1,300
1,000
900
7
5
600
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 Price Index

S&P 500 P/E Ratio (RS)
47
Strategic Research
Productivity and Scale
Standard & Poor's 500 Index Positive Surprises Indexed 100=1-31-2007
140 135 11% 130 125 120 115 110 105 100 95 6% 90 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
Source: Bloomberg Indices, KSR
Relative Strength of US Corporate Net Cash Flow SA versus US Nominal GDP (SAAR)
12%
10%
9%
8%
7%
1959 1962 1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007
US Corporate Profits With IVA and CCA Net Cash Flow SA / Gdp Us Nominal Dollars Saar
The collapse in nominal economic activity around the world in Q4 2008, established a base of pessimistic expectation for operating companies that was discontinuous from their ability to manage fixed and variable cost. So, once demand recovered, incremental margins exploded, and so did cash flow.
The expectation that margin expansion was primarily being fueled by payroll cuts and working capital reductions, was misguided. We believed then (March 09) what we believe now; namely that the IP deployments made over the past decade got the full attention of management teams trying to drive profitability given weak demand prospects.
48
Strategic Research
Incremental Corporate Profitability Is Growing Exponentially
900 800 $1,000
Growth of NIPA US Non-Financial Profits per Employed Person

$1,200
NIPA Profits (billions) vs. Number Employed (thousands)
700
600 500 $600
$800
400
300 200 $200
$400
100
0 1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008
Source: Bureau of Economic Analysis, Bureau of Labor Statistics, KSR
$0 50,000 60,000 70,000 80,000 90,000 100,000 110,000 120,000 130,000 140,000 150,000
The acceleration of profitability per employee has gone exponential. This supports our IP-Scale construct, and certainly explains the intensifying weakness of labor.
Another way of looking at the same productivity data; this chart shows that the last $400MM of corporate profit was made with only 5 million incremental jobs. Thats an incremental profit per employee of $80,000 versus average profitability $14,000. Stunning.
49
Strategic Research
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 been able to take market share and utilize its flexibility to shift capacity based upon market conditions.
MAIN STREET LOSSES ARE PUBLIC CO. GAINS

CAPACITY SHRINK
WEAK COMPETITION; POORLY FINANCED; WEAK COMPETITION; POORLY FINANCED; OVER-LEVERAGED; NONOVER-LEVERAGED; NON-COMPETITIVE COMPETITIVE
SHARE GAINS FLAT REVENUE
WELL FINANCED; STABLE/GROWING MARKET SHARE; COMPETITIVE ADVANTAGE
Source: Knight Strategic Research Knight Capital Americas, L.P.
CREDIT CONTRACTION
ANEMIC NOMINAL GDP
50
Strategic Research
Unquestionably, Corporate America Is Thriving Relative to Main Street
Corporate Cash Flow vs. Household Net Worth The Growing Chasm
Billions
$1,600 $1,400
$60,000
$50,000 $1,200 $1,000 $800 $600 $20,000 $400 $200 $0 $10,000 $40,000
$30,000
$0 US Corporate Profits With IVA and CCA Net Cash Flow SA

1951 1955 1959 1963 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003 2007
Household Net worth (RS)
Billions
$1,800
$70,000
51
Strategic Research The Game Is Over
If investors all get caught in a 1914-style crisis, they will all go down 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 major geopolitical crisis to the realm of uncertainty, and treat it like the risk of an asteroid hitting the earth. Common sense tells us that a major war is much more likely than an asteroid, or indeed the melting of the polar ice caps. But there are incentives for investors and financial professionals to ignore the risk of crises. Niall Ferguson Barrons: March 12, 2007
Strategic Research
The Commodity Markets Are Overrun and Present a Major Risk to Global Stability
UN Food and Agriculture World Food Price Index
220
340
Crude vs Copper vs CRB Raw Industrials Indexed to 100 1/2/09
200
300
180
260
220
160
180
140
140
120
100
100
60
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
WTI CRUDE FUTURE Indexed 100=1-2-2009
80 Jan-91 Sep-92 May-94 Jan-96 Sep-97 May-99 Jan-01 Sep-02 May-04 Jan-06 Sep-07 May-09
Source: Food and Agriculture Organizat, KSR
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
Quite obviously, controlling food price inflation is critical to the well-being of the world. We cannot understand why the United States agricultural belt is still being used to produce corn for ethanol rather than being markedly expanded to increase production for trade around the world. Perhaps an enlightened client will inform us?
It is incredible to us that the debate regarding the deleterious and destabilizing impact that speculators have on the commodity markets still rages on. We fully appreciate the necessary role that true speculators bring to the markets, but we are aghast that more isnt done to rationalize access. How can it possibly not distort price and, therefore, the operations of real businesses and the functioning of the global economy, when investment banks are caught stockpiling? And how can the profusion of ETFs which are heavily marketed to individuals not be a negative?
53
Strategic Research
Manufacturing Labor Has a Call on Finished Goods Pricing
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 buy 100 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 your productivity increases by 10%/year, your compensated value would decline even further.
COMMODITY PRICES FORCE WAGE INFLATION
IN ARG M
DECLINING VALUE OF LABOR
INPUT COSTS
LABOR
54
Strategic Research
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 tied to commodity prices, rising finished goods prices will face stiff elasticities of demandor outright substitution. So if commodity price increases persist, the manufacturing intensive emerging world will 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 marginal capacity.
WEAK DEMAND
FLAT PRICES
CFLO
CREDIT PROBLEMS
DEVELOPED WORLD DEFLATIONARY PRESSURE RISING COMMODITY PRICES
CHINA INFLATIONARY/ STAGFLATIONARY PRESSURE FOREIGN EXCHANGE RESERVES FALL
WEAKER DEMAND
INCREASED PRICES
WAGES
INFLATION
55
Strategic Research
So Really, Commodity Price Increases Will NOT Lead to Inflation Here
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 price inputs MUST be passed along to export markets, or domestically, through imports or direct to consumer price increases.
Inflation Flows in the Economy

Export Price Index Producers Price Index (outputs)
Import Price Index
Production Sector outputs
Expenditure by production/government sector
Expenditure by household Sector
Labor costs
Current costs
Capital costs
Labor Cost Index
Producers Price Index (inputs)
Capital Goods Price Index
Consumers Price Index
Source: Government of New Zealand, KSR Knight Capital Americas, L.P.
56
Strategic Research
Because in the Aggregate, Nominal Consumer Demand Is Structurally Impaired
COLLATERAL?
NO CREDIT/DELEVERAGING
EQUITY? EXCESS CASH FLOW? RISING ASSET VALUES?
Inflation Flows in the Economy

Export Price Index Producers Price Index (outputs)
ANEMIC WAGES
Import Price Index
Production Sector outputs
Expenditure by production/government sector
Expenditure by household Sector
Labor costs Current costs Capital costs
JOB SECURITY?
RISING PROPENSITY TO SAVE
CUSHION? NEW RETIREMENT CALCULUS DEMOGRAPHICS
Labor Cost Index
Producers Price Index (inputs)
Capital Goods Price Index
Consumers Price Index
Source: Government of New Zealand, KSR
COMPETITIVE IN IP MODEL?
BLEAK WAGE & ROI EXPECTATIONS
DRIVE VALUE IN IP CHAIN? INVESTMENT/EQUITY RETURNS?
57
Strategic Research
We Therefore Believe The Game Is Over
We first made our Game Over call back in November; and since then, our conviction level has increased. What we are saying is that structurally, per this chart, the global terms of trade have been pushed past their tipping point. And it is our hope that the elements of this publication will all come together in support of our position. In essence, we believe the disparity between the prevailing economic and financial structures around the world, in conjunction with the policies being effected by governments (particularly China) are in the process of pushing the markets towards a significant dislocation. Specifically, as we will cover later in this report, China is caught in a double-bind of its own making. We believe that the price/wage spiral that has commenced will not be contained by policy initiatives. Attempts to do so, will only keep the upward pressure on commodities and input prices firm, making the inevitable breakdown of past trend that much worse.
GOVERNMENT POLICY
TERMS OF TRADE
ECONOMIC SECURITY
RESOURCE & INDUSTRY
58
Strategic Research
We Believe the BRIC and Commodity Rally Is An Echo Bubble
MSCI BRIC (12/10) vs DOW 1929 vs NDX 2000
5,000 4,500 4,000 3,500 3,000 250 2,500 500 450 400 350 300
200
2,000 150 100 50
1,500
1,000 500 NDX Index 2000 Peak
5 YEARS
MSCI BRIC 2007 Peak DOW Index 1929 Peak (RS)
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Strategic Research
Which Is More Plausible Looking At This Chart
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 commodities since 1800; the importance is that it has reached a well defined trend line.
Commodity Prices in the US 10-Year Average Growth Rate Commodity Prices in the US 10-Year Average Growth Rate
12% 12% 10% 10% 8% 8% 6% 6% 4% 4% 2% 2% 0% 0% -2% -2% -4% -4% -6% -6% -8% -8% 1805 1805
1835 1835
1865 1865
1895 1895
1925 1925
1955 1955
1985 1985
2015 2015
Source: U.S. Census Bureau, BLS, KSR Source: U.S. Census Bureau, BLS, KSR
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Strategic Research
And As Confirmed By These
102.4
US Stock Prices Relative to Commodity Prices Four Periods of Commodity Outperformance
S&P 500 INDEX / ThomReuters/JefferiesCRB

1100% 1000%
51.2
900%
25.6
800%
12.8
Logarithmic Scale
700%
6.4
600%
3.2
500%
1.6
400%
0.8
300%
0.4 1871 1881 1891 1901 1911 1921 1931 1941 1951 1961 1971 1981 1991 2001 2011
Source: Shiller, US Census Bureau, Bloomberg, KSR
200% 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
Stocks have underperformed commodities in four distinct periods since 1900. The difference now, and the argument against the prior 10-year average 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 conditions in the developed world cant tolerate a different outcome.
Calling long-term cycles on the basis of charts alone is foolhardy, but the evidence is starting to build.
61
Strategic Research We Are the Masters Now
It would be foolish, in forming our expectations, to attach great weight to matters which are very uncertain...[since] investment based on genuine long-term expectation is...scarcely practicable [because] capital investment [is controlled] by persons [without special 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)
Strategic Research
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 the 1980s: 1. Massive disparity of wealth, income, and education. 2. Rapid industrialization and displacement of labor. 3. Opaque and misleading economic and financial data. 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 in disintermediated credit. 7. Expected transference of economic growth to domestic demand. 8. Accelerating price/wage spiral.
Source: IMF
The clearest investment case against China is also the most fundamental. It is trapped in a double bind of its own making. For despite the CPCs own hubrisand the ubiquity of the worlds confidence in itChina appears to have lost control. And in an ironic twist, it has 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 threatens widespread social unrest. And what is its option? To crush speculation and the extension of credit and risk a deflationary collapse? China no longer controls its own destiny; the free markets do.
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Strategic Research
Fixed Asset Investment Is Now 70% of GDP
China GDP; Composition of Growth Net Exports, Capital Formation, Final Consumption
100% 80%
14,000
China Fixed Assets Investment versus China Export Trade (Projected 6 Months)
R = 0.9988
160
R = 0.9506
12,000
140
60%
10,000
120
100
CNY Billions
40%
80 6,000 60 4,000 40 20 0 12M Avg. China Fixed Assets Investment China Export Trade (RS) $ Billions
20%
0%
2,000
-20% 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 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
0 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
Poly. (12M Avg. China Fixed Assets Investment)

Source: China Economic Information Net, KSR
Poly. (China Export Trade (RS) $ Billions)
Much like Japan in the 1980s, Chinas culture of thrift has prevented the hand-off of economic growth to domestic consumption. The bull case is that this impediment (household savings rate runs between 30% - 50%) will vanish when the CPC establishes a social security system. We dont agree. If the U.S. populace does not trust our governments management of a similar system, will the trust of the Chinese populace be so strong as to transform its own culture?
Plain and simple, the physics of finance and economicsand all that makes for good common sense and practical experiencesays that the exponential expansion of fixed assets supported by a pyramid of debt always ends in tears.
64
$ Billions
8,000
Strategic Research
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.
Intensity and Duration of Capex Booms

(Fixed Asset Investment/GDP and Years)
70%
CHINA (2010)
65%
60%
55%
China ('96-2009)
50%
45%
Maylaysia (90-97) Thailand (89-97)
40%
Japan (68-74)
Korea (90-97)Singapore (91-99)
35% 5
Source: IMF, KSR
10
11
12
13
14
Number of Sequential years of Capex Boom
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Strategic Research
Banking System Leverage and Government Debt Are Grossly Understated
China's Debt to GDP Is At Least 70% versus the "Official" 17.5%
70%
Net New Credit Flows (CNY Billions)

12,000
10,000
60%
8,000
50%
6,000
40%
30%
4,000
20%
2,000
10%
2007
0% "Official" Policy Bank Bonds Government Bonds NPLs on stateowned AMC LGFV Bonds LGFV Infrastructure Loans LGFV "Other" Loans
CNY and FX Loans
2008
2009
H109
H110
Undiscounted Acceptances Claims of Hong Kong Banks on China
9M09
9M10
CWMPs and CTPs (Credit-Related Wealth Management/Trust products)
Source: Wind, Fitch, KSR
Source: Merrill Lynch
Chinas arcane system of laws and the requirement that local governments fund the bulk of infrastructure development, has given rise to an opaque network of over 8,000 LGFVs (local government funding vehicles). Essentially these are Chinas form of public sector SIVs, and its massive build-up of debt isnt included in official estimates of national debt, as we see it.
Fitch Ratings has done groundbreaking work on uncovering the disintermediation of domestic credit in China. According to its research, some 3 trillion yuan of credit has been created within Chinas trust banking system, in 2010. This is a 40% increase over the governments 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 to understate leverage to regulators.
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Strategic Research
The Incremental Productivity of Chinas Runaway Credit Growth Is Collapsing
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.
China Total Loans YoY Change vs. GDP YoY Change (CNY)
12,000
As Adjusted Per Fitch Findings

10,000
8,000
6,000
4,000
2,000
0
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 of Financial Institutions YoY Change (CNY Billions)

China GDP 4Q Sum YoY Change (CNY Billions)
Source: China Economic Information Net, Bloomberg, KSR
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Strategic Research
And This Is a Great Risk for Asia
Citigroup Economic Asia Pacific Surprise
60
10
-40
-90
-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-1 Citigroup Economic Surprise Index - Asia Pacific
Source: Citigroup, KSR
Source: Hong Kong Monetary Authority
The Hong Kong Monetary Authority published this data. It shows the CoVAR between Asian nations as measured by CDS volatility. If China catches a cold....
The trend of economic surprise in Asia is already perilous.
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Strategic Research
And for the Developed World
%
14
G7 Composite Leading Index YOY % vs. MSCI World Index YoY

75%
Number of US Cos Issuing Financial Outlooks Up / Number of US Cos Issuing Financial Outlooks Down
1.6 1.4
50%
+4 Stdev
10
+3 Stdev 1.2
6
25% 2 0% -2 -25% -6 -50%
1.0 0.8 0.6 0.4 0.2
+2 Stdev
+1 Stdev
Median
-1 Stdev
-2 Stdev 0.0 -0.2 -3 Stdev
-10
-14
-75%
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
-0.4 Jan-00 Dec-00 Nov-01 Oct-02 Sep-03 Aug-04 Jul-05 Jun-06 May-07 Apr-08 Mar-09 Feb-10
Source: Bloomberg Indices, Bloomberg, KSR
-4 Stdev Jan-11
OECD G7 Composite Leading Ind. Total Trend Restored YOY %

Source: Organization for Economic Coop, KSR
MSCI WORLD YoY % Change
It looks to us like the global equity markets have done a very thorough job of pricing in the recovery of G7 leading indicators.
This chart is striking. As we entered 2011, the imbalance between US companies raising and lowering guidance was almost 4 standard deviations above normal. And although we cannot gauge just how much guidance would soften in the event of a China breakdown, given such acute sentiment, a major disruption seems reasonable.
69
Strategic Research Dont Trust the Orthodoxy
Too large a proportion of recent mathematical economics are mere concoctions, as imprecise as the initial assumptions they rest on, which allow the author to lose sight of the complexities and interdependencies of the real world in a maze of pretentious and unhelpful symbols. John Maynard Keynes, The General Theory of Employment, Interest and Money (1935)
Strategic Research
We Heartily Disagree with the Consensus View and Orthodox Theory
We believe that consensus opinion and the orthodox theoretical views of how government indebtedness and the actions of the U.S. Treasury and the Federal Reserve impact interest rates, inflation, and ultimately, fiscal sustainability, are wrong. The prevalent view is very powerful because it is quite intuitive. It is based upon two central beliefs: 1) that the monetary policies of the Federal Reserve can create inflation; and 2) that the deteriorating fiscal position of the United Statesfueled by persistent budget deficits, and guaranteed by the growing unfunded liabilities of Social Security and Medicarewill cause Treasury bond holders to demand higher rates of return on their loans. The natural extension of this reasoning, therefore, is that interest rates will go up; and when they do, the interest expense on accumulating government debt will spiral without bound, and with it, the purchasing power of the dollar will collapse. We heartily disagree, and fully appreciate that of all our dissenting opinions, none is more controversial than this one. This is a very complex issue, and recognizing that our position is far afield from what is commonly understood, we expectand hopethat many of you will desire a more detailed presentation than the high-level introduction that follows. (We would like to acknowledge our deep gratitude and indebtedness to Scott T. Fullwiler, Associate Professor of Economics and James A. Leach, Chair in Banking and Monetary Economics at Warburg College, for their work and assistance in helping us understand the view to which we now subscribe.)
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Strategic Research
Monetary System Basics Within A Free-floating Currency Regime
1. Central banks operating target is necessarily an interest rate target. 2. Modern, currency issuing sovereigns with free-floating FX spend via the crediting of reserves. a. Printing money vs. financing spending is a false dichotomy. b. Present value of liabilities or pre-funding makes no sense since user and issuer of the currency are one and the same. 3. Bond sales and tax collections are interest rate maintenance operations, NOT financing operations. 4. Deficits with or without bond saleswhether to the Fed or to the private sectorhas no affect other than on the overnight rate. a. It is the size of the deficits themselves, not whether bonds are sold, that matters for aggregate demand, as government deficits necessarily increase private savings. b. Whether deficits actually raise aggregate demand and potentially create inflation depends upon the private sectors relative proclivity to save or spend. i. Note Japans deficits of >7% of GDP.
Source: Interest Rates and Fiscal Sustainability, Scott T. Fullwiler Working Paper No. 53 Knight Capital Americas, L.P.
5. Interest rates are Monetary, Not Real Phenomena a. Central bank targeted rate anchors other rates. b. With interest payment on reserves and no bond sales, rate on national debt is rate paid on reserves. c. If short-term bonds are issued, these rates are set via arbitrage with Feds target. d. If long-term bonds are issued, these rates are set via arbitrage with current and expected Fed target AND premium attached to debt of increasing maturity. e. Long end of term structure is set mostly by expectations of short-term rates.
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Strategic Research
Money Supply Growth Does Not Cause or Reflect Rising Inflation
Despite prevalent belief to the contrary, expanding monetary aggregates do not cause or reflect rising inflation. Inflation is a self-reinforcing systemic issue, not a simple matter of rising prices. For rising prices cannot be sustained if they are not supported by inelastic demand; and inelastic demand cannot exist unless supported by rising wagesor credit. Thus, in the current environment, when commodity prices rise the effect is deflationary, because discretionary spending is redirected to satisfy non-discretionary needs.
% 12
US Personal Consumption Expenditure Core Deflator Three Month Annualized % vs. M2 YoY%
14%
10
12%
10% 8 8% 6 6% 4 4% 2
2%
0 1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 US Personal Consumption Expenditure Core Deflator Three Month Annualized % Federal Reserve Money Supply M2 SA YoY % Change (RS)
0%
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Strategic Research
The Fed Cannot Create Credit Growth
The Federal Reserve targets interest rates by managing the mix of government liabilities held by the public. These are: currency in circulation, bank reserves, and Treasury debt. So, by dramatically increasing the asset side of its balance sheet, the Fed dramatically increases the governments liabilities; in this case, mostly bank reserves. However, as is clear, huge reserve balances have no affect on credit growth when the system is already overleveraged.
Fed Balance Sheet

Extraordinary Balance Sheet Growth
2,000
1,500
1,000
Treasury Holdings Now Just Above Normal
500 0 -500 -1,000
Extraordinary Reserve Growth
-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
Treasury Securities Held Emergency Facilities & Other Assets All Other Liabilities Source: Federal Reserve, , KSR
Fed Agency Securities Held Currency in Circulation
MBS Held Balances with Reserve Banks
$ Billions
2,500
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Strategic Research
Thus as Experienced in Japan, QE2 Cannot Force Credit Growth Either
Since its founding in 1913, the Federal Reserve has held an amount of Treasury bonds about equal to currency in circulation; that is, until it liquidated a huge portion of its holdings to shore up emergency funding activity in 2008. Thus, until just the past sixty days, the Fed was simply reconstituting its normal position. But now, as the Feds purchases continue, its excess holdings are further inflating the asset side of its balance sheet and putting more reserves into the system. And to what effect? Interest rates are rising, and so too are concerns about the fiscal position of the United States.
$ Billions
1,200
Federal Debt Held by Federal Reserve Banks vs Currency in Circulation
1,000
800
600
400
200
0 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 Currency In Circulation
Federal Debt Held by Federal Reserve Banks
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Strategic Research
So the Justifiable Concern Is Sustainability
The Orthodox View of Fiscal Sustainability

The governments total fiscal policy may be considered balanced if todays publicly held debt plus the present value of projected non-interest spending is equal to the present value of projected government receipts. For the entire federal governments policy to be sustainable, its fiscal imbalance must be zero. The government cannot spend and owe more than it will receive as revenue in present value.
Fiscal Imbalance Present Value Expenditures Present Value Revenues Net National Debt
Source: Interest Rates and Fiscal Sustainability, Scott T. Fullwiler Working Paper No. 53
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Strategic Research
The Orthodox View Is Quite Easy to Understand
The Governments Budget Constraint
G + iB = T + B + M
Where: G = Government Spending B = Accumulated Deficit T = Taxes B = Budget Deficit M = Change in Money Supply iB = Interest on Debt
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Strategic Research
Because It Requires a Balanced Budget, Which Makes Sense
Fiscal Imbalance and Sustainability

For Fiscal Imbalance = 0, projected (G-T) = -B If Fiscal Imbalance=0, then B/GDP does not grow Does not require B 0 DOES require (G-T) <0 if currently B>0 If Fiscal Imbalance>0, B/GDP grows without bound (i.e., is UNSUSTAINABLE) due to iB and B (pace depends on G-T and r-) Where: r = Real Interest Rates = Real GDP Growth
78
Strategic Research
But the Government Can Print Money to Pay Interest; So It All Hinges on Rates
The top table illustrates the orthodox view. Rates are assumed to be higher than GDP growth, since it is intuitive that the markets would demand higher compensation for funding a deteriorating fiscal position. This data was intended to show that the only way out was through a budget surplus varying inversely with GDP growth.
Real GDP
3% 3%
Infinite Horizon Fiscal Primary Imbalance Deficit Eq. (12) g-t

0 44,214 -0.28% 2.13%
In 30 Years PV of future Primary Deficits

-5,137 39,077
In 75 Years
int/GDP
1.68% 4.33%
b 30
1.4% 6.45%
b 30
48.0% 126.7%
int/GDP
1.68% 9.43%
b 75
1.4% 11.56%
b 75
48.0% 273.6%
2% 2%
0 44,214
-0.75% 5.73%
-5,137 39,077
1.69% 10.01%
0.94% 15.74%
48.0% 293.9%
1.69% 33.25%
0.94% 38.98%
48.0% 962.6%
This table shows another way out; interest rates must remain below GDP growth. And note, under this condition, both debt/GDP and interest expense/GDP are a decreasing burden in a slower growth environment.
Sustainable Fiscal Policy with - r = 1%
Real GDP
3% 2%
Infinite Horizon Fiscal Primary Imbalance Deficit Eq. (12) g-t

0 0 0.47% 0.47%
In 30 Years PV of future Primary Deficits

-5,137 -5,137
In 75 Years
int/GDP
0.93% 0.47%
b 30
1.4% 0.94%
b 30
48.0% 48.0%
int/GDP
0.93% 0.47%
b 75
1.4% 0.94%
b 75
48.0% 48.0%
Source: Interest Rates and Fiscal Sustainability, Scott T. Fullwiler Working Paper No. 53 Knight Capital Americas, L.P.
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Strategic Research
And THIS IS THE KEY: The Fed Anchors Rates and Arbitrage Limits the Spread
US Generic Govt 10 Year Yield Less Federal Funds Effective Rate US
+4 Stdev
5.7
+3 Stdev
+2 Stdev 3.7 +1 Stdev 1.7
Median
-0.3
-1 Stdev
-2 Stdev -2.3 -3 Stdev
-4.3 Feb-89
Source:Bloomberg,KSR
Dec-90
Oct-92
Aug-94
Jun-96
Apr-98
Feb-00
Dec-01
Oct-03
Aug-05
Jun-07
Apr-09
-4 Stdev Feb-11
Ping all they want, but the bond market vigilantes and the market do NOT set rates. Banks need reserve balances to settle +/- $2 trillion of transactions per day. As a result, through its target rate, the Fed influences all other short-term rates through arbitrage. And this affect holds true at longer maturities as the coupons flow down the term structure of the yield curve. Thus, Any market inducedforeign or domesticdrivenupward pressure on U.S. intermediate or long-term rates would/will be limited by the leash of the Feds...anchoring of the Fed funds rate...[functionally] there is a limit to how steep the yield curve can get if the Fed just says noagain and again. (Paul McCulley, Fed Focus, October 2003, PIMCO)
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Strategic Research
Also, Note That Budget Austerity Crushes the Impact of Fiscal Stimulus
DeflationaryImpactofFiscalSpending GivenTrendTowardAusterity
Fiscalstimulusthroughdeficitspendinganchorsforward expectationsofexpensecutsand/ortaxincreases. PastpatternsofGovernmentbehaviorstronglyfavortaxincreases. 1% Taxes 3% GDP
EconomicBenefit from FiscalSpending
NetPresentLiabilityof ExpectedFutureTax Increases
81
Strategic Research
But What About Persistent Balance of Payments (BOP) Deficits?
ADifferentPerspectiveontheU.S.BalanceofPayments
BalanceofPayments(BOP)=CurrentAccount+CapitalAccount CurrentAccount=TradeBalance+NetReturnonCapitalAccount CapitalAccount=NetInvestmentPosition IP(IntellectualProperty) CapitalMarkets CentralBanking
U.S.
Labor Oil TradeSurplus
ROW
It is common wisdom that global imbalances are a negative for growth and necessitate major currency adjustments. We dont agree, however. Cost differentials between countriessuch as wage rates in the U.S. and Chinacannot be balanced through currency changes. And since said imbalances have been persistent for decades, we think it more likely that a different balance is being struck. As shown in this graphic, we think that the United States has effectively exported: IP, global central banking, and the deepest and most secure financial markets in the world; in exchange for: cheap labor, oil, and capital investment.
82
Strategic Research
Trade Is the Largest Component of the BOP; and Its Not So Bad
Net US Trade Deficit & Positive Services Offset
Net Trade Balance & Balance Net of Petroleum Imports
$10 $0 -$10 $10 $0 -$10 -$20 -$30 -$40 -$50 -$60 -$70 -$80 Jan-04 Aug-04 Mar-05 Oct-05 May-06 Dec-06 Jul-07 Feb-08 Sep-08 Apr-09 Nov-09 Jun-10 Positive Services Balance (Billions)
Source: U.S. Census Bureau, KSR
-$20
-$30 -$40 -$50 -$60 -$70 -$80 Jan-04 Aug-04 Mar-05 Oct-05 May-06 Dec-06 Jul-07 Feb-08 Sep-08 Apr-09 Nov-09 Jun-10 Net US Trade Balance (Billions) Net Trade Balance (Billions)
Source: U.S. Census Bureau, , KSR
Trade Balance Less Crude Imports (Billions)
The U.S. trade deficitone of the hottest political footballs of recent timesreally has three component parts. The first is the services balance, which has always beenand remainspositive. The other component, which gets all the attention, is the US negative product account. (We dont believe this accurately reflects a thing given the vagaries of accounting for technologynot to mention the vast amounts of IP that are pirated.)
So the product account is decidedly negative, but guess what? Petroleum has been averaging 50% of the deficit since mid-2007. By the looks of the orange linewhich represents the U.S. trade deficit net or petroleum imports it appears that our non-oil negative balance has been cut by 50% since 2005.
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Strategic Research
And Then the Capital Account; Though They Own More, We Earn More
Foreign-owned assets in the United States vs U.S.-owned assets abroad
$ Billions
$25 10.0% 9.0% $20 8.0% 7.0% $15
U.S. Return on Foreign Owned Assets vs. Foreign Return on U.S. Owned Assets
6.0%
5.0%
$10
4.0% 3.0%
$5
2.0% 1.0%
$0 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 Foreign-owned assets in the United States
1976
1979
1982
1985
1988
1991
1994
1997
2000
2003
2006
2009
Payments on Foreign-Owned Assets in the U.S. / Foreign-Owned Assets in the U.S.

Income on U.S.-Owned Assets Abroad / U.S.-Owned Assets Abroad
Source: BEA, KSR
U.S.-owned assets abroad
Yes, the U.S. capital account is negative, and consistently so since 1990; i.e. they own more of us than we own of them. But, so what? Can you blame them? The United States has long had the most attractive asset pool in the world; particularly when coupled with the strength of our property laws and the depth of our capital markets.
But despite our negative capital account, the spread between our returns on their assets, and their returns on our assets has always been positive. So much so, that in the aggregate, the U.S. investment account is also positive. This is easy to understand if we consider the U.S. to be the worlds banker.
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Strategic Research
The U.S. Chooses to Sell Bonds; and We Dont Need China to Buy Them
China Holdings of US Treasuries vs. US Household Treasury Holdings (ex-Savings Bonds) and Household Holdings as % of Net-Worth
1,000 900 800 700 2.0% 2.5%
600
500 400 300 200 100 0
1.5%
1.0%
0.5%
0.0%
Mar-00 Feb-01
Jan-02
Dec-02 Nov-03 Oct-04
Sep-05 Aug-06
Jul-07
Jun-08 May-09 Apr-10
US Treasury Foreign Holders China $ Billions FOF Households and NPO Total Treasury Securities Ex-Savings Bond Assets $ Billions Treasuries as % of Household Net Worth (RS)
Source: US Treasury, Federal Reserve, Bloomberg, KSR
As a sovereign issuer of fiat currency within a free-floating foreign exchange regime, the U.S. government in not financially constrained. As we view it, the Treasury sells bonds at their own discretion. That said, however, the consensus seems to believe that the United States needs China to buy its bonds. Not true. As shown in the chart above, U.S. households now own more Treasury bonds than China, a position acquired in just 18 months and one that only represents about 2% of their net-worth.
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Strategic Research
But If All That Is True, What About the Value of the Dollar?
The Shocking Truth About Money
Money is the most basic form of credit; it has no value in and of itself. Thus, fiatderived from the Latin origin let it be doneis not backed by the tangible wealth of the issuing Sovereign; but rather, by the full faith of the issuing government to uphold the laws and regulations which support its value as a transaction medium. Moreover, it is the Sovereign itselfthrough the collection of taxes, which must be paid with fiat, and through payment of its own obligations with the same fiatthat ensures private sector acceptance of the currency; and therefore, ensures its foundation of credit worthiness. And as a reserve credit (i.e. a reserve currency) the utility of any fiat is directly related to the breadth of its use and the scope of its acceptance around the world. In this sense, gold is not money; nor is any other store of value. That does not mean that barter systems could notand do notuse such things as money, but ultimately, as history is our guide, those systems have always failed.
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Strategic Research
The Rising Use and Acceptance of the Euro Helps Explains the Trend of the EUR/USD
%
74
Foreign Exchange Holdings
%
30
%
80 78 76
% of Foreign Exchange Holdings In US Dollars vs. Euro/USD Exchange Rate (inverted)

0.8 0.9
72
28
70
26
1.0
74 1.1 1.2 1.3 1.4
68
24
72 70 68
66
22
64
20
66 64 62 1.5 1.6 Mar-00 Mar-01 Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Total Foreign Exchange Holdings In US Dollars As A Percentage Of Total Allocated
Source: International Monetary Fund, Bloomberg BGN, KSR
62
18
60 Mar-99 Mar-00 Mar-01 Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Total Foreign Exchange Holdings In US Dollars As A Percentage Of Total Allocated Total Foreign Exchange Holdings In Euros As A Percentage Of Total Allocated (RS)
Source: International Monetary Fund, KSR
16
60 Mar-99
EURO SPOT (RS)
The ECB did an outstanding job of increasing the structural demand for the euro once Trichet took over. By inserting the euro and the ECB into various types of international transactions (some rather esoteric like the old Brady bonds), the amount of global reserves held in Euros rose from 18% to 27% in a decade.
Accordingly, we believe the secular increase in demand for the Euro versus the static demand for dollars (by definition given its dominant reserve position) was a driving factor in determining the cross-rate. Moreover, and certainly more conjecturally, we believe that the invasion of Iraq by the United States, ignited a fire storm of anti-imperialist sentiment which directly translated into the accelerating use and preference of the euro.
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Strategic Research
In the Short-Term, Sentiment and Momentum Drive FX
Currency Market Price Signals Are Often Untrustworthy
BBThe Foreign Exchange Market (FX) is the worlds largest and most liquid financial
bazaar with close to $4 Trillion being traded each and every day. BBImportantly, the market itself has an expected return of zero. In other words, individual traders may be able to derive repeatable positive returns, but in the aggregate, profit and loss will always equal zero. BBAnd yet, despite this starkly non-investable quality; academics, consultants, and institutional investors alike are coming to believe that FX trading is an asset class. BBWhy? For precisely the same reasons many believe commodities are an asset class; because the returns generated from various active and passive strategies are both: 1) Uncorrelated to the performance of their core portfolio holdings, and 2) Because the hope of return enhancement justifies the means.
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But the Exchange Value of Reserve Currencies Are Self-Correcting
The Dollar Cannot Collapse Without Causing a Global Depression
BBHighly regarded orthodox economists correctly predicted a financial crisis for the United States,
but their expectation was that foreign savings would abandon the dollar and drive down real rates abroad, and drive up real rates in the U.S. BBIn addition, reflecting the change in rates, asset prices abroad should have risen while all U.S. asset prices fell. Moreover, this would spike savings in the U.S. relative to other countries, which would not only correct the U.S. account deficit, but the real value of the dollar was to fall by 40% to reflect the adjustment to more production and less consumption. So much for theory. BBAs we see it (and as briefly covered earlier) the United States will remain the global safe haven; and therefore, the worlds banker. But more than that, because some 85% of the worlds financial transactions occur in dollars, and because of the now obvious structural factors which preclude the euro from ever becoming a primary reserve vehicle, we consider abandonment of the dollar standard to be literally impossible. BBTherefore, as THE reserve currency for the foreseeable (and most likely distant future), the exchange value of the dollar versus every other fiat currency is of significant and material importance to every open economy in the world. BBMoreover, the exchange value of the dollar cannot change by itself. Again, as a unit of creditnot a store of valueshifting exchange rates directly impact the relative price and competitive position of goods and services from different countries. BBThus, as was experienced when the EUR/USD traded near 1.60, the economic pressure on EU nations was severe. BBWe will not make our case herenamely, that we see the EUR/USD trading towards parity over time but simply reinforce a very fundamental idea: FX cross-rates cannot materially change without forcing or reflectingmaterial changes in economic position and structure.
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So Heres the Good News
BBLong-term fiscal sustainability results when nominal interest rates are kept below
nominal GDP growth; as we see it, it is a mathematical reality. BBThe Federal Reserve anchors the yield curve by maintaining a targeted rate and paying reserves on unused balances. And if the Feds policy stays firm, arbitrage will reverse any attempt by speculators to drive yields past what is defined by the coupon roll down the term structure. BBThe degree to which future deficits might cause inflation is a function of their size and the private sectors proclivity to save or spend. BBThe dollar has no value other than its use a vehicle for exchanging credits. On this basis, the dollar standards security is a function of its use; and currently, some 85% of all the worlds financial transactions are in dollars. BBThe exchange value of the dollaras the established reserve currencyis gated by its relative impact on other economies; and therefore, it cannot decline significantly and precipitously without having materially negative consequences for the global economy. BBThe U.S. account deficit, as it is today, does not need to be balanced in a conventionally theoretical way; and does not present a material risk to the U.S. economy or global trade.
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Strategic Research The Long Road Ahead
The ideals which have lighted me on my way and time after time given me new courage to face life cheerfully, have been Truth, Goodness, and Beauty. . . . The ordinary objects of human endeavour -- property, outward success, luxury -- have always seemed to me contemptible. Albert Einstein; The World As I See It (1934)
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It is our great hope that the credit crash of 20072008 has ended the era of governance based upon the extension of social entitlements without sacrifice, and the guarantee of prosperity without vision. We contend that the death of the 75-year Consumer Credit Super Cycle has rent the fabric of power in Washington; and whether the political establishment knows it or not, America is just fine, but the old ways of government are on the way out.
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The Water Line Has Receded and the Truth Is Exposed
Steadily increasing transfer payments have obscured the weakening condition of household income growth. If we could chart standard of living growth relative to income, we are quite sure the line would have been steeper than at any other time in modern history and warned of great danger ahead.
YoY% Change US Disposable Personal Income Less Transfer Payments (w/ Recession Bars)
19.00% +4 Stdev
+3 Stdev 14.00% +2 Stdev
9.00%
+1 Stdev
Median 4.00%
-1 Stdev
-2 Stdev -1.00% -3 Stdev
-6.00% 1951 1955 1959 1963 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003 2007
Source: NBER, Bloomberg, KSR
-4 Stdev
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The Disparity in Income and the Public Sectors Self-Enrichment Are Shocking
US Share of Income for Top 1% Population
23% 21% 19% 17%
Average Compensation: June 2010 $ per hour worked Public Sector Total compensation $39.74 Wages and salaries 26.13 Benefits 13.62 Paid leave 3.01 Supplemental pay 0.34 Health insurance 4.55 Defined-benefit pension 2.86 Defined contribution pension 0.31 Other benefits 2.55 Private Sector $27.64 19.53 8.11 1.86 0.78 2.08 0.42 0.54 2.43 Public/Private Ratio 1.44 1.34 1.68 1.62 0.44 2.19 6.81 0.57 1.05
15%
13% 11% 9% 7% 5% 1913 1918 1923 1928 1933 1938 1943 1948 1953 1958 1963 1968 1973 1978 1983 1988 1993 1998 2003 2008
Source: Emmanuel Saez, Income and Wealth Inequality, KSR
Source: Bureau of Labor Statistics
The disparity of wealth and income is accelerating around the world. In the United States, we surmise (this data series stops in 2008) that it is now equal to the top set before the Great Depression. Moreover, not only will this factor greatly intensify political pressure in the tough times ahead, but from an analytical perspective, we are convinced that it distorts aggregate measurements of consumer behavior.
And the income disparity is not just between the rich and the poor; but between the public and the private sectors. Even though this issue has received a growing amount of attention, we dont believe that the U.S. body politic is fully aware of just how outrageous the differential is. But of course, there is more...
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Public Labor Unions Are in the Cross-Hairs; and They Will Lose
14
California % Unemployment vs YoY % Chg Total Non-Farm US Payroll
-6%
Private and Public Union Membership and Density, 1977-2006

16 14 45% 40% 35% 30% 25% 8 20% 6 4 2 0 1977 15% 10% 5% 0% 2006
%Union `
12
-4%
10
-2%
12
Members (millions) `
10
0%
2%
4%
6%
1976
1979
1982
1985
1988
1991
1994
1997
2000
2003
2006
2009
Source: Barry Hirsch, Georgia Tech University: W.J. Usery Chair of the American Workplace
1980
1983
1986
1989 1991
Priv_Mem
1994
1997
2000
2003
Unemployment Rates by State California

US Non-Farm Payroll YoY % Chg Inverted (RS)
Pub_Mem
%U_Private
%U_Public
Although Californias real estate market has rationalized itself much faster than other distressed markets (due to a more effective legal structure), employment as not improved. We believe this reflects both the large impact of its fiscal crisis, as well as the broadly disparate wealth and income profile across the state. Moreover, we surmise that high unemployment will improve the fight to change the states charter and attack its public unions.
We first heard about the push to enable states to declare bankruptcy back in the September. It made great sense then, and still does, as it appears to be the only real way to bust public union strangleholds.
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The Excesses of the Past Decade Are Extraordinary
Square Feet of Housing Built Per Occupant
1,000 950
$17,000 $19,000
Per Capita (Working Population) Cost of Transfer Payments
900 850 800

$13,000
$15,000
750 700 650 600

$7,000 $11,000
$9,000
550 500 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007
Source: U.S. Census Bureau, Current Population Survey, KSR
$5,000 Jan-90 Oct-91 Jul-93 Apr-95 Jan-97 Oct-98 Jul-00 Apr-02 Jan-04 Oct-05 Jul-07 Apr-09
The gluttony of square footage built during the housing boom has left an overhang that will never effectively clear. Essentially, with the speculative premium now gone, value will be driven by proximity to work. Therefore, excess square footage becomes a liability; particularly given the likely pressure from property taxes and rising utility bills.
Thats right: $17,000 per capita is the annual cost of transfer payments.
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And the Population Is Growing Older Quite Quickly
The Accelerating Explosion of the AGED US Census Projection of Population Change by Age
14000
RETIREMENT CALCULUS
LIFE EXPECTANCY BASE EQUITY EXPECTED RETURNS WAGE EXPECTATIONS SAFETY NET
Thousands
12000
YOU ARE HERE
10000
8000
SAVINGS INVESTMENT
6000
4000
CONSUMPTION
2000
0 2000-2010
2010-2020
2020-2030
2030-2040
2040-2050
20-64
Source: Census.gov
65-85+
LIKELY DEPENDENTS
Demographic shifts are immutable; and ours is favorable. Less workers coming on-line will be fortuitous given ongoing productivity increases and the preexisting challenges facing the current labor pool.
The credit crash has ushered in a new retirement calculus. People are living longer, accumulated wealth is lower, expected returns from both wages and investments are lower, confidence in pension and social entitlements is lower, and the most fortunate will most likely need to help support family.
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And Older Populations Mean More Pressure on Retirement Funding
Demographic Inflation Forecast
3,000,000 18% 14% 2,500,000 10% 2,000,000 6% 1,500,000 2% -2% 1,000,000 -6% 500,000 -10% 0 -14% 1914 1921 1928 1935 1942 1949 1956 1963 1970 1977 1984 1991 1998 2005 2012 2019 2026 2033 2040 Annual Labor Force Growth (20yr olds - 63 yr olds)
Source: Census.gov Projected Population, Bureau of Labor Statistics
Public Pension Plans Median Annualized Returns by Time Span

20%
15%
10%
5%
0%
-5% 1 Year
Source: Callan Associates, NASRA, KSR
3 Year
5 Year
10 Year
25 Year Expected Return of 8%
Annual Inflation CPI YoY (RS)
Median Annualised Returns for Public Pension Plans by Time Span
This long-term inflation model is a trend indicator, not a forecasting tool. But that said, as illustrated in our retirement calculus slide, the impact of demographic shifts on inflation are positive from an overall perspective, but decidedly not for those counting on cost-of-living adjustments through retirement.
The most significant thing about the management of pension funds is the discount rate they (on average) use to calculate their benefit obligations. 8% is NOT feasible given their heavy allocations to bonds; and a stretch even if equities were 100% of their holdings. The world is awash with current assets looking for long duration return; something that is very, very scarce.
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And Pension Assets Are Enormously Important to American Households
Household balance sheets have been whipped around by shifting exposures to stocks and housing. Clearly, the aggregate numbers here are misleading, as the population as a whole was far more affected negatively by declining home prices than they are currently being helped by rising stock prices. That said, there is one constant shift: the move away from privately-held businesses to pension reserves. This will be an enormous issue going forward; particularly for the public sector, as the analyses we have reviewed suggest a $3 trillion to $4 trillion under-funding.
Composition of Household Net-Worth; 1945-2010Q3

100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 1945 1950
Deposits Treasury & Agency Securities Privately Held Businesses Source: Federal Reserve Z.1, KSR
1955
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
2010
Life Insurance Reserves Corporate Bonds & Mortgages Stock Investments
Municipal Securities Pension Fund Reserves Residential Home Equity
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Confidence in the Economy and Political Leadership Go Together
Conference Board Consumer Confidence SA 1985=100
140
111th Congress Previous Work Work experience Members of 111th uS Congress PreviousExperience
350 300
120
250
100
200
80
150
60
100
40
50
0
20 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009
Source: NBER, Conference Board, KSR
Career Politicians
Blue Collar
Healthcase Professionals Law Entertainment Professionals Enforcement
Judges Lawyers
Military
Ministry
Source: Congress Demographic
It is truly startling to see just how pessimistic the consumer has been, and still is. It is not without good reason and cause however; and clearly Congress has not helped.
The 111th US Congress recorded the lowest approval ratings in history; and for good reason. Casting all partisanship aside, not only was the entrenched approach to governance and leadership diametrically opposed to what the country needed through this crisis, but a review of the personal histories of the legislators confirmed one of our greatest fears; hardly any had the experience and facility to deal with the complexity of the financial issues at hand.
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When Wants Are Supplanted by Needs; Ideology Gives Way to Pragmatism
Political ideology often carries a very high price. So the propensity for ideological support is not a function of personal convictionbut at the marginoffset by relative economic cost. So, as societal wealth/prosperity falls (represented by the arrows pushing down on the curve), there is a non-linear acceleration of those who can no longer afford the principled beliefs they held during more prosperous times.
UNAFFORDABLE IDEOLOGY
WEALTH WEALTH
FINANCIAL PRESSURE
IDEOLOGY
Self Preservation
JOBS
IDEOLOGY
TRANSFER PAYMENTS
LIBERTARIAN
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We Dont Subscribe to the Widely Touted New Normal
New Normal proponents suggest that the future will hold more extreme surprises. In simple non-statistical terms, that means less happens around the median and more happens towards the edges of good and bad.
FAT TAIL
)
FAT TAIL
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We Are Thinking That Normal Has Become an Abnormal Skew
The chart below, and as would be intuitively obvious, the distribution of tax returns by frequency and income level is negatively skewed. That simply means that a lot more returns are filed below the median than above. And given the structural economic and financial backdrop described in this report, we think this curve is a better descriptor of future surprises.
Distribution of 2006 Tax Returns by Frequency of Gross Income Bracket & Percentage of National Gross Income
30% 25% 20% 15% 10% 5% 0%
Income Disparity accelerates dramatically above $200K, and from $1.5MM and above, less than half of one percent earn over 17% of the nation's Gross Income.
Percentage of Filed Returns

Source: IRS Tax Stats, KSR
Percentage of National Gross Income
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100. Minack, Gerard and Jason Todd, Reconsidering the Set-back, Downunder Daily, Morgan Stanely Research Asia/Pacific, February 14, 2010 101. Nash, John Forbes, Non-Cooperative Games, A Dissertation, Presented to the Facility of Princeton University in Candidacy for the Degree of Doctor of Philosophy, May 1950 102. Obstfeld, Maurice and Kenneth Rogoff, Global Imbalances and the Financial Crisis: Products of Common Causes, paper prepared for the Federal Reserve Bank of San Francisco Asia Economic Policy Conference, October 18-19, 2009 103. Obstfeld, Maurice and Kenneth Rogoff, Perspectives on OECD Economic Integration: Implications for U.S. Current Account Adjustment, University of California, Berkeley, Recent Papers 2000 104. Obstfeld, Maurice and Kenneth Rogoff, The Unsustainable US Current Account Position Revisited, abstract, First draft: October 14, 2004, Second draft: November 30, 2005 105. Obstfeld, Maurice, Lenders of Last Report and Global Liquidity Rethinking the system, World Bank Institute, Development Outreach, December 2009 106. Ostry, Jonathan D., Atish R. Ghosh, Karl Habermeier, Marcos Chamon, Madvash S. Qureshi, Dennis B.S. Reinhardt, Capital Inflows: The Role of Controls, International Monetary Fund, Research Department, JEL Classification Numbers: F21, F32, February 21, 2010 107. Ostry, Jonathan D., Atish R. Ghosh, Karl Habermeier, Marcos Chamon, Madvash S. Qureshi, Dennis B.S. Reinhardt, Capital Inflows: The Role of Controls, International Monetary Fund, IMF Staff Position Note, February 19, 2010, SPN/10/04 108. Pakko, Michael R., Considering the Capital Account, Economic Synopses, Federal Reserve Bank of St. Louis, 2004, Number 26 109. Pension Benefit Guaranty Corporation, Pension Insurance Data Book 2008, by the Policy, Research and Analysis Department, produced by the Communications and Public Affairs Department, Pension Benefit Guaranty Corporation, Number 13, Summer 2009 110. Pettis, Michael, Chinas Loan Growth Isnt Boosting My Confidence in Chinas Green Shots, ChinaStakes.com, July 29, 2009 111. Plender, John, Decline but no fall, FT.com, Financial Times, November 12, 2009 112. Poulson, Barry W. Ph.D., Arthur P. Hall, Ph.D., State Pension Funds Fall Off a Cliff, American Legislative Exchange Counsel, 2010 113. Public Pension Systems, Statements of Key Investment Risks and Common Practices to Address Those Risks, Endorsed by: Association of Public Pension Fund Advisors, July 2000 114. Reinhart, Carmen M. and Kenneth s. Rogoff, The Forgotten History of Domestic Debt, Abstract, April 17, 2008 115. Reinhart, Carmen M., and Kenneth S. Rogoff, This Time is Different: A Panoramic View of Eight Centuries of Financial Crises, National Bureau of Economic Research, Working Paper 13882, March 2008 116. Reinhart, Carmen M., and Kenneth S. Rogoff, This Time is Different: A Panoramic View of Eight Centuries of Financial Crises, Abstract, April 16, 2008 117. Roche, David and Bob McKee, New Monetarism, An Independent Strategy Publication, 2008 118. Roosevelt, Franklin D., First Inaugural speech 1932 by the President of the United States 119. Rotenberg, Jason and Amit Srivastava, Corporate Profits, Bridgewater Daily Observations, November 25, 2009 120. Roosevelt Institution, Make Markets Be Markets, Project on Global Finance, Step 1, Restoring the Integrity of the U.S. Financial System 121. Sack, Brian P., The Feds Expanded Balance Sheet, Remarks at the Money Marketeers of New York University, New York City, Executive Vice President, Federal Reserve Bank of New York, December 2, 2009 122. Sowell, Thomas, Economic Facts and Fallacies, Published by Basic Books, A Member of the Perseus Books Group, 2008 123. Stiglitz, Joseph E., The Challenge of Creating Jobs in the Aftermath of the Great Recession, testimony before the Joint Economic Committee, December 10, 2009 124. Stroebel, Johannes and John Taylor, Analysing the impact of the Feds mortgage-backed securities purchase, VOX, January 27, 2010 125. Surowiecki, James, The Wisdom of Crowds, Anchor books, A Division of Random House, Inc., 2004, 2005
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126. U.S. Bureau of Labor Statistics, Consumer Price Indexes for Rent and Rental Equivalence, Consumer Price Index, February 9, 2010 127. U.S. Department of the Treasury, Presentation to the Treasury Borrowing Advisory Committee, U.S. Department of the Treasury Office of Debt Management, November 3, 2009 128. U.S. Department of the Treasury, Office of Debt Management, November 3, 2009, Presentation to the Treasury Borrowing Advisory Committee 129. United States Government Accountability Office, Defined Benefit Pension Plans, Guidance Needed to Better Inform Plans of the Challenges and Risks of Investing in Hedge Funds and Private Equity, Report to Congressional Requesters, GAO-08-692, August 2008 130. United States Government Accountability Office, Loan Performance and Negative Home Equity in the Nonprime Mortgage Market, memorandum to The Honorable Carolyn B. Maloney, Chair Joint Economic Committee House of Representatives, The Honorable Charles E. Schumer, Vice Chairman Joint Economic Committee United States Senate, December 16, 2009 131. Warsh, David, Why The Rich Stay Rich, The Poor Stay Poor, The Boston Globe, December 8, 1985 132. Wheeler, Christopher H., Earnings Inequality within the Urban United States 2000 to 2006, Research Officer, Federal Reserve Bank of St. Louis, July 2008 133. Wheeler, Christopher H., Employment Growth in American Exploring Where Good Jobs Grow, Research Officer, Federal Reserve Bank of St. Louis, July 2005 134. Whyte, Jamie, Crimes Against Logic, McGraw Hill, 2004Wikipedia, the free encyclopedia, 2008-2009 Keynesian resurgence 135. Wikipedia, the free encyclopedia, Balance of payments 136. Wikipedia, the free encyclopedia, International monetary systems, (Redirected from Bretton Woods, II) 137. Wikipedia, the free encyclopedia, Nash equilibrium 138. Wong, Alfred and Tom Fong, Analysing Interconnectivity Among Economies, Research Department, Hong Kong Monetary Authority, Working Paper 03/2010, 10 May 2010 139. Xiaochuan, Zhou, Ph.D., Reform the International Monetary System, Governor of the Peoples Bank of China, Essay, March 23, 2009 140. Yang, Du, Gao Wenshu, Wang Meiyan, The Lewisian Turning Point and Its Implications to Labor Protection 141. Zakaria, Fareed, The Post-American World, W.W. Norton & Company, 2008 142. Zandi, Mark, The Causes and Current state of the Financial Crisis, written testimony before the Financial Crisis Inquiry Commission, Chief Economist and Cofounder, Moodys Economy. com, January 13, 2010 143. Zandi, Mark, The Growing Mortgage Foreclosure Crisis: Identifying Solutions and Dispelling Myths, written testimony before the House SubKnight Capital Americas, L.P.
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Strategic Research
FebRuARy 11, 2011
WWW.KNIGHT.COM
MARK O. LAPOLLA, CFA

404.736.2431 | MLAPOLLA@KNIGHT.COM
Important Disclosures
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02.11.2011 The Final Chapter of The Old Story

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02.11.2011 The Final Chapter of The Old Story

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Strategic Research

FebRuARy 11, 2011

MARK O. LAPOLLA, CFA

The Final Chapter of The Old Story

Refer to important disclosures at the end of this document.

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Strategic Research The Gist

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Strategic Research The Fall of Labor

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Source: Federal Reserve, Bureau of Labor Statistics, KSR

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5% Govt as Percent of Total (RS)

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US Personal Income versus Transfer Payments SAAR (Indexed 100=1-31-1999)

+2 Stdev 11.00% +1 Stdev 6.00%

Reflects services growing to 70% of the employed labor base.

10-Year Payroll Growth

Household Debt YoY % Change

ACCELERATING ECONOMIC BIFURCATION

ACCELERATING ECONOMIC BIFURCATION

LIFESTYLE /CREDIT SQUEEZE

Source: Knight Strategic Research

Source: Knight Strategic Research

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LABOR DENSITY ECONOMIC VALUE ADD COMPENSATION

WAGE PRESSURE RISING DEMAND

WAGE PRESSURE SCALE

TECHNOLOGY IP RICARDIAN ADVANTAGE

Source: Knight Strategic Research

Source: Knight Strategic Research

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Strategic Research The Necessary Rise of Credit

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3% 1946 1951 1956 1961 1966 1971 1976

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Knight Capital Americas, L.P.

THE CONSUMPTION BUBBLE

CONSUMER CREDIT / LEVERAGE WAGES

DECLINING MANUFACTURING RISING IP

Stronger Balance sheets Increase B/S size

Asset price boom

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Debt Intensity of US Economy (Annual Debt Growth / GDP Growth)

US Total Domestic Debt YoY Change

GDP US Nominal Dollars SAAR YoY Change

The prevailing belief was that home prices couldnt fall.

And no one cared until they had to.

Annual Percentage Change

2.6 2.24 1.7 0.8 0.45 1.75

Commercial Bank Credit Creation

HOUSE PRICE APPRECIATION

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Sharpe Ratio for Residential Real Estate

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Net financial investment / Personal Income vs. Personal Savings Rate

10% 5 5% 0 0% 0 -5 -5% -10 -100 0% 300 200 100 2%

-15 Net financial investment / Disposable Personal Income

-4% 2008-Q4 MEW Annualized $ Billioins

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Contribution to Real GDP Growth (Volatility by Component)