02.11.2011 the Final Chapter of the Old Story

8/3/2019 02.11.2011 the Final Chapter of the Old Story

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Strategic ResearchMARK O. LAPOLLA, CFA

WWW.KNIGHT.COM

FebRuARy 11, 2011404.736.2431 | [email protected]

Refer to important disclosures at the end of this document. Knight Capital Americas, L.P.

The Final Chapter of The Old Story

Nevertheless, like me in 1958, investors refused to see the ground shifting beneaththem, even though the environment was no longer what they knew and thoughtthey understood. Like me, they were walking into a trap where the responses werenot what they had anticipated. Like me, they were headed toward big surprises forwhich they had no preparation.

It has been said that good forecasters have a good sense of history. I suppose that istrue. But the best lesson from the past is to forget it before it shoves you into trouble

and remember that surprises and ruptures surely lurk ahead.Peter L. Bernstein, (1919-2009) on the Financial Crisis

To Botch A Forecast, Rely on Past Experience

The New York Times; December 30, 2007


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Knight Capital Americas, L.P.

Strategic Research

2

We believe that the credit crash of 20072008 ended a 75-year Consumer

Credit Super Cycle in the developed world, and that government policy actions

particularly in China and the United Statesand the market responses to them,

have pushed the cyclical and structural terms of global trade past their tipping

points.

Thus, we believe that the consensus global growth story is ending, and so too,

the gilded age of the Emerging Markets.

The global economy will fully enter into a generational transformationrequiring the painful maturation of the developing world, the end of

entitlements based democracy in the developed world, and the hopeful

renaissance of U.S. economic and geopolitical leadership.


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3

Say It Aint So

Surely the endgame is upon us. Higher commodity prices will fuel inflation and materially higher interest rates. And necessarily,

this will precipitate a collapse in the dollar and threaten the fiscal sustainability of the United States. Moreover, if prevailing

economic and financial theory are to be believed, then all these statements are true and the implications quite troubling. But,

the prevailing orthodoxy is NOT to be believed, nor the de facto conclusions which they imply.

With the presumption of a broadening economic

recovery around the world, the global financial

markets are once again focused on rising

commodity prices, the global growth story and the

present risk that economic and foreign exchange

imbalances will trigger the end game of theSovereign Debt Crisis leading to higher interest

rates, currency debasement, and the possibility of

hyper-inflation.

And such is the nearly uniform consensus around the

world. The storyline goes something like this:

Profligate developed world nationsmost

particularly the United Stateshave recklessly and

irresponsibly adhered to expansive monetary policies

and regulatory regimes to support undisciplined

fiscal spending and gross excess consumption by

the household sector.

In turn, as a matter of accounting identity, domestic

dis-savings had to be balanced by foreign savings;

namely, the purchases of Government debt

obligations by rich nations flush with trade

surpluses and excess foreign exchange reserves.

This dynamic led to an ever-widening current account

deficit which drove the exchange rate of the dollar

down and should have resulted in higher interest

rates; but in a startling divergence from economic

theory, it did not.

In his now famous speech given in April 2005, Ben

Bernanke offered an explanation for why long-term

interest rates stayed low. It wasnt excess consumption

that fueled the current account imbalance; rather,it was a global savings glutprimarily in Asia

which by extension (we are being facetious here)

forced the United States to consume more in order

to absorb the excess savings of our trading partners.

But causal clarity is not important to the story line.

What is, however, is the entrenched belief that we

are dependent upon them for economic balance

and survival.

And nothing has changed. Today, the Federal Reserve

is proceeding apace with QE2, U.S. budget deficits

ensure an ongoing ramp-up of accumulated debt,

and stock and commodity prices have skyrocketed.

Inflation is breaking out across the emerging world,

the December UK Retail Price Index of inflation (4.8%)

doubled wage growth, and German unionsciting

rising inflationare pushed for higher wages at the

European Union Summit.

Surely the endgame is upon us. Higher commodity

prices will fuel inflation and materially higher interestrates. And necessarily, wont this precipitate a collapse

in the dollar and threaten the fiscal sustainability of

the United States? And if so, wasnt the leader of

the Communist Party of China, Hu Jintao, correct

when he declared at the G20 summit this past

November, We are the masters now.?

If prevailing economic and financial theory are tobe believed, the resounding answer to all these

questions is, yes. But the prevailing orthodoxy is

NOT to be believed, nor the de facto conclusions

which they imply.

And this is the ruband the ambitious

(foolhardy?) challenge of this publication: to

present our views in a simple and approachable

form that efficiently challenges the orthodox

consensus, and at a minimum, will serve as

the foundation for spirited dialogue going

forward.

To accomplish this, we have chosen to minimize

verbiage and maximize illustrations; and on

balance, to keep the logical flow going without

succumbing to tediousand in all likelihood

unconvincing detail. Ultimately, our objective

with this publicationas with all our workis to

apply experience, common sense, and intuition to

uncover powerful investment themes obscured bythe fallacies of conventional thinking.


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Strategic Research

The Gist

To understand reality is not the same as to know about

outward events. It is to perceive the essential nature ofthings. The best-informed man is not necessarily the wisest.

Indeed there is a danger that precisely in the multiplicity of

his knowledge he will lose sight of what is essential. But on

the other hand, knowledge of an apparently trivial detail

quite often makes it possible to see into the depth of things.

And so the wise man will seek to acquire the best possible

knowledge about events, but always without becoming

dependent upon this knowledge.

Dietrich Bonhoeffer, Lutheran Minister


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5

Executive Summary

It is our contention that the current levels of

unemployment are structural, and likely understatethe magnitude of dislocation across the workforce.

It was Keynes who first wrote of technological

unemployment back in the days when machine was

replacing man at a furious rate.

Today, we believe the U.S. economy is suffering

from the cumulative effect of a different type of

technological unemployment; in this case, the rapidly

diminishing value of average human capital within

a society where IP (intellectual property) is the driver

of marginal productivity and profit.As a result, labor has been steadily losing its power,

and with it, wage growth. Thus, we view the housing

boom and bust in the context of a society desperately

trying to extend lifestyle gains to a workforce desiring

to live far above what their economic value justifies.

Needless to say, this was an outcome broadly

supported and cheered by the political establishment

(who have historically retained power through theextension of benefit,) as well as the financial sector

whose power and sway upon the affairs of the world

crested at unimaginable heights.

At the same time, the world was growing fond

of the rising emerging markets; in some cases

laden with resources, in most cases laden with

inexpensive labor, and in all cases, laden with

large populations hungry for higher standards

of living. This of course implied an insatiable

demand for commodities and all the elementsnecessary for massive infrastructure development;

and ultimately, of course, explosive demand for

branded goods from the developed world.

It is our contention that the emerging market

storywhich has now blossomed into the

global growth thesishas matured and come

to its cyclical end. Moreover, we believe that the

consensus view on U.S. monetary policy and theimpact that accumulated debt, persistent budget

and trade deficits will have on interest rates,

inflation, and the dollar, is wrong.

Our view remains that stable/growing cash flow

streams denominated in U.S. dollars are the most

attractive assets in the world. We believe that

unlevered cash on cash returns will once again

become the measure of value.

By design, this publication does not delve into

tactical concerns, sector weights, or securityselection. It is our hope that by providing clarity on

pivotal macro issues, this work will be applicable

to all investors and those concerned with the

allocation of assets over the coming decade.

Listed below are some key takeaways from our

work.

B The U.S. Labor Market Is Structurally Broken

B Consumer Credit Is Dead

B The Recovery Is Just a Stabilization

B Nominal GDP Will Remain Anemic for Years

B Corporate Profitability and Main Street Economics Are Uncoupled

B Corporate Margins Will Not Revert Back to Their Long-Term Mean

B Rising Commodity Prices Are Deflationary in the Developed World

B Sustaining Inflation in the U.S. Will Not Be Possible for Years

B The Global Terms of Trade Are Past Their Tipping Point

B Monetary Policy Cannot Create Inflation

B The U.S. Current Account Deficit Is a Non-Issue

B The Fed Anchors and Controls Rates

B The U.S. Is Fiscally Sustainable

B Interest Rates Will Remain Low

B The Euro Will Survive, but the Dollar Standard Will Grow Stronger

B Nominal Is All That Really Matters

B The Global Growth Story Is Over: and China Is the Linchpin

B Food Is More Important than Oil


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Strategic Research

For the moment the very rapidity of these changes is hurtingus and bringing difficult problems to solve. Those countries aresuffering relatively which are not in the vanguard of progress. Weare being afflicted with a new disease of which some readers maynot yet have heard the name, but of which they will hear a greatdeal in the years to come--namely, technological unemployment.This means unemployment due to our discovery of means of

economising the use of labour outrunning the pace at which wecan find new uses for labour.

John Maynard Keynes

Economic Possibilities for our Grandchildren (1930)

The Fall of Labor


7/110 Knight Capital Americas, L.P.

Strategic Research

7

The transformation of laborand the steadily

declining EVA (economic value added) of its core

lies at the root of todays economic crises and is

the singular challenge of this generation.

Two hundred years ago, some 92 percent of

Americans worked in agriculture, 5 percent inmanufacturing, and 3 percent in the service sector

(i.e.household servants.)

By 1890 less than 100 years latermachines had

already grown to dominate the economic landscape.

But rapid industrialization into the new century

brought with it serious abuses and unacceptable

business practices which needed major reform.

And through this period, the American Federation

of Labor (A.F.L.) was the dominant organizationrepresenting unionized labor.

Founded in 1886 by Samuel Gompers, the A.F.L.

was the culmination of labors long struggle to

create a super union of all crafts. From its launch

until the early 20s, the A.F.L. had great success.

As membership grew (peaking at 5.1 million in

1920), their powerful political influence resulted in

reducing the work week, dramatically increasing

real wages, improving working rights for women

and children, and restrictive immigration policy.On a relative basis, this was labors best time. It

was the period of Upton Sinclairs The Jungle; the

nation was sympathetic, and the politicians were

falling in line. Times were good.

But unfortunately for laborthanks to the Roaring

Twenties and the attendant explosion in stock

prices and debttimes got too good; and laborlost its power. Until, that is, The Great Depression.

Immediately following the Crash, President Hoover

adopted a tough love policy based upon his belief

that a strong, dependable wage for those employed

would carry the nation through the storm. And

although less than ten percent of big corporations

actually cut wages in 1930, collapsing demand and

the crush of debt service forced smaller and weaker

companies to slash both wages and jobs; and sothe cycle of deflation accelerated. By November of

1932, it is estimated that some 33 percent of all

wage earners were unemployed. Between 1929

and 1933, labor income had declined a staggering

48 percent.

But then, Franklin D. Roosevelt emerged as the

Democratic candidate for the Presidency and

immediately won labors strong support. Rightfully

so, the nation was tired of Hoovers mantra of

rugged individualism, and devastated by his refusalto use Federal money to relieve unemployment.

Moreover, Hoovers belief that Federal support

would undermine the character of the American

worker, was all labor needed to galvanize its

support around FDR.

And with these words, spoken in April of 1938,

FDR firmly established Governments heavyhand in the free markets: Not only our future

economic soundness but the very soundness

of our democratic institutions depends on

the determination of our government to give

employment to idle men.

And with that proclamation, and as furthered

by Lyndon Johnsons Great Society pledge, the

United States plunged forward with a growing

belief that it was governments role to guaranteeprosperity.

And it is our contention, that from this base of

expectationreinforced time and again by those

governing the landmany workers in America

allowed their economic value to grow stale; even

as the world was changing and their indebtedness

grew.

So today, without the benefit of massive credit

subsidies and the elixir of rising home prices,

much of the economy and far too many of itsworkers are struggling.

And it is our contention, that from this base of expectationreinforced time and again by those governing the landmany

workers in America allowed their economic value to grow stale; even as the world was changing and their indebtedness grew.

So today, without the benefit of massive credit subsidies and the elixir of rising home prices, both the economy and far too

many of its workers are struggling.

Prosperity Cannot Be Guaranteed



Strategic Research

8

Productivity Explosion: Exponential Output Growth and Steady Labor Decline

y = 50e0.6931x

R = 1

y = -33x + 133R = 1

0

100

200

300

400

500

600

700

800

900

1950 1980 2010

US Manufacturing Output Growth vs.Manufacturing Labor Decline 1950-2010

"US Manufacturing Output (1950=100) "US Manufacturing Workers (1950=100)

Expon. ("US Manufacturing Output (1950=100)) Linear ("US Manufacturing Workers (1950=100))

Source: Federal Reserve, Bureau of Labor Statistics, KSR



Strategic Research

9

X Marks the Spot

5%

10%

15%

20%

25%

30%

35%

40%

40%

45%

50%

55%

60%

65%

70%

1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Non-Farm Payroll Components as Percent of Total Non-Farm Payroll

Private Service as Percent of Total (LS) Govt as Percent of Total (RS)

Manufacturing as Percent of Total (RS)

Source: Bureau of Labor Statistics, KSR

Despite perceptions to the contrary, by output, the United States is still the leading

manufacturer in the world. By value-added, the gap is 3X China. Yet, as shown below,the government employs twice as many people as manufacturers.


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10

In times of heavy leverage and deflationary pressure;NOMINAL dollars are everything.

Reflects services growing to 70% of the employedlabor base.

This divergence between government and privatesector payroll growth is a VERY big deal.

Despite the housing boomor perhaps because ofit, transfer payments grew twice as fast as personalincome.

As Manufacturing Intensity Declined, So Did Wage and Output Growth

-6.37%

-350%

-300%

-250%

-200%

-150%

-100%

-50%

0%

50%

100%

19 52 195 7 1 962 19 67 19 72 197 7 1 982 19 87 199 2 1 99 7 2 002 20 07

Acceleration (second derivative) in Household Debt

US Recession Household Debt YoY % Change

Source:Federal Reserve,KSR

10-Year Payroll Growth

-10%

0%

10%

20%

30%

40%

50%

60%

1959 1962 1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010

US Employees on Nonfarm Payrolls Total SA 120-Month % Change

US Employees On Nonfarm Payrolls Total Government SA 120-Month % Change

US Employees on Nonfarm Payrolls Total Private SA 120-Month % Change

Source:Bure au of LaborStatistics, KSR

100

120

140

160

180

200

220

240

J an- 99 J an- 00 J an- 01 J an- 02 J an- 03 J an- 04 J an- 0 5 J an -0 6 J an -0 7 J an -0 8 J an -0 9 J an -1 0

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

US Personal Income SAAR Indexed 100=1-31-1999

Personal Income Transfer Payments to Persons SA Indexed 100=1-31-19 99

Source: Bureau of Economic Analysis, KSR

-4 Stdev

-3 Stdev

-2 Stdev

-1 Stdev

Median

+1 Stdev

+2 Stdev

+3 Stdev

+4 Stdev

-9.00%

-4.00%

1.00%

6.00%

11.00%

16.00%

1 94 9 1 95 4 1 95 9 1 96 4 1 96 9 1 97 4 1 97 9 1 98 4 1 98 9 1 99 4 1 99 9 2 00 4 2 00 9

US Nominal GDP Per Capita YoY % Change

Source: Bloomberg, KSR


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Strategic Research

11

As IP has followed Moores law, innovative

competition has pushed most workers EVA below

their compensation costs.

This, in conjunction with rising benefit and regulatory

expense, has kept wage growth anemic and job

insecurity high. Thus, credit has been the necessary

lifeblood to keep most workers lifestyles moving

higher.

For the past twenty years, the global economy

has been rapidly bifurcating between Intellectual

Property (IP) and Scale.

Commonly known as the global labor arbitrage,

Ricardos theory of comparative advantage has been

playing out in dramatic fashion.

COMPENSATION

LIFESTYLE /CREDIT SQUEEZE

WEALTH WEALTH

IP SCALERICARDIAN ADVANTAGE

ACCELERATING ECONOMIC

BIFURCATION

LABOR DENSITY

ECONOMIC VALUE ADD

COMPETITION

Source: Knight Strategic Research

The Global Economy Has Rapidly Bifurcated Between IP and Scale

POLITICAL PRESSURE

WEALTH WEALTH


INNOVATION

ACCELERATING ECONOMIC

BIFURCATION

LABOR DENSITY

ECONOMIC VALUE ADD



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12

IP Versus Scale

The disparity of wealth and income is easily

understood from this chart. IP is accelerating at the

highest levels, while debt deflation is crushing the

vast majority of workers down the chain.

So too, those who own Scale production are the

robber barons of this day, but rising input costs have

triggered a wage-price spiral that will likely end their

era of exponential growth.

So as wage pressures and the modern form of Keynes

technological unemployment have accelerated,

aggregate nominal earnings and demand have been

falling in the IP world.

Conversely, demand for low-cost manufacturing

and assembly to feed this disinflationary trend

has accelerated. This has markedly increased wage

pressures in the Scale world.

LABOR DENSITY

ECONOMIC VALUE ADD

COMPENSATION

WAGE PRESSURE

IP & MATURE CREDIT = DEFLATION RISK

SCALE & ACCELERATING CREDIT = INFLATION

RISING DEMAND

WEALTH


WAGE PRESSURE

FALLING DEMAND

WEALTH

.


LABOR DENSITY

ECONOMIC VALUE ADD

COMPENSATION

IP & MATURE CREDIT = DEFLATION RISK

SCALE & ACCELERATING CREDIT = INFLATION

DEFLATION

INFLATION

DISINFLATION

WEALTH


COMMODITIESTECHNOLOGY

WEALTH

.



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Strategic Research

The Necessary Rise of Credit

Keeping up with the Joneses. The phrase was popularized when a comicstrip of the same name was created bycartoonist Arthur R. "Pop" Momandwhich first appeared in The New YorkWorld in 1916.

It offered a sad parody of abjectconsumerism; the title of which, is stilla widely used colloquial expression forneedless consumption.


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Strategic Research

14

And as financial innovation and capital formation accelerated, the competitive dynamics and speed of commerce intensified.

Moreover, the development of technology and transportation systems unleashed an enormous productivity wave and the now

fabled Ricardo global labor arbitrage. But no matter. The aggressive subsidization of mortgage credit and home ownership, and

all forms of seductive consumer lending, bridged the gap between labors falling economic value add and its desire for an ever

increasing standard of living.

Since our founding, the United States has been

generally committed to the pursuit of two seemingly

opposite agendas: free-market capitalism and social

welfare. Without the benefit of experience, planning,

or continuity, the course of economic developmentwas charted by politicians, bureaucrats, and the

rising influence of special interests. Money was

the lubricant for the inherently sordid affair; as power

desired wealth, and wealth desired power.

Naturally, avaricious political promises often collided

with prudence and reality; thus, forward progress

required ever-increasing indebtedness. Our nation

moved forwardeven through the Great Depres-

sionbut with each economic cycle, government

intervention and social assistance grew more impor-tant, and so did our dependence upon debt.

So, after the devastating inflation of the 1970s, the

US Government and all its monetary and regulatory

authorities, committed to leveraging the American

dream of homeownership to launch the greatest

consumer credit boom in history.

With an economy duly tied to credit growth and

politicians duly tied to the extension of social benefit,

it shouldnt be surprising that housing became theUniversal Good.

Although our financial markets were always

forward leaning, it wasnt until the end of The

Great Inflation and the Volker era that the

democratization of capital exploded full force. The

stage was set with the signing of the EmploymentRetirement Income Security Act of 1974 (ERISA)

and the subsequent control of pension portfolios

by consultants; the explosion of mutual funds and

defined contribution retirement plans; the Interstate

Banking and Branch Efficiency Act of 1994, and

the 1999 repeal of the Glass-Steagall Act of 1934;

and of course, the nearly 20-year reign of laissez-

faire capitalism under Ayn Rand devotee, Federal

Reserve Chairman Alan Greenspan.

It was these factors that fueled an unprecedentedexplosion in financial innovation, but it was the

politically-mandated expansion of home ownership

which laid the foundation and drove the trend.

Under the auspices of the US Department of Housing

& Urban Development (HUD) and as executed by the

quasi-governmental Fannie Mae and Freddie Mac,

politicians transferred wealth to the private sector,

whileas we now knowirresponsibly allowing the

socialization of risk.

Culturally, we made a wholesale shift from debt aversion

to credit dependency; and from saving to consumption.

From a societal perspective, we progressed from Hey

Buddy, can you spare a dime?to Hey Buddy, do you

want to borrow a dime?from A chicken in every pot

to A home for every household.This virtuous cycle of rising asset values and expanding

leverage fostered an unprecedented period of capital

gains and economic expansion.

And as financial innovation and capital formation

accelerated, the competitive dynamics and speed of

commerce intensified. Moreover, the development

of technology and transportation systems unleashed

an enormous productivity wave and the now fabled

Ricardo global labor arbitrage.

As a result, labor lost its power rather quickly, and

the earnings gap between those who produced

and those who supported began to widen

dramatically; and metaphorically, having previously

sold their inheritance for free health care coverage,

rising benefits costs soon eclipsed wage gains.

But, no matter. The aggressive subsidization of

mortgage credit and home ownership, and all forms

of seductive consumer lending, bridged the gap

between labors falling economic value add and itsdesire for an ever increasing standard of living.

A Home for Every Household


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Strategic Research

15

Debt Growth Plateaued After the Baby Boom

3%

5%

7%

9%

11%

13%

1946 1951 1956 1961 1966 1971 1976

US Consumer Credit Outstandingas a % of Nominal GDP (1946-1980)

Source: Federal Reserve, Bureau of Economic Analysis, KSR


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Strategic Research

16

Productivity Growth and Declining EVA Caught Up With Labor

0%

2%

4%

6%

8%

10%

12%

14%

16%

40%

42%

44%

46%

48%

50%

52%

54%

56%

1949 1954 1959 1964 1969 1974 1979 1984 1989 1994 1999 2004 2009

Nominal Wage & Salary and Corporate Profitsas a % of Congressional Budget Potential Nominal GDP

Wage & Salary From The GDP Report US Nominal Dollars SAAR / Congressional Budget Office PotentialNominal GDPUS Corp Profits With IVA Total SA / Congressional Budget Office Potential Nominal GDP (RS)

Source: Bureau of Economic Analysis, #N/A N/A, KSRKSR


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Strategic Research

17

DECLINING MANUFACTURING RISING IP

THE CONSUMPTION BUBBLE

CONSUMER CREDIT / LEVERAGE

EVA

WAGES

LIFESTYLE


Massive Amounts of Credit Was Needed to Facilitate Lifestyle Growth


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Strategic Research

18

The Housing Bubble Marked the End of a 75-year Credit Super Cycle

Asset price boom

Stronger

Balance sheets

Target leverage

Increase

B/S size

Source: Federal Reserve Bank of New York

The pro-cyclicality of the credit cycle was immenselypowerful. As leverage increased and balancesheets grew larger, direct flows into assets droveprices higher. This in turn, strengthened creditorsand induced more lending.

When mega cycles end, they are usually thecompletion of many convergent trends. In the caseof the housing boom, it capped the transition fromthe totally debt averse post-Depression cultureto the credit dependent sense of entitlement sovisible at the peak.


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Strategic Research

19

And no one cared until they had to.

Hall of Fame Metrics

Deregulation and gross regulatory failure facilitatedthe disintermediation of the banking system.

The Most Pronounced Debt Cycle Ever

YoY % Change in Household Credit Growth

2.24

0.8

0.45

1.7

2.6

1.75

5.5

0

1

2

3

4

5

6

2 Q5 8 - 1Q60 1 Q6 1 - 3Q69 4 Q7 0 - 3Q73 1 Q7 5 - 4Q79 4 Q8 2 - 2Q90 1 Q9 1 - 4Q00 4 Q0 1 - Cu rren t

AnnualPercentageChange

Source:FederalReserve,Bloomberg,KSR

-1,000,000

-500,000

0

500,000

1,000,000

1,500,000

2,000,000

2,500,000

3,000,000

1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008

Commercial Banks versus Shadow BankingCredit Creation (Billion $ SAAR)

Shadow Banking Credit Creation Commercial Bank Credit Creation

Source:Federal Reserve,KSR

-1,500

-500

500

1,500

2,500

3,500

4,500

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

$Billions

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

US Total Domestic Debt YoY Change GDP US Nominal Dollars SAAR YoY Change

Source:Federal Reserve,Bureau of Economic Analysis, KSR

20%

25%

30%

35%

40%

45%

50%

55%

60%

65%

1978 1981 1984 1987 1990 1993 1996 1999 2002 2005

Total Consumer Debt Including

Mortgages Relative to Personal Income


2007

The prevailing belief was that home prices couldntfall.

And whats worse, job creation during the boomwas the weakest of any modern expansion.


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Strategic Research

20

Certainly the origination machine believed in thespeculative value of residential real estate.

As shown here, the cost of capital actually

fellmateriallyin relation to the rate of priceacceleration in local markets.

Wow.

So lets be honest: who really thought aboutanything other than how much house they could

buy?

Both House Prices and the Allocation of Credit Were Unhinged from Reality

PEAK HOME VALUE CALCULUS

EQUIVALENT RENT

+

TAX BENEFITS

-

PROPERTY TAXES

+

PROXIMITY PREMIUM (Jobs, Schools, Community, Climate)-

COST OF CAPITAL (Required Equity + API)

+

SPECULATIVE PREMIUM


PERVERSE SELECTION

HOUSE PRICE APPRECIATION

MO

RTGAGERATES

5% 30%

6%

10% 15% 20% 25%

3%

4%

5%



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Strategic Research

21

We calculated this ratio by applying the average amount of leverage in the housing

market (Fed data, adjusted for the multi-decade 30% of homeowners with nomortgage), the Case-Shiller 20-market index, and the 5-yr treasury bond yield as the

risk-free rate.

How Can There Be Any Risk When Prices Never Fall?

-4

-2

0

2

4

6

8

10

12

14

Dec-94 Apr-96 Aug-97 Dec-98 Apr-00 Aug-01 Dec-02 Apr-04 Aug-05 Dec-06 Apr-08 Aug-09

Sharpe Ratio for Residential Real Estate

Source: Blooomberg; Case-Shiller; Federal Reserve, KSRSource: Bloomberg, Case-Shiller, Federal Reserve, KSR


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Strategic Research

22

Mortgage equity withdrawals (MEW) playedan enormous role in fueling consumption from

20032007.

Remember the Bank of America ads? I bet youdidnt know your home was your own personal

ATM!

Incredible.

By 1998, households were liquidating financialassets in earnesteven as their savings rate

diminished.

Asset Rich and Cash Poor

-4%

-2%

0%

2%

4%

6%

-400

-300

-200

-100

0

100

200

300

400

500

600

1 99 5-Q2 1 99 6-Q4 1 99 8-Q2 1 99 9-Q4 2 00 1-Q2 2 00 2-Q4 2 00 4-Q2 2 00 5-Q4 2 00 7-Q2 2 00 8-Q4

PCE Quarterly Change vs. Quarterly MEW and

MEW as a Percent of Nominal GDP

Quarterly Change PCE $ Bil lions SAAR MEW Annuali zed $ Bill ioins

MEW as Percentage of Nominal GDP (RS)Source: Bureau of Economic Analysis, Federal Reserve, Bloomberg, KSR

-15

-10

-5

0

5

10

15

-15%

-10%

-5%

0%

5%

10%

15%

20%

1 96 9 1 97 2 1 97 5 1 97 8 1 98 1 1 98 4 1 98 7 1 99 0 1 99 3 1 99 6 1 99 9 2 00 2 2 00 5 2 00 8

Net financial investment /

Personal Income vs. Personal Savings Rate

Net financial investment / Disposable Personal Income

US Personal Saving as a % of Disposable Income (RS)

Source: Federal Reserve, KSR


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Strategic Research

A sound banker, alas, is not one who foresees danger and avoidsit, but one who, when he is ruined, is ruined in a conventionaland orthodox way along with his fellows, so that no one canreally blame him.

John Maynard Keynes

The Consequences to the Banks of the Collapse of Money Values

(1931)

The Crash


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26

As with most every asset market; volume follows

price. However, as seen in 2010, price did notfollow spiking volumes. And why would it? A very

large part of the transactions were foreclosureliquidations.

What we find most amazing, is how the most

sophisticated financial analysts around the worldfailed to account for the inevitable reversion

of HPA (house price appreciation) in their riskmodels.

But then again, the OFHEO told us in 2002 thatHPA was not part of their risk models because

the price series isnt volatile enough and nevergoes negative. Really?

500

700

900

1,100

1,300

1,500

1,700

3.5

4.0

4.5

5.0

5.5

6.0

6.5

7.0

7.5

Jan-00 Nov-00 Sep-01 Jul-02 May-03 Mar-04 Jan-05 Nov-05 Sep-06 Jul-07 May-08 Mar-09 Jan-10 Nov-10

$Billions

SAAR

Home Sales vs. Transaction Dollar Volume

US Existing Homes Sales Millions SAAR Existing Home Sales Transaction Value (Sales * Median Price) (RS)

Source: National Assoc. of Realtors, KSR

Q2 2006

Q4 2008

Q4 2009

Q2 2010 Q3 2010

Q4 2010

$0

$50,000

$100,000

$150,000

$200,000

$250,000

$300,000

0 50 100 150 200 250 300 350 400 450 500

Existin

gOneFamilyHomeSalesAveragePrice

Diaposable Income / 10-Treasury

Over Valued Homes

Source: National Assoc. of Realtors, Federal Reserve, Bureau of Economic Analysis, Bloomberg, KSR

The Failure to Incorporate Stress Tests for HPA in Risk Models Set Up the Crash


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Strategic Research

27

Now thats deceleration; kind of like a test car

hitting a wall.

The rise in delinquencies across the consumer

credit markets has been unprecedented. But suchare the conditions when 75% of the debt is tied

to deflating collateral.

Moreover, with the now ingrained sense of

what we will call debt entitlement, as well asthe credit markets eagerness to bring bankrupt

households back into the fold, delinquency,default, and foreclosure, dont carry the same

penalty or societal stigma as they used to.

Delinquencies As % Of Total Loans

3.5

4.0

4.5

5.0

5.5

6.0

6.5

7.0

7.5

8.0

8.5

9.0

9.5

10.0

Mar-79 Mar-83 Mar-87 Mar-91 Mar-95 Mar-99 Mar-03 Mar-07

Source: Mortgage Bankers Association

-6.37%

-350%

-300%

-250%

-200%

-150%

-100%

-50%

0%

50%

100%

1952 1957 1962 1967 1972 1977 1982 1987 1992 1997 2002 2007

Acceleration (second derivative) in Household Debt

US Recession Household Debt YoY % Change


The Magnitude of this Shock Has Definitely Increased the Propensity to Save


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Strategic Research

28

Were it not for massive government interventionand regulatory forbearance, there is no questionin our minds that the credit crash would have

resulted in a global depression.

As shown, the deleveraging cycle is as reflexiveand procyclical as its twin.

Federal Reserve Disintermediation

Credit Created By Shadow Banking System (Trillions $ SAAR)

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008


Reflexivity Works Both Ways; Aggressive Policy Action Prevented a Depression

Asset price decline

Weaker

Balance sheets

Target leverage

ReduceB/S size

Source: Federal Reserve Bank of New York

The ugly unwind works the same way as theexpansion did; only in reverse. Weaker balance

sheets force deleveraging which cuts off the flowof capital supporting asset values. In turn, this

makes smaller, more conservative balance sheetsweaker still, which drives further deleveraging.


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29

The Crash Exposed a Labor Market That Was Already Broken

Similarly, the duration of unemployment has beenon the rise for the past several decades.

The crash in nominal GDP accelerated the

elimination of excess capacity and the maturationof web-based IP services, systems, and processes

has massively increased business productivity.

The collapse of the credit market slammednominal economic activity. And nominal is what

matters in a deflating economy.

Thus, even as the IP vs. Scale dynamic was

permanently eliminating a rising percentageof jobs, the blow to marginal consumption and

intensifying competition has accelerated what iscommonly called creative destruction.

6

11

16

21

26

31

36

41

1949 1954 1959 1964 1969 1974 1979 1984 1989 1994 1999 2004 2009

US Unemployment Duration Average Num Weeks SA

US Recession US Unemployment Durat ion Average Number of Weeks SA

Source: NBER, Bureau of Labor Statistics, KSR

21%

26%

31%

36%

41%

46%

51%

56%

1 96 7 1 97 0 1 97 3 1 97 6 1 97 9 1 98 2 1 98 5 1 98 8 1 99 1 1 99 4 1 99 7 2 00 0 2 00 3 2 00 6 2 00 9

Permanent Job Loss as Pct of Total Unemployment



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30

Markets are amazing. They will just move from one game to the next regardless of the

underlying thesis. But then again, the incentive structures around the world guaranteeit.

But Amidst the Crash, Wall Street Invented De-Coupling

80

90

100

110

120

130

140

150

2-Jul 24-Jul 15-Aug 6-Sep 28-Sep 20-Oct 11-Nov 3-Dec 25-Dec 16-Jan 7-Feb 29-Feb 22-Mar

MSCI BRIC, GSCI Commodity TR, SPX, FTSE 100Indexed 100=7-2-2007

MSCI BRIC Indexed 100=7-2-2007

S&P GSCI Enhanced Commodity (Total Return) Indexed 100=7-2-2007

S&P 500 INDEX Indexed 100=7-2-2007

FTSE EUROTOP 100 INDEX Indexed 100=7-2-2007

Source: Bloomberg, Goldman Sachs Commodity Index, KSR


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31

And although some seemed to understand that

within a deflating economy, increases in moneyspent on non-discretionary items directly reducedthe funds available for discretionary use; the

world was focused on the inflationary impacts of$100/bbl oil. Amazing.

Rule of Thumb: 10% $/bbl oil 2.5% GDP

In 2008, we were among the few who warned

that: 1. The commodity markets were beingoverrun by speculators, and 2. That risingcommodity prices were not inflationarybut

would actually accelerate deflation in the cash-strapped developed world.

Thus, we warned that every .01/gal increase ingasoline was the equivalent of a $1.5b (annualized)

tax to consumption.

The De-coupling Fueled a Commodity Boom... and Deflation

10

30

50

70

90

110

130

-3.0

-1.0

1.0

3.0

5.0

7.0

Mar-91 Nov-92 Jul-94 Mar-96 Nov-97 Jul-99 Mar-01 Nov-02 Jul-04 Mar-06 Nov-07 Jul-09

US GDP Nominal Dollars YoY %

versus Crude Oil (Inverted)

US GDP Nominal Dollars YoY SA WTI CRUDE FUTURE (RS Inverted $/bbl)

Source: Bureau of Economic Analysis, New York Mercantile Exchange, KSR

-250

-200

-150

-100

-50

0

50

100

150

200

250

$1.50

$1.75

$2.00

$2.25

$2.50

$2.75

$3.00

$3.25

$3.50

$3.75

$4.00

$4.25

Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10

AnnualizedBillions$ofConsumerSpending

GasPricePerGallon

Impact of Gas Price Change on Consumer Spending

(Billions $ Annualized)

Consumer Spending Hit when above $2.75 (RS) Daily National Avg $/ Gal Unleaded

Cumulative Consumer Spending Hit (RS)

Source: American Automobile Associatio, Federal Highway Administration, KSR


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32

And the Fear Was Inflation

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

5.0%

Jan-02 Aug-02 Mar-03 Oct-03 May-04 Dec-04 Jul-05 Feb-06 Sep-06 Apr-07 Nov-07 Jun-08 Jan-09 Aug-09

Global Aggregates Core InflationYoY % Change

Core Inflation World Core Inflation Industrial Economies

Core Inflation Emerging Economies

Source: IMF Publ ications, KSR


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Strategic Research

The more I see, the more I find reason for those who love thiscountry to weep over its blindness. The inquiry constantly is whatwill please, not what will benefit the people. In such a governmentthere can be nothing but temporary expedient, fickleness, andfolly.

Alexander Hamilton

All the Kings Horses andAll the Kings Men


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Strategic Research

34

We will keep making the point. NOMINAL is what matters in a deflating/deleveraging

economy. Debt is a cruel taskmaster; it requires what it requiresregardless of assetprice and monetary velocity deltas.

The Government Faced an Unprecedented Post-War Collapse in Nominal GDP

-150

-100

-50

0

50

100

150

200

250

-500

-300

-100

100

300

500

700

900

19 51 1 95 5 19 59 1 96 3 19 67 1 97 1 19 75 1 97 9 19 83 1 98 7 19 91 1 99 5 19 99 2 00 3 20 07

YoY Chg Consumer Credit vs. YoY Chg Nominal GDP

YoY Chg Nominal GDP ($ Billion) YoY Nominal Chg Consumer Credit (RS $ Billions)

Source: Bureau of Economic Analysis, Federal Reserve, KSR


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35

Although most agree with our positionnamely that the multiplier of fiscal spending is

at best 1X; in our minds the spending was absolutely necessary to help forestall a completecollapse in confidence. The debate on how it was spent is another matter entirely.

So the Legislative Branch Blew Out the Budget and Spent

-3,000

-2,000

-1,000

0

1,000

2,000

3,000

4,000

5,000

6,000

-3,000

-2,000

-1,000

0

1,000

2,000

3,000

4,000

5,000

6,000

Mar-05 Aug-05 Jan-06 Jun-06 Nov-06 Apr-07 Sep-07 Feb-08 Jul-08 Dec-08 May-09 Oct-09 Mar-10 Aug-10

Borrowing by Sector (Billions SAAR)

Non-Financial Domestic Private Sector Financial Sector

Total Federal & Local Govt Total Domestic + Financial Sector (RS)



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Strategic Research

36

The Collapse in Both Stocks and Home Prices Crushed Household Net Worth

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

1954 1958 1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006

Nominal US Household Net Worth12-Quarter % Change



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37

The simple story is that the Fed stood underneath the collapsing shadow banking

system and caught the junk so the banks could recapitalize by milking the steep yieldcurve. Then, the Fed bought up the mortgage market to accelerate deleveraging and

to lower rates to stimulate refis and encourage origination.

-2,500

-2,000

-1,500

-1,000

-500

0

500

1,000

1,500

2,000

2,500

Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10

$

Billions

Fed Balance Sheet

Treasury Securities Held Fed Agency Securities Held MBS HeldEmergency Facilities & Other Assets Currency in Circulation Balances with Reserve Banks

All Other LiabilitiesSource: Federal Reserve, , KSR

Extraordinary Balance

Sheet Growth

Extraordinary Reserve

Growth

Treasury Holdings

Now Just Above

Normal

The Fed Became the Lymph Node of the Credit System; Then It Was Mortgage Time


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Strategic Research

38

Credit creation requires collateral; it cannot beextended substantively without it. And since

75+% of consumer credit balances are residentialmortgages, we see reignition of the credit

machine as impossible.

The game is over. The speculative premium isgone, and now the market is returning to a

sustainable model for home prices.

And the foundation, community level cash flows,

is nothing more or less than the proximity toincome. Its all about the prospect of jobs and

economic vitality .

The Housing Market Is Structurally Broken; and Therefore, So Is Credit Creation

SUSTAINABLE HOME PRICE MODEL

COMMUNITY LEVEL

SUSTAINABLE CASH FLOWS

LOCATION PREMIUM -(PROPERTY TAXES)

COST OF

CAPITAL

EQUIV.

RENT

TAX INCENTIVESTAX INCENTIVES


LENDER BORROWER

SHOW ME THE COLLATERAL!

COLLATERAL

DEBT SERVICE

EQUITY



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Strategic Research

39

1/31/2011

0

5

10

15

20

25

30

35

40

0 1 2 3 4 5 6 7 8 9 10 11 12

AvgDurationofUneploymentNumberofWeeks

Unemployment Rate (%)

Unemployment Rate (%) vsDuration of Unemployment Number of Weeks SA

1948 to Nov 2007 Dec 2007 -P resent Linear (1948 to Nov 2007)


Financial System Stability but No Improvements In Employment


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Strategic Research

40

Now this chart is REAL. It doesnt depict a theory.There is a certain rate of job creationcurrently

somewhere around 140,000/monththat isneeded to satisfy population growth.

But as most are aware, shockingly weak jobgrowth isnt new. The last recession was also the

weakest in history.

The concept of NAIRU (the rate of unemploymentbelow which inflation would accelerate) is really

a theoretical compromise since the data neversupported the natural rate of full employment

concept. Lets just say, we dont buy ANY of it.

Economists regress past data with the assumption

that all environments trend toward someamorphous state of equilibrium, and then they

call it a theory. Unfortunately, their theories dontaccount for changes in the underlying structural

conditions.

So the Fed Reinforced Its Politically Inspired Dual-Mandate

125

130

135

140

145

150

J an -0 5 Nov-0 5 Sep -0 6 J ul-0 7 M ay-0 8 M ar -0 9 J an -1 0 Nov-1 0 Sep -1 1 J ul-1 2 M ay-1 3

Millions

Full Employment Gap

US Nonfarm Payrolls Total SA


11,000,000 JOBS SHORTOFMATCHINGPOPULATION GROWTH

:// . . / / / / / / - - - . / x- - - - . . / / : :


h


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Strategic Research

41

Source: Ahead of the Curve by Joseph H. Ellis, KSR

So Without Credit Growth and No Job Creation, What Lever Could the Fed Pull?

No collateral, no cash

flow, no credit.

Note to Self:

Inflation? Really???

IP vs. Scale andmassive slack

IP needs smartNOT numbers.

And the winner is?

The stock market.

i h


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Strategic Research

42

No matter how often we look at this chart, we arestunnedbut not surprisedat the condition of

the job market.

And some would like to argue that highunemployment rates and duration arent

structural?

Small business operators are facing the mostchallengingand potentially rewardingtime in

modern history. With the nominal demand andcredit likely to remain weak, and with technology

continuing to accelerate, this is the time to takeshare or die.

Rising Stock Prices Havent Inspired Small Business and It Creates the Jobs

01/31/2011

-7%

-6%

-5%

-4%

-3%

-2%

-1%

0%

1%

(28)(26)(24)(22) (20)(18)(16)(14) (12) (10) (8) (6) (4) (2) 0 2 4 6 8 10 12 14 16 18 20 22

Non-FarmP

ayrollasaPercentofPeakNFP

Number of Months Before to After Maximum Job Loss

US Jobs Lost and Months to Recover Peak

Aligned at Maximum Loss

1948

23

1953

24

1957

25

1960

21

1970

19

1974

20

1980

11

1981

29

1990

33

2001

49

2007

31


5

10

15

20

25

30

35

4080

85

90

95

100

105

110

1983 1986 1989 1992 1995 1998 2001 2004 2007 2010

NFIB Optimism Index vs.

Average Duration of Unemployment(Inverted Lagged 16-Months RS)

NFIB Small Business Optimism Index Unemployment Duration Avg Weeks Lagged 16-Months Inverted (RS)

Source: Nat'l Fed. of Ind. Business, Bureau of Labor Statistics, KSR

S i h


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Strategic Research

43

Income Expectations Are Shockingly Weak So Deleveraging Continues

Love does make the

world go round....

but VAR and FICO hold

it together Son

-17

-12

-7

-2

3

8

13

18

23

28

1 98 0 1 98 2 1 98 4 1 98 6 1 98 8 1 99 0 1 99 2 1 99 4 1 99 6 1 99 8 2 00 0 2 00 2 2 00 4 2 00 6 2 00 8 2 01 0

6 Month Forward Consumer Expectations:Spread between Higher Income - Lower Income

Source: Conference Board, KSR

-12%

-8%

-4%

0%

4%

8%

12%

16%

20%

24%

Jan-90 Sep-91 May-93 Jan-95 Sep-96 May-98 Jan-00 Sep-01 May-03 Jan-05 Sep-06 May-08 Jan-10

Revolving Consumer Credit YoY % Change


One thing IS certain; ongoing deleveraging

is consistent with income expectations andunemployment trends.

This chart truly reflects deep seated

pessimism because mathematically, the

consumer income expectations shown here

cannot be true given recent data releases.

Some suggest the recent upturn in spending,

which is unconfirmed by employment andwage growth, implies the data is wrong

because tax receipts are strong. We wouldemphasize this series more heavily than

that nuanced approach.

S i R h


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Strategic Research

44

The economic recovery has really just been a stabilization. Inappropriately in our

view, the market continues to focus on real growth, when in fact, nominal iswhat matters. And from that perspective, nominal GDP growth under 5% should be

considered recessionary.

And This Is All We Get With All That Stimulus?

-4%

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

-80%

-60%

-40%

-20%

0%

20%

40%

60%

80%

100%

Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10

Composition of US Nominal GDP Growth

PCE Inventories Government

Res Invest Non-Res Invest Net Exports

Nominal GDP YoY % (RS)

Source: Bureau of Economic Analysis, Bloomberg, KSR

S i R h


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Strategic Research

45

It Aint Mew, but Look What the Cat Dragged In

We havent heard anyone else talking about this. So, we got to wondering: How much

money was being saved/spent by squatters? The chart below is self-explanatory. Wedont have anyway of knowing how/if these funds are accounted for in the national

accounts data, but we would guess they arent. Windfall?

-400

-300

-200

-100

0

100

200

300

Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10

Monthly Change in Nominal PCE (SAAR) vs.Annualized Monthly "Savings" of Non-Performing Mortgages*

(Assumes $1250/mo as imputed "Squatters" benefit)

Annualized Non-Performing Mortgages @$1250 Monthly Change in Nominal PCE (SAAR)

Source: Bloomberg; BEA; * Lender Processing Services (2007 montly data imputed from industry trend), KSR

$

Billions

St t i R h


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Strategic Research

46

Again, real doesnt tell the story. Whenreported inflation is collapsing, aggregate data

paints a flawed pictureparticularly whendisinflation turns into deflation. (No, the economy

is not IN deflation, but the primary collateral stock(real estate) is.

Inflation? Really?

This data is shocking. Biblical wisdom says Thepoor will always be with you, but almost 15% of

the population of the most powerful nation onearth???

The Recent Spending Rise Doesnt Jive

0

5

10

15

20

25

30

35

40

45

1969 1973 1977 1981 1985 1989 1993 1997 2001 2005 2009

Millions

US Food Stamp Participants

Source: USDA, Food and Nutrition Service, KSR

-4 Stdev

-3 Stdev

-2 Stdev

-1 Stdev

Median

+1 Stdev

+2 Stdev

+3 Stdev

-4

0

4

8

12

16

1961 1964 1966 1969 1972 1975 1978 1981 1983 1986 1989 1992 1995 1998 2000 2003 2006 2009

US Nominal PCE YoY % Change SA


%

St t i R h


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Strategic Research

47

5

7

9

11

13

15

17

19

21

23

25

600

700

800

900

1,000

1,100

1,200

1,300

1,400

Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11

S&P 500 Index vs S&P 500 P/E Ratio

S&P 500 Price Index S&P 500 P/E Ratio (RS)


But What About the Stock Market? Doesnt THAT Indicate Recovery?

The amazing run in stocks from the July lows has actually seen the S&P 500s P/E Ratiofall. This is consistent with a move considered cyclical rather than secular, and we are

fast approaching an inflection where valuations will need to expand or stocks will fail.

St t i R h


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Strategic Research

48

The expectation that margin expansion wasprimarily being fueled by payroll cuts and working

capital reductions, was misguided.

We believed then (March 09) what we believenow; namely that the IP deployments made

over the past decade got the full attention of

management teams trying to drive profitabilitygiven weak demand prospects.

The collapse in nominal economic activity aroundthe world in Q4 2008, established a base of

pessimistic expectation for operating companiesthat was discontinuous from their ability to

manage fixed and variable cost.

So, once demand recovered, incremental margins

exploded, and so did cash flow.

Productivity and Scale

6%

7%

8%

9%

10%

11%

12%

1959 1962 1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007

Relative Strength of US Corporate Net Cash FlowSA versus US Nominal GDP (SAAR)

US Corporate Profits With IVA and CCA Net Cash Flow SA / Gdp Us Nominal Dollars Saar


90

95

100

105

110

115

120

125

130

135

140

Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Jan-11

Standard & Poor's 500 Index Positive SurprisesIndexed 100=1-31-2007

Source: Bloomberg Indices, KSR

St t i R h


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Strategic Research

49

Incremental Corporate Profitability Is Growing Exponentially

Another way of looking at the same productivitydata; this chart shows that the last $400MM of

corporate profit was made with only 5 millionincremental jobs.

Thats an incremental profit per employee of

$80,000 versus average profitability $14,000.

Stunning.

The acceleration of profitability per employee hasgone exponential.

This supports our IP-Scale construct, and certainly

explains the intensifying weakness of labor.

$0

$200

$400

$600

$800

$1,000

$1,200

50, 000 60, 000 70, 000 80, 000 90, 000 100,000 110,000 120,000 130,000 140,000 150,000

NIPA Profits (billions) vs.Number Employed (thousands)

Source: Bureau of Economic Analysis, Bureau of Labor Statistics, KSR

0

100

200

300

400

500

600

700

800

900

1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008

Growth of NIPA US Non-Financial Profitsper Employed Person

Source: Bureau of Economic Analysis, Bureau of Labor Statistics, KSR

St t i R h


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Strategic Research

50

And Bigger Is Better

We believe that scale has been an enormous benefit in this recession. As weaker/

poorly capitalized operations have suffered or closed; stronger competition has beenable to take market share and utilize its flexibility to shift capacity based upon market

conditions.

ANEMIC

NOMINALGDP

CREDITCONTRACTION

MAIN STREET LOSSES ARE PUBLIC CO. GAINS

CAPACITY SHRINK

WEAK COMPETITION; POORLY FINANCED;

OVER-LEVERAGED; NON-

COMPETITIVE

WELL FINANCED; STABLE/GROWING

MARKET SHARE; COMPETITIVE

ADVANTAGE

SHARE GAINS

FLAT REVENUE


WEAK COMPETITION; POORLY FINANCED;OVER-LEVERAGED; NON-COMPETITIVE

St t i R h


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Strategic Research

51

Unquestionably, Corporate America Is Thriving Relative to Main Street

$0

$10,000

$20,000

$30,000

$40,000

$50,000

$60,000

$70,000

$0

$200

$400

$600

$800

$1,000

$1,200

$1,400

$1,600

$1,800

1951 1955 1959 1963 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003 2007

Billions

Billions

Corporate Cash Flow vs. Household Net WorthThe Growing Chasm

US Corporate Profits With IVA and CCA Net Cash Flow SA Household Net worth (RS)

Source: Bureau of Economic Analysis, Federal Reserve, KSR

St t i R h


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Strategic Research

If investors all get caught in a 1914-style crisis, they will all godown together and nobody will underperform the benchmark,he says.But if they become pessimistic too early and are wrong,they will underperform. Therefore its better to consign a majorgeopolitical crisis to the realm of uncertainty, and treat it like therisk of an asteroid hitting the earth. Common sense tells us thata major war is much more likely than an asteroid, or indeed the

melting of the polar ice caps. But there are incentives for investorsand financial professionals to ignore the risk of crises.

Niall Ferguson

Barrons: March 12, 2007

The Game Is Over

Strategic Research


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Strategic Research

53

The Commodity Markets Are Overrun and Present a Major Risk to Global Stability

60

100

140

180

220

260

300

340

Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10 Jan-11

Crude vs Copper vs CRB Raw Industrials

Indexed to 100 1/2/09

WTI CRUDE FUTURE Indexed 100=1-2-2009

COPPER FUTURE Indexed 100=1-2-2009

Commodity Research Bureau/Reuters US Spot Raw Industrials Indexed 100=1-2-2009

Source: Bloomberg, Commodity Research Bureau, KSR

80

100

120

140

160

180

200

220

Jan -9 1 S ep -9 2 May-9 4 Jan -9 6 S ep -9 7 May-9 9 Jan -0 1 S ep -0 2 May-0 4 Jan -0 6 S ep -0 7 May-0 9

UN Food and Agriculture World Food Price Index

Source: Food and Agriculture Organizat, KSR

It is incredible to us that the debate regarding thedeleterious and destabilizing impact that speculators

have on the commodity markets still rages on. We fullyappreciate the necessary role that true speculators bring

to the markets, but we are aghast that more isnt doneto rationalize access. How can it possibly not distort

price and, therefore, the operations of real businessesand the functioning of the global economy, when

investment banks are caught stockpiling? And how canthe profusion of ETFs which are heavily marketed to

individuals not be a negative?

Quite obviously, controlling food price inflation iscritical to the well-being of the world. We cannot

understand why the United States agricultural belt isstill being used to produce corn for ethanol rather than

being markedly expanded to increase production fortrade around the world. Perhaps an enlightened client

will inform us?

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The economic value of manufacturing labor is inextricably linked to finished goods pricing. If for

example, you worked the factory floor making lawn mowers and your gross annual wage could buy100 machines, if input prices rose 20% and finished goods prices rose 10%, your value in the chain

declined by 9%; because now you could only buy 91 machines. Moreover, if we assume that yourproductivity increases by 10%/year, your compensated value would decline even further.

Manufacturing Labor Has a Call on Finished Goods Pricing

MARGI

N

INPUT COSTS

LABOR

MARGI

N


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Knight Capital Americas, L.P.55

Thus Commodities Can Drive Wage/Price Spirals When Manufacturing Density Is High

But that is NOT the case for IP-centric economies like the United States. Because wages are NOT tiedto commodity prices, rising finished goods prices will face stiff elasticities of demandor outright

substitution. So if commodity price increases persist, the manufacturing intensive emerging worldwill either:

1. Have to hold margins and sell less

2. Hold prices and earn less, or

3. Hold wages flat.

The latter promises revolt, and either of the first two risk the deflationary collapse of marginalcapacity.

WEAKER DEMAND

WEAK DEMAND FLAT PRICES CFLO CREDIT PROBLEMS

INCREASED PRICES WAGES INFLATION

DEVELOPED WORLD

DEFLATIONARYPRESSURE

RISING

COMMODITY PRICES

CHINA

INFLATIONARY/

STAGFLATIONARYPRESSURE

FOREIGN EXCHANGE

RESERVES FALL


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56

This schematic (borrowed from the government of New Zealand!) shows the flow of

prices across a balanced economy. As you will note, rising commodity producer priceinputs MUST be passed along to export markets, or domestically, through imports or

direct to consumer price increases.

So Really, Commodity Price Increases Will NOT Lead to Inflation Here

Inflation Flows in the Economy

ProducersPrice Index

(outputs)Import Price Index

Export Price Index

Labor Cost IndexProducers Price

Index (inputs)

Capital Goods

Price Index

Consumers

Price Index

Expenditure by production/government sector Expenditure by household SectorProduction

Sector

outputs

Labor

costs

Current

costs

Capital

costs

Source: Government of New Zealand, KSR

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Because in the Aggregate, Nominal Consumer Demand Is Structurally Impaired

COLLATERAL?

EQUITY?

EXCESS CASH FLOW?

RISING ASSET VALUES?

ANEMIC WAGES

JOB SECURITY?

CUSHION?

NEW RETIREMENT CALCULUS

DEMOGRAPHICS

COMPETITIVE IN IP MODEL?

DRIVE VALUE IN IP CHAIN?

INVESTMENT/EQUITY RETURNS?

RISING PROPENSITY TO SAVE

NO CREDIT/DELEVERAGING

BLEAK WAGE & ROI EXPECTATIONS

Inflation Flows in the Economy

Producers

Price Index

(outputs)Import Price Index

Export Price Index

Labor Cost IndexProducers Price

Index (inputs)

Capital Goods

Price Index

Consumers

Price Index

Expendi ture by product ion/government sector Expendi ture by household SectorProduction

Sector

outputs

Labor

costs

Current

costs

Capital

costs

Source: Government of New Zealand, KSR

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ECONOMIC SECURITY

GOVERNMENT POLICY

RESOURCE & INDUSTRY

TERMS OF TRADE


We Therefore Believe The Game Is Over

We first made our Game Over call back in November; andsince then, our conviction level has increased. What we aresaying is that structurally, per this chart, the global terms oftrade have been pushed past their tipping point. And it is ourhope that the elements of this publication will all come togetherin support of our position.

In essence, we believe the disparity between the prevailingeconomic and financial structures around the world, inconjunction with the policies being effected by governments

(particularly China) are in the process of pushing the marketstowards a significant dislocation.

Specifically, as we will cover later in this report, China iscaught in a double-bind of its own making. We believethat the price/wage spiral that has commenced will not becontained by policy initiatives. Attempts to do so, will onlykeep the upward pressure on commodities and input pricesfirm, making the inevitable breakdown of past trend thatmuch worse.

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We Believe the BRIC and Commodity Rally Is An Echo Bubble

0

50

100

150

200

250

300

350

400

450

500

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

5,000

MSCI BRIC (12/10) vs DOW 1929 vs NDX 2000

NDX Index 2000 Peak MSCI BRIC 2007 Peak DOW Index 1929 Peak (RS)


5 YEARS

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60

With all the hoopla about an extended cycle for commodities; is it possible that ALL related

things are coming to an end? This chart depicts the 10-year average growth rate of commoditiessince 1800; the importance is that it has reached a well defined trend line.

Which Is More Plausible Looking At This Chart

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

12%

1805 1835 1865 1895 1925 1955 1985 2015

Commodity Prices in the US 10-Year Average Growth Rate

Source: U.S. Census Bureau, BLS, KSR

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

12%

1805 1835 1865 1895 1925 1955 1985 2015

Commodity Prices in the US 10-Year Average Growth Rate

Source: U.S. Census Bureau, BLS, KSR

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61

Calling long-term cycles on the basis of charts

alone is foolhardy, but the evidence is starting to

build.

Stocks have underperformed commodities in

four distinct periods since 1900. The difference

now, and the argument against the prior 10-yearaverage growth chart? This cycle has only lasted

about two-thirds as long.

So are the bulls right and the trend lines wrong?

We dont think so, because the structural condi-

tions in the developed world cant tolerate a dif-ferent outcome.

And As Confirmed By These

200%

300%

400%

500%

600%

700%

800%

900%

1000%

1100%

Jan-95 May-96 Sep-97 Jan-99 May-00 Sep-01 Jan-03 May-04 Sep-05 Jan-07 May-08 Sep-09 Jan-11

S&P 500 INDEX / ThomReuters/JefferiesCRB


0.4

0.8

1.6

3.2

6.4

12.8

25.6

51.2

102.4

1 87 1 1 88 1 1 89 1 1 90 1 1 91 1 1 92 1 1 93 1 1 94 1 1 95 1 1 96 1 1 97 1 1 98 1 1 99 1 2 00 1 2 01 1

LogarithmicScale

US Stock Prices Relative to Commodity PricesFour Periods of Commodity Outperformance

Source: Shiller, US Census Bureau, Bloomberg, KSR

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It would be foolish, in forming our expectations, to attach greatweight to matters which are very uncertain...[since] investmentbased on genuine long-term expectation is...scarcely practicable[because] capital investment [is controlled] by persons [withoutspecial knowledge or perspective] seeking to outwit the crowd,and pass the bad, or depreciating, half-crown to the other fellow.

John Maynard Keynes,

The General Theory of Employment, Interest and Money (1935)

We Are the Masters Now

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63

China Is Caught in Its Own Trap

China circa 2011 shares many similarities with the United

States in both 1929 and 2007, as well as Japan in the1980s:

1. Massive disparity of wealth, income, andeducation.

2. Rapid industrialization and displacement oflabor.

3. Opaque and misleading economic and financialdata.

4. Massive build-up of leverage across the rising

class.5. Bubbles in both residential real estate and fixed

asset/infrastructure development.

6. Accelerating and uncontrolled growth indisintermediated credit.

7. Expected transference of economic growth todomestic demand.

8. Accelerating price/wage spiral.

The clearest investment case against China is also themost fundamental. It is trapped in a double bind of its

own making. For despite the CPCs own hubrisandthe ubiquity of the worlds confidence in itChina

appears to have lost control. And in an ironic twist, ithas done so by doing everything it can not to. For in its

own zeal to placate the masses through rapid growth,

China has created a tide of inflation that threatenswidespread social unrest. And what is its option? To

crush speculation and the extension of credit and risk adeflationary collapse?

China no longer controls its own destiny; the freemarkets do.

Source: IMF

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R = 0.9988 R = 0.9506

0

20

40

60

80

100

120

140

160

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

May-99 Apr-00 Mar-01 Feb-02 Jan-03 Dec-03 Nov-04 Oct-05 Sep-06 Aug-07 Jul-08 Jun-09 May-10

$Billions

CNY

Billions

China Fixed Assets Investment versusChina Export Trade (Projected 6 Months)

1 2M Av g. Ch ina Fi xed As se ts Inv es tment Ch in a E xp or t Tr ad e (RS ) $ Bi ll ion s

Poly. (12M Avg. China Fixed Assets Investment) Poly. (China Export Trade (RS) $ Billions)Source: China Economic Information Net, KSR

-20%

0%

20%

40%

60%

80%

100%

1 99 5 1 99 6 1 99 7 1 99 8 1 99 9 2 00 0 2 00 1 2 00 2 2 00 3 2 00 4 2 00 5 2 00 6 2 00 7 2 00 8 2 00 9 2 01 0

China GDP; Composition of Growth

Net Exports, Capital Formation, Final Consumption

China Yearly GDP by Expenditure -Net Exports of Goods & Serv

China Yearly GDP by Expenditure -Gross Capital Formation

China Yearly GDP by Expenditure -Final Consumption

Source: CEIC Data, KSR

Much like Japan in the 1980s, Chinas culture ofthrift has prevented the hand-off of economic

growth to domestic consumption. The bull caseis that this impediment (household savings rate

runs between 30% - 50%) will vanish when theCPC establishes a social security system. We dont

agree. If the U.S. populace does not trust ourgovernments management of a similar system,

will the trust of the Chinese populace be so strongas to transform its own culture?

Fixed Asset Investment Is Now 70% of GDP

Plain and simple, the physics of finance and

economicsand all that makes for good commonsense and practical experiencesays that theexponential expansion of fixed assets supported

by a pyramid of debt always ends in tears.

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Does It Have to End? This Chart Speaks Volumes

This IMF chart has been widely published by analysts struggling to put Chinas capex boom into context.

But now that we have 2010 data we have updated the illustration. Hmmm.

Japan (68-74)

Singapore (91-99)Korea (90-97)

Thailand (89-97)

Maylaysia (90-97)

China ('96-2009)

CHINA (2010)

35%

40%

45%

50%

55%

60%

65%

70%

5 6 7 8 9 10 11 12 13 14

Number of Sequential years of Capex Boom

Intensity and Duration of Capex Booms(Fixed Asset Investment/GDP and Years)

Source: IMF, KSR

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0%

10%

20%

30%

40%

50%

60%

70%

"Official"Government Bonds

Policy Bank Bonds NPLs on state-owned AMC

LGFV Bonds LGFV InfrastructureLoans

LGFV "Other"Loans

China's Debt to GDP Is At Least 70%

versus the "Official" 17.5%

Fitch Ratings has done groundbreaking work onuncovering the disintermediation of domestic credit

in China. According to its research, some 3 trillionyuan of credit has been created within Chinas trust

banking system, in 2010. This is a 40% increase over thegovernments stated numbers. The primary purpose

is to create yield-enhanced, short-term instruments.Moreover, Fitch recently reported that Chinese banks

are broadly utilizing undiscounted acceptances tounderstate leverage to regulators.

Chinas arcane system of laws and therequirement that local governments fund the

bulk of infrastructure development, has givenrise to an opaque network of over 8,000 LGFVs

(local government funding vehicles). Essentiallythese are Chinas form of public sector SIVs, and

its massive build-up of debt isnt included inofficial estimates of national debt, as we see it.

Banking System Leverage and Government Debt Are Grossly Understated

0

2,000

4,000

6,000

8,000

10,000

12,000

2007 2008 2 009 H109 H110 9M09 9M10

Net New Credit Flows (CNY Billions)

CNY and FX Loans Undiscounted Acceptances

CWMPs and CTPs (Credit-Related Wealth Management/Trust products) Claims of Hong Kong Banks on China

Source: Wind, Fitch, KSR

Source: Merrill Lynch

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The Incremental Productivity of Chinas Runaway Credit Growth Is Collapsing

0

2,000

4,000

6,000

8,000

10,000

12,000

Mar-00 Feb-01 Jan-02 Dec-02 Nov-03 Oct-04 Sep-05 Aug-06 Jul-07 Jun-08 May-09 Apr-10

China Total Loans YoY Change vs. GDP YoY Change (CNY)

China Total Loans of Financial Institutions YoY Change (CNY Billions)

China GDP 4Q Sum YoY Change (CNY Billions)

Source: China Economic Information Net, Bloomberg, KSR

As Adjusted Per Fitch Findings

Chinas economic growth appears increasingly dependent upon a system of Ponzi finance. And given the

price/wage spiral that its own zeal for growth has unleashed, it is most certainly caught in a double bind.

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The trend of economic surprise in Asia is already

perilous.

The Hong Kong Monetary Authority published

this data. It shows the CoVAR between Asiannations as measured by CDS volatility.

If China catches a cold....

And This Is a Great Risk for Asia

-140

-90

-40

10

60

Jan -0 7 M ay -0 7 S ep -0 7 Jan -0 8 M ay -0 8 S ep -0 8 Jan -0 9 M ay -0 9 S ep -0 9 Jan -1 0 M ay -1 0 S ep -1 0 Jan -1

Citigroup Economic Asia Pacific Surprise

Citigroup Economic Surprise Index - Asia Pacific

Source: Citigroup, KSRSource: Hong Kong Monetary Authority

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This chart is striking. As we entered 2011, the

imbalance between US companies raising andlowering guidance was almost 4 standarddeviations above normal.

And although we cannot gauge just how muchguidance would soften in the event of a China

breakdown, given such acute sentiment, a majordisruption seems reasonable.

It looks to us like the global equity markets

have done a very thorough job of pricing in therecovery of G7 leading indicators.

-4 Stdev

-3 Stdev

-2 Stdev

-1 Stdev

Median

+1 Stdev

+2 Stdev

+3 Stdev

+4 Stdev

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

Jan-00 Dec-00 Nov-01 Oct-02 Sep-03 Aug-04 Jul-05 Jun-06 May-07 Apr-08 Mar-09 Feb-10 Jan-11

Number of US Cos Issuing Financial Outlooks Up /Number of US Cos Issuing Financial Outlooks Down

Source: Bloomberg Indices, Bloomberg, KSR

And for the Developed World

-75%

-50%

-25%

0%

25%

50%

75%

-14

-10

-6

-2

2

6

10

14

1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009

G7 Composite Leading Index YOY %vs. MSCI World Index YoY

OECD G7 Composite Leading Ind. Total Trend Restored YOY % MSCI WORLD YoY % Change

Source: Organization for Economic Coop, KSR

%

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Dont Trust the Orthodoxy

Too large a proportion of recent mathematical economics aremere concoctions, as imprecise as the initial assumptions theyrest on, which allow the author to lose sight of the complexitiesand interdependencies of the real world in a maze of pretentiousand unhelpful symbols.

John Maynard Keynes,

The

Documents

02.11.2011 the Final Chapter of the Old Story