A&O Insights July 2012

EORUM CLARITATEM VESTIG ATIONES ! 10. JULI 2012

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A&O InsightsJuly 2012

Inside:

A&O Insights July 2012

Page 4

What to do We are at a maximum equity ex-posure as of June 29, 2012. - Bonds are a „hold“ to us. Support from yen exchange rate looks iffy.

Page 24

Demographics U.S. June labor market data positive surprise. ,Broad improvement. - European CDI dips into negative late 2013.

Page 17

The Economy There is steady progress in our indicators. Our Composite Economic Indicator suggests GER GDP bottom for SEP 2012.


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The analysis presented in this publication is based on the conviction that major economic trends are rooted in demographic forces, which are the main drivers of consumption. Notably, household formation by people seeking permanent employment after education and by those engaging in family formation is for a substantial portion of consumer expenditure. Eventually, consumption is followed by investment, employment, shifts in inflation and interest rates etc. Gradually, financial markets are affected by what is going on in the "real" economy regardless of whether or not these goings-on become apparent in the official statistics.

The DEMOGRAPHIC ROAD-MAP focusses on medium-term and long-term demographic trends and explains how they feed through to the financial markets.

Economic trends can be characterized by looking at new business orders and production, rep-resenting demand and supply. These data, however, are often not available on a timely basis and are sometimes subject to substantial revisions. Monetary data, on the other hand, are much more consistent. In our approach money serves as a proxy for demand in the economy and loan growth is usually a good approximation of the trend in supply. The interplay of these two forces is one of the cornerstones of our monetary analysis.

Monetary analysis attempts to detect emerging monetary stress or ease reflecting the ever changing balance between demand and supply in the economy. Our proprietary indicators rep-resent our operational "tool-box" for forecasting trend changes in bonds and equities.

Equity prices are - last but not least - the result of an auction market at work. Market prices may deviate from the path set by any methodology. The analysis presented on the following pages is grounded on the conviction that market prices can over- and undershoot fundamental trends only for a relatively brief period of time. Emphasis is, therefore, placed on a disciplined yet flexible fundamental approach to market analysis. What is presented here is solely based on facts - objective data obtained from official sources - rather than more or less arbitrary es-timates.

Additional background information is available upon request.

NOTE: Market trading can result in losses as well as profits. This statement is required by law. We strive for accuracy in our advice and info, but all conclusions and decisions based thereon are the sole responsibility of the reader.

A d v i c e & O p i n i o nDemographics & MarketsInh. Dipl.-Kfm. Rüdiger Braun

Steinkaul 10 – D-40589 Düsseldorf – Germany Website: www.aodemographics.eu

FON: +49-(0)211-6400113 Cell: +49-(0)1525-8705859

All rights reserved. No part of this publication may be reproduced without written consent. Copyright by Advice & Opinion Demographics & Markets, 2012.

Introduction

A&O Insights July 2012 2


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Page 4 The Investment Box - Just the results

Page 5 Summary - Most Important Observations Some brief explanations

Monetary and Economic Background - The DetailsPage 12 Monetary Indicators Page 17 Economic Indicators

Page 24 The Demographic Road-Map How, where and when population shifts drive the economy and markets. Page 28 The Demographic Chart-Book Charts to keep in mind

Where to Find ...

Timeline: A Possible Scenario For 2012 & 2013

4Q 2013: Stock Mkt. Top Begins to Form

Mid-2012:Equity Bear End

3Q 2011:Recession Begins


Overview

1Q 2013Econo Bottom


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I. The Investment Box: Just The ResultsStocks: Our demographics-based asset allocation model for the German market went bearish stocks in April 2011. The DAX then stood at 7,514 points. It went long stocks again as of June 209, 2012. The DAX was at 6,416 at the time. Following the model thus saved you a loss of 14.6%. Going long the REX total return index in April would have produced a gain of 11.9% for the whole portfolio. Well, now we are back at a balanced exposure: 50% long DAX and 50% long the REXP. Our demographics-based asset allocation model will be bullish equities until October 2013. --- World stock markets are doing much better than the European ones. The lingering euro crisis and the unknown policy responses are a major drag on equities. Stock se-lection is key to performance at present. Our new product TREND INSIGHTS is designed to help you master this challenge successfully. What to do: We are at a maximum equity exposure. A tactical stop level may be placed at a three day closing below DAX 5,800.

Bonds: We continue to view bond markets as increasingly risky. In the U.S., for instance, the margin indicator shown on p. 23 is certainly still positive, but at levels which more often than not triggered a reversal. In addition, we are worried about the yen vs. euro rate. Our yen model shows a persistent loss of momentum. The euro re-cycling is at risk. Also, German banks are increasingly reluctant to buy bonds. In short: Profit protection is our top priority. What to do: We are still long Bunds, but use trailing stops. We let the market decide.

Gold/Commodities: Gold continues bullish. Industrial metals suffer from recession. The firm dollar has been depressing gold in past months. This may be changing now, though, as we are detecting early signs of the dollar losing momentum vs. the euro. What to do: Stay clear of mining stocks (AMEX Gold Bugs). If still long, sell into the current re-bound. We will go long physical gold above 1700 USD and add to positions above 1800 USD.

Economy: It is a mixed bag, but we think that the weight of the evidence is gradually impro-ving. In the U.S. the unexpected weakness of the ISM index caused some dismay. On the other hand industrial production continues in a solid up trend. The labor market data was disappoin-ting, too, as far as the Establishment Survey was concerned. Yet the Household Survey data came in amazing across the board. Most important: the first-time entrant labor force participa-tion rate moved very close to a long-term trend change. --- In Europe, data remain rather con-fusing and contradictory. New business orders for Germany appear to stabilize and export or-ders from outside the EMU lead. Employment remains stable, but demand for labor is heading south. Input prices plunge, but sales prices are not affected. It is difficult to read anything con-sistent from the data. Yet there is one bullish development: In Germany, short-term business loans are turning down and this has been a classic indicator of rising cash flows/stock market.

Demographics: Our purely demographics-driven asset allocation model is long equities since June 30, 2012. The next exit point for equities is October 2013. --- The German economy will hit bottom in spring 2013 and peak in 4Q 2013.

What to do


Currencies: The Pacific currencies are signaling that the global economy is gaining pace. The Australian and NZ dollar are super strong versus the euro. The U.S. dollar is also re-gaining momentum vs. the euro but our monthly model is clearly getting tired. What to do: We are long U.S. dollars enjoying the ride. Adjust your stop to 1.2700 vs. euro.


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II. Summary

II. 1. Where We Are: Most Important Observations

Stocks: Stocks are groping for a bottom. That should be a choppy affair going for-ward. The bottom chart illustrates a scenario based on past interest rate patterns. Eventu-ally, beginning in the fourth quarter 2012, a broad rally should get underway. The top chart on this page is from TREND INSIGHTS, our new publication in

which we analyze (amongst others) 130 German stocks (DAX, MDAX, and SDAX). The chart illustrates the extremely split na-ture of today‘s stock market. During the spring correction the percentage of stocks rated „favorable“ by our system fell to slightly above 50%. The percentage of vul-nerable stocks climbed to about 25%. Now

Equity Summ

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GER DAX (Top) vs. Inverted Call Money Rate (Advanced)

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Jan 07, 2011 Apr 08, 2011 July 08, 2011 Oct 07, 2011 Jan 06, 2012 APR 05, 2012 JUL 06, 2012

Weekly "ALL DAX" Trend Survey (2011 to Date)

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PC Favorable Stocks

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DAX Index & Long-Term Moving Average


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20311 270511 190811 111111 60212 30512

DAX vs. 10 & 30 Day OB/OS Oscillator

10211 90611 131011 170212 28061257

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DAX vs. Relative Strength: DUAV/DAX

Mär 16,2007 Mär 14,2008 Mär 13,2009 Mär 12,2010 Mar 11, 2011 Mar 09, 2012

USA Percent Stocks in Stage I & II vs. DAX

Jun 21,2002 Jun 18,2004 Jun 16,2006 Jun 13,2008 Jun 11,2010 JUN 01, 2012

Percent Global Stock Markets (Euro based) in Stage I & II

have a look at the dotted line in the chart, which is the percentage of stocks in a pattern of „indecision“, consolidating or potentially topping (We call it Stage 3). It rose to a hefty 50%. It will be very important to track how this big chunk of Stage 3 stocks will proceed going forward. Currently, we think they will revert to an up trend (Stage 2). - Notice that our Stage Analysis for the MSCI Universe of stock markets and the U.S. could register healthy gains since our last writing. Both indi-cators are in the 75% vicinity. It is also posi-tive that our unweighted German equity index DUAV continues to outperform the DAX. As of this writing, the OB/OS oscillator (top right) is displaying a small negative divergence, but the red 30-day-oscillator is moving into posi-tive territory. In addition, the percentage of German stocks in medium-term uptrends has improved strongly in recent weeks, which is bullish. But in the short-run this indicator is over-extended so that a little rest would be no surprise. The bottom line is that the majority of indicators continue in o.k. shape, not great but not bad either. This is also true for the U.S. bullish percentage index. The trend is up and this is probably all we need to know. *****

quity Summ

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Percent GER Stocks in Medium-Term Uptrends

Mär 26,2010 Mar 25, 2011 MAR 23, 2012

USA Bullish Percent Index vs. DJIA (2009 to date)


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Bonds: In the bond markets the trend is still up. But it is a very mature trend. Similar to an aging gigolo it is trying to attract new buyers, easy meat, so to speak, with lit-tle experience, those who only see the seductive smile but not the missing tooth. Typically, the loss of momentum is an early warning of something being wrong. Notice the deterioration in our weekly and monthly models since last month. The rebound from the recent correction has done nothing to better the situation. The performance ration shown below is just another item to worry. The 10-year-REX index has retraced about half of its cor-rection, but the performance ratio has barely

moved. In our opinion there is now a nega-tive divergence building. In the first half of 2012 the money was

made in the bond market and this may well reverse in the second half. The momentum loss we reg-ister is the reflection of the fact that the underlying fundamentals do no longer look rosy, as we will demonstrate through the remain-der of this report. This leaves the fear of a Eurozone meltdown as the main buying motive for Ger-man government bonds.

Opposite to the German stock market investor sentiment for U.S. Treasuries is high AND rising, as the insert chart illustrates. This certainly does not raise our comfort level. We remain defensive.

Jul 28,2006 Aug 24,2007 Aug 22,2008 Aug 21,2009 Aug 20,2010 Aug 19, 2011

REX Price Index vs. Weekly Model

93 JAN 98 JAN 03 JAN 08 JAN 13 JAN

REX Price Index vs. Monthly Model

Bond Summ

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19.06.2009 14.06.2010 03.06.2011 24.05.2012120

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GER 10-Yr.-REX vs. 10/5-Yr. REX Performance Ratio

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C

Currencies/Commodities/Gold: Industrial metals continue dormant. Especially in euro terms they have ceased to go down. Nickel, our pet gauge for the strength of the global economy, has been going sideways for many months and is now shy of crossing its mov-ing average on the upside. Message: Global demand and economic activity is bottoming. Precious metals are a different story. gold has been correcting for many months and a falling triangle has been developing. Notice that the long-term moving average is beginning to flatten out and that the gold price is running into the apex of the triangle.

Chart theory has it that this reduces the like-lihood of a downside breakout. So let us be patient and see what happens. The critical factor behind the gold price is, of course, the U.S. dollar. The dollar vs. euro exchange rate has hit long-term resis-tance and the monthly model is showing a massive bearish divergence vs. the previous peaks. Yet also in the short-run the model has failed to produce a new recovery high (arrow). The practical implication is that we should treat a short-term sell signal, let‘s say a trend line violation, as a signal with long-term implications.

omm

odity & Currency Summ

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88 JAN 93 JAN 98 JAN 03 JAN 08 JAN 13 JAN

USD vs. Monthly Model

(c) 1997-2004 Tai-Pan

Gold USD/UnzeWPK: 999003 Rohstoff

vwd Rohstoffe

ISIN: XC0009655157

(c) Tai-Pan

900,00

1.000,00

1.200,00

1.400,00

1.600,00

1.800,00

US-$

900,00

1.000,00

1.200,00

1.400,00

1.600,00

1.800,00

US-$

LOG

Kurs:1.581,44- SMA(30):1.596,07 - SMA(200):1.659,93

27.01.2009 09.07.2012 900 Kurse

F M A M J J A S O N D 10 F M A M J J A S O N D 11 F M A M J J A S O N D 12 F M A M J J


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Equity AnalysisII. 2. Equities

! The main themes remain unchanged. There is increasing evidence that the global economy is gaining traction. On the other hand, there is increasing evidence that the Eurozone is facing a collapse. Despite all sorts of „rescue“ action (for Spain in particu-lar) there is no indication that the markets are beginning to discount a turn for the better. Similar to the pre-euro period, bond yield spreads keep widening between the Eurozo-ne surplus and deficit member states. In o-

ther words, the bond markets continue to anticipate a devaluation of the „deficit euros“ vs. Germany, the Netherlands, Luxemburg and Finland. Capital flight is on and drains deposits from the southern European banks. The (negative) Target2 balance of Spain rose by 63 billion euros in June! How can a new rescue package for the Spanish banks of 100 billion euros help the banking system under such circumstances? Anyway, stock markets seem to turn a deaf ear on such


88 JAN 91 JAN 94 JAN 97 JAN 00 JAN 03 JAN 06 JAN 09 JAN 12 JAN 15 JAN

GER Equity Index vs. AUD Ann. %

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GER Total Equity Holdings at Major German Banks (Ann. %)

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Equity Analysis

looming scenarios of eurozone armageddon. The two charts on the preceding page are an attempt to illustrate these two factors. Notice that the Aussie dollar, which enjoys an almost immaculate track record of mirro-ring the state of the global economy, is gra-dually establishing a turnaround. Its annual rate-of-change is in the process of moving above the long-term moving average line. At the same time the pace at which German banks have been reducing equity holdings seems to slow. All of this takes place at historically low holdings anyway and leaves a lot of room for increasing positions

once sentiment vs. the stock market begins to improve. We believe that banks will only move into the market late, when the traditio-nal fundamental indicators report about an improving economy. We like the fact that we get support from international (and the U.S. in particular) stock markets. The MSCI world equity index (in euro) is close to moving above long-trem resistance. Our monthly model for the Nikkei is making progress moving closer to positive territory. The DJIA (in euro) has already ac-complished a long-term buy signal. This is an important step ahead compared to last month. The U.S. is the economic juggernaut.


90 JAN 92 JAN 94 JAN 96 JAN 98 JAN 00 JAN 02 JAN 04 JAN 06 JAN 08 JAN 10 JAN 12 JAN 14 JAN

DJIA (in Euro) vs. Monthly Model


Nikkei 225 (in Euro) vs. Monthly Model


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Bond Analysis II. 3. Bonds

! We view the bond market with a jaun-diced eye. It is holding well, the up trend is still intact, but it is hard to find a justification for that among the indicators we follow. One can hold bonds with tight and trailing stops, because capital flight out of southern Europe generates demand for safe haven investments. In addition, the trade surplus re-cycling out of Japan is another important factor propping up bond prices. Should the yen, however, fail to make a new

high vs. the euro, this pillar could crumble overnight. Notice on the bottom chart how incredibly tight the correlation between the yen and the Bund future (blue graph) has been! Also notice that there has been virtually nil support for the bond market stemming form the domestic side. Net mutual fund contributions have been negative despite the rally. Domestic demand is low, and foreign demand can turn on a dime.


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78 JAN 83 JAN 88 JAN 93 JAN 98 JAN 03 JAN 08 JAN 13 JAN

GER Mutual Bond Funds: Net Contributions (% of Fund Volume)

A B

(c) 1997-2004 Tai-Pan

100 Japan.Yen in EuroWPK: 000091 Japan

Forex

(c) Tai-Pan

0,6000

0,6500

0,7000

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LOG

Kurs:1,0220

DE: BUND-Future (adj.)

- SMA(30):1,0060 - SMA(200):0,9663

01.01.2008 06.07.2012 1179 Kurse

Q2Q1'08 Q3 Q4 Q1'09 Q2 Q3 Q4 Q1'10 Q2 Q3 Q4 Q1'11 Q2 Q3 Q4 Q1'12 Q2 Q3


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Monetary Analysis

III. Monetary & Economic Background

III. 1. Bank Lending & Related Indicators

III. 1. 1. Bank Lending

! Cross border bank lending in the Euro-zone has long come to a virtual standstill. The consequence is that lending is now do-ne via the national central banks. As a result, the Target2 balances are ballooning. The be-low (top) chart shows the exponential rise in

the (positive) Target2 balance of the Deut-sche Bundesbank. The source behind these balances is international trade needed ot be financed and, increasingly, capital flight. Ultimately, the Bundesbank (the German taxpayer) is financing the zombie banks of


Charts courtesy www.querschuesse.de


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Monetary Analysisthe deficit countries which lose deposits at a very heavy clip. It is quite unlikely that the claims of the Bundesbank on the central banks of the deficit countries will ever be settled. The bottom chart on the previous page shows why. It shows the annual rate-of-change in outstanding loans to private households and businesses in the Eurozone, which turned negative in May. The Eurozone is in debt deflation. At the same time, public spending is slashed. Under these circum-stances there will be no economic growth. It seems, however, increasingly likely that this situation will not continue for much

longer. The Eurozone is close to breaking up. The economic strategy is untenable and the balance of (political) power is shifting away from Germany. Economic logic and common sense might be thrust upon the European elites or else the Eurozone will become a failed state altogether. In Germany, it is remarkable that growth in short-term business loans is finally subsiding. That is bullish for stocks since it is the precursor of rising cash flows and profits. In contrast to the Eurozone, inter-bank lending is healthy. There is no credit crunch and this is another sine qua for an economic recovery.


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GER Inter-Bank Lending (Ann. %) Advanced by 6 Months vs. GER Equity Index

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GER ST Business Loans (Ann. %; RS) vs. Job Offers (Ann. %)

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Liquidity Indicators

III. 1. 2. Liquidity Indicators

! Ten - That is the reading of our Com-posite Liquidity Indicator this month. It is the maximum rating last registered in 2009. It then lasted from January to June and pro-vided a solid base for the rebound of the stock market after the Lehman slump. The important shift compared to last month was the trend break in short-term business loans (see p. 13). Slowing demand for short-term business loans has been a

reliable clue to reduced financial stress and a precursor of falling business risk. Another major positive this month is the surge in real M1 growth in Germany and the Eurozone. M1 is a leading indicator of new business orders and we expect orders to improve in the third quarter 2012. If our assessment is correct, it would be very bull-ish for equities. There is nothing better than rising demand meeting a business sector that is retrenching and thus lean and mean.

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GER Composite Liquidity Indicator (Monetary Trend) vs. Real GDP (Ann. %)

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GER NBO Goods-for-Further-Processing (Ann. %) Top vs. Real M1 (Ann. %) Bottom

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iquidity IndicatorsThat said, there is a little fly in the ointment, however. Notice that Bank Liquidity is tread-ing water presently. German banks are again reluctant to buy government bonds so that the liquid asset ratio is barely changed com-pared to the previous month. Needless to say that this is a drag on the bond market. On the other hand Corporate Liquidity has surged. With bank lending stagnant this is entirely due to the rise in M1 growth. The

implications for the stock market should be bullish going forward. Mind you that the concept of Corpo-rate Liquidity is based on the composition of the consolidated banks‘ balance sheet in an economy. It monitors the change in the dif-ference between private debt and deposits. This difference is the sum of all net savings by private households and retained profits of the corporate sector. A positive and expand-ing Corporate Liquidity indicator is thus the


GER Bank Liquidity (Liquid Assets Ratio Ann. %) vs. Inverted Bond Yield

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GER Corporate Liquidity vs. Equity Index


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Liquidity Indicators

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GER Bank Liquidity (Liquid Assets Ratio; Smoothed Ann. %) Advcd. by 6 MonthsAn

nual

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sine qua of an economic upswing and rising profits. On the upper chart we note further progress in the smoothed and advanced version of Bank Liquidity. This indicator is not to be ignored and its message is bullish. It is also positive that bank reserves continue to grow at a healthy pace. Notice that both moving averages are now in bullish territory. A highly liquid banking system is essential to a healthy economy and stock market. Given the dire situation of the Euro-zone it is even more important since it in-

creases the ability of the banks to incur higher business risks. It must not be forgot-ten that the German banks have practically no exposure to the stock market. Compared with historical standards the investment ex-posure in mutual equity funds is also very low. In other words, there is room to change and move once all the locked-up wallets are being opened. The bottom line is that monetary growth is accelerating and lending is very subdued. Bank reserves are abundant. The stage is set for the economy to grow.

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GER Bank Liquidity II (Central Bank Reserves - Ann. %)

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E

conomic Indicators

III. 2. Economic Indicators

III. 2. 1. General Economic Indicators

! As we have argued so far, the technical situation of the German stock market is more or less satisfactory. The economy‘s liquidity situation is improving and the banking sys-tem is awash with reserves and liquidity. Does the real economy also look upbeat? Well, our Composite Economic Indicator re-mains in positive territory. It has been posi-tive for four months in a row and this means

that its six-month moving average is close to becoming positive as well were it advanced and not centered! All the same we think that a bullish crossover is n the cards. September is the likely month unless we see an uptick in the ISM before or a return of life to the Ger-man job offers. Both constituents are still rated negative and depress our composite gauge.


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GER Composite Economic Indicator (LS) vs. Real GDP (Ann. %)

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GER Exports to EMU Relative

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Economic Indicators

Last month we noted that the econo-mies outside the EMU have taken the lead by looking at new business orders. The bot-tom chart on the preceding page delivers the same message. Since 2009 German exports to the Eurozone have lost importance relative to total exports and exports to Europe. This is the reflection of the austerity policy in Eu-roland and the beneficial impact of the strong U.S. dollar/weak euro. All of this, however, could not yet lift our „Real“ Corporate Liquidity Indicator into positive ground. In fact, it notched down this month. Industrial production is still outstrip-ping the growth rate of new business orders.

But that may change very soon as we have noted before, if orders recover on the back of strong monetary growth within the Euro-zone. The bottom chart depicts the German current account balance. Export growth is the cornerstone of the German business model and so far Germany has managed to avoid a deterioration of its export surplus. In fact, there is a pattern of a rising triangle now and this means that intermittent down-swings in the current account have become systematically smaller. De-emphasizing the Eurozone has certainly helped accomplish-ing this little wonder.



GER "Real" Corporate Liquidity Ann. % (New Business Orders - Production)

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GER Current Account Balance (Mln Euro) vs. Equity Index

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U.S.Econom

ic Indicators In the U.S. the ISM indexes fell in June. New orders were hit hardest, but the employment sub-index remained re-markably resilient. This is consistent with the data from the Household Survey we analyze in the demographics section. -Industrial production also dipped mar-ginally in the durable consumer goods and business equipment area. Nothing special and no trend change in sight. - Most important to us, though hardly visi-ble in the chart, is the uptick in the wholesale employment to a new recovery high. This is an ace coincident indicator of the U.S. economy and it is bullish!

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USA Balance of Payments Goods & Services (Millions of Dollars) vs. DJIA

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6250USA Wholesale Trade Employment (000) vs. Ann. % (Bottom)

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110USA Industrial Production Consumer Durables: Index vs. Ann. %

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110USA Industrial Production Business Equipment: Index vs. Ann. %

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70USA ISM Total Index vs. Ann. % (Bottom)

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No new data


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III. 2.2. New Business Orders

! Isn‘t the stock market deemed to be a discounting mechanism? Its current pattern is one of diverging trends even within indus-try groups. We can make this observation in the U.S. as well as in Europe. And our new publication Trend Insights confirms this for the majority of markets under survey. That said, the obvious question is, what the mar-ket discounts at present? Will the negative camp win of the bullish one? Well, our demographic indicators provide a clear-cut answer. But how about other, fundamental indicators? The fact that the market itself can no longer be treated as a monolith teaches us that we cannot paste a straight-forward label on today‘s economic back-ground. We have to come up with a more complex answer, as unpleasant as the fact

may be. Let us take a look at the index of new business orders first. The arrow in the chart marks the low of the index in September 2011. Since then the index managed to re-cover and is now above its moving average line. Barring any severe fit of weakness the annual rate-of-change of the index will re-cover soon above its moving average and the zero reference line. If so, it would be a classic buy signal for the stock market. The export vs. domestic order ratio ex-ploded on the upside in May. Sure it was helped by base effects, too. Yet the non-EMU business is much stronger than the domestic one and may prove to be the White Knight for Europe and Germany in particular. In Germany, domestic orders for con-

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New Business O

rderssumer goods are falling sharply. This is the likely result of rising job insecurity. The offi-cial German labor market data show a steady decline in the jobless rate since April 2009 no matter how the economy is doing. We suspect that the official statistics have long become a political figure hiding the large degree of underemployment from the public. But help may be on the way for the domestic consumer sector. As we will show in the demographics section, the number of

marriages is in an up trend and this suggests a rise in big ticket consumer spending be-ginning soon. A brief glance at the below charts con-firms why the economy and the stock market is so split: it is domestic growth vs. exports. Notice the huge jump in the machinery sec-tor and the more modest rebound in the steel industry. Yes, there is life outside the Eurozone!


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Profit Gauges

III. 2. 3. Corporate Profit Gauges

Isn‘t this funny? New business orders have been displaying large swings. Industrial production has sharply fallen in the recent past. The growth rate in the number of job offers has slumped. Yet somehow the job-less rate managed to decline through all of this. Does this make sense to you? Has the Bundesagentur managed a miracle? The job-less rate (seasonally adjusted) has remained at 6.8% for seven months in a row and de-

clined steadily since April 2009 when it stood at 8,3%. That said, it is unsurprising that proxy #1 largely fluctuates in sympathy with the new business orders component. There is no new message here. The German margin proxy at the bot-tom of this page is of course different but equally stuck in an uptrend with virtually zero volatility. Input prices have plunged speaking of weakness in the industrial sector. It did

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Profit Gauges

not have any effect on employment and it seemingly did not affect sales prices either. Consumer prices have barely responded to the dramatic change in input price inflation. Another miracle of economic management. Profit margins continue to expand relent-lessly and this supports the stock market. Well, there has been change this month. It is proxy #3, the consumer vs. capital goods ratio. Somehow, the adjust-ment to lower levels of demand is afoot, which is positive, of course. Until now, how-ever, it has not hurt the stock market and, as experience shows, does not have to. But it is

certainly one development, which explains the extremely split nature of the market at present. Thank God, not all economies are run by the miracle concept. The U.S. margin proxy eked out another recovery high. It is now back at its historic highs and this may well mean that the U.S. bond market rally is close to being over, too. The stock market should follow the lead of this key indicator with a lag of about six months, which argues in favor of an ex-citing second half.


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Demographics

IV. The Demographic Road-Map! The U.S. data continues to surprise us positively. It didi so last month too, but the June data looks even more compelling. Dis-guised by a surprisingly weak ISM index for June the demographics-driven labor market data shows an upbeat picture of the U.S. economy. At the core is a mildly up trending family formation cycle and a first-time entrant pat-t e r n , w h i c h i s groping for a bot-tom to be followed by a modest up-turn. Both should also stimulate the global economy. As a consequence w e a r e s e e i n g growing opportuni-ties in the stock market(s) and in-creasing risks for bond investments. The dollar exchange rate may also benefit and the recent momentum loss made up. The insert chart shows the annual rate-of-change in the employment/population rate for men. It gained in June and remains comfortably above its moving average line as well as above the zero reference line. That

said, the bulk of the U.S. employees appears to enjoy rather healthy labor market condi-tions. Yet as you are aware of, we place a lot of attention to the employment situation of women and first-time entrants. Both popula-

t i o n a n d l a b o r market segments are very sensitive to subtle shifts in economic activity. As some would phrase it, they are the last to be hired and the first to be fired. Therefore, trend changes in the labor force participation rate of first-time en-trants have been an ace economic indicator with an

almost immaculate track record. We simply cannot overemphasize the fact. Now, check out the chart below. The first-time entrant labor force participation rate „jumped“ to 35% in June. This does not seem to be an exciting event, but notice that it has crossed its moving average and now exceeds the previous high! In addition, the moving aver-


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Demographics

age line is beginning to flatten out. All of this sure looks encouraging though a whipsaw cannot be ruled out. There was a kind of false start in May 2008 (circle) when the par-ticipation rate jumped by 1,4 percentage points from April and fell back by 1,8 per-centage points in June. Yet we do not anticipate a similar flash in the pan this time. One of the reasons is that the employment situation among women made progress. The employment/population ratio remained flat at 53,2%, but compared to the year-ago level it notched into positive ground in June. We have not

seen this since 2008. To remind all readers: In the past there has never been a solid economic recovery and equity bull market (in Germany) without this indicator traveling in positive territory. So we give it the benefit of the doubt for the time being and treat it as bullish. The same indicator for the first-time entrants is shown in the bottom chart (at the bottom) in comparison with the growth rate of German export orders. We showed the same graph here last month but we have to repeat it. The annual rate-of-change of the first-time entrant employment/population


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Demographics

ratio spurted to a new recovery high! Proba-bly not so incidentally the export order graph violated its moving average line on the up-side. The bottom line is that - with a bit of luck - the fresh U.S. labor market momentum is already beginning to spill over to Germany/Europe. After many months of delay, the Fed-eral Statistics Office published new data And we like what we are seeing. For starters marriages are now show-ing a favorable upturn. Over the remainder of

the year this will help push consumer de-mand, specifically big-ticket spending. The below chart illustrates that real GDP tends to respond positively to a rising trend in mar-riages and that marriages typically lead the general economy by roughly one year. So that‘s the good news. The bad news is that the end of the budding economic rebound is almost sure to occur in the third quarter of 2013. The bot-tom chart on this page depicts a European CDI dipping into the negative. This means that the preceding peak is an exit point for


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Demographics

the stock market investor. One year from now, in June 2013, our modified version of the CDI that is shown below and which we use as a proxy for the evolution of corporate costs will have topped out. As we have just shown, the demand side of the economy will turn sour as of Oc-tober 2013. Finally, in November 2013, the German family formation cycle will embark on a fresh and steep down leg. No economic cycle or bull market has ever survived such an adverse combination of demographic pat-terns. As for the bond markets we are not so sure what will emerge from the above sce-nario. Typically, bonds tend to benefit from a growing economy because cash flows and tax revenues rise and thus reduce financial stress. But this time around the unresolved euro crisis remains the big imponderable. should the U.S. dollar surge in response to a lift of the U.S. economy then flow-of-funds may weigh on European bond prices.

A lot will also depend on the capital flight movements, which have so far propped up the bond markets of the Eurozone surplus countries. One possible outcome of such a mess of conflicting and confusing crosscur-rents may be that there won‘t be a clear trend for many months. We are seeing the same phenomenon in today‘s stock markets, which are terribly split in Europe and the U.S. Even though the indices are inching up they do not reflect a monolithic market trend any more even within individual industry groups. Given the current problems in Europe and the unknown policy responses, bonds may have to be treated on a country-by- country basis rather than buying „the index“. Sounds pretty much old-fashioned, doesn‘t it? Diversity, not diversification, may be the key to performance in the next twelve months. *****

July 10, 2012



European CDI Inverted & Advanced (Proxy for Corporate Costs)

JUN 2013


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Demographic Chart-Book

V. The Demographic Chart-Book

Chart # I

Chart # II

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Chart I, a 90%-Floor Fund concept, and chart II illustrate what demographics can do to your portfolio. The simulation is based on the employment of demographic data input only in order to demonstrate that it is possible to outperform by adding the demographic element to your investment process. To make demographics work for you instead of being at its mercy. please, contact us.


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Demographic Asset Allocation (DEMAA) incl. 90% Floor b/o High Water Mark


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Chart # III

Chart III is key to understanding the implications of population shifts for the future course of our economies and financial markets. The births of the past will translate into equivalent variations in the number of young adult consumers who are the ultimate drivers of private consumption, the bulk of GDP. The rationale for this is the fact that first-time entrants and family founders enjoy the highest percentage rise in personal incomes and, therefore, consumer expenditures. Older people may have higher incomes but a large part of their spending is largely tied to the replacement of consumer goods like stereo systems, TV-sets, cars, refrigerators, furniture etc. Nothing can compete with the household formation spending among young adult consumers.

While the economy as a whole benefits from a rising number of young adult consumers (because of rising births in the past) there are also specific industries which are affected more than others from demographic shifts. Evidently, residential construction and automobiles, two core areas of the economy, are very sensitive to population shifts. Chart IV depicts the consequences of the demographic pattern for these industries and the economy as a whole. It demonstrates that your future is indeed based on the past. Notice that the number of young adult consumers, the first-time entrants and family founders, will increase in the years ahead. This is very bullish news for equities in particular.


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Chart # IV

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Demographic Tailwind

The baby bust of the sixties and seventies caused a steep fall in the number of young adult consumers decades later and the result was a demographic headwind for the economy, which started in the early nineties and lasted until 2003. Since then, the demographic headwind has become a demographic tailwind, which is a major plus for the economy and the equity markets.

Chart # V

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This slump in the number of young adult con-sumers will be followed by an economic slump.



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On chart V the red graph illustrates the change in the employment of the thirty-year old population segment, the typical family founders, based on the data from the micro-census. It follows the “forecast” of the red graph, the annual rate-of-change of the number of births advanced by thirty years. In other words, the actual employment pattern tracks the hypothetical pattern very closely. The practical relevance lies in the fact that economic growth rates (the blue line) follow the pattern of young adult consumers, in this case the thirty-year olds.

Chart # VI

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First-Time Entrants &Family Founders

Chart VI shows how powerful the demographic shift is. The combined number of first-time entrants and family founders is set to increase steadily until the year 2020. This pattern is in stark contrast to the decline in the size of the total labour force on the back of demographic ageing.

There is no empirical evidence that the total size of the labour force is critical to economic growth. Notice that the first post WWII recession in the early seventies was triggered by the steep drop in the number of young adult consumers because of the drop in births during WWII some thirty years before. In the same period, from 1970 to 1974, the total labour force actually rose.

Other European countries are subject to demographic patterns, which are very similar to the German one. The U.S., however, exhibit a different pattern, which has its roots in the Vietnam war. The modification of the Selective Service Act led to a brief baby boom and bust in the late sixties/early seventies. Chart VII shows in which way this brief interlude created a very different pattern compared to other countries.

The draft deferral baby bust has caused painful damage to the global economy (via a sudden drop in the number of young adult consumers) and will continue to do so in the future. The global slump in 2001 and 2002 is the most recent example of such an intermittent recession, which has demographic roots. The recession of the years 2011 to 2014 will be next.



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Chart # VII

Chart # VIII

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The demographic shift, which has ended a dozen years of subdued growth in the Western industrialised countries a few years ago, will bring about a revival in the domestic economies. Beginning in 2003 this has lifted the equity markets, especially the small and mid-caps. The bill for this bullish reversal will, however, be eventually presented to and paid by the bond market. That’s yet another secular change being underway. (The bull market in commodities is the third one.) Chart VIII should give you an idea of how powerful the consequences of the demographic shift are for all investors. Whether these consequences will be pleasant or painful depends on how informed you are about these goings-on. You are invited to profit from our know-how. *****


Documents

A&O Insights July 2012