LONGER TERM THEMES
A GUIDE FOR ASSET APPRECIATION
Sound Advice 19th May 2009
VOODOO ECONOMICS PART II
James Vinall – Senior Investment Officer
Premise
This is a guide to the emerging themes EquityBell is pursuing. This report does not attempt to
define the exact timing for entry into or exit from an investment, but explores the basis for
considering proactive longer term asset switching.
Dominant Theme
Central Bankers are in a race against time to inspire fiscal confidence and resumption of normal
economic activity. Politicians cannot sit back doing nothing while letting companies fail, voters
lose jobs and economies collapse, but you cannot spend on borrowing forever as you have to
earn to pay off your debt.
Henry Morganthau Jr. (FDR’s US Treasury Secretary) said in 1939 of
the failed fiscal stimulus packages during the Great Depression that
\"We have tried spending money. We are spending more than we have
ever spent before and it does not work. And I have just one interest,
and if I am wrong somebody else can have my job. I want to see this
country prosperous. I want to see people get a job. I want to see people
get enough to eat. We have never made good on our promises ...I say
after eight years of this Administration we have just as much
employment as when we started ...and an enormous debt to boot\". John
Morton Blum - “From the Morgenthau Diaries”
History shows that borrowing more to solve a debt crisis is a high risk “Voodoo Economics”
strategy that often fails.
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LONGER TERM THEMES
A GUIDE FOR ASSET APPRECIATION
Sound Advice 19th May 2009
Fixed Income
Let us have another look at government debt and earnings in the table below. Debt levels of the leading
economies are at extraordinarily high levels. We should particularly note UK External Debt and US and Japanese
Public Sector Net Debt.
Country Public Sector Public Debt GDP External Debt External Debt External Debt
Net Debt per Worker (billions) (billions) per Worker as a % of GDP
(billions)
UK $1,178 $40,249 $2,254 $9,725 $332,301 432%
USA $11,239 $79,702 $14,076 $13,642 $96,746 97%
Japan $9,908 $158,662 $5,727 $2,187 $35,021 38%
France $1,519 $55,054 $2,234 $4,881 $176,884 218%
Germany $1,351 $33,511 $3,384 $5,123 $127,036 151%
Source: BoE, ONS, US Fed, BdF, Bundesbank, BOJ and MoF
External debt (or foreign debt) is that part of the total debt in a country that is owed to creditors outside the country.
The debtors can be the government, corporations or private households. The debt includes money owed to private
commercial banks, other governments, or international financial institutions such as the IMF and World Bank.
We are in the middle of massive debt deleveraging as US financial institutions currently have debt of 117% of GDP
where it was 22% in 1982. US households are not much better off with current debt of 96% of GDP compared to
47% in 1982. The UK and US public sector net debt are both currently less than their respective GDP’s. As global
debt deleveraging sees funds repatriated home where they are needed, UK corporations may have trouble
delivering assets with external debt four times greater than GDP. This is why it is an absolute imperative that
central bankers around the world create an environment where money keeps circulating normally, because if
everyone suddenly wants their cash back (to buy hard assets like commodities), the run on the central banks will
be very ugly.
This may explain why banks receiving government funds have been very reluctant to lend it out.
Government and Central Bank “spin” that we are seeing the green shoots of recovery are supporting expectations
that inflation will pick-up as fiscal stimulus packages start to have an effect on money supply, despite the current
deflationary environment.
The Fed has two policy imperatives
1. Engender banking stability and confidence
2. Provide liquidity and balance sheet support so banks can resume lending
It is strange that Banks are reporting profits despite having record numbers of loans in arrears, mortgage defaults
and repossessions. It is reported that banks are funnelling much their capital resources to their proprietary trading

LONGER TERM THEMES
A GUIDE FOR ASSET APPRECIATION
Sound Advice 19th May 2009
desks which are doing very well on Gold, FX and Fixed Income. The American banks are doing particularly well as
Obama has suspended the need to mark their assets to market. They have valued their “toxic assets” at a price
they deem appropriate and have not been required to take write downs which inflates their balance sheets in what
is called “mark to myth”. The central bankers appear to be using this “perception tool” to underpin their primary
objective of restoring confidence in the banking system to promote resumption of “normal” economic activity.
The equity and fixed income markets are looking favourably at bank earnings without asking too many questions
where these phenomenal profits are coming from, but may be better served focussing on the vast level of debt they
have to service. Only Barclays seem to be pro-actively shoring up their balance sheet by funding CVC Capital and
Blackstone to buy their iShares and BGI units (which they will probably buy back later) as they realise this
refinancing window may not be open for long before a third wave of bank failures ensue. As major banks appear to
be concentrating on making money for themselves, the resources they are using to speculate are still not being
extended to borrowers. Corporations not widely able to borrow from the banks are now issuing bonds at a record
pace. There has been EUR115 billion worth of bonds issued in the first four months of 2009, which is greater than
the last record period in 2002 and 85% of the entire EUR135 billion total for 2008. Last week the US banks were
told by the US Treasury that they need to raise US$75 billion just to meet their capital adequacy requirements and
that is while they are disguising the true value of their toxic assets under Obama’s “mark to myth” initiative. While
the US Federal Reserve Bank (Fed) and the Bank of England (BoE) and all the other central bankers continue to
keep short term rates close to zero to provide liquidity, longer term rates (10 years and up) are set to rise under
massive demand while the confidence exists in the market for them to borrow.
It should be noted that the current corporate demand for money is for refinancing and survival, not investment,
expansion and capex requirements. Once companies have restructured though this year, demand for longer term
borrowing is likely to decline, bring interest rates down.
The chart on the right shows the longer
term US Treasury Note yields from
Long Dated US Treasury Yield
16.00
1925. At the start of the Great 4.50
Depression in 1929, rates initially 14.00 4.00
declined as governments provided 3.50
liquidity. Two years after the initial 12.00 3.00
2.50
crisis, debts were restructured and
10.00 2.00
rescue packages agreed with rates
rising sharply (see inset graph from 8.00
1929 to 1936).
6.00
Three years into the crisis, companies 4.00
had either survived or died and demand
2.00
for expansion capital evaporated. Long
term rates came down to even lower 0.00
levels over the following decade.
1925
1928
1931
1934
1937
1940
1943
1946
1949
1952
1955
1958
1961
1964
1967
1970
1973
1976
1979
1982
1985
1988
1991
1994
1997
2000
2003
2006
2009
Data Source: Federal Reserve Bank of St. Louis
We conclude that longer term rates in US$, Sterling and Euro are set to rise over the coming months to reach a
rescue package / restructuring crescendo early next year and then decline slowly. Short term rates in the US$,
Sterling, Euro and Yen are likely remain close to zero for a very long time.

LONGER TERM THEMES
A GUIDE FOR ASSET APPRECIATION
Sound Advice 19th May 2009
Yen longer term rates are likely to remain low as Japan’s external debt reveals their corporations are relatively cash
rich, but have little appetite for expansion funded by borrowing.
borrowing
Equities
As we have said before, equity markets rarely end a recession with a “V” shaped bounce from expensive
valuations. There is usually a protracted period of doom and disbelief with price / earnings ratios settling between 5
to 8 times. This has not happened this year as government and central bank “spin” has created an impressi that
impression
inflation is coming and the worst will soon be behind us. The 2010 forward price / earnings ratio for the S&P 500
l
index is currently estimated at 26 times and the FTSE 100 is said to be 16 times suggesting equity markets are not
“desperately” cheap.
The current fiscal stimulus packages are a government sponsored high risk strategy to generate growth Current
growth.
policy actions appear to be delaying the recession / depression, but do not seem to be slowing corporate fai
depression, failures
and job losses which is where the earnings come from. The world has never been in this situation before and
from.
politicians cannot sit back and do nothing while letting companies fail, voters lose jobs and economies collapse.
There are no easy options, but throwing more money at the largest debt mountain the world has ever seen will
,
probably make things worse in the end.
Data Source: Yahoo Finance
On the right is a chart of equity index
performance following the ultimate
peak of the market during a financial
crisis caused by overburdening debt.
We can directly compare how Wall
Street 1929, Japan 1989, NASDAQ
2000 and the S&P500 now pan out
over the successive days as
governments struggle to reflate
economies.
For the individuals that have missed
th
the 33% rally in equities since 9
March, people like George Soros
saying “we are on the road to
recovery, at last” spurs them to ignore
bad news and jump in.
As we have not yet sucked in all the
bystanders to reach the “point of
maximum bullishness”, stock markets are likely to have a last leg higher with the FTSE 100 reaching 4,667 (the
s
high set on 3rd November 2008) after a pause at 4,520. The S&P 500 should reach 1,003 (the high set on 4th
) 4,520 ch
November 2008) after a pause at 930.
By September 2009 (or sooner) we expect a toping pattern around 4,650 for the FTSE 100 and 1,000 for the S&P
500. It should then start to become clear that forward corporate earnings are not strong enough to support
elevated equity prices while bankruptcies, defaults, redundancies, repossessions are increasing and consumer
confidence is falling.

LONGER TERM THEMES
A GUIDE FOR ASSET APPRECIATION
Sound Advice 19th May 2009
These concurrent events should see equity markets retreat in a grinding slide to the year end. We would expect
the FTSE 100 to eventually bottom out at 2,700, which is a 60% decline from the ultimate index peak of 6,751 on
th
15 October 2007. The target for the S&P 500 would be around 400, which will be a 75% decline from the ultimate
market peak of 1,565 on 9th October 2007. Remember, the Dow Jones Industrial index took three years to finally
bottom at 10% of its ultimate peak.
The reason why the S&P 500 decline is set at 75% from the ultimate peak and the FTSE 100 is set at 60% is that
commodities are probably going to perform well against equities and the S&P 500 has a commodity weighting of
14% whereas the FTSE 100 is 27%.
As bond markets are more than twice the size of the equity markets, fixed income flow data is the window to the
soul of global economies. While the bond markets are willingly buying new paper from governments and
corporations, the “keep calm and carry on” recovery will remain on track and equities will advance. If and when
bond investors start demanding sharply higher rates to cover escalating credit risk, that may be a sign that
restructuring is getting desperate and signal the peak in equities.
We keep a close eye on equity option implied volatility via the S&P 500 VIX Index = 31.37
VIX index which is a good fear indicator. 1400 90
1300 80
The chart on the right shows reveals that when the S&P 500 (in 1200
70
red – left hand scale) falls sharply, the VIX index (in blue – right 1100
60
hand scale) as a measure of option implied volatility, rises as 1000
50
put option protection is bought in a falling market. 40
900
30
800
Implied volatility in a normal market is generally between 18% 20
700 10
and 28%. Fear in November 2008 saw the VIX index hit an all
600 0
time high over 80%. Fear has subsided during the rally over
the past month and the VIX is currently 31%.
Data Source: Yahoo Finance
The VIX index should give some indication of rising fear at the peak of a rally in equities.
We had previously said “sell in May and go away” but this current bear market rally could take a little longer before
the reality of falling earnings and consumer confidence brings high valuations sharply into focus. We continue to
believe the best opportunity in the stock market will be on the short side during the second half of this year.
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