Quarterly

Equity Research
19 July 2004
Global
Investment Strategy
Global equity strategy
ASSET ALLOCATION
We raise our equity weightings slightly from 5% to 2% underweight. Our year-end target remains unchanged at 1,100 on the
S&P 500. Our worries are: economic momentum has peaked, excess liquidity is at a three-year low, interest rates are rising
and the US profit share of GDP is already at 40-year highs. Valuations globally look reasonable with the caveat that if ten-
year US bond yields rise to our target of 5.5%, then bond-to-equity valuations return to more neutral levels. We take our bond
weightings down to 5% underweight from 3% underweight. Inflation is the risk here.
REGIONS
Our most preferred region remains continental Europe. It is late-cycle, looks obviously cheap (on FCF, P/E and HOLT) and
has historically outperformed into periods of Fed tightening. We push the UK up to benchmark on early signs of a slowdown
and better valuations for UK banks. We stick with a marginal overweight of Japan but are becoming more sceptical. We
underweight the US. We stay benchmark GEM but overweight non-Japan Asia.
Asset allocation and regional outlook
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report as only a single factor in making their investment decision.
research team
Andrew Garthwaite
44 20 7883 6477
andrew.garthwaite@csfb.com
Jonathan Morton
44 20 7883 8273
jonathan.morton@csfb.com
Richard Woolhouse
44 20 7883 6481
richard.woolhouse@csfb.com
Jonathan White
44 20 7883 6484
jonathan.white@csfb.com
Marina Pronina
44 20 7883 6476
marina.pronina@csfb.com
Source:CSFBResearch.

Global equity strategy 19 July 2004
2
Table of contents
Executive summary...........................................................................................................3
Asset allocation .............................................................................................................3
Regional selection .........................................................................................................5
Macro scenarios................................................................................................................8
Asset allocation...............................................................................................................15
Equities (reduce tactical underweight to 2% from 5%)................................................15
Bonds (reduce to 5% underweight).............................................................................26
Regional strategy ............................................................................................................28
Continental Europe (15% overweight versus benchmark)..........................................28
UK (raising weightings to benchmark).........................................................................34
Japan (maintain 3% overweight versus benchmark): .................................................39
Global emerging markets (we stick to benchmark).....................................................48
US (7% underweight versus benchmark)....................................................................53
Growth versus value? .....................................................................................................55
Appendix 1: Regional quantitative framework ................................................................59

3
Executive summary
Asset allocation
We lift our tactical (one- to three-month) equity weightings from 5% underweight to 2%
underweight. We believe the equity market has slightly more downside than upside
potential over the summer months. We still keep to our long-standing year-end target of
1,100 on the S&P 500 (we have had this in place since last October). On a 12-month
view, we are only marginally more optimistic and are thus benchmark of equities.
Figure 1: Recommended tactical asset allocation (%)
Benchmark weight Recommended weight Change
Equities 60 58 +3
Bonds 30 25 -2
Cash 10 17 -1
Source: CSFB estimates
Why are we still a modest tactical underweight of equities?
(1) Economic lead indicators and earnings momentum have clearly peaked. Historically,
the S&P 500 has had a ‘local’ peak two months after the peak in ISM new orders and
one month after the peak in forward earnings momentum.
(2) Our indicator of excess liquidity (that is, money demand less money supply) is at a
three-year low. Again, over the last three weeks, US corporates have reverted to being
net sellers of equities.
(3) The second rate hike in 1994 caused a near-10% correction in the S&P 500. We
believe the market is still too complacent on the extent to which rates need to rise and
their impact. A neutral level for the Fed Funds rate is 4% (2% real) in our opinion and
we believe this should be achieved towards the end of 2H 2005. If anything, the impact
of rising rates is now more problematic than in 1994 as: (i) there is now more private
sector financial leverage (the US consumer debt service ratio is at a record high—back
in 1994 it was at its historical lows—banks have a record proportion of asset invested in
bonds and there is now US$1.2tr of assets at hedge funds); (ii) financials account for
nearly a third of corporate sector profits (50% higher than 1994 levels) and finally we are
much later into the economic cycle and the earnings cycle.
(4) Earnings are extended. Could 2005 be a down year for earnings? The profit share of
GDP is at a 40-year high in the US. Earnings (in real terms) are 20% above trend (as
they were in 2000). On our current forecasts, our model of top-down non-financial
corporate earnings growth shows just 2% growth in 2005 but this assumes 3.0% growth
in unit labour costs and 3.6% real GDP growth for 2005. If unit labour costs grow at
3.5% and real GDP grows at 3%, profits could be down 2%.
The economic dilemma. To support consensus estimates for US consumption growth,
we need 250,000 monthly jobs growth to be sustained. However, if this occurs, unit
labour costs rise (which is negative for equities) and inflation and thus interest rates rise
(which are bad for financial assets).

4
Why do we modestly lift weightings?
(a) Valuations are more reasonable but still deceptive in our view. The 12-month
forward P/E ratio for the US market, at 15.9 times, is now close to its monthly average
lows of 15.3 in October 2002 and 15.2 in February 2003 (indeed ex-financials the 2005E
P/E ratio at 17.4 is in line with its average of the 1960s). The recent fall in US ten-year
Treasury bond yields has left US equity-to-bond valuations modestly cheap. Even taking
the three-to-five year consensus (I/B/E/S) estimates to 6.4% (from 12%) leaves the
equity risk premium at 3.3%, yet at this stage of the cycle our models suggests that it
can trade at 3.1%.
These valuations are deceptive because: (i) earnings are extended; and (ii) if bond
yields rise as we suspect (our model projects that US ten-year Treasury bond yields rise
to 5.5%), equities end up being mildly expensive against bonds.
(b) There is now slightly better visibility than at the end of Q1 on the three key issues:
US rates, China and oil.
However, we are not out of the woods. We believe that a neutral level of Fed Funds is
4% (this is only priced into the forward curve in 2Q 2006); a soft landing in China
requires sub 10% year-on-year domestic electricity consumption (compared with 18%
now) and Saudi Arabia, which holds the key to the oil price, is making ambiguous
statements in our view.
(c) Three out of six of investor sentiment indicators now show complacency. Both skew
and risk appetite have moved to pessimistic levels (with risk appetite being mildly below
its average and skew being at an all-time high).
(d) The technicals have not broken down. Market breadth is still at reasonable levels.
Strategic issues:
We are strategically benchmark of equities. Strategically, there are three major
considerations for equities: (i) the relationship between real bond yields (currently 2.5%)
and assumed trend real GDP growth (currently 3.25%); (ii) the profit share of GDP (at
an all-time high); and (iii) the equity risk premium (which varies with the cycle). If we just
normalise the equity risk premium and the relationship between real bond yields and
terminal real GDP growth, fair value is 1,100 on the S&P 500.
Bonds (we increase our underweight to 5% from 3%)
We push weightings down to be 5% underweight bonds. Our model of nominal US ten-
year Treasury bond yields shows fair value to be 5.5%. We believe real growth in the
US over the second half of the year is likely to be 3.5–4.0%. The inflation risk looks
quite high (real wage growth has already accelerated to 3% and if non-farm payrolls
growth remains around 200–250k per month, as suggested by the best lead indicators
of employment growth, real wage growth will rise further at the same time as
productivity growth slows). US banks have bought US$300bn of US government
securities over the last year and they will likely sell as the yield curve flattens.
Macro outlook
Overall, we see the risks as being more towards higher inflation than a slowdown in
growth. Our house view is for 4.5% and 3.8% real GDP growth in 2004 and 2005

5
globally (and 4.3% and 3.6% in the US). We would stress that: (i) despite having clearly
peaked, the best lead indicators of the cycle are still strong (ISM new orders and
Michigan consumer confidence expectations); (ii) almost all lead indicators of
employment suggest that payroll growth remains around 200–250k and that along with
3% real wage growth pushes real disposable income up by 4%; (iii) there are signs of
recovery in both the Japanese and European consumer; and (iv) the outlook for
corporate spending, based on record corporate sector FCF, and very low net-
investment shares of GDP, is still very good. The risk is that inflation develops into more
of a problem and that the subsequent rise in bond yield causes a sharper-than-expected
slowdown in growth in the second half of 2005.
Regional selection
Figure 2: Regional recommendations
Benchmark weight (%) Recommended weight
(%)
% over/underweight vs
benchmark
Change (%)
US 54.4 50.8 -7 -1
Japan 9.6 9.9 3
UK 10.3 10.3 0 +3
Europe 17.9 20.5 15
Asia Pacific* 3.2 3.8 20
Emerging Markets 4.6 4.6 0
100 100
* Asia Pacific = MSCI Asia Pacific x Emerging Markets
Source: MSCI, CSFB research
Continental Europe (15% overweight relative to benchmark)
Our main overweight remains continental Europe, which we leave unchanged at 15%
overweight. We have the following observations:
(1) Continental European equities have outperformed US equities in common currency
terms on the last four occasions when the US raised rates (in the first three and six
months).
(2) Continental Europe is now later-cycle (with a recovery in household consumption
coming after the export/investment growth recoveries). Consensus forecasts for
continental European GDP have been a very conspicuous laggard relative to elsewhere.
There are now increasingly better signs of life on GDP (such as the service sector PMI,
consumer confidence and auto sales). Our European strategy team shows that
European earnings have historically lagged US earnings by 12 months.
(3) Valuations look cheap (continental Europe has the highest FCF yield globally at
6.8% based on consensus estimates). On the HOLT AggreGator, for continental
European equities to be fair value, we need to assume real asset growth of 2.25%
(which once we account for the fact that 30% of earnings come from the US, leaves real
asset growth at just 1%).
(4) There is less investor complacency in Europe than elsewhere (when we examine
implied volatility against historical averages).
Our favoured sectors are some deep-value cyclicals (some autos, paper, cement); later-
cycle corporate spend plays (advertising and capital goods), banks in Italy and France,

6
specific Telecom incumbents, spirits and defensives on very high FCF with some growth
potential (Unilever and Aventis).
Japan (We stick to our marginal 3% overweight)
The reasons for this are as follows.
(1) Economic and earnings momentum are the best of any region.
(2) If domestic demand stays at 2% (in nominal terms) for another year, there will be an
end to deflation (even using the BoJ’s output gap) and this means negative real short
rates, which allows domestic real estate proxies (banks, transport, railways, retailing) to
outperform as well as there being widespread bond for equity switching.
(3) Japan can be a hedge on rising US interest rate expectations. Over the last ten
years, the Nikkei has had a very close fit with 12-month forward rates in the US.
(4) Finally, we would note that on one occasion (1999), equities peaked eight months (in
relative terms) after the peak in lead indicators.
However, we are growing increasingly worried.
(a) Normally, Japan peaks in relative terms five months after the peak in global lead
indicators. This means investors now have to make up their mind whether the story is
structural as opposed to cyclical.
(b) Japanese equities have been a euphoria trade for foreign investors with foreign net
buying now at 3.1% of market cap over the last year and foreign investors now being
1.8% overweight. The recent banks merger probably suggests more domestic selling of
cross-holdings.
(c) Valuation look ambiguous. On FCF yield basis, we would point out that continental
Europe is cheaper on consensus estimates. On HOLT, Japan is fair value against
Europe—even assuming that CFROI® increases from 3.6% to 6% over the next
decade. Yet in the case of the US technology sector between 1960 and 1996, 70% of all
companies that were value-destroying stayed that way.
(d) We have not yet seen the end of deflation (in terms of CPI or deflators).
We tend the cheap exporters (Takeda) and tend to be biased towards the domestic sectors
(preferring drugs, homebuilders and railways companies).
UK (we raise weightings to benchmark)
We raise weightings marginally to be benchmark from 2% underweight to reflect the
following.
(1) There are now very tentative signs of an economic slowdown, which suggest to us
that there is less risk of a boom/bust cycle than we had previously thought.
(2) UK mortgage banks now look cheap (8.6 times consensus 2005E earnings versus
10.5 times in Europe with their price-to-book now virtually in line with their average
versus continental Europe). We stress that we would still be underweight UK mortgage
banks but less than we were.
(3) The UK is a defensive market (outperforming when lead indicators slow down).

7
However, we prefer not to be overweight. With UK unemployment at a 30-year low,
wage growth at 4.2% and both consumption and GDP above trend (in both levels and
growth), our worry is that ultimately UK base rates need to rise towards 5.5–6.0% in
order to push the debt service ratio back to its long-run average.
Furthermore, valuations are neutral against continental Europe.
Within the UK, we would favour value (GSK, Vodafone), cheap defensive growth (Tesco
and Diageo) and RBOS. We are underweight of mortgage banks and energy. We would
also highlight stocks that screen cheaply on HOLT and have a FCF yield (2004E) above
5%. These include: Vodafone, Pearson, GSK and GKN.
We generally underweight domestic plays and energy.
Global emerging markets (maintain benchmark)
It is too early to raise weightings from benchmark in our view despite the compelling long-
term valuation story and the degree of structural change underway in non-Japan Asia.
Global emerging market (GEM) equities are cheap (trading on a 42% discount to global
markets on a 12-month forward P/E basis). In Q2, there were five headwinds for GEM:
higher US interest rates, higher oil price, a slowdown in China, peaking in global lead
indicators and a stronger dollar. We would want to see at least three out of these five
factors turning positive before we would add to our weighting in GEM (and at this stage,
we only see visibility on two: the dollar and the oil prices peaking).
We stick to our 20% overweight of non-Japan Asia despite our near-term concerns on
the technology sector (we are negative); China (a soft-landing has yet to occur) and the
rollover in global lead indicators (that has, on all occasions, led to a negative six-month
rate change of non-Japan Asian equities relative to global equities).
Our reason for ignoring these tactical factors is the compelling strategic case for the
region. The region has double the risk premium of the US, structurally undervalued
currencies and, above all, a current account position that gives macro policy enormous
flexibility. The structural story dominates the cyclical question marks, in our opinion.
US (increasing underweight to 7% from 6%)
Normally, the time to buy US equities is when there is a sharp slowdown in the rate of
growth in lead indicators (with the year-on-year rate falling below 2%) or if there is a
global market correction of 10%-plus.
We fear that this time round, the US will be less defensive than normal as most of the
macro policy tools that aided its defensiveness in the past have now been used up.
Notice that this year, despite a range-bound market, the US has outperformed Japan
and Europe in single currency terms.
The valuation anomaly of the US remains stark to us and the domestic savings/current
account imbalance clearly suggests that long-run US domestic demand growth needs to
slow relative to global growth.
Within the US, we would favour the industrials and capital goods sectors and
underweight banks and consumer cyclicals.

8
Macro scenarios
Below we run through our main global macroeconomic scenarios. Our view is that
growth remains more robust than generally expected in the second half of the year
(2004 consensus estimates for real growth in the US, Euro area and Japan are 4.2%,
1.9% and 3.5% respectively in 2H 2004). Our optimism is based on five factors:
(i) The two best leading indicators of the US economic cycle (the manufacturing ISM
new orders index and Michigan consumer confidence expectations), despite rolling over
from their cycle highs, both suggest that activity remains close to peak levels. ISM is in
the top decile of its 1990s range and Michigan consumer confidence expectations are at
the top of their 2003 range (excluding January’s spike).
Figure 3: ISM New orders index versus US IP (3mth/3mth %
annualised)
Figure 4: Michigan consumer expectations index versus real
personal consumption (yoy%)
20
30
40
50
60
70
80
90
Jun-50 Jun-55 Jun-60 Jun-65 Jun-70 Jun-75 Jun-80 Jun-85 Jun-90 Jun-95 Jun-00
ISMNewordersindex
-30
-20
-10
0
10
20
30
40
IP(3mth/3mth%ann.)
ISM New orders index (LHS)
US IP growth 3mth/3mth % annualised (RHS)
40
50
60
70
80
90
100
110
120
Jan-91 Jul-92 Jan-94 Jul-95 Jan-97 Jul-98 Jan-00 Jul-01 Jan-03 Jul-04
Index
-2
-1
0
1
2
3
4
5
6
7
yoy%
Michigan consumer confidence Expectations index (LHS)
Real personal consumption growth yoy%(RHS)
January2004 spike
upwards in confidence
Source: Institute of Supply Managers, Federal Reserve, CSFB research Source: University of Michigan, BEA, CSFB research
(ii) The best leading indicators of US employment growth (such as the ISM employment
indices and temporary payrolls), suggest that employment and real wage growth can
take over from tax cuts and mortgage equity withdrawal. Essentially, employment
growth should be roughly 1.5% and real wage growth is nearly 3%, suggesting therefore
that real disposable income growth should be in the 4–4.5% mark.
We suspect that growth
will be stronger for longer
in 2H 2005
(i) the best leading
indicators of growth have
peaked at a high level
(ii) employment and real
wage growth in the US are
likely to take over from tax
cuts and mortgage equity
withdrawal

9
Figure 5: ISM non-manufacturing employment index versus
change in services payrolls
Figure 6: US temporary employment versus non farm
payrolls
40
42
44
46
48
50
52
54
56
58
60
Jan-97 Oct-97 Jul-98 Apr-99 Jan-00 Oct-00 Jul-01 Apr-02 Jan-03 Oct-03 Jul-04
ISMindex
-300
-200
-100
0
100
200
300
400
Changeinpayrolls(000's)
ISM Non-manufacturing Employment index (LHS)
Change in private sector Services payrolls, 3MMAV (RHS)
-20
-15
-10
-5
0
5
10
15
20
Jan-91 Jan-93 Jan-95 Jan-97 Jan-99 Jan-01 Jan-03
Temporaryemployment,yoy%
-2.0
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
Overallnon-farmemployment,yoy%
Non-farmpayrolls, yoy%(RHS)
Temporarynon-farmemployment yoy%(LHS)
Source: Bureau of Labour Statistics, CSFB research Source: BEA, Bureau of Labour Statistics, CSFB research
(iii) The outlook for corporate spending is still very strong. Corporate sector free cash
flow is at record highs across all the major regions and global (ex-Japan) capex could
potentially rise by 33% over the next 18 months if the capex-to-sales ratio follows its
normal lagging relationship with net income margins.
Figure 7: US non-financial corporate sector FCF % of GDP Figure 8: Global (ex-Japan) capex/sales ratio versus net
income margins
-5.0
-4.0
-3.0
-2.0
-1.0
0.0
1.0
2.0
3.0
4.0
Q11960 Q11964 Q11968 Q11972 Q11976 Q11980 Q11984 Q1 1988 Q1 1992 Q11996 Q1 2000 Q1 2004
%ofGDP
-5.0
-4.0
-3.0
-2.0
-1.0
0.0
1.0
2.0
3.0
4.0
%ofGDP
After dividends
Beforedividends
5.0%
5.5%
6.0%
6.5%
7.0%
7.5%
8.0%
8.5%
9.0%
1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
7.0%
Capex/Sales trend Capex/Sales Net income margin (1 year lead)
5.0%
5.5%
6.0%
6.5%
7.0%
7.5%
8.0%
8.5%
9.0%
1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
7.0%
Capex/Sales trend Capex/Sales Net income margin (1 year lead)
Source: Federal Reserve Board, CSFB research Source: Worldscope, I/B/E/S International, CSFB research
We show in the sector strategy section that motivation to spend is very strong given the
high return on capital relative to the cost of capital and the high cost of labour
(especially with non-wage costs) relative to the cost of capital—both these measures
are close to 20-year extremes.
(iii) the corporate spend
outlook remains very
strong

10
(iv) There are early signs of life for both the Japanese and continental European
consumer. Recall that the continental European consumer has a savings ratio that is
almost double that of Japan and, critically, leading indicators are now suggesting an
improvement in employment growth.
Figure 9: Japanese household income, spending and
employment
Figure 10: Consumer employment expectations versus
employment growth
-7
-6
-5
-4
-3
-2
-1
0
1
2
3
4
5
Jun-01 Dec-01 Jun-02 Dec-02 Jun-03 Dec-03
Spending/income(yoy%,3mmav)
-2.0
-1.5
-1.0
-0.5
0.0
0.5
1.0
Employment(yoy%,3mmav)
Houshold disposable income(LHS) Household spending (LHS) Employment (RHS)
-30
-25
-20
-15
-10
-5
0
5
10
15
86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
-2.5
-2
-1.5
-1
-0.5
0
0.5
1
1.5
2
2.5
3
Employment, y/y%, rhs
Employment expectations
-30
-25
-20
-15
-10
-5
0
5
10
15
86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
-2.5
-2
-1.5
-1
-0.5
0
0.5
1
1.5
2
2.5
3
Source: Cabinet Office, ministry of Public Management, Home Affairs,
Posts and Telecommunications, CSFB research
Source: Eurostat, CSFB European economics research
(v) The interest-rate sensitive components of growth have slowed less quickly than
generally expected (both in the US and UK); for example, US new building permits and
new homes sales in the US are close to record highs. In addition, the manufacturing
inventory-to-shipments ratio is still well below trend.
Figure 11: US new home sales and building permits (000s of
units)
Figure 12: US manufacturing inventory-to-shipments ratio (%
deviation from trend)
0
500
1000
1500
2000
2500
Jan-80 Jan-83 Jan-86 Jan-89 Jan-92 Jan-95 Jan-98 Jan-01 Jan-04
Buildingpermits
0
200
400
600
800
1000
1200
1400
1600
Newhomesales
Building permits, 000's (LHS) New home sales, 000's (RHS)
-8
-6
-4
-2
0
2
4
6
8
10
12
Jan-82 Jan-84 Jan-86 Jan-88 Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04
%deviaitonfromtrend
-8
-6
-4
-2
0
2
4
6
8
10
12
%deviaitonfromtrend
Source: National Association of Realtors, CSFB research Source: Department of Commerce, CSFB research
(iv) early signs of life in
Japanese and continental
European consumers
(v) interest-rate sensitive
sectors remain robust in
US/UK

11
What are the risks?
The risk, which is rapidly becoming our central case, is that bond yields rise to levels
that begin to cause damage to growth in the second half of 2005. We estimate that a
50bp rise in bond yields is enough to take 0.5% points off real US GDP growth over a
12-month period. This is largely because the interest-rate sensitive components of
growth are so high, as is household financial leverage.
Figure 13: The interest-rate sensitive components of the US
economy (share of real GDP)
Figure 14: US household mortgage debt + credit outstanding
as a share of net worth - % deviation from trend
7
8
9
10
11
12
13
14
15
16
Mar-82 Mar-85 Mar-88 Mar-91 Mar-94 Mar-97 Mar-00 Mar-03
%ofrealGDP
7
8
9
10
11
12
13
14
15
16
%ofrealGDP
Long term average
-20.0
-15.0
-10.0
-5.0
0.0
5.0
10.0
15.0
20.0
25.0
Mar-60 Mar-64 Mar-68 Mar-72 Mar-76 Mar-80 Mar-84 Mar-88 Mar-92 Mar-96 Mar-00 Mar-04
%deviationfromtrend
-20.0
-15.0
-10.0
-5.0
0.0
5.0
10.0
15.0
20.0
25.0
%deviationfromtrend
Source: Bureau of Economic Analysis, CSFB research Source: Federal Reserve Board, CSFB research
Our fear is that the pick-up in inflation near term could be sustained for longer than most
investors we speak to believe. Real wage growth has already picked up sharply. As
Figure 5 suggests, non-farm payrolls could continue to grow at 200–250k per month,
which is nearly double the rate of growth of the labour force and thus unemployment
should fall to 4.5% by end-05 (even assuming that the year-on-year rate to growth in the
participation rate rises to seven-year highs). This happens at the same time as
productivity growth slows (see Figure 16). In addition, there are also anecdotal signs:
note the pick-up in manufacturing suppliers’ delivery times (which are now at a 25-year
high) and Philly Fed prices received (which is now at a 15-year high).
Bond yields could damage
growth in 2005 . . .
. . . near term we think
inflation will continue to
surprise on the upside . . .

12
Figure 15: US real wage growth versus unemployment rate
(inverted axis)
Figure 16: Productivity growth usually slows into an
economic recovery . . . hence unit labour costs rise!
-40
-30
-20
-10
0
10
20
30
40
Feb-82 Feb-84 Feb-86 Feb-88 Feb-90 Feb-92 Feb-94 Feb-96 Feb-98 Feb-00 Feb-02 Feb-04
Unemploymentrate(yoy%)
-2
-1
0
1
2
3
4
5
6
7
8
9
Realwagegrowth(yoy%)
Unemployment rate (yoy%), RHS, INVERTED AXIS
Real wage growth (yoy%) RHS
Forecast assuming unemployment rate
reaches NAURI level by July 2005
-3
-2
-1
0
1
2
3
4
5
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Number of quarters from trough in business cycle
yoy%changerebasedatzero
-3
-2
-1
0
1
2
3
4
5
%changesincetroughingrowth
Average performance following growth troughs since 1961
Since 4Q 2001 trough in real growth
Source: BEA, BLS, CSFB research Source: BLS, CSFB research
The consensus is still forecasting just 2.3% inflation for 2005.
We are concerned that too much growth and near-term inflation surprise will lead to an
overshoot in bond yields (which could take ten-year US Treasury bond yields to the 5.5–
6% range) and that will end up dampening growth prospects in the second half of 2005.
Our conclusion on the macro:
In conclusion, the prospect is stronger growth for longer. The main risk to this is that
higher-than-expected inflation (that is, core PCE inflation rising above 2%, the ceiling of
the Fed’s perceived comfort zone) leads to more of a slowdown in second-half growth in
2005.
In passing, we would highlight three main macroeconomic anomalies that we feel have
to correct:
(i) The record gap between the investment and consumption share of GDP in the US
(hence our positive stance of corporate investment, which we partly explained above,
and relative concern on US consumer cyclicals).
. . . consensus remains
relaxed
Three macro anomalies . . .
Gap between US
consumption and
investment

13
Figure 17: The differential between the business investment share of GDP and
consumption share of GDP in the US
-63
-61
-59
-57
-55
-53
-51
-49
-47
-45
Dec-50 Dec-55 Dec-60 Dec-65 Dec-70 Dec-75 Dec-80 Dec-85 Dec-90 Dec-95 Dec-00 Dec-05
Percentagepoints
-63
-61
-59
-57
-55
-53
-51
-49
-47
-45
Percentagepoints
Source: Bureau of Economic Analysis, CSFB research
(b) The undervaluation of the non-Japan Asian currencies. This is already manifesting
itself in some very high monetary growth. This leaves us positive on domestic non-
Japan Asia (particularly banks).
Figure 18: Non-Japan Asian real effective exchange rates Figure 19: Taiwan M1B money supply (yoy%)
-25
-20
-15
-10
-5
0
Korea India Taiwan Thailand China Philippines Malaysia Indonesia
%deviationfromtrend
-25
-20
-15
-10
-5
0
%deviationfromtrend
Real effective exchange rate %deviation from long-run average
Average deviation
-10
-5
0
5
10
15
20
25
30
Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04
yoy%
-10
-5
0
5
10
15
20
25
30
yoy%
Source: Datastream, CSFB research Source: Central Bank of China, Bloomberg, CSFB research
(c) US index-linked bond yields look too rich compared with any of the measures we
look at (see Figure 45). Hence, we see a risk that long-duration stocks and stocks with
high financial leverage perform poorly.
Undervaluation of NJA
currencies
Real bond yields

14
What about the dollar?
To end, we would note that we continue to be dollar bears given that tighter monetary
policies will have a negative impact on global liquidity, making funding the record US
current account deficit more problematic.
Figure 20: Net-foreign purchases of US securities versus current account balance (US$bn)
-
100
200
300
400
500
600
700
800
900
1,000
Feb-82 Nov-84 Aug-87 May-90 Jan-93 Oct-95 Jul-98 Apr-01 Jan-04
Netpurchases(US$billions)
-1,000
-900
-800
-700
-600
-500
-400
-300
-200
-100
-
Currentaccount,invertedaxis(US$billions)
Net purchases of US securities, US$ billions - 12mth sum (LHS)
Current account balance, US$ billions (RHS inverted axis)
Source: US Treasury, Bureau of Economic Analysis, CSFB research
However, we do not think the dollar will collapse since it now has a degree of real
interest-rate support.
Figure 21: US real interest rate differentials versus the dollar trade-weighted index
-5%
-3%
-1%
1%
3%
5%
7%
Interestratedifferentials
0.8
0.9
1.0
1.1
1.2
1.3
1.4
1.5
1.6
DollarTWI
Real US yield minus trading partners - LHS
LOG [ USD index (Finex DXY contract) ]- RHS
Source: Bloomberg, CSFB research
Finally, we remain dollar
bears
Although a collapse in the
dollar is unlikely, in our
view

15
Asset allocation
We believe that the tactical underweight call we made on equities back in May (see
Strategy changes, dated 10 May 2004) is now less strong but still do not see sufficient
resolution of the issues in order to raise our tactical weightings to benchmark. We
believe that the equity market has slightly more downside than upside potential over the
summer months. Our year-end target on the S&P 500 is 1,100 as it has been since last
October. Following the recent bear market rally in ten-year US Treasury yields, we
increase our underweight in bonds from 3% to 5%.
Figure 22: Recommended tactical asset allocation (%)
Benchmark weight Recommended weight Change
Equities 60 58 +3
Bonds 30 25 -2
Cash 10 17 -1
Below we discuss what has improved and what has not.
Equities (reduce tactical underweight to 2% from 5%)
What are the near-term negatives?
(i) Economic lead indicators and earnings momentum have both peaked
Normally this is a slightly problematic state of affairs for the equity market. In the past,
the S&P 500 has typically peaked around two to three months following a peak in lead
indicators and one month after a peak in forward earnings momentum. Earnings
momentum is also at record levels and unlikely to get significantly better from here in
our view.
Figure 23: ISM new orders index versus S&P 500 (%
deviation from six-month trend)
Figure 24: Breadth of global earnings revisions at record
levels
-40
-30
-20
-10
0
10
20
30
S&P500%deviaiton
0
10
20
30
40
50
60
70
80
ISMIndex
S&P 500 %deviation from 12mth avg (LHS) ISM New orders index (RHS)
-30.0%
-25.0%
-20.0%
-15.0%
-10.0%
-5.0%
0.0%
5.0%
10.0%
15.0%
20.0%
Jun-87
Jun-88
Jun-89
Jun-90
Jun-91
Jun-92
Jun-93
Jun-94
Jun-95
Jun-96
Jun-97
Jun-98
Jun-99
Jun-00
Jun-01
Jun-02
Jun-03
Jun-04
Monthly - Breadth 3 Month - Breadth
Source: Institute of Supply Managers, Datastream, CSFB research Source: I/B/E/S International, Datastream, CSFB research
Tactically underweight
equities, strategic
weightings at benchmark
Negatives: lead indicators
and earnings momentum
have peaked

16
(ii) Liquidity conditions are not supportive
OECD excess liquidity (that is, money supply versus money demand) is at three-year
lows and falling sharply, while US corporations are now net sellers of equities.
Figure 25: OECD excess liquidity indicator Figure 26: US corporate net-buying of equities
-4%
-3%
-2%
-1%
0%
1%
2%
3%
4%
Feb-81 Feb-83 Feb-85 Feb-87 Feb-89 Feb-91 Feb-93 Feb-95 Feb-97 Feb-99 Feb-01 Feb-03
-4%
-3%
-2%
-1%
0%
1%
2%
3%
4%
Calculated as the ratio of OECD broad money supply-to-output less real short term interest rates
Corporate Net buying (selling) - 70% of announced share buybacks plus cash-financed bids less new
issuance (4w-MA)
-8
-6
-4
-2
0
2
4
6
8
10
12
14
Jan-98 Jul-98 Jan-99 Jul-99 Jan-00 Jul-00 Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04
US$billions(4wkMA)
-8
-6
-4
-2
0
2
4
6
8
10
12
14
US$billions(4wkMA)
Long term average
Avg at market lows = US$6.0bn
Source: Datastream, CSFB research Source: Trim Tabs, CSFB research
(iii) The second Fed rate rise could be problematic—as it was in 1994.
Figure 27: The S&P 500 fell by 9% six weeks after the start of the 1994 tightening cycle
-10
-8
-6
-4
-2
0
2
4
6
8
01-Jan-94 01-Mar-94 01-May-94 01-Jul-94 01-Sep-94 01-Nov-94 01-Jan-95 01-Mar-95 01-May-95
%changeinS&P500index
0
1
2
3
4
5
6
7
8
Fedfundstarget%
S&P 500, % change since start of 1994 tightening (LHS) Fed funds target rate (RHS)
Source: Datastream, Federal Reserve Board, CSFB research
Of course, if anything we are more worried now because as we have written on many
occasions before, we are later into the earnings cycle (earnings are 14% above trend,
not 10% below as they were in 1994), later into the economic cycle (the Fed is now
tightening after the peak in lead indicators and not before), the proportion of the market
Liquidity not supportive
Second-rate rise could be
problematic . . .
. . . given leverage and the
weight of financials

17
accounted for by financials is now 50% larger than the share back in 1994 and there is
far more consumer leverage and leverage on bank balance sheets than in 1994.
Figure 28: US household debt service ratio versus Fed
Funds rate target
Figure 29: US financials earnings as percentage of market
earnings
0
2
4
6
8
10
12
14
Nov-84 Aug-87 May-90 Jan-93 Oct-95 Jul-98 Apr-01 Jan-04 Oct-06
Fedfundstarget(%)
10.0
10.5
11.0
11.5
12.0
12.5
13.0
13.5
Debtservice(%)
FedFundstarget rate(LHS)
Interest paymentsasa%of disposableincome(RHS)
Debt servicewasat historiclows, nowit
isat itshistorichighs
0%
5%
10%
15%
20%
25%
30%
35%
'48 '52 '56 '60 '64 '68 '72 '76 '80 '84 '88 '92 '96 '00
Then; Now
0%
5%
10%
15%
20%
25%
30%
35%
'48 '52 '56 '60 '64 '68 '72 '76 '80 '84 '88 '92 '96 '00
Then; Now
Source: Federal Reserve Board, CSFB research Source: Bureau of Economic Analysis, CSFB research
(iv) As CSFB’s Jonathan Wilmot notes, in the past when real US two-year interest rates
have risen by more than 2% at the onset of Fed tightenings, a financial crisis has
usually ensued. Because financials are now more important, if this were to occur this
time around it could lead to a degree of over-reaction in the stock market.
Figure 30: US real two-year note yield with Fed tightening cycles marked
-1
0
1
2
3
4
5
6
Jan-86 Jan-88 Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04
%
-1
-
1
2
3
4
5
6
%
Start of tightening cycle End of tightening cycle
Nasdaq peak
Russia/LTCM
Mexican Crisis /
Orange county
Asian crisis
March 1997 25bps rate hike
Peak in Nikkei
US real estate
crash
October crash
Source: Datastream, CSFB research

18
(v) Profits are already cyclically high (the profit share of GDP is currently close to its
post-1970s peaks, see Figure 31 and Figure 32).
Figure 31: US non-financial corporate sector pre-tax profit
share of GDP
Figure 32: US real earnings versus trend
6.0%
7.0%
8.0%
9.0%
10.0%
11.0%
12.0%
13.0%
14.0%
Q11978
Q11980
Q11982
Q11984
Q11986
Q11988
Q11990
Q11992
Q11994
Q11996
Q11998
Q12000
Q12002
Q12004
0
50
100
150
200
250
Jan-76
Jan-77
Jan-78
Jan-79
Jan-80
Jan-81
Jan-82
Jan-83
Jan-84
Jan-85
Jan-86
Jan-87
Jan-88
Jan-89
Jan-90
Jan-91
Jan-92
Jan-93
Jan-94
Jan-95
Jan-96
Jan-97
Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Source: Bureau of Economic Analysis, Federal Reserve, CSFB research Source: MSCI, CSFB research
On our model (we model non-financial corporate sector pre-tax profit growth using the
difference between unit selling price inflation and unit labour cost inflation for the non-
financial sector, which is by far the most important driver in the model, capacity
utilisation growth and real GDP growth), it is not that hard for profits growth to be
negative next year.
Figure 33: Regression model for US non-financial corporate profits
Co-efficient T-ratio
Intercept 3.6 2.6
Diff. btw output and input prices 7.6 25.5
Capacity utilisation rate 1.5 5.2
Real GDP growth 1.2 0.8
Source: Bureau of Economic Analysis, Federal Reserve, CSFB research
If we assume that unit selling prices rise to their 1990–2000 average of 1.5% in 2005, unit
labour cost inflation rises to 3.0% (against a 1990–2000 average of 1.5%), the capacity
utilisation rate rises to 80% by 4Q 2005 and real GDP grows in line with our economists’
assumptions (3.6%), pre-tax profit growth should fall to 2% from over 30% now (see Figure
34). If unit labour costs rise to 3.5%, profits would be down 1%.
Profit growth to slow

19
Figure 34: US non-financial corporate sector pre-tax profit
growth versus model estimate
Figure 35: 2005E non-financial corporate sector growth
scenarios based on unit labour costs and real GDP growth
sensitivities
-30
-20
-10
0
10
20
30
40
50
60
70
Mar-76 Mar-79 Mar-82 Mar-85 Mar-88 Mar-91 Mar-94 Mar-97 Mar-00 Mar-03 Mar-06
yoy%
-30
-20
-10
0
10
20
30
40
50
60
70
yoy%
Non-financial corporate sector Pre-tax profits Model estimate
3.0 % 3.6 % 4.5 %
2.5% 4 .9 6 .0 7 .0
3.0% 1 .6 2 .0 3 .0
3.5% -1 .9 -1 .0 0 .0
4.0% -6 .1 -4 .9 -3 .8
Re al GDP g r o w th
Unitlabourcosts
Base caseRisk
Source: Bureau of Economic Analysis, Federal Reserve, CSFB research Source: Bureau of Economic Analysis, Federal Reserve, CSFB research
What has improved?
(a) Valuations are a little better
(i) The US market forward P/E ratio is getting back to its monthly average lows seen in
October 2002 and February 2003 (of course on a much higher profit share of GDP).
Excluding financials, the 2005E PE ratio at 17.4 is back in line with the average of the
1960s.
Positives: P/Es almost
back to March 03 levels

20
Figure 36 P/E of US market including and excluding financials
0
5
10
15
20
25
30
35
Jan-60
Jan-63
Jan-66
Jan-69
Jan-72
Jan-75
Jan-78
Jan-81
Jan-84
Jan-87
Jan-90
Jan-93
Jan-96
Jan-99
Jan-02
Jan-05
S&P x Fins S&P 500
2005e (S&P 500)
2005e (S&P 500 x Fins)
1960s average P/E ex-fins
Source: Datastream, I/B/E/S International, CSFB research
(ii) Bond-to-equity valuations are neutral to mildly cheap. Our equity risk premium
analysis below shows that the US risk premium is currently 3.3%. At this stage of the
cycle, based on corporate credit spreads, implied equity market volatility and macro
momentum, the risk premium ‘should’ be closer to 3.1%. This does give a marginal
degree of upside. (We do acknowledge that some conventional forward-looking equity
risk premium models could show equities to be a lot more attractive if they adopt the
consensus I/B/E/S three-to-five year forward growth rate estimate at 12%, whereas we
revise this number down to 6.4%—something that is reasonable as the profit share of
GDP is at an all-time high).
Equities neutral/mildly
cheap versus bonds

21
Figure 37: US equity risk premium versus lead indicators*
(inverted axis)
Figure 38: Regression model for ‘warranted’ US equity risk
premium model
-2.0
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
Jul-92 Jul-93 Jul-94 Jul-95 Jul-96 Jul-97 Jul-98 Jul-99 Jul-00 Jul-01 Jul-02 Jul-03 Jul-04
Macromomentumindicator(invertedaxis)
0.4
1.4
2.4
3.4
4.4
5.4
6.4
Equityriskpremium
Lead indicators*
LHS, inverted axis
US EquityRisk Premium, RHS
Long-term
average ERP
Lower risk
premium, stronger
Macromomentum
Our assumptions, ERP = 3.3%
Assumptions: 12-mth fwd EPS= $64.9 (= I/B/E/Sest. adjusted for usual annual upward
forecast bias of 6%); 12-24 mth EPSgrowth =6.4%; 3-5yr growth rate = 6.4%
*Equally weighted combinationof ISMNeworders and OECDleadindicator
Inputs:
Moody's Baa rated
corporate bond spread
(bps)
Lead indicators Implied equity market
volatility (%)
ISM New orders index = 60.0
Output:
Warranted equity risk premium from model = 3.1%
230 16
Inputs:
Moody's Baa rated
(bps)
volatility (%)
OECD (ann. 3m/3m) = 4.7%
Inputs:
Moody's Baa rated
(bps)
volatility (%)
Output:
Warranted equity risk premium from model =
Inputs:
Moody's Baa rated
(bps)
volatility (%)
Inputs:
Moody's Baa rated
(bps)
volatility (%)
Output:
Inputs:
Moody's Baa rated
(bps)
volatility (%)
Inputs:
Moody's Baa rated
(bps)
volatility (%)
Output:
Inputs:
Moody's Baa rated
(bps)
volatility (%)
Source: ISM, OECD, I/B/E/S International, CSFB research Source: ISM, OECD, I/B/E/S International, CSFB research
However, we would highlight two points of caution: First by the end of Q3, the relative
neutrality of equities to bonds is likely to be eroded as lead indicators continue to roll over
(which would lead to the warranted risk premium rising to 3.4%). Our second cautionary
point is if (as we believe) US bond yields rise to 5–5.5%, this will undermine valuations.
(b) The investor sentiment indicators have become a little bit less complacent.
Currently, three of our six sentiment indicators point to complacency.
Figure 39: Investor sentiment indicators: Only three of our six indicators point to complacency
Date of peak Bullish sentiment
(1)
Inflows into US Agg.
Growth funds (2)
S&P100 implied vol.
(VIX)
Put/call ratio (3) CSFB Global Risk
Appetite (4)
Slope of implied
vol. Skew (5)
Current (16 July 04) 55.3 0.24 14.7 1.35 -0.11 0.238
Average at previous market lows 37.3 -0.39 43.7 1.96 -2.61 0.211
Average at previous bear market peaks 46.4 0.40 26.8 1.33 -1.67 0.195
Memo: Long-term average 43.4 0.38 21.4 1.40 0.70 0.205
1- Investors Intelligence survey results: % of investors who are fundamentally positive (four-week moving average); 2- US$bn of flows into aggressive
growth funds (four-week moving average); 3- Ratio of put to call volume on S&P 500 (weekly); 4- Based on Sharpe-ratios of 70 assets; 5- Slope of
implied volatility skew measures how much extra premium is required to buy out-of-the-money three-month S&P 500 put options versus out-of-the-
money three-month S&P 500 call options. Data since end of 1997.
Source: Barrons, AMG DataServices, CME, Bloomberg, NYSE, CSFB Equity derivatives research
Note that risk appetite has corrected considerably from its highs and the skew indicator has
been persistently above its long-term average since March (implying investor bearishness)
but is probably misleading given that implied volatility is below its long-run averages.
Sentiment indicators have
become less complacent

22
Figure 40: CSFB risk appetite has come off complacency
levels
Figure 41: S&P 500 implied volatility skew: Persistently
bearish
-6.0
-4.0
-2.0
0.0
2.0
4.0
6.0
8.0
10.0
Jan-81
Sep-82
May-84
Jan-86
Sep-87
May-89
Jan-91
Sep-92
May-94
Jan-96
Sep-97
May-99
Jan-01
Sep-02
May-04
0.10
0.15
0.20
0.25
0.30
0.35
11/09/94
03/16/95
07/17/95
11/15/95
03/20/96
07/19/96
11/20/96
03/26/97
07/25/97
11/26/97
04/01/98
08/03/98
12/08/98
04/20/99
08/26/99
01/06/00
05/17/00
09/20/00
01/30/01
06/05/01
10/11/01
02/13/02
06/17/02
10/16/02
02/19/03
06/23/03
10/21/03
24-Feb-04
25-Jun-04
Source: CSFB Global strategy team, CSFB research Source: CSFB Equity derivatives research
(c) The technicals are essentially neutral to better.
The equity market has been in a fairly tight trading range since the start of the year (the
S&P 500 has traded within 8% of its value at the start of the year). Our US quantitative
equity derivatives analysts note that in the past, there have only been four distinct
periods when equities have traded in such a tight range (January 1979, December
1991, December 1992 and February 1996) and typically the market has gone on to
break out on the upside following all such occasions. We would note, however, that the
breakout following the October 1999–May 2002 trading range was to the downside.
The technicals are neutral
to better

23
Figure 42: S&P 500 breakouts from trading ranges are normally to the upside
-5.0
-3.0
-1.0
1.0
3.0
5.0
7.0
9.0
1 21 41 61 81 101 121 141 161 181 201 221 241
Number of days
%changefrombasedate
-5.0
-3.0
-1.0
1.0
3.0
5.0
7.0
9.0
%changefrombasedate
% performance since start of 2004 Median performance since start of trading range
Looking at internal leadership of the market (as shown by the cumulative advance less
declines, Figure 43), we find overall market breadth is currently neutral.
Figure 43: S&P 500 cumulative advance-decline line shows no trend
80
90
100
110
120
130
140
150
160
Jul-78
Jul-79
Jul-80
Jul-81
Jul-82
Jul-83
Jul-84
Jul-85
Jul-86
Jul-87
Jul-88
Jul-89
Jul-90
Jul-91
Jul-92
Jul-93
Jul-94
Jul-95
Jul-96
Jul-97
Jul-98
Jul-99
Jul-00
Jul-01
Jul-02
Jul-03
Jul-04
Source: Company data, CSFB research

24
(d) There is slightly better visibility on the three key issues of China, US rates and oil:
• On China, there has been some mildly good news. Inflation has fallen (month on
month) and at last we are seeing a slowdown in investment growth (up 15% year on
year from a peak of 42%). However, we have yet to have a soft landing. That probably
requires electricity consumption to slow down to sub-10% year on year from current
levels of 18% (against a peak of 24%). Recall with investment nearly half of GDP, it is
hard to see a slowdown in investment not having more of an impact.
• On oil, a view on Saudi Arabian supply intent is critical and on this point there has
been some confusion. Initially, the Saudi Arabian oil minister, Ali al-Naimi, stated that
the oil price was ‘fair’ at US$35–36/bbl (WTI). Later, in an interview in the Middle
Eastern Economic Survey, he then went on say that Saudi Arabia did not support a
change in the current OPEC oil price band of between US$22/bbl and US$28/bbl and
that a price of US$25/bbl is reasonable for both customers and producers. The worry
on oil is that Saudi Arabia has little near-term incentive to weaken the oil price (the
country’s budget requires a US$30 oil price).
• On US interest rates, as Figure 44 below shows, we have had the bulk of the
adjustment in forward expectations. However, we still believe that market expectations
are too conservative. We believe that a neutral fed funds rate needs to be priced in for
2H05 and that a neutral fed funds rate is 4% (that is, 2% real). Bearing in mind that
the forward curve normally overshoots by 50bp, this implies that the market should be
pricing in Fed funds for mid-2005 of 4.5% (the June three-month Euro-dollar contract
is currently pricing in rates at 3.1%).
Figure 44: Three-month Euro-dollar implied rate in 12-months’ time
-
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
Jan-04 Mar-04 May-04 Jul-04 Sep-04 Nov-04 Jan-05 Mar-05 May-05 Jul-05
%
-
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
%
So overall, the outlook for Q3 is a close call.
Better visibility on macro
risks: China, oil and to a
lesser extent US rates

25
What about the strategic case?
We continue to be strategically benchmark of equities.
There are three drivers of equity valuations:
• the gap between real GDP and real bond yields (if assumed real GDP remains
constant and real bond yields rise, equities derate);
• the profit share of GDP; and
• the equity risk premium.
The problem is what happens if we normalise for all of these factors:
Real bond yields seem to be too low relative to real GDP growth. We believe that in
equilibrium, real bond yields should be ¼% above real GDP growth. Our model below
shows suggests that real bond yields are too low.
Figure 45: Real US ten-year Treasury bond yield versus
model estimate
Figure 46: Regression model for real US ten-year Treasury
bond yield
-2.0
0.0
2.0
4.0
6.0
8.0
10.0
Jun-66 Jun-70 Jun-74 Jun-78 Jun-82 Jun-86 Jun-90 Jun-94 Jun-98 Jun-02
%
-2.0
0.0
2.0
4.0
6.0
8.0
10.0
%
Real bond yield (based on core PCE deflator)
Model estimate
10-year TIP yield
1966-1980
Intercept Real GDP
growth
Fiscal
balance/GDP
Core inflation
volatility
Change in net
foreign assets
Co-efficient 2.40 9.06 -2.29 -0.01 -40.22
T-ratio 14.0 3.1 -0.1 -7.3 -2.9
1980-2002
Intercept Real GDP
growth
Fiscal
balance/GDP
Core inflation
volatility
Change in net
foreign assets
Co-efficient 2.6 29.0 2.6 0.03 5.7
T-ratio 16.3 9.5 0.7 12.2 1.6
Source: Federal Reserve, BEA, BLS, CSFB research Source: Federal Reserve, BEA, BLS, CSFB research
The profit share of GDP is close to its post-1970s peaks and earnings (in real terms) are
now 20% above their long-term trend-line.
Finally, we assume the equity risk premium will revert to 3.4% (its average) in the long
run.
If we mean-revert two variables (nominal bond yields and the equity risk premium), then
we arrive at the following conclusion (that is, around 1,100 on the S&P 500). If we mean
revert all three, then fair value falls a lot further.
Strategically, if we
normalise all three factors
in our model fair value is
well below current levels

26
Figure 47: Implied level of S&P 500 on normalised bond yield and earnings assumptions
Nominal bond yield = terminal growth rate = 5%
Equity risk premium reverts back to long-term average = 3.4%
2004E EPS = I/B/E/S estimate = US$65.2
Implied level of S&P 500 = 1,080
Nominal bond yield = terminal growth rate = 5%
Equity risk premium reverts back to long-term average = 3.4%
2004E EPS = I/B/E/S estimate = US$65.2
Implied level of S&P 500 = 1,080
Bonds (reduce to 5% underweight)
On bonds, we have actually seen a little of the bear market rally that we thought might
happen when we raised our bond weightings back in May (when yields were at 4.6%)
and now reduce weightings again to be 5% underweight from 3% underweight.
Our fair-value model on nominal bond yields is pointing to yields at 4.9%, assuming a
2% Fed Funds target rate by the end of this year. If we additionally assume core
inflation rises to 2.5%, then fair value is around 5.5%. There is something of an inflation
risk as eluded to in the Macro scenarios section. The clear risk is that bad inflation data
and ‘measured rate rises’ would lead to the expectations that the Fed is behind the
curve and thus requires over not under-valuation.
Figure 48: Ten-year US Treasury bond yield versus model
estimate
Figure 49: Regression model for Ten-year US Treasury bond
yield
2
3
4
5
6
7
8
9
10
Jan-88 Jul-89 Jan-91 Jul-92 Jan-94 Jul-95 Jan-97 Jul-98 Jan-00 Jul-01 Jan-03 Jul-04
%
2
3
4
5
6
7
8
9
10
%
10-year US Treasury bond yield Estimated fair value
Fair-value profile assuming core CPI rises
to 2.5% and Fed Funds of 2% end 2005
Constant ISM New
orders
index
Core
inflation
rate
Output
Gap
3mth
interest
rate
Fiscal
budget
deficit %
GDP
Coefficient -1.98 0.08 0.70 -0.06 0.45 -1.52
T-ratio -5.0 12.5 11.6 -3.6 15.5 -0.4
Source: ISM, BLS, FRB, BEA, Bloomberg, CSFB research Source: ISM, BLS, FRB, BEA, Bloomberg, CSFB research
The funds flow is overall negative. The carry trade for the banks has yet to unwind. It
must! And foreign buying of US bonds looks to have been at an unsustainable level
(recall foreign investors own 37% of the liquid US Treasury bond market).
We reduce our bond
weightings further from 3%
underweight to 5%
Funds flow is likely to be
negative

27
Figure 50: Net foreign purchases of US Treasury bonds Figure 51: Proportion of US Treasury bond market held by
foreign investors
-40
-20
0
20
40
60
80
100
120
140
160
Mar-77 Mar-80 Mar-83 Mar-86 Mar-89 Mar-92 Mar-95 Mar-98 Mar-01 Mar-04
US$bn(3mthsum)
-40
-20
0
20
40
60
80
100
120
140
160
US$bn(3mthsum)
0
5
10
15
20
25
30
35
40
1990 1992 1994 1996 1998 2000 2002
%
0
5
10
15
20
25
30
35
40
%
Foreign holdings of US Treasuries (% of total)
Official foreign holdings (% of total)
Private foreign holdings (% of total)
Source: US Treasury, CSFB research Source: Federal Reserve Board, CSFB research
We are also fast approaching the threat that the sell-off in the JGB market might start to
influence the US bond market.
Figure 52: Yield spread between ten-year US Treasury bonds and ten-year JGB bonds
0.0
1.0
2.0
3.0
4.0
5.0
6.0
%
0.0
1.0
2.0
3.0
4.0
5.0
6.0
%
% yield gap between US 10-year Treasury bonds and 10-year JGB's
2.5%
threshold
Normally, the peak in bond yields is associated with a clear overshoot in forward rate
expectations. This has yet to happen. We believe a neutral level of Fed policy is 4% (2%
real rates and 2% inflation) and thus the Fed funds futures should be discounting 4.5%,
instead for mid-2005 it is discounting 3.1% and 3.9% end 2005. Recall sometimes the
overshoot is considerably more (back in 2002, the three-month rate in 12 months’ time
hit almost 5% despite the Fed leaving rates unchanged).
Normally interest-rate
expectations overshoot at
the peak of bond yields

28
Regional strategy
Our preferred big-cap region is continental Europe. We leave Japanese weightings at
3% overweight. We take our UK weightings up to benchmark and offset this by taking
weightings in the US down slightly.
Figure 53: Regional recommendations
Benchmark weight (%) Recommended weight
(%)
% over/underweight vs
benchmark
Change (%)
US 54.4 50.8 -7 -1
Japan 9.6 9.9 3
UK 10.3 10.3 0 +3
Europe 17.9 20.5 15
Asia Pacific* 3.2 3.8 20
Emerging Markets 4.6 4.6 0
100 100
* Asia Pacific = MSCI Asia Pacific x Emerging Markets
Source: MSCI, CSFB research
Below we briefly go through our regional strategy.
Continental Europe (15% overweight versus benchmark)
Our preferred developed market region is continental Europe.
(i) Continental Europe is much later-cycle than normal: We believe Europe is much
later-cycle than normal because the consumer is later-cycle than normal, relying on an
improvement in employment growth that typically occurs after both investment and
export growth have picked up. We would note there are already early signs of life in
Euro area services GDP growth and consumer employment expectations signalling a
further improvement in employment growth.
Figure 54: PMI Services index versus Euro area service GDP
growth
Figure 55: Consumer employment expectations versus
employment growth
46
48
50
52
54
56
58
60
62
92 93 94 95 96 97 98 99 00 01 02 03 04
Index
-1.0
0.0
1.0
2.0
3.0
4.0
5.0
6.0
GDP(q0q%)
Services GDP, q/qsaar%, 2QMA, RHS
Services PMI, LHS
-30
-25
-20
-15
-10
-5
0
5
10
15
86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
-2.5
-2
-1.5
-1
-0.5
0
0.5
1
1.5
2
2.5
3
-30
-25
-20
-15
-10
-5
0
5
10
15
86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
-2.5
-2
-1.5
-1
-0.5
0
0.5
1
1.5
2
2.5
3
Source: Eurostat, CSFB European economics research Source: Eurostat, CSFB European economics research
Europe is our preferred
region, being later cycle
than normal . . .

29
(ii) European earnings have more upside potential than the US. European earnings
revisions (earnings upgrades to downgrades) are now at their best level on record.
In addition, as our European strategy team shows in Figure 57, earnings in Europe
clearly lag US earnings by about 12 months.
Figure 56: Earnings momentum is at record levels Figure 57: MSCI European earnings lagged 12 months
-22%
-17%
-12%
-7%
-2%
3%
8%
13%
Jan-91
Jul-91
Jan-92
Jul-92
Jan-93
Jul-93
Jan-94
Jul-94
Jan-95
Jul-95
Jan-96
Jul-96
Jan-97
Jul-97
Jan-98
Jul-98
Jan-99
Jul-99
Jan-00
Jul-00
Jan-01
Jul-01
Jan-02
Jul-02
Jan-03
Jul-03
Jan-04
Jul-04
Monthly - Breadth 3 Month - Breadth
50
100
150
200
250
300
350
Dec-87 Oct-89 Aug-91 Jun-93 Apr-95 Feb-97 Dec-98 Oct-00 Aug-02 Jun-04
50
100
150
200
250
300
US Europe loc. Cur. (rhs)
We measure earnings momentum by looking at earnings upgrades less
downgrades as % of total estimates.
Source: I/B/E/S estimates, CSFB research
Source: MSCI, Datastream, CSFB European equity strategy
We also find that when we look at European EPS in real terms over the last 30 years,
earnings are just 7% above trend (Figure 58). This compares with the US where
measured over the same time period real EPS is now 20% above trend.
(In Figure 59 below we compare the percentage deviation of real EPS from trend in both
Europe and the US. This shows that European earnings have historically risen further
above trend than they are now, whereas in the US real EPS deviation from trend is
close to ex-bubble peak levels.)
. . . earnings have more
upside potential

30
Figure 58: Real European EPS Figure 59: Real EPS percentage deviation from trend in
Europe and the US
40
60
80
100
120
140
160
180
200
220
240
Jan-76
Jan-77
Jan-78
Jan-79
Jan-80
Jan-81
Jan-82
Jan-83
Jan-84
Jan-85
Jan-86
Jan-87
Jan-88
Jan-89
Jan-90
Jan-91
Jan-92
Jan-93
Jan-94
Jan-95
Jan-96
Jan-97
Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
European real EPS is now 7% above trend
40
60
80
100
120
140
160
180
200
220
240
Jan-76
Jan-77
Jan-78
Jan-79
Jan-80
Jan-81
Jan-82
Jan-83
Jan-84
Jan-85
Jan-86
Jan-87
Jan-88
Jan-89
Jan-90
Jan-91
Jan-92
Jan-93
Jan-94
Jan-95
Jan-96
Jan-97
Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
European real EPS is now 7% above trend
-50%
-40%
-30%
-20%
-10%
0%
10%
20%
30%
40%
50%
Jun-81
Jun-82
Jun-83
Jun-84
Jun-85
Jun-86
Jun-87
Jun-88
Jun-89
Jun-90
Jun-91
Jun-92
Jun-93
Jun-94
Jun-95
Jun-96
Jun-97
Jun-98
Jun-99
Jun-00
Jun-01
Jun-02
Jun-03
Jun-04
US Europe
Europe
US
-50%
-40%
-30%
-20%
-10%
0%
10%
20%
30%
40%
50%
Jun-81
Jun-82
Jun-83
Jun-84
Jun-85
Jun-86
Jun-87
Jun-88
Jun-89
Jun-90
Jun-91
Jun-92
Jun-93
Jun-94
Jun-95
Jun-96
Jun-97
Jun-98
Jun-99
Jun-00
Jun-01
Jun-02
Jun-03
Jun-04
US Europe
Europe
US
Source: MSCI, Datastream, CSFB European equity strategy Source: MSCI, Eurostat, CSFB European equity strategy
(iii) The CSFB AggreGator points to continental Europe being the second-cheapest
major market after Japan (with the assumptions for Japan being overly optimistic in our
view). Bearing in mind that 30% of continental European earnings growth comes from
the US and if we give those US earnings the same real asset growth, then by default we
are assuming a domestic European P/E and asset growth of only 1.2% in real terms.
Figure 60: CSFB HOLT AggreGator scorecard for regions
Real asset growth
rate during initial
period (%)
CFROI®
2004E (%)
CFROI® at end
of initial fade
period (%)
Length of fade
period (yrs)
WACC (%) Potential
upside/downside
(%)
Non-Japan Asia* 4.50 8.9 8.0 10 5.5 16.4
Japan 0.00 4.0 6.0 10 5 7.3
Europe xUK 2.25 7.3 7.0 10 5 5.4
UK 2.75 9.6 7.0 10 5 -21.4
US 3.75 8.8 7.5 10 5 -24.9
* Includes emerging Asia, Source: CSFB HOLT, CSFB research
In addition, the FCF yield and simple P/E look surprisingly cheap.
Valuations are cheaper

31
Figure 61: Regional valuations
P/E*
2004E
(x)
P/E 2004E
sector adj
(x)
Implied
growth
(%)
Dividend
yield
(%)
Free cash
flow yield 2004E
(%)
EV/ EBIT
2004E
(x)
US 17.5 16.4 6.9 1.70 4.7 15.2
Europe ex UK 13.1 13.9 5.2 2.69 6.8 16.1
UK 12.6 12.4 6.0 3.26 6.1 18.8
Japan 18.4 19 8.7 0.82 5.1 16.4
Asia x Japan 10.5 n/a n/a 2.44 6.5 12.3
Global 16.2 16.2 6.6 2.03 5.4 15.7
* Excluding goodwill, Source: I/B/E/S International, MSCI, CSFB HOLT
(iv) There is less complacency in Europe than elsewhere: We find less complacency in
Europe, whether we look at inflows into mutual funds or market implied volatility
compared with other regions. Figure 62 shows that current implied volatility in Europe
has not deviated from its long-term average as much as it has in the US or in Japan,
pointing to less investor complacency in Europe.
Figure 62: Market implied volatility: Europe is less complacent than Japan or the US
Current implied vol ten-year average % deviation from ten-year average No. of standard deviations from
ten-yr avg
Europe (DAX) 19.2 24.3 -21.1% -0.5
Japan (Nikkei) 20.0 24.4 -18.2% -0.7
US (S&P500) 16.3 21.5 -24.4% -0.8
Figure 63: German DAX implied volatility index: Less
investor complacency compared with the US
Figure 64: S&P 500 implied volatility index (VIX)
0
10
20
30
40
50
60
70
Jun-94 Dec-95 Jun-97 Dec-98 Jun-00 Dec-01 Jun-03 Dec-04
%
0
10
20
30
40
50
60
70
%
10-yearaverage
-1STD
+1STD
0
5
10
15
20
25
30
35
40
45
50
Jun-94 Jun-95 Jun-96 Jun-97 Jun-98 Jun-99 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04
%
0
5
10
15
20
25
30
35
40
45
50
%
10-yearaverage
-1STD
+1STD
Source: Bloomberg, CSFB research Source: Bloomberg, CSFB research
(v) Europe tends to outperform in the short term when US rates rise. As shown in the
Figure 65, Europe has outperformed the US in the first three months of the last three
Fed tightening cycles (in single currency terms).
. . . there is less investor
complacency than
elsewhere
The macro backdrop could
support some
outperformance

32
Figure 65: Continental Europe price performance relative to the US during the periods of
Fed tightening (US$ terms)
Europe ex UK price performance relative to US ($ terms)
First Fed rate hike 1 month after the rate rise 3 months after the rate rise 6 months after the rate rise
04-Feb-94 -3.9 3.0 4.2
25-Mar-97 2.3 1.4 -0.2
30-Jun-99 3.9 8.7 14.6
Source: Datastream, MSCI, CSFB research
(vi) On our factor model continental Europe has outperformed Japan and the UK when
lead indicators roll over and the global yield curve flattens.
Figure 66: Macro factor sensitivities to scenario of flatter global yield* curve and slowdown
in OECD leading indicator
-1.6
-1.4
-1.2
-1.0
-0.8
-0.6
-0.4
-0.2
0.0
0.2
US Euro-5 UK Japan
-1.6
-1.4
-1.2
-1.0
-0.8
-0.6
-0.4
-0.2
0.0
0.2
*Note that a flatter global yield curve is assumed to occur through higher US and UK short rates
.Source: CSFB research
Sectors and stocks selection within Europe
The major difference between our global sector strategy and our regional strategy are to
favour the undiscounted consumer recovery story and financials. We are overweight
continental European banks, focusing on Italy and France. For more on this, see our
forthcoming sector overview. The rationale behind our focus on the European consumer is
simply that there are signs of life (for example, Euro area car sales are up 7.1% year on year
in June and up 3.6% on a cumulative YTD basis versus the comparable six-month period of
2003), the consumption share of GDP is 12% points below that of the US and the European
consumer (specially ex Holland and Germany) is structurally under-leveraged at a time
when house prices are rising and there is potential for financial innovation. We would play
the Euro consumer theme through: PSA, Credit Agricole, Kesa and PPR.
Owing to our slightly more positive stance on these areas from a European perspective,
we would be less positive on European telecoms than we are on global telecoms.
We favour the
undiscounted consumer
plays and financials

33
Below we show the stocks in Europe that look cheap on HOLT (implied CFROI
®
versus
history of implied CFROI
®
), trade on a high FCF yield (greater than the market yield)
and have positive revenue and earnings momentum.
Figure 67: European stocks that look cheap on HOLT (implied less historical implied), have attractive FCF yield and positive
revenue momentum
--------------- Market implied CFROI ----------- ------------ Momentum *-------------
Name Industry Current
implied
CFROI
Implied CFROI
less average of
implied
Implied CFROI
less HOLT’s
default predicted
CFROI
FCF yield
2004e
revenue
expectations
earnings
expectations
CSFB rating
Renault Sa Automobiles -5.8 -7.4 -11.0 20.2% 1.4% 3.3% Neutral
Heidelbergcement Construction Materials -0.4 -6.1 -5.2 15.7% 1.1% 27.6% Neutral
Assa Abloy Capital Goods 11.6 -3.2 -0.7 7.1% 3.2% 2.4% Neutral
Securitas Commercial Services 12.2 -2.3 -0.3 7.8% 0.3% -5.4% Nr
Stmicroelectronics Semiconductors 5.6 -2.3 -0.3 5.9% 7.4% -3.8% Outperform
Volkswagen Ag Automobiles 0.7 -2.2 -3.1 9.4% 0.9% -15.8% Outperform
Carlsberg Beverages 7.7 -2.2 1.1 15.3% 0.4% -4.3% Neutral
Aguas De Barcelona Utilities 7.2 -2.1 -0.4 13.2% 0.7% 0.3% Outperform
Mediaset Media 14.9 -1.8 0.4 5.3% 1.7% 2.1% Neutral
Publicis Groupe Sa Media 11.8 -1.6 3.5 7.3% 0.2% 0.7% Neutral
Tpg Nv Transportation 9.2 -1.6 -0.4 10.4% 0.1% 3.6% Nr
Delhaize Group Food Retailing 7.5 -1.5 -1.1 11.2% 0.1% -3.0% Neutral
Clariant Chemicals 5.2 -1.4 0.0 13.2% 1.0% -1.6% Neutral
Deutsche Telekom Telecommunications 8.3 -1.3 0.6 15.8% 0.3% -4.1% Outperform
Endesa Sa Utilities 2.9 -1.2 -1.9 7.6% 1.2% -1.7% Neutral
Italcementi Construction Materials 3.1 -1.1 -2.3 12.2% 0.5% 1.5% Neutral
Tf1 - Tv Francaise Media 20.1 -1.1 1.1 5.0% 0.0% -2.9% Outperform
Norske Skogsindust Pulp & Paper 3.4 -1.0 -2.0 15.2% 0.4% -62.8% Neutral
Metro Ag Food Retailing 8.1 -1.0 -0.5 8.6% 0.1% 26.7% Neutral
Michelin (Cgde) Automobiles 3.9 -0.8 -0.9 11.5% 0.7% 2.6% Neutral
Snam Rete Gas Utilities 7.5 -0.8 1.5 8.5% 0.0% -0.4% Neutral
Fraport Ag Transportation 3.4 -0.7 -0.9 7.3% 0.1% -0.5% Outperform
Royal Dutch Petrol Energy 5.5 -0.7 -2.6 13.2% 7.3% 13.2% Neutral
Cie De St-Gobain Capital Goods 5.5 -0.6 -0.9 10.2% 1.2% 0.7% Outperform
Svenska Cellulosa Materials 5.4 -0.4 -1.1 6.8% 1.9% -5.1% Underperform
Thyssenkrupp Ag Metals & Mining 1.5 -0.4 -1.9 13.8% 0.5% 4.1% Outperform
Repsol Ypf Sa Energy 4.4 -0.4 -1.6 10.8% 3.2% 13.9% Neutral
Ciba Spezialitaten Materials 7.7 -0.3 3.2 8.7% 1.8% 0.1% Neutral
Lvmh Moet Hennessy Consumer Durables 13.6 -0.2 2.3 5.2% 0.7% 0.7% Outperform
Lafarge Construction Materials 6.8 -0.2 -0.5 7.7% 0.8% 1.4% Neutral
Crh Materials 8.1 -0.1 0.1 9.1% 3.3% 5.7% Neutral
Schneider Electric Capital Goods 9.1 -0.1 -1.5 6.7% 2.3% 2.5% Outperform
Alstom Capital Goods 7.2 -0.1 1.7 5.2% 0.1% n/m Outperform
Amadeus Glob Travel Software & Services 8.2 0.0 -8.0 12.0% 1.4% 7.2% Neutral
* 3m percentage change in FY 2004 consensus expectations
Source: Company data, I/B/E/S International, CSFB HOLT

34
UK (raising weightings to benchmark)
(i) Some evidence of slowdown is emerging—hinting at less risk of a boom/bust cycle.
Our core scenario has been that with consumption and GDP growth above trend and
unemployment at a 30-year low, the MPC would have to return the debt service ratio
back to its long-run average requiring 6% rates.
We now find that there are early signs of slowdown, perhaps suggesting that high
leverage levels (along with factors such as a higher oil price and the Bank of England’s
increasingly vociferous warnings on house prices) are having an impact earlier than
generally expected.
The evidence of a slowdown is the following: Mortgage lending has fallen by £1bn, total
consumer lending growth is slowing (down £0.5bn in May to £10.2bn with lending secured
on dwellings falling by £0.8bn), house price inflation is slowing (Halifax and Nationwide
house price indices slowed to 0.9% and 1.2% respectively in June), Provident Financial
warned that consumer lending had declined by 5% in the five months to May 2004, the RICs
survey showed a modest slowdown in confidence and finally employment actually fell on the
month in June and above all wage growth slowed down to 4.2%. In addition, note that
mortgage equity withdrawal slowed to £15.8bn in 2Q with the ratio relative to after-tax
income falling 0.9% points from its all-time high of 8.9%.
However, we do suggest that this is tentative. There is very little convincing evidence of
a fall in retail sales (volatile weather conditions and Euro 2004 probably accounted for
most of the deceleration in the BRC retail survey’s like-for-like sales growth to 2.4% in
June from 3.7% in May), employment expectations (both manufacturing and service
sector employment expectations are at seven-year highs) and house prices are still up
around 20% year on year (the ODPM national house price index has current year-on-
year growth at 12%).
Figure 68: UK retail sales are still growing briskly Figure 69: UK CIPS employment expectations indices
0
1
2
3
4
5
6
7
8
9
10
yoy%
-4
-2
0
2
4
6
8
10
yoy%
Nominal sales growth Real sales growth
25
30
35
40
45
50
55
60
Jul-92 Jul-93 Jul-94 Jul-95 Jul-96 Jul-97 Jul-98 Jul-99 Jul-00 Jul-01 Jul-02 Jul-03
Manufacturingindex
30
35
40
45
50
55
60
Servicesindex
Source: Office of National Statistics, CSFB research Source: CIPS, CSFB research
We raise the UK to
benchmark
There are now some
tentative signs of a
moderation in activity

35
(ii) Parts of the domestic UK market have fallen to valuation levels that are slightly more
attractive. While we are still negative on UK mortgage banks, we are less negative than
we were as their valuations have corrected a long way relative to the continental
European banks.
Figure 70: UK mortgage banks price-to-book value relative to
continental European banks
Figure 71: UK mortgage banks P/E relative
-50
-40
-30
-20
-10
0
10
20
30
40
50
Jun-97 Jun-98 Jun-99 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04
%premium/discount
-50
-40
-30
-20
-10
0
10
20
30
40
50
%premium/discount
UK mortgage banks price-to-book value % premium/discount to European banks
Historical average
0%
20%
40%
60%
80%
100%
120%
140%
160%
180%
Dec-87
Dec-88
Dec-89
Dec-90
Dec-91
Dec-92
Dec-93
Dec-94
Dec-95
Dec-96
Dec-97
Dec-98
Dec-99
Dec-00
Dec-01
Dec-02
Dec-03
Dec-04
UK banks P/E (x HSBC & STAN) relative to EU banks UK banks P/E relative to EU banks
Average
`
Source: MSCI, CSFB research Source: I/B/E/S International, CSFB research
More generally, valuations of the UK market against continental Europe are broadly
neutral.
Figure 72: UK forward P/E % premium/discount to
continental Europe
Figure 73: UK equity risk premium versus continental
European equity risk premium
60%
70%
80%
90%
100%
110%
120%
Jul-87
Jul-88
Jul-89
Jul-90
Jul-91
Jul-92
Jul-93
Jul-94
Jul-95
Jul-96
Jul-97
Jul-98
Jul-99
Jul-00
Jul-01
Jul-02
Jul-03
Jul-04
UK 12m fwd P/E relative to Europe
1.00
2.00
3.00
4.00
5.00
6.00
7.00
Aug-91
Mar-92
Oct-92
May-93
Dec-93
Jul-94
Feb-95
Sep-95
Apr-96
Nov-96
Jun-97
Jan-98
Aug-98
Mar-99
Oct-99
May-00
Dec-00
Jul-01
Feb-02
Sep-02
Apr-03
Nov-03
Jun-04
UK Euro-5
Based on earnings before goodwill
Source: I/B/E/S International, CSFB research
Based on earnings before goodwill
Source: I/B/E/S International, CSFB research
Value is emerging in the
domestic parts of the UK
market

36
(iii) The sector exposure of the UK is clearly defensive: If we exclude financials,
defensive stocks represent 48% of the UK market cap versus only 31% for cyclicals.
This compares with global weights of 37.7% for defensives and 52% for cyclicals.
The defensive nature of the market is also illustrated by the close positive correlation
between UK relative performance and the ratio of global cyclicals to defensives (see Figure
75 below). We are a small overweight of defensives globally, reflecting our concern that the
yield curve needs to flatten and that the growth of lead indicators has peaked.
Figure 74: Super-sector composition of major equity markets
(excluding financials)
Figure 75: UK equities price relative versus global cyclicals
relative to defensives
0.0%
10.0%
20.0%
30.0%
40.0%
50.0%
60.0%
70.0%
80.0%
UK US Europe Japan
Defensives Cyclicals Energy
1
1.1
1.2
1.3
1.4
1.5
1.6
1.7
1.8
1.9
31-May-98 31-May-99 31-May-00 31-May-01 31-May-02 31-May-03 31-May-04
Defensivesrelativetocyclicals
1.5
1.6
1.7
1.8
1.9
2.0
2.1
UKrelativetoworld
Global defensives relative to cyclicals UK relative to global equities
Source: MSCI, CSFB research. * Cyclicals include media and technology Source: Datastream, CSFB research
On the UK from a local perspective, our top picks focusing on the top 20 stocks would,
on our estimates, be Diageo (6.5% FCF yield ex General Mills in an industry that is
enjoying its strongest top line growth since the 1960s), Unilever (8.0% FCF yield, 34%
of revenue from GEM), Vodafone (8.6% FCF on 2005 numbers and the worse is now
behind us temporarily on regulatory risk, capex-to-sales and 3G is unlikely to be mass
market until second half of 2005), RBOS (7.3X ex Chartered), GSK (FCF yield of 7.1%).
The UK’s sector exposure
is defensive

37
Below we show the stocks in the UK that look cheap on HOLT (implied CFROI
®
versus
history of implied CFROI
®
) and are trading on an attractive FCF yield (greater than the
market yield).
Figure 76: UK stocks that look cheap on HOLT (implied less historical implied) and have an attractive FCF yield
--------------- Market implied CFROI®
----------- ------------ Momentum *-------------
Name Industry Current
implied
CFROI®
Implied CFROI
less average of
implied
Implied CFROI®
less HOLT’s
default predicted
CFROI ®
FCF yield
2004E
revenue
expectations
earnings
expectations
CSFB rating
Intl Power Utilities -0.9 -7.6 -5.3 5.0% -4.9% 1.1% Neutral
Shire Pharma Group Pharmaceuticals 5.0 -6.2 -7.1 11.4% 0.7% -0.6% Nr
Rmc Group Materials 2.7 -3.3 -2.2 9.0% 1.2% -11.1% Neutral
Vodafone Group Telecommunications 11.2 -2.8 -1.7 8.3% -1.9% n/m Outperform
Pearson Media 13.1 -0.9 2.1 8.5% 0.6% n/m Outperform
Aegis Group Media 12.6 -0.4 -3.0 6.9% 0.8% -14.5% Neutral
Glaxosmithkline Pharmaceuticals 12.4 -0.2 -0.5 7.1% -0.6% -0.8% Outperform
Wpp Group Media 16.0 -0.2 0.2 6.8% 0.0% -0.3% Neutral
Gkn Autocomponents 6.3 -0.1 0.9 9.8% 2.8% -1.8% Outperform
Bpb Capital Goods 7.1 -0.1 0.0 9.1% 2.4% 5.6% Outperform
Travis Perkins Retailing 11.1 -0.1 -2.0 7.5% 0.2% -0.5% Neutral
* 3m percentage change in FY 2004 consensus expectations
Source: Company data, I/B/E/S International, CSFB HOLT
However, we still do not believe that this is the right to time buy the mortgage banks:
The price relative of UK mortgage banks against the forward curve suggests that if rates
rise towards 5.5%, banks will continue to underperform.
We are also reminded of the experience of Australia where despite rates peaking,
domestic banks have continued to underperform (perhaps because as growth
expectations peak so does the currency).
Figure 77: UK mortgage banks versus the forward curve Figure 78: Australian banks price relative versus 3mth rates,
3mths’ forward
0.47
0.52
0.57
0.62
0.67
0.72
0.77
Oct-99 Apr-00 Oct-00 Apr-01 Oct-01 Apr-02 Oct-02 Apr-03 Oct-03 Apr-04
Relativeperformance
3.0
3.5
4.0
4.5
5.0
5.5
6.0
6.5
7.0
Shortsterling(invertedaxis)
Mortgage banks outperformas
forward rates fall
Mortgage banks relative performance (LHS)
3-month LIBOR 3-months'forward (RHSinverted)
1.20
1.25
1.30
1.35
1.40
1.45
1.50
Mar-03 Apr-03 Jun-03 Aug-03 Oct-03 Dec-03 Feb-04 Apr-04 Jun-04
Pricerelative
4.5
4.7
4.9
5.1
5.3
5.5
5.7
5.9
6.1
6.3
Forwardrates(invertedaxis)
Australianbankspricerelative ThreemonthT-bill rate, 3mthsforward(RHS, invertedaxis)
Source: I/B/E/S International, CSFB research Source: I/B/E/S International, CSFB research
It is still too soon to buy the
mortgage banks though, in
our view

38
Finally we would highlight a potentially interesting UK-specific anomaly between the
performance and valuation of UK tobacco relative to UK pharmaceuticals.
Figure 79: UK tobacco price relative to UK drugs Figure 80: UK tobacco P/E relative to UK drugs
0.0
5.0
10.0
15.0
20.0
25.0
30.0
35.0
40.0
45.0
50.0
Jul-77
Jul-79
Jul-81
Jul-83
Jul-85
Jul-87
Jul-89
Jul-91
Jul-93
Jul-95
Jul-97
Jul-99
Jul-01
Jul-03
+1 stdv
-1 stdv
Average
0.0%
20.0%
40.0%
60.0%
80.0%
100.0%
120.0%
140.0%
160.0%
Jul-76
Jul-78
Jul-80
Jul-82
Jul-84
Jul-86
Jul-88
Jul-90
Jul-92
Jul-94
Jul-96
Jul-98
Jul-00
Jul-02
Jul-04
Source: Datastream, CSFB research Source: Datastream, CSFB research

39
Japan (maintain 3% overweight versus benchmark):
A riddle within an enigma.
For now we keep our marginal overweight based on macro momentum being very
positive. If macro momentum is maintained at these sorts of levels, then we are likely to
see an exit from deflation and with it strongly negative real interest rates.
(i) Macro and earnings momentum on our measures are better than that of any region.
As Figure 81 shows, while 2004 GDP growth forecast revisions remain fairly flat for the
major regions in the past few months, Japan clearly stands out as having the best
economic momentum. Consensus currently goes for a 4.1% real Japanese GDP growth
in 2004, a whole percentage point above a 3.1% consensus estimate just a month ago
(note that the initial 2004 growth forecast for Japan was a meagre 0.8% one and a half
years ago). A string of better-than-expected economic data, together with positive
comments from the Bank of Japan, provide support to the strong macro momentum.
As shown in Figure 82 below, Japanese earnings momentum relative to the rest the
world appears to have troughed. In absolute terms, Japanese earnings momentum is at
record levels. Japan now ranks first on our regional earnings momentum scorecard (see
weights and measures appendix).
Figure 81: Real GDP consensus forecasts: % point revisions
from initial estimates: Japan leaping ahead
Figure 82: Japanese earnings momentum relative to the rest
of the world has now turned
-0.8
-0.4
0.0
0.4
0.8
1.2
1.6
2.0
2.4
2.8
3.2
Feb-03
Mar-03
Apr-03
May-03
Jun-03
Jul-03
Aug-03
Sep-03
Oct-03
Nov-03
Dec-03
Jan-04
Feb-04
Mar-04
Apr-04
May-04
Jun-04
%pointchgfrom2004initialforecast
US Japan UK Euroarea
-8%
-6%
-4%
-2%
0%
2%
4%
6%
8%
10%
12%
Jul-88
Jul-89
Jul-90
Jul-91
Jul-92
Jul-93
Jul-94
Jul-95
Jul-96
Jul-97
Jul-98
Jul-99
Jul-00
Jul-01
Jul-02
Jul-03
Jul-04
Relative Japanese earnings momentum has turned
-8%
-6%
-4%
-2%
0%
2%
4%
6%
8%
10%
12%
Jul-88
Jul-89
Jul-90
Jul-91
Jul-92
Jul-93
Jul-94
Jul-95
Jul-96
Jul-97
Jul-98
Jul-99
Jul-00
Jul-01
Jul-02
Jul-03
Jul-04
Relative Japanese earnings momentum has turned
Source: Consensus economics, CSFB research Source: I/B/E/S International, Datastream, CSFB research
(ii) If domestic demand remains at current growth rates, then within a year we are
probably close to the end of deflation. With domestic nominal GDP growth up 2% year
on year without ‘pump-priming’, we have clear signs that domestic Japan is emerging
from deflation. Most surprisingly, employment growth is now positive (and has been for
seven years) and most of this increase is driven by ‘domestic’ factors—female, mid-cap
and service-related components.
If domestic nominal GDP were to remain at current levels for another year, the output
gap would get to levels that would be close to generating positive inflation.
We stick to a slight
overweight of Japan
Macro momentum and
relative earnings
momentum are supportive
At current growth rates, we
could see an end to
deflation next year

40
Figure 83: Output gap (official BOJ method) and CPI inflation Figure 84: Tankan Survey-based “Quasi Output Gap”
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05
-12
-10
-8
-6
-4
-2
0
዁, YoY
CPI, LHS
዁
Output Gap, RHS
level associated with past points of
accelerating inflation
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05
-12
-10
-8
-6
-4
-2
0
዁, YoY
CPI, LHS
዁
Output Gap, RHS
level associated with past points of
accelerating inflation
-2
-1
0
1
2
3
4
Jun-91 Jun-92 Jun-93 Jun-94 Jun-95 Jun-96 Jun-97 Jun-98 Jun-99 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04
-40
-30
-20
-10
0
10
20
30
40
CPI (adjustedfor consumptiontax rises), YoY%, LHS
BOJ's quasi output gap, RHS
ptsYoY%
Source: Bank of Japan, CSFB research Source: Bank of Japan, CSFB research
After all, capacity utilisation (owing to a 12% fall in capacity since 2000) is close to pre-
bubble peaks.
If we were to get inflation, then we believe there would be a strong case for buying
domestic Japan. This is because negative real rates would be a boom for property,
which has an impact on much of the index (as well as railways, banks and retailing).
Figure 85: Domestic Japan tends to do well when real rates fall
0.02
0.04
0.06
0.08
0.10
0.12
0.14
0.16
0.18
0.20
0.22
Jan-99 Jul-99 Jan-00 Jul-00 Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04
Japanrealestatepricerelativetolocalmarke
-0.50
0.00
0.50
1.00
1.50
2.00
2.50
Japaneserealinterestrates(inverted),%
Japanreal estate pricerelativeto local market (LHS)
Japan real interest rates (2-yr gov bond yield- CPI, %), inverted (RHS)
An end to deflation would
present a strong case for
buying domestic Japan

41
And negative real rates would surely lead to some switching of household liquid assets
into other forms of asset classes.
Figure 86: Financial assets held by households
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
US
Japan
Percentage of total financial assets
Cash & deposits
(55.9%)
Bonds
(9.7%)
Investment
trusts
(12.5%)
Shares (32.4%)
Insurance & pension
reserves (28%)
Others
(3.9%)
Insurance & pension
reserves (30%)
Cash &
deposits
(12.4%)
Shares
(7.4%)
Investment
trusts (2.3%)
Bonds
(2.5%)
Others
(3.0%)
Total: ¥1,410 trillion
Total: $34.3 trillion
Source: Bank of Japan, CSFB research
(iii) On HOLT Japanese valuations look reasonable: If we assume that Japanese
CFROI
®
returns to close to global norms after ten years, and there is 0% real asset
growth, then Japan is neutrally valued (see our HOLT AggreGator scorecard for regions
in the weights and measures appendix). If we were to assume that Japan were able to
grow its real asset growth at 1% pa, then Japan would be 11% cheap.
(iv) Japan can be very late cycle: Sometimes Japan can be very late cycle peaking as
late as eight months after the peak in relative lead indicators (see Figure 88 below).
Figure 87: Japanese equities relative performance versus the
OECD lead indicators
Figure 88: Japanese equities tend to peak (relatively) on
average five months after the peak in global lead indicators
-12.5
-8.5
-4.5
-0.5
3.5
7.5
11.5
15.5
Dec-88 Oct-90 Jul-92 Apr-94 Feb-96 Nov-97 Aug-99 Jun-01 Mar-03
OECDleadindicator
-30
-25
-20
-15
-10
-5
0
5
10
15
20
25
Pricerelative
Japanequitypricerelative
OECDLeadingindicator, 3mth/3mth(LHS) Peak in OECD lead
indicator
Peak in Japan equity
price relative
Number of months gap
Jun-91 Nov-91 6
Apr-92 Oct-92 7
Mar-93 Jun-93 3
Mar-94 Jul-94 4
May-96 May-96 0
Mar-99 Oct-99 8
May-01 Aug-01 3
Mar-02 Aug-02 6
5Average
Source: OECD, Datastream, CSFB research Source: OECD, Datastream, CSFB research
Valuations look reasonable
on HOLT
Japan can be late-cycle

42
(v) Japan is a hedge on rising US forward rates
Japan acts as a ‘hedge’ when US rate expectations are rising. Figure 89 shows that in
absolute terms, the Nikkei tends to rise when US forward rates rise.
Figure 89: The Nikkei index versus US 3mth rates, 12-months’ forward
0.0
1.0
2.0
3.0
4.0
5.0
6.0
7.0
8.0
9.0
10.0
Jan-91 Dec-92 Nov-94 Oct-96 Sep-98 Aug-00 Jul-02 Jun-04
0
5000
10000
15000
20000
25000
30000
3m rate expectations (12mf) Nikkei
Source: Bloomberg
We have heard the positive story, so why are we de facto hugging the benchmark?
(i) Japan has been the foreign euphoria trade: We find there are no strong signs of
domestic buying and find ourselves reluctant to follow a consensus trade.
We also believe that an overweight position of foreign investors (Figure 91) probably
means that Japan’s resilience to global headwinds will be less than normal.
. . . and is a hedge on
rising US rates

43
Figure 90: Japanese institutional and individuals net-
purchases of Japanese equities
Figure 91: US EAFE investor weightings in Japanese
equities relative to benchmark (%)
-400
-300
-200
-100
0
100
200
300
Jan-03 Mar-03 May-03 Jul-03 Sep-03 Nov-03 Jan-04 Mar-04 May-04
Yenbillions
-400
-300
-200
-100
0
100
200
300
Yenbillions
Net-purchases of Trust banks Net-purchases of individuals
-35
-30
-25
-20
-15
-10
-5
0
5
Q196 Q496 Q397 Q298 Q199 Q499 Q300 Q201 Q102 Q402 Q303
%deviaitonfrombenchmark
-35
-30
-25
-20
-15
-10
-5
0
5
%deviationfrombenchmark
Average
Source: Tokyo Stock Exchange, Bloomberg, CSFB research Source: OECD, Datastream, CSFB research
(ii) The risk is that Japan remains in deflation. CPI is still negative (0.5% yoy), land
prices are still falling and the consumption deflator remains negative (-2.6% yoy).
Figure 92: Deflation in Japan is probably running at about
1% yoy
Figure 93: Tokyo region condominiums—price per sq metre
yoy (3mma)
-3.0
-2.0
-1.0
0.0
1.0
2.0
3.0
4.0
Jan-93 Jun-94 Oct-95 Mar-97 Jul-98 Dec-99 Apr-01 Sep-02 Jan-04 May-05
yoy%
-3.0
-2.0
-1.0
0.0
1.0
2.0
3.0
4.0
yoy%
Consumptiondeflator CPI
-30%
-20%
-10%
0%
10%
20%
30%
40%
Jan-81 Jan-83 Jan-85 Jan-87 Jan-89 Jan-91 Jan-93 Jan-95 Jan-97 Jan-99 Jan-01 Jan-03
-30%
-20%
-10%
0%
10%
20%
30%
40%
Source: Cabinet Office, Datastream, CSFB research Source: Cabinet Office, Japan Real Estate Institute, CSFB research
(iii) We have yet to see the impact of a Chinese slowdown: We are worried that we
have yet to see the impact of the Chinese slowdown on Japanese GDP (recalling that
China probably ended up adding nearly 1% to GDP in 2003).
(iv) The valuation case remains ambiguous: When we look at Japanese cross-border
valuations at a sector level on a number of metrics, we find that the valuation case for
Japan less clear cut. On free cash flow yield, only 4 out of 23 sectors have a higher free
cash flow yield than both their US and European peers (see Figure 94). If anything, free
. . . we have yet to see the
impact of the slowdown in
China
Other valuation metrics are
more ambiguous

44
cash flow overstates the attractiveness of Japan as the capital spending to sales ratio is
abnormally low. Normalising capital spending would push the free cash flow yield down
to 4.1%. On the positive side, there is the issue of write-offs/exceptionals depressing
cash earnings.
Figure 94: Japanese sectors above the dotted line have a free cash flow yield above both
their US and European peers
-------------------------- Free cash flow yield -----------------------
Japan US Europe Japan rel US Japan rel Europe
Utilities 13.6 1.8 6.1 11.8 7.6
Hotels & Leisure 6.0 2.6 4.4 3.4 1.6
Beverages 6.5 4.3 6.4 2.2 0.1
Food Retailing 3.2 1.7 2.0 1.5 1.2
Energy 6.4 5.0 6.7 1.4 -0.3
Commercial Services 4.7 4.1 5.6 0.7 -0.9
Pharmaceuticals 4.9 4.4 5.6 0.5 -0.7
Semiconductors 6.0 5.8 7.4 0.3 -1.3
Telecommunication 8.5 8.4 11.0 0.1 -2.5
Household Products 4.4 4.4 4.7 -0.1 -0.3
Transportation 2.4 2.6 4.4 -0.2 -2.0
Capital Goods 5.1 5.3 5.7 -0.2 -0.6
Technology Hardware 4.0 4.3 7.0 -0.3 -3.0
Materials 6.2 7.0 7.4 -0.7 -1.1
Health Care Equipment 3.6 4.4 4.1 -0.9 -0.6
Food Products 4.3 5.7 6.7 -1.3 -2.4
Retailing 1.7 3.3 5.2 -1.6 -3.5
Tobacco 7.2 9.2 8.5 -2.0 -1.2
Media 1.4 4.4 5.7 -3.1 -4.3
Automobiles & Comps 3.1 6.9 5.4 -3.8 -2.3
Software & Services -0.5 4.7 4.1 -5.2 -4.6
Consumer Durables 3.1 8.4 8.0 -5.2 -4.9
Market 5.1 4.7 6.5 0.4 -1.4
Source: CSFB HOLT
However, there are plenty of reasons why Japan ought to have clearly cheap valuations:
• Poor demographics lead to poor growth since in the long run the rate of growth of
GDP is simply the rate of growth of the labour force and rate of growth of productivity.
• A business investment share of GDP that is 50% higher than that of the US (despite
having an inferior capital-to-output ratio) probably means that the investment is less
productive and thus a ‘normal’ return on capital is harder to achieve.
• Finally, there is the issue of debt. According to the OECD, net debt to GDP is 86%
(2004) and gross debt is 161%. Debt is a tax on future growth either literally or via
currency weakness (that is, printing their way out of a debt trap).
We find that if Japan were to optimally re-leverage balance sheets, then earnings would
only be 10% higher.
(v) The domestic sectors have already outperformed sharply. We would also warn that
the domestic sectors (real estate) are already up sharply in relative terms.
There are good reasons
why Japan is cheap . . .
. . . and domestic sectors
have already outperformed
sharply

45
Figure 95: Japanese real estate sector price performance
relative to local market
Figure 96: Japanese financials price performance relative to
local market
100
105
110
115
120
125
130
135
140
145
150
Apr-03 Jun-03 Aug-03 Oct-03 Dec-03 Feb-04 Apr-04 Jun-04
Japanrealestatesectorrelativetomarket
90
110
130
150
170
190
210
Apr-03 Jun-03 Aug-03 Oct-03 Dec-03 Feb-04 Apr-04 Jun-04
Japanbankspriceperformancerelativetomarket
Source: MSCI, Datastream, CSFB research Source: MSCI, Datastream, CSFB research
Our bias is still towards the cheap exporters. Long term and according to our FX
strategy team (headed by Joe Prendergast) in the near term, the yen is likely to weaken
(our three-month and 12-month Y/$ targets are 115 and 117, respectively). Although
this sector is over-owned by foreign investors, some stocks do look demonstrably
cheap.
(vi) The political situation is now looking perhaps a little questionable. With a relatively
poor performance from the LDP in the Upper House election, it may be the case that
PM Koizumi’s reformist zeal will be dented by old guard factions. The test case is
whether Tanaka is put in charge of the privatisation of the Post Office.
In Figure 97 we highlight in bold those Japanese exporters that trade on an implied
growth rate discount to their peers and have a free cash flow yield above 4%.

46
Figure 97: Japanese exporters (Stocks with over 30% of sales from abroad)
------ Implied growth rate -----
Name TickerSector % of sales from
abroad
Absolute relative FCF yield
(%)
% of foreign
investors
CSFB rating
Nintendo Co. 7974Consumer Durables 75.0 12.7 137% 4.5% 30.9 Underperform
Pioneer Corp 6773Consumer Durables 63.1 8.5 91% 1.6% 31.5 N/r
Sony Corp 6758Consumer Durables 61.7 9.6 103% 1.0% 39.6 N/r
Minebea Co 6479Capital Goods 58.9 10.5 111% 5.6% 35.3 Neutral
Kyocera Corp 6971Technology Hardware 49.3 13.1 107% 5.5% 29.1 Outperform
Honda Motor Co 7267Automobiles 47.2 3.9 74% 7.1% 22.3 Outperform
Canon Inc 7751Technology Hardware 44.1 10.2 84% 5.7% 43.9 Outperform
Fuji Photo Film Co 4901Consumer Durables 42.5 8.2 89% 3.4% 37.3 Outperform
Amada Co 6113Capital Goods 41.8 13.8 147% n/a 17 Neutral
Konica Corporation 4902Consumer Durables 40.7 9.4 101% 5.8% 18.9 Outperform
Nissan Motor Co 7201Automobiles 40.1 2.8 52% -1.4% 31.2 Outperform
Yamanouchi Pharm 4503Pharmaceuticals 36.2 7.0 97% 5.3% 42.7 Neutral
Fujisawa Pharma 4511Pharmaceuticals 36.2 7.7 106% 5.4% 19.7 Neutral
Terumo Corp 4543Health Care Equipment 32.1 4.2 148% 4.8% 22 N/r
Kao Corp 4452Household & Personal 31.9 9.1 93% 6.0% 31.8 Neutral
Takeda
Pharmaceuticals
4502Pharmaceuticals 30.0 5.5 76% 6.2% 29.9 Outperform
Source: Worldscope, I/B/E/S estimates, CSFB research
We also stress that Japanese companies that have an implied CFROI
®
below their
historical average CFROI
®
(that is, they do not need a strong fade up to be at fair
value).
Of these, Sony, Kyocera, Canon, Amada, Nissan, Fujisawa Pharmaceuticals and
Takeda Pharmaceuticals have positive earnings momentum.
On the domestic side, we find that the best story is in the homebuilders. (There is a 30-
year replacement cycle, improving household formation and of course they are a hedge
in case there is inflation and hence negative real rates), railways (cheap, play on both
economic recovery and an improvement in real estate prices) and drugs (very cheap—
look at Takeda Pharmaceuticals).
Below we show our Japanese strategist’s model portfolio.

47
Figure 98: CSFB Japan strategy model portfolio
Name Ticker Sector Market cap (¥bn)
Oji Paper Co Ltd 3861 Materials 775.9
Shiseido Co Ltd 4911 Materials 576.1
Kirin Brewery Co Ltd 2503 Food 1,064.3
Ajinomoto Co Inc 2802 Food 854.7
Japan Tobacco Inc 2914 Food 1,696.0
Yamanouchi Pharmaceutical 4503 Pharmaceutical 1,314.8
Shionogi & Co Ltd 4507 Pharmaceutical 664.7
Ebara Corp 6361 Machinery 153.1
Omron Corp 6645 Machinery 607.9
Hitachi Ltd 6501 Tech equipment 2,452.0
Tdk Corp 6762 Tech equipment 1,069.5
Sharp Corp 6753 Tech equipment 1,882.6
Toyota Motor Corp 7203 Transport equipment 15,667.4
Dai Nippon Printing Co Ltd 7912 Other manufacturing 1,272.9
Shimizu Corp 1803 Construction & real estate 376.1
Sekisui House Ltd 1928 Construction & real estate 837.8
Hankyu Department Stores Inc 8242 Retail 170.2
Uny Co Ltd 8270 Retail 250.8
Yamada Denki Co Ltd 9831 Retail 334.1
East Japan Railway Co 9020 Transport and warehousing 2,416.0
Yamato Transport Co Ltd 9064 Transport and warehousing 841.3
Kamigumi Co Ltd 9364 Transport and warehousing 212.6
Nippon Telegraph & Telephone 9432 Communications 9,066.9
Trend Micro Inc 4704 Services 614.2
Sumisho Computer Systems 9719 Services 138.6
Konami Corp 9766 Services 348.9
Tokyo Electric Power Co Inc 9501 Electricity & gas 3,355.1
Mitsubishi Tokyo Financial 8306 Banks 6,171.7
Millea Holdings Inc 8766 Insurance 2,841.4
Orix Corp 8591 Other financials 1,010.7
Source: Company data, CSFB research

48
Global emerging markets (we stick to benchmark)
We fully buy into all the structural arguments for GEM; not least that P/E relatives are
much lower than during past periods of crisis and that, particularly in non-Japan Asia,
countries are now net creditors to international capital markets.
Figure 99: GEM 12-month forward P/E multiple Figure 100: NJ Asian current account balance % of GDP
0
5
10
15
20
25
Jan-90 Jul-91 Jan-93 Jul-94 Jan-96 Jul-97 Jan-99 Jul-00 Jan-02 Jul-03
Multiple
0
5
10
15
20
25
Multiple
Mexican peso crisis
Asia crisis
Russia crisis
0
5
10
15
20
25
30
35
India China Philippines South
Korea
Indonesia Thailand Taiwan Maylasia Hong Kong Singapore
%ofGDP
0
5
10
15
20
25
30
35
%ofGDP
Source: I/B/E/S International, CSFB research Source: Datastream, CSFB research
The problem is that we have had to face five negatives during the second quarter: a
stronger dollar, rising US rate expectations, increasing fears of a slowdown in China,
peaking of global lead indicators and higher oil prices.
To re-establish the structural story, we really need to see visibility on three of these five
issues. While oil and the dollar look like they have peaked (the former being particularly
important for Asia’s performance against Japan, see Figure 101 below).
Figure 101: Non-Japan equities relative to Japanese equities versus crude oil prices
15
20
25
30
35
40
45
Dec-99 Jun-00 Dec-00 Jun-01 Dec-01 Jun-02 Dec-02 Jun-03 Dec-03 Jun-04
WTI(US$/bbl)
-30
-20
-10
0
10
20
30
40
50
60
Pricerelative(yoy%,INVERTEDAXIS)
WTI crude oil price (LHS) Non-Japan Asian relative to Japanese equities (RHS, inverted axis)
We remain benchmark of
GEM
Two of five headwinds
against GEM are receding
(the dollar and oil prices) . . .

49
We believe it is too early to envisage a peak in ‘concerns’ over the other three factors in
our view.
(i) China has had a temporary cessation of ‘choke therapy’, but industrial
production and electricity consumption growth still need to slow to below
10% year on year.
(ii) The forward curve in the US is not discounting a neutral level of interest
rates (circa 4%) until early 2006.
(iii) Lead indicators are most likely to slow down further from here. This is a
worry since historically as year-on-year lead indicators fall so too does the
GEM relative performance (see Figure 102).
Figure 102: GEM equities price relative (yoy %) versus OECD leading indicators
-60
-40
-20
0
20
40
60
80
Jul-91 Sep-92 Oct-93 Nov-94 Dec-95 Jan-97 Feb-98 Mar-99 May-00 Jun-01 Jul-02 Aug-03 Sep-04
GEMequitypricerelative,yoy%
-6.0
-4.0
-2.0
0.0
2.0
4.0
6.0
8.0
OECDG7leadindicator,yoy%
Emerging market relative to developed equities, yoy% OECD G7 leading indicators yoy% - RHS
Source: OECD, Datastream, CSFB research
On the last four occasions year-on-year G7 lead indicators fell, GEM equities
underperformed developed markets by an average of 30% from their peak point. Since
the peak in GEM equities in April, GEM have underperformed by 11.3% relative to the
developed markets (see Figure 103).
Figure 103: GEM equities relative to developed markets corrections following the rollover in OECD G7 lead indicators
Peak in G7 OECD lead
indicators (yoy,%)
Peak in GEM price performance relative to
developed equities
Trough in GEM price performance relative to
developed equities
Correction in GEM relative performance since
its peak
Jul-94 Oct-94 Mar-95 -28.7%
Jan-97 Apr-97 Sep-98 -61.6%
Oct-99 Feb-00 Dec-00 -30.6%
May-02 Jul-02 Oct-02 -13.9%
Mar-04 Apr-04 current date -11.3%
Median -29.7%
Source: OECD, MSCI, Datastream, CSFB research
. . . but we are still
concerned on US interest
rates, China and the
rollover of lead indicators

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