This document summarizes the key findings from an analysis of past deleveraging cycles in the US economy in the mid-1970s and early 1990s. Some of the main points include: - Past deleveraging cycles were actually good periods for stock market performance and saw leadership from consumer discretionary and technology stocks. - Deleveraging is a lagging phenomenon that typically occurs late in an economic slowdown. - Housing activity, as measured by building permits, tended to bottom out early in past deleveraging cycles and then rise steadily through the cycle. - Inflation tended to decline during deleveraging periods, suggesting disinflation may lie ahead. - Mon

1. Fri
Sep 26
2008
ISI INTERNATIONAL STRATEGY & INVESTMENT
Portfolio Strategy Report
François Trahan 212 446 5634 ftrahan@isigrp.com
Kevin Cheng 212 446 5630 kcheng@isigrp.com
Brian J. Herlihy 212 446 9421 bherlihy@isigrp.com
Michael J. Kantrowitz, CFA 212 446 5632 mkantrowitz@isigrp.com
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Deconstructing The Deleveraging Cycle
Fear of the “D” word is the one commonality we currently see amongst investors. For some, it is
fear of a Depression, for others it is of Deflation. We have discussed the market implications of
both scenarios in recent months, today we tackle the third “D” word: Deleveraging. Unlike the first
two, we believe this one is legitimate. In fact, we cannot see a scenario by which deleveraging
does not happen. That said, there are a lot of foregone conclusions floating out there about what it
means for the economy and the markets. In this piece, we review the last two periods of
deleveraging (mid-70s and early-90s) to see what we might expect from markets.
Economic Deleveraging Is Likely Ahead, But Should We Fear It?!
Since the 1970s,
we have only seen
two major
episodes of
deleveraging …
0.8
0.9
1.0
1.1
1.2
1.3
1.4
1.5
1.6
1.7
1.8
1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 2012
30
40
50
60
70
80
90
100
110
120
Deleveraging Period U.S. Private Debt % GDP (L) Leading Economic Index (Adv 24m, YoY % Chg, R)
… this typically occurs well
into an economic slowdown.
?
There is little doubt in our
minds that we are entering a
deleveraging cycle ...
… leading
indicators
suggest a third
one is upon us.
Source: ISI Portfolio Strategy.
The first thing that may come as a surprise for investors is that the last two periods of deleveraging
were actually quite good for stocks. We believe this is partly explained by the fact that inflation
decelerated in both episodes. Even more surprising, or counter-intuitive, is that the best
performing sectors were Consumer Discretionary and Technology. In essence, deleveraging is a
late-cycle phenomenon, or worded differently a lagging indicator.
Looking ahead, we expect that this deleveraging period could last for some time given today’s
historically high level of debt-to-GDP. If the authorities can come up with a plan that allows the
banking system to recover then we would expect financial markets to behave more or less as they
have in the past episodes of deleveraging. Hopefully, the following pages will help demystify what
deleveraging means for the markets.

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Market and Economic Implications of Deleveraging
Thus far, 2008 has been a year filled with “D” words. The credit crisis has caused fear to loom
over the markets as “D” words ranging from Deleverage to Depression have created investor
anxiety. In recent months, fears of inflation have transitioned into hopes for Disinflation with some
even raising the specter of Deflation. We think the largest-ever policy response from the Fed is
likely to minimize the likelihood of the two most worrisome “D” words – Depression and Deflation.
However we believe that Disinflation and Deleveraging are two trends that lie ahead of us. As the
cover chart illustrates, economic deleveraging in not something new, it is a normal symptom of our
economic cycle. In every decade since the 70s we have seen periods of deleveraging, albeit some
longer than others. In the following pages we deconstruct two of the longer periods of economic
deleveraging in the past 30 years, the mid 1970s and the early 1990s, and discuss the potential
implications for markets and the economy from the likely upcoming deleveraging cycle.
Macroeconomic & Market Trends To Expect During A Deleveraging Cycle
In the past couple of days, investors have been glued to the television watching Bernanke and
Paulson plead their case while they are probed by politicians asking questions regarding the
solution for the current financial and economic disarray. To be sure, the outcome of a future
deleveraging cycle will also depend on the resolution of the bailout in question. Our studies of
financial market history, specifically of past booms and bust cycle, showed that busts met with an
aggressive policy response are more likely to avoid a “Minskey Moment” (a downward spiral of
asset/debt deflation). On the contrary, students of the Austrian school of Economics would argue
that ineffective central bank policies are partly to blame for past boom and bust cycles. Putting the
Keynesian vs. Austrian economics debate aside, we believe that the Fed’s proactive policy
response will help the U.S. economy avoid a debt deflation spiral and more likely allow for a more
‘normal’ deleveraging process in the years to come.
The chart on the cover suggests that debt as a percent of GDP should likely slow for at least the
next two years. Seeing that this deleveraging process is inherently lagging, we would caution
investors from becoming overly bearish going forward for this reason alone. In fact, the last two
major periods of deleveraging were actually very good periods for equities and the economy. In
some respects, this process of economic normalization is a natural part of the economy cycle.
The table above summarizes the 1970s and 1990s periods of deleveraging. On balance, these
were periods where inflation was declining and economic prospects, particularly in the housing
sector, improved. On the policy front, deleveraging periods typically saw an accommodative Fed.
For stocks, market returns were above average and sector leadership came from Discretionary
and Technology. Ironically, the evidence suggests that deleveraging, and in many ways credit, is a
lagging phenomenon, as these periods were actually some of the best for equity investors.

3. 3
9/26 ISI Group
During previous deleveraging cycles, one of the primary beneficiaries was the homebuilding
industry. As the chart below demonstrates, building permits bottomed near the start of both
deleveraging cycles in the early 70’s and mid 90’s and steadily rose thorough out the entire
deleveraging process. Currently, building permits sit at their lowest levels in 18-years. In the third
quarter, homebuilding stocks have performed particularly well on a relative basis. Interestingly,
both periods of deleveraging saw homebuilders outperform the market.
One Of The Primary Beneficiaries During Deleveraging Cycles: Homebuilding
200
700
1200
1700
2200
2700
1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009
80
90
100
110
120
130
140
150
160
170
180
Building permits (000s, L) Private Debt (As a % of GDP, R)
near term bottoms in
building permits
?
?
Counter-
intuitively, the
housing sector
has typically
benefitted from
past deleveraging
cycles.
Source: ISI Portfolio Strategy.
Another important economic factor that is typically influenced during deleveraging cycles is inflation.
As the chart below illustrates, inflation typically trends lower during deleveraging cycles. Notably
during both these cycles, core PCE declined by an average of 2.3%, suggesting that disinflation
may be on the short-term horizon. Moreover, headline CPI also fell by an average of 4.7% ppts
during both these deleveraging periods – lending further evidence for Ed and Nancy’s inflation
estimate of 1% by the second half of 2009.
Inflation Transitions Towards Disinflation During Deleveraging Cycles
0.5
1.5
2.5
3.5
4.5
5.5
6.5
7.5
8.5
9.5
10.5
1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010
80
90
100
110
120
130
140
150
160
170
180
Core PCE Price Index (YoY % Chg, L) Private Debt (As a % of GDP, R)
Inflation measures typically decline
during deleveraging cycles
?
?
Inflation tends to
ebb in
deleveraging
cycles.
Source: ISI Portfolio Strategy.

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From a historical perspective, the beginning of deleveraging cycles has typically signaled shifts in
monetary policy. As the chart below shows, the Fed had previously adopted a more
accommodative monetary policy during past deleveraging cycles. During the ‘74 deleveraging
cycle, the Fed cut the overnight target rate by 450bps, while the early 90’s deleveraging cycle saw
rate cuts of 275bps. Not surprisingly, the end of a deleveraging cycle is typically marked by
monetary policy as well, as the Fed typically hikes rates.
Policy Is Typically Accommodative During These Deleveraging Cycles
The Fed has
typically eased
during prior
deleveraging
cycles …
0.0
5.0
10.0
15.0
20.0
25.0
1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
80
90
100
110
120
130
140
150
160
170
180
Fed Funds Target Rate (%) Private Debt (As a % of GDP, R)
Another rate cut
in the cards?
?
?
… this cycle has
followed the same
path so far.
Source: ISI Portfolio Strategy.
As we’ve previously written, one of the best indicators of future economic performance has been the
yield curve. What typically happens during deleveraging cycles is that the Fed begins to cut rates to
stimulate lending and economic prospects causing the yield curve to steepen notably. As the table
below illustrates, the yield curve has historically steepened during periods of deleveraging and so far
the current deleveraging cycle has traced a similar path. Since March 2008 (the estimated start of
the current cycle), the yield curve has steepened by 65bps. At the margin, should the current
deleveraging cycle play out like prior ones, this would imply that the Fed has more rate cuts in the
pipeline ahead – consequently strengthening Tom Gallagher’s forecast for further rate cuts by the
end of 2008.
The Yield Curve Typically Steepens During Deleveraging Cycles
Yield Curve Shifts During Deleveraging Cycles
Start End
Change in Slope of
the Yield Curve
Deleveraging Cycle: Sept '74 - Mar '76 -1.31 2.91 + 4.22
Deleveraging Cycle: Dec '90 - Jun '94 1.06 3.07 + 2.01
Yield curve
typically steepens
during
deleveraging
cycles.
Source: ISI Portfolio Strategy.

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Despite all the bearish sentiment in the market regarding the deleveraging process, stocks have
generally rallied during past cycles. As illustrated in the diagram below, during the 1974
deleveraging cycle, the S&P 500 rose 48% (or 37% CAGR), while during the deleveraging cycle of
the early 90’s, the S&P 500 gained 38% (or 14% CAGR). At the margin, this suggests that equity
markets can, and have rallied in past while the credit markets were still contracting. It was also
interesting to note that each deleveraging cycle had been preceded by a market correction.
The Market Has Proven Resilient In Past Deleveraging Cycles
The past two
deleveraging
periods were
preceded by
market
corrections …
1.5
1.7
1.9
2.1
2.3
2.5
2.7
2.9
3.1
3.3
1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010
80
90
100
110
120
130
140
150
160
170
180
S&P 500 (L) Private Debt (As a % of GDP, R)
Past periods of economic
deleveraging have been good for
equity investors.
?
… and both
periods also
coincided with the
beginning of bull
markets.
Source: ISI Portfolio Strategy.
One of the notable implications of the deleveraging cycle on financial markets can be summed up
into the cliché “size matters”. As the diagram below illustrates, small caps have typically
outperformed their large cap counterparts during past deleveraging cycles. For example, during the
1974 deleveraging cycle, small caps outperformed large caps by 24%. In addition, small caps
outperformed by 34% during the relative longer deleveraging cycle of the early 90’s.
Size Matters: Small Caps Tend To Outperform During Deleveraging
0.50
1.50
2.50
3.50
4.50
5.50
6.50
1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011
85
95
105
115
125
135
145
155
165
175
185
Small to Large Cap Relative Performance Private Debt (As a % of GDP, R)
Small Caps Typically Surge
During Deleveraging
?
During
deleveraging
cycles, small caps
usually
outperform their
large cap
counterparts.
Source: ISI Portfolio Strategy.

6. 6
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Don’t Be Defensive About Deleveraging
Drilling down further, we analyzed what impact the deleveraging cycle had on various sector
performances. As the table below illustrates, past deleveraging cycles had typically favored early-
cyclicals sectors (i.e. Discretionary, Technology and Industrials). In contrast, we found that
defensive sectors such as Utilities, Health Care and Telecom Services, generally underperformed
during that part of the cycle. In fact, Discretionary and Technology were the only two sectors to
outperform in both periods while Healthcare, Energy, Utilities and Telecom all underperformed in
both episodes. Hence the title of this section, don’t be defensive about deleveraging!
Annualized Sector Performance During Past Deleveraging Periods
In the chart below, we illustrate one of the primary defensive sectors, the Healthcare sector. The
chart demonstrates that Healthcare sector underperforms during the first deleveraging cycle of 74
by 14ppts. Indeed, this underperformance is also present during the 94 cycle, with Healthcare
underperforming on a relative basis by 4ppts. Coincidentally, the Utility sector also demonstrated
considerable underperformance during these two periods, with relative underperformance of 13 ppts
in the ’74 cycle and 10 ppts in the early 90’s.
Healthcare & Defensive Sectors Have Typically Underperformed In These Cycles
90
92
94
96
98
100
102
104
1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984
0.16
0.18
0.20
0.22
0.24
0.26
0.28
0.30
0.32
Private Debt (As a % of GDP, L) Health Care Relative Sector Performance (R)
Healthcare stocks
underperformed in both
periods of deleveraging!
Healthcare tends
to underperform
in deleveraging
cycles as leading
indicators grind
higher.
Source: ISI Portfolio Strategy.

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In contrast to the defensive sectors, early-cyclical stocks typically performed well during periods of
deleveraging. One of the early cyclical segments that faired the best was Discretionary. As the chart
below demonstrates, the Discretionary sector managed to outperform the index by 4.2 ppts during
the previous deleveraging cycle. Through our lens, we expect this trend in outperformance to be
maintained during this deleveraging cycle as economic prospects rebound.
Discretionary Was Among The Top Performers In The Last Two Cycles
80
90
100
110
120
130
140
150
160
170
180
1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011
55
65
75
85
95
105
115
125
135
Private Debt (As a % of GDP, L) Consumer Discretionary Relative Sector Performance (R)
Discretionary stocks were the
strongest performers in past
deleveraging periods.
?
?
The Discretionary
was one of the
top relative
performers during
the last
deleveraging
cycle.
Source: ISI Portfolio Strategy.
As we’ve previously written, the flipside to Discretionary outperformance has been Energy
underperformance and this thematic trade remained largely intact during the prior two deleveraging
cycles. As the chart below illustrates, the Energy sector underperformed by about 13 ppts during the
early 1990 deleveraging cycle and also underperformed by 10 ppts during the cycle of 1974. In our
view, given the current needs of the energy sector (i.e., high capital intensive costs and therefore
high demand for debt) the existing deleveraging cycle should likely have a significant impact on the
sector’s funding needs and ultimately their return on equity / profitability metrics.
Energy Lagged During Both Prior Deleveraging Cycles
Energy
outperformed
ahead of the last
deleveraging
cycle.
90
100
110
120
130
140
150
160
170
180
1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011
20
40
60
80
100
120
140
160
180
Private Debt (As a % of GDP, L) Energy Relative Sector Performance (R)
Energy stocks
underperformed in both
deleveraging episodes. ?
Source: ISI Portfolio Strategy.

8. 8
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Portfolio Factor Positioning For a Deleveraging Environment
Now that we have some understanding of how past periods of deleveraging have panned out for
market indices and sectors, we thought we should dive a little deeper into some of the quantitative
factors that outperformed during these periods. As we have shown, periods of deleveraging have
typically coincided with periods of economic normalization and above-average equity market
returns. Accordingly, the factors that have typically outperformed are also those that usually coincide
with improving economic prospects. On balance, stocks that are smaller in size, cheaper in
valuation and more domestically focused were the strongest. Below we list a handful of factors and
the corresponding speculative/defensive end of the spectrum that outperformed.
Factors That Have Outperformed In Past Deleveraging Periods
Interestingly, in the past few months we have seen some of these same factor performance trends
emerge in concert with the ascension of ‘deleveraging’ speak. Ironically, in a lower debt-to-GDP
environment, those firms with greater amounts of leverage were the ones to outperform their
conservative low-levered counterparts. The chart below illustrates the relative performance of
Higher vs. Lower ROE stocks in the S&P 500 during the last deleveraging period. The relative
performance trends tracked the ratio of leverage-to-GDP rather closely. If you believe we are
entering into a deleveraging period, this chart suggests that a portfolio stocked with high ROE firms
would be inconsistent the past performance trends.
S&P 500 Factor Chart: Higher vs. Lower ROE
1.10
1.12
1.14
1.16
1.18
1.20
1.22
1.24
1.26
1.28
1.30
1990 1991 1992 1993 1994 1995 1996 1997 1998
0.70
0.75
0.80
0.85
0.90
0.95
1.00
1.05
Private Debt % GDP (L) S&P 500 Relative Performance of ROE: High vs Low (R)
Lower ROE equities
outperformed during the
1990 deleveraging cycle
The past cycle of
deleveraging
suggest a bias for
lower ROE stocks.
Source: ISI Portfolio Strategy.

9. 9
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Stocks With Factor Profiles Consistent With
Outperformance During Past Deleveraging Periods
The following screen lists the top five stocks in each sector that possess the factor characteristics of
stocks that have historically outperformed during past periods of deleveraging. Although the data
show that a preference for Consumer Discretionary and Technology share is suggested, we
understand that many investors may be unable to take measureable sector positions. Therefore, we
provide the list below to help investors on an intra-sector basis. Email strategy@isigrp.com and your
ISI salesperson for a more complete list, or the entire S&P 500 ranked by these factors.
Company Foreign Market Debt / Earnings Div LT Price
Symbol Company Name Industry Exposure Cap Equity Yield ROE BETA Div Yld Growth 9/24/08
Consumer Discretionary
JNY Jones Apparel Group Inc. Apparel Accessories & Luxury Goods 8.5 1,529 39 6 3 2 3 10 18.33
LEN Lennar Corp. (Cl A) Homebuilding 0.0 2,373 75 -68 2 5 9 14.77
AN AutoNation Inc. Automotive Retail 0.0 2,244 42 11 6 2 0 9 12.70
KBH KB Home Homebuilding 1,575 170 -68 2 5 9 20.32
MDP Meredith Corp. Publishing 0.0 1,272 52 11 17 1 3 27.98
Consumer Staples
SVU SUPERVALU Inc. Food Retail 0.0 4,825 138 13 10 2 3 8 22.76
CCE Coca-Cola Enterprises Inc. Soft Drinks 29.8 8,191 285 8 1 2 6 16.79
SLE Sara Lee Corp. Packaged Foods & Meats 46.2 9,147 83 8 1 3 7 12.95
PBG Pepsi Bottling Group Inc. Soft Drinks 32.3 6,508 141 8 21 1 2 9 30.41
WFMI Whole Foods Market Inc. Food Retail 0.0 2,729 56 6 10 1 0 16 19.45
Energy
TSO Tesoro Corp. Oil & Gas Refining & Marketing 0.0 2,588 60 -4 2 2 10 18.78
VLO Valero Energy Corp. Oil & Gas Refining & Marketing 13.8 17,851 34 12 13 1 2 1 34.00
SUN Sunoco Inc. Oil & Gas Refining & Marketing 4,525 71 5 9 1 3 11 38.72
MRO Marathon Oil Corp. Integrated Oil & Gas 8.8 28,563 35 10 16 1 2 8 40.23
MEE Massey Energy Co. Coal & Consumable Fuels 0.0 3,313 147 2 1 0 50 41.02
Financials
HBAN Huntington Bancshares Inc. Regional Banks 0.0 3,406 130 17 2 1 7 5 9.30
GGP General Growth Properties Inc. Retail REITs 0.0 4,240 2 3 2 8 7 15.84
CMA Comerica Inc. Diversified Banks 5,269 253 11 9 1 9 6 35.02
AIV Apartment Investment & Management Co. Residential REITs 0.0 2,884 854 -4 1 7 6 32.99
DDR Developers Diversified Realty Corp. Retail REITs 0.0 3,744 244 3 5 1 8 6 31.18
Health Care
CVH Coventry Health Care Inc. Managed Health Care 0.0 5,078 44 11 17 1 0 12 33.48
KG King Pharmaceuticals Inc. Pharmaceuticals 0.0 2,369 15 15 5 0 0 9.61
WLP WellPoint Inc. Managed Health Care 0.0 23,370 46 10 13 1 0 12 45.64
THC Tenet Healthcare Corp. Health Care Facilities 2,864 -1 0 0 11 6.01
UNH UnitedHealth Group Inc. Managed Health Care 0.0 30,371 58 11 19 1 0 12 25.10
Industrials
AW Allied Waste Industries Inc. Environmental & Facilities Services 0.0 4,848 150 6 9 2 0 11 11.19
RRD R.R. Donnelley & Sons Co. Commercial Printing 23.3 5,267 78 11 5 1 4 15 24.88
CTAS Cintas Corp. Diversified Support Services 0.0 4,328 41 7 14 1 1 11 28.33
MAS Masco Corp. Building Products 21.2 6,324 100 6 4 1 5 13 17.97
TXT Textron Inc. Industrial Conglomerates 39.2 8,090 176 10 26 2 2 12 32.55
Information Technology
UIS Unisys Corp. IT Consulting & Other Services 57.0 1,111 272 -1 2 0 9 3.09
CIEN Ciena Corp. Communications Equipment 16.1 985 79 6 9 2 0 16 10.91
CVG Convergys Corp. Data Processing & Outsourced Services 13.9 1,813 18 9 11 1 0 13 14.88
FIS Fidelity National Information Services Inc. Data Processing & Outsourced Services 3,693 106 9 12 1 1 13 19.48
JAVA Sun Microsystems Inc. Computer Hardware 59.3 5,881 23 8 7 2 0 8 7.82
Materials
NUE Nucor Corp. Steel 0.0 14,303 38 11 23 2 4 5 45.18
IP International Paper Co. Paper Products 21.9 11,836 94 8 10 1 4 6 27.68
MWV MeadWestvaco Corp. Paper Products 30.9 4,299 62 8 8 1 3 11 25.17
WY Weyerhaeuser Co. Forest Products 19.1 12,867 92 -4 1 4 6 60.90
EMN Eastman Chemical Co. Diversified Chemicals 42.0 4,414 72 9 17 1 3 6 57.84
Telecommunication Services
Q Qwest Communications International Inc. Integrated Telecommunication Services 6,002 2,658 15 534 2 8 3 3.44
EQ Embarq Corp. Integrated Telecommunication Services 0.0 6,065 6,616 11 818 1 6 2 42.06
Utilities
PNW Pinnacle West Capital Corp. Electric Utilities 0.0 3,534 82 8 8 1 6 4 35.09
NI NiSource Inc. Multi-Utilities 0.0 4,108 126 8 6 0 6 4 14.98
AEE Ameren Corp. Multi-Utilities 0.0 8,314 90 8 10 1 6 4 39.57
CMS CMS Energy Corp. Multi-Utilities 0.0 2,841 250 4 5 1 3 3 12.60
DTE DTE Energy Co. Multi-Utilities 0.0 6,659 123 6 8 1 5 5 40.83