Third Quarter 2010 GTAA Equities Valuation

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GTAAEquities − Valuation

June 14th , 2010

Damien Cleusix

Clue6 Third Quarter 2010

am en c ue .com



1Executive Summary

StocksValuations have improved slightly after the recent correction but remain way above fair value in most regions. Buy &

.

exception of the last few months of 1929 and the 1997-2000 absurdity (but at least then there was a huge style dispersion with

small caps and value stocks undervalued). And one has to keep in mind that assets and earnings quality is not what it was in the

past adding uncertainties to the mix.

Analysts and strategists are starting to use cash flows and free cash flows ratios extensively to demonstrate markets

undervaluation. It is true that markets look less expensive using those measures. The main reason is that companies are not

investing and have capital expenditures which are below their amortizations & depreciations. This is a rationale decision when

your WACC is lower than your expected return. Nominal growth is likely to be low in this new environment of deleveraging,

re uct on o overcapac ty, r s ng taxes an regu atory uncerta nt es. T e same cas ows rat os w ere use n Japan n t e ear y

90’s.

All of this does not imply that the markets will fall in the short or even the medium term but that a further rise will only

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gains are to be expected in the next 7-10 years (even 17 years).

Our base assumption remains that we will fall to significantly undervalued levels before a new secular bull market canstart (in the developed world as, as ou know, ou know we believe that we are in a secular bull market in emerging markets).

This currently imply a sub-530 level on the S&P 500 going up by 5-6% (could be higher if inflation picks up significantly)

a year.

Emerging markets are too expensive even if one consider that they are in a structural bull market (structural as we think that the


an ow w o .



2Equities: Valuations

Valuations are not useful for short-term market projections but are essential in forecastinglong-term returns. They become informative in the shorter term when they reach extremes

in combination with technical deterioration, sentiment extreme, internal or intermarket

diver ences. When the are ver hi h one should not allow the other indicators in one’s arsenal

US Earnings VolatilityChart 1

to deteriorate too much before pushing the exit button, the reverse is true when they reach very

low levels.

The perpetual question is what constitutes high and low valuation and which valuation ratios toconsider. We look at normalized rice to earnin ratios normalized usin a trailin re orted

earnings moving average (R. Shiller method), trend earnings, average margins or peak earnings

(J. Hussman method)), price to book value and the Tobin Q. We like to look at a historical dataset

as long as possible.

One often hears that valuations should be hi her because the markets are less risk .

We disagree, strongly and the past few years have strengthen this conviction.

Main Street cycles have clearly been less volatile in the past 30 years (well up to now), as has

inflation. The consequence is that companies have increased their leverage dramatically (cf.

Source: R. Shiller, Clue6

Chart 2 US Earnings Quality

A. Greenspan’s “Paradox of Credibility” or H. Minsky’s “Unstable Stability”) . In the

process earnings volatility has increased rapidly in the past 10 years (Chart 1). From the mid

50’s to the mid 80’s, real annual earnings were rising or falling by 3.8% for every percent change

in annual real GDP growth. In the past 10 years if was 22%...

Furthermore the quality of those earnings has decreased dramatically (Chart 2). Don’t be

fooled… Reported earnings (GAAP not operating which are even worse) have grown much

faster than what W. Buffett calls “owners earnings” which are the increase in book value and the

dividends paid. The difference between the 2 are mainly due to stock option programs true price

never being charged to earnings and indicates that earnings are not what they used to be.


ource: ue




US Tangible Assets to

Total AssetsChart 3

This has been aggravated by a substantial

deterioration of assets where:

Chart 4

Europe Tangible Assets

to Total Assets

1. intangibles have dramatically gained in

importance in some regions (Charts 3-6) (ask

a bondholder of a bankrupt high intangibles

company what intangibles are worth...),.o man ac s as ca cu a e a e

500 constituents asset/equity ex-goodwill has

risen from 2.5 in the 80s to 4.4 today.

2. Financial asset have proportionally increased.

3. Assets' mark to market which increase their

pro-cyc ca y.

In brief, as often repeated in the past, we think

market should be valued at lower levels, not

higher levels than historically.

Japan Tangible Assets toTotal AssetsChart 5 Chart 6

Emerging Markets TangibleAssets to Total Assets

Source: Bloomberg, Clue6Source: Bloomberg, Clue6

This is thus not surprising that AAA and AA

bonds represented almost 60% of the Barclays

Capital Investment Grade Index at the end of the 70s while they only represent 25% today.


,,



4Equities: Valuations – What Drives the Long Cycles

Investors attach a lots of importance to what happen to earnings on the very short term

while the have a ver ne li ible influence on the intrinsic value of the markets. Indeed even

S&P 500 and Middle to Young

CohortChart 7

if earnings were to be 0 in the next 2 years, this would not affect by more than a few percentage

points the intrinsic market value derived by a dividends or cash flows discount model.

Remember that markets are a claim on a very long-term stream of cash flows.

What moves market valuation around fair value in the short-term is investors’ risk appetite.

This is what we analyze extensively in the sentiment, breadth, liquidity, seasonality and cycle

section of our presentations.

In the long-term, we believe that the main driver of long-term generational fluctuation in

valuation ratios from very undervalued to very overvalued, is the reallocation of the stock of

wealth (as demonstrated by J. Tobin more than 40 years ago). One can see this phenomenon in

action looking at the Saver/Spender ratio or Middle to Young cohort (Chart 7).

This is the ratio of the population aged 40-49 years to 20-29 years. For the US we think the time

for the next structural bull market to start will be the low made between 2014-2016 (with a

Source: Census Bureau, Clue6

preference for 2014). This is not a forecast but something to keep in the back of her/his mind.

As we have been saying during the past 10 years, this does not mean that there won’t be cyclical

bull markets to take advantage from in between.

During structural bull markets the market rises around 85% of the time while in structural

bear market it rises approximately 65% of the time…




5Equities: Valuationsor onger- erm re urn pro ec ons years , we use a me o o ogy s m ar o ran am, ayo,

Van Otterlo & Co so let’s use their graphs (Chart 8 and 9) showing their estimated 7 years

forward performance for the various categories if they trade at the average valuation normalized

to average margin in 7 years .

Return ForecastChart 8

February 2010

no er n ca or we oo a s e a ue ne e an pprec a on o en a w c

P. Bernstein used in his valuation estimation of the market. It is the median price appreciation

potential estimated by Value Line of the all of the 1700 stocks they cover for the following 3 to 5

years. It fell below 50% which is at the bottom end of its history… One should start

accumulating stocks when it rises above 100%... After having fallen to 45% in April it has now.

High quality stocks expected return has declined by 2.3% to 7.6%. This is where we still

would be greatly overweight (and as an aside valuation our macro scenario favor "bunker-

like" balance sheets).

Source: Grantham, Mayo, Van Otterlo & Co

As we will show in the next few pages, we think there is a non-negligible risk (it is a risk identified and not a prediction…) that the markets will make “THE” bottom at levels up to

50% below where the markets are now. Chart 9 April 2010

could start, we still believe that this is a potential outcome (but we would add 5-6% a year to this

objective going forward (would be a combination of extension and time to determine the final low

target I.e. the longer it takes the lower the required decline…)

our recommended allocation on declines once we fall below 700-750 on the S&P 500 and we

see breadth extremes without regard to the trend. The allocation will be increase as price

declines exactly as we did in March 2009.

One need a lan to stick to in such environment and this is ours. We will also limit the extent


to which we take net short positions the closer we are to what we consider rock bottomvaluations.



Equities: Valuation 6

US NIPA Tax Rate

Source: Clue6 Idea: J Early

This graph is another attempt to demonstrate the importance of starting valuation for longer-term returns.

According to this model, the real 17 years total return should be negative. In 2027 you will not have made any real profit.


, , … ,

problem in the medium-term) might produce this surprisingly low return.




US NIPA Tax Rate

Source: Clue6 Idea: J Early

A grap we ave use n t e past. We assign a 100% probability that the S&P 500 real index will fall below the broadest black line e ore we can

embark into a new structural bull market. We assign a 85% probability (but think we should say 100%) that it will fall below the middle black line

and we would say that there is a 25% risk (for those invested) chance (for those who have been able to preserve capital) that we will fall below the

bottom, light black line.

“ ”


, . .

in 1996. At that time the markets were as expansive as during all the major recent market tops (29, 66). So please, don’t be anchored to the valuation

of the past 15 years, they are likely to be seen as an aberration by future markets historians.




Current Normalized PE RatioChart 11 Normalized PE Ratio and Forward ReturnsChart 10

Source: MS

Note the correlation between starting normalized price earning ratio and markets performance (Chart 10).

Source: MS

It is important to keep in mind that we do not believe that a market priced a 20 time normalized earning will produce positive returns as Chart 10

imply but we believe that cheaper markets will outperform more expansive ones.

Where do markets stand now? Chart 11 give you the answer.


In the future we will give you a table with the market we except to outperform in the long-term vs the one we think will underperform, the resultswill not be similar to chart 11.




PE using NIPA TablesChart 12

Chart 12 and 13 are constructed using the Bureau

of Economic Analysis NIPA tables. The data is

Chart 13 PS using NIPA Tables

less likely to be impacted by the CFO

“prouesses”. We have not normalized them but the

message is clear. Markets are OVERVALUED.

The message is similar if one look at the TobinQ C art 14 . We are at t e same eve s o a t e

major tops ex 98-2000 folly.

The price to book ratio gives a more flattening

picture (Chart 15) even if we are far from the

eve s w ere t e mar et ottome n t e past. ut

remember the book value is not what it used tobe.

US Tobin QChart 14 Chart 15 US PB

Source: BEA, Clue6Source: BEA, Clue6


, ,



Equities: Valuation – Earnings vs. Cash Flows 10

s one as pro a y a rea y starte to ear, stoc s are c eaper t an average on a cas ows an ree cas ows as s w e t ey are muc more expens ve pro a y

not hearing this part much…) on all other metrics.

Cash flows are good, better than earnings which are simply an accounting construct. We agree on this and always look at Sloane’s accruals when analyzing a stock but what we

have now are large cash flows which are the results of net disinvestments (amortizations & depreciations higher than investments as demonstrated in our January macro note).

The end results is lower expected long-term growth.


Note that we understand companies not investing as for many the WACC is higher than the expected return. Welcome to a low nominal growth world where overcapacity and

over-leverage have to be worked out, slowly but surely.




Europe PBChart 16

Europe is cheaper than the US but this is justified

(Chart 16).

Chart 17 Japan PB

It is still trading at more than 1.5 times the book

value.

Japan is cheap based on book value, especially at

book value (Chart 17-18). The reason why Japan

is cheap on a book value basis but expensive on an

earning basis is that they have very low return on

equity. The low historical ROE should be seen

standard now that Japan is slowly, but surely,becoming more shareholder friendly.

In our last report we said that

Japanese Small Caps PBChart 18 Chart 19 Asia ex Japan PB


“Emerging markets are getting increasingly expensive.They

are profiting most from the excess liquidity pumped by

central banks around the world and from the cheap USD

but... The USD won't fall forever and once you reach a

certain level of valuation you are only counting on finding a

bi er ool. Trend chan e should de initel be acted u on

from here on...”

Markets are now cheaper but not by much.

Asia is trading at almost 2 times book (Chart 19).


, ,




Latin America PBChart 20 Chart 21 Eastern Europe PB

Latin America is more expensive than 80% of the

time in the past 20 years (Chart 20).

We remain careful on Eastern Europe. Buy

aggressively on a return to 0.5-0.6 PB, especially

in the sound countries suffering the domino effect

(Czech Republic,…)

Chart 22 Global Tobin Q (MedianEV/Total Assets)


The global Tobin Q is historically high as the chart 22 demonstrate.

Source: ML





UK Median Vs Mean PEChart 24US Median Vs Mean PEChart 23

In 2007 we said that the coming bear markets would be very different that the one we experienced in 2000 because the overvaluation was almost

universal. In 2000-2003 value and small cap managers did very well but they lost a lots of money in the 2007-2009 decline.

Source: MSSource: Clue6

We did those forecasts using ,among other, something similar as the Chart 23 and 24. The later is not up to date.

When the average valuation is much higher than the median, the overvaluation is concentrated and astute stock pickers (and you know we

are value investor at heart) tends to navigate the decline relatively well. This was the case in 2000 for example. When, on the contrary, median

valuation are hi her than mean valuation stock ickin is almost meanin less.


Chart 23 indicates that there is some margin for stock selection but not much.




S&P 1500 Earning EstimatesChart 25Analysts are expecting peak earnings to bereached next year and much more in 2012 and

2013 (Chart 25). As shown on the next page their

record do not speak for them and they are

Chart 26 S&P 1500 Margin Estimates

expected to be even wrongerthan they have been

in the past.

Margins are expected only to reach the 2007

level in 2012 (Chart 26). Let’s be clear on this. We

strongly doubt that we will see the 2007

margins in… our life time (and for those who

wonder we are still quite young and in good

health).

On Chart 27 one can see the margin before tax for

the overall US economy. They are rapidlyapproaching the 2007 highs and are not likely to

reach them. But might reach them in our life-time,

maybe… The big difference with the Chart 26 is

US Domestic MarginsChart 27 Chart 28 S&P 1500 Long-Term EarningGrowth Estimates


that they are BEFORE TAXES and taxes have

only one way to go.

Finally long term earning growth expectationhave ticked higher recently (Chart 28). Even if

the economy was to grow at its fastest 20 years

pace of the century it would not be able to produce

such earning growth. Earnings grow more slowly

than nominal GDP, everywhere. This is set in

stone. Why? Dilution as we will show later in this


report.

,,




S&P 500

Source: McKinsey

If you want to be the most accurate analyst on the street, the only skill required is some mental calculus capabilities or a calculator. Take

the consensus and remove a certain percentage which is linear to the time period since the last recession. The longer we are from a recession the

higher the percentage you subtract. You can also had the Wright’s yield curve recession model to the mix if you want to work hard. When it flashes

a probable recession you can remove at least 50% from the consensus and then take a 12 months vacation.


You can then write reports with a lots of complicated equations and graphs that nobody can understand but as they can’t they believe that you aresuperiorly intelligent and this would do the trick. Never tell them how you do it they could not handle the truth.




US NIPA Margin with Constant Tax RateChart 30US NIPA Tax RateChart 29

Source: MS

We said that we doubted that after-tax margin would reach 2007 level in our life time and the main reason, beside the fact that financial profits willcollapse to more normal level as a % of total profits, are taxes. Taxes will be raised and quite aggressively, sometime in the future.

Source: BEA, Clue6

As you can see taxes have declined steadily since the 50’s (Chart 29). An if taxes had remained the same, margins today would not be this

impressive (Chart 30). The same is true for ROE.

Not only taxes will be risen but tax evasion, legal or illegal will be an area of intense official scrutiny. Big US companies will have to pay much


more taxes in the US and won’t be able to book their profits in fiscal paradises has they have done in the past.




Market Cap vs. Price IndexChart 32Constituents of Real Stocks ReturnChart 31

Source: “Earning Growth: The2 Percent Dilution”, R. Arnott, W. Bernstein, FAJ

Source: BEA, Clue6

.

way to look at this is looking at the ratio of market cap to price (cf. “Earning Growth: The2 Percent Dilution”, R. Arnott, W. Bernstein, FAJ).

Real Earnings have grown by 1.4% and dividends by 1.1% since 1871 based on professor Shiller data. So one can only laugh or cry at

analysts long-term growth estimates.





US NIPA Profit CompositionChart 34US NIPA and S&P 500 Operating ProfitsChart 33

US NIPA profit have yet to turn down which they have historically done a couple of quarters before S&P 500 GAAP earnings (Chart 33).

Source: BEA, Clue6Source: BEA, Bloomberg, Clue6

But one has to take into account the financial sector contribution to those earnings. Financial earnings represent 55% of total domestic

earnings (Chart 34). This is simply absurd. Financial earnings have historically been more resilient during recession (well except the last one…)

which explain some of the historical spike in the ratio but now the financial sector is earning as much as it was in 2007 (some investment banks

even had perfect trading quarter during the first 3 months of the year, not loosing money a single day).


In 10 years we do not expect financial profit to be more than 25% of total … and 25% is likely to be optimistic. This will be the result of amixture of greater regulations and higher taxes.




Hours of Work to Buy the S&P 500Chart 36US Private Compensation/GDPChart 35

Longer-term we are expecting to see a mean-reversion in the Private compensation to GDP (Chart 35) which will weight on margins whichmight stay lower for longer and not reach the 2007 and even 2000 high for quite some time if ever. Workers will ask for their fair share of

Source: Thechartstore.comSource: Bloomberg, Clue6

profits.

This should be associated with a reduction in inequalities,... And lower economic growth…

On Chart 36, one can see another reason of the increase in wealth inequality…Financial assets price have risen much more than average income…


This will also mean revert (and not as a consequence of rapidly rising average income…)



Equities: Valuation – The Price has to be Right 20

Emerging Markets Real GDP Vs Real

Stock Return (1988-2007)Chart 38Real GDP Growth Vs Real Stock

Return 1899-2008)Chart 37

Source: Societe GeneraleSource: Smithers & Co

Do not confound good potential secular macro growth with good investment . As W. Buffet said “Price is what you pay, value is what you get”.

As you can see on Chart 37, even if you knew in hindsight which countries would grow the fastest, you would not have outperformed. One has to

take into account that the 2 World War have had a significant impact (some of the less directly impacted lands have had the best performance) but

the same is true for the past 25 years in emerging markets (Chart 38)…

The price you pay (in term of valuation) is determinant… Countries with high expected growth are expensive to buy… Only buy them on


panic…



Equities: Valuation – Price Stability 21

PE Ratio and InflationChart 40Average PE Ratio By Range of

InflationChart 39

Source: Crestmont Research

Source: Crestmont Research

PE ratio are higher in low inflation environment than when inflation is high as is commonly known, but PE are also lower when low

inflation become deflation.

Note that we have always been puzzled by analyst using the low inflation high PE argument as what really matter is how the market perform going

forward. And market perform better (on a 5-10 years basis) when PE are low and inflation high.




Equities: Valuation – US Future GDP Growth 22

Source: CBO,Clue6 Idea: J.Hussman

As said in the past, in the long run, earnings tend to grow slightly less than GDP. The above concept to estimate forward growth was first

proposed by J.Hussman. For the US real GDP to reach the CBO potential real GDP forecast in 10 years, the growth should be 2.7% which is one of

the lowest in history.

If one add that there is a non-negligible risk of deleveraging and overcapacity related deflation (if Central Banks and Government do not go all-in


where inflation might become a problem) this does not bode well for nominal growth which is what people and companies use for theyinvestment and consumption decisions…



23Equities: Conclusion

Valuations have improved slightly after the recent correction but remain way above fair value in most regions . Buy & hold is not an option

.

and the 1997-2000 absurdity (but at least then there was a huge style dispersion with small caps and value stocks undervalued). And one has to keep

in mind that assets and earnings quality is not what it was in the past adding uncertainties to the mix.

Analysts and strategists are starting to use cash flows and free cash flows ratios extensively to demonstrate markets undervaluation. It is true that

markets look less ex ensive usin those measures. The main reason is that com anies are not investin and have ca ital ex enditures which are

below their amortizations & depreciations. This is a rationale decision when your WACC is lower than your expected return. Nominal growth is

likely to be low in this new environment of deleveraging, reduction of overcapacity, rising taxes and regulatory uncertainties. The same cash flows

ratios where used in Japan in the early 90’s.

All of this does not im l that the markets will fall in the short or even the medium term but that a further rise will onl have s eculative and

no investment merits if bought and that if one buy today to hold for the long-term, negative capital gains are to be expected in the next 7-10

years (even 17 years).

Our base assumption remains that we will fall to significantly undervalued levels before a new secular bull market can start (in the developed

world as, as you know, you know we believe that we are in a secular bull market in emerging markets). This currently imply a sub-530 level on the

S&P 500 going up by 5-6% (could be higher if inflation picks up significantly) a year.

Emerging markets are too expensive even if one consider that they are in a structural bull market (structural as we think that the 2003 and 2009 low

will hold).


Documents

Third Quarter 2010 GTAA Equities Valuation