The Frugal Future

September 2008 Date US Economics David A. Rosenberg +1 212 449 4937 North American Economist MLPF&S david_rosenberg@ml.com The Frugal Future Merrill Lynch does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Refer to other important disclosures on pages 75 to 76. 10767535 1 The Five Chapters of the Downturn Chapter 1: The End of the Housing Boom Housing Boom Ends In 2006 Q1 Housing Starts (thousands) 2400 2200 2000 1800 1600 1400 1200 1000 800 98 99 00 01 02 03 04 05 06 07 08 peak Source: Census Bureau, Merrill Lynch 4 No Bottom According To Homebuilder Survey NAHB Housing Market Index (All Good = 100) 90 80 70 60 50 40 30 20 10 0 85 87 89 91 93 95 97 99 01 03 05 07 At a record low! Shaded region represents period of US recession Source: National Association of Home Builders, Merrill Lynch 5 Another View Of The Inventory Backlog Total Vacant Housing Units: Year-round for Sale Only (thousands) 2300 2200 2100 2000 1900 1800 1700 1600 1500 1400 1300 1200 1100 1000 900 800 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 Homeowner Vacancy Rate (percent) Record! 3.0 2.8 2.6 2.4 2.2 2.0 1.8 1.6 1.4 1.2 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 Record! Source: Census Bureau, Merrill Lynch 6 Homeownership Rate In Mean Reverting Phase Homeownership Rate (percent) 70.0 69.0 68.0 67.0 66.0 65.0 64.0 63.0 83 85 87 89 91 93 95 97 99 01 03 05 07 Source: Census Bureau, NBER, Merrill Lynch 7 Too Much House? Average Square Feet of Floor Area In New Single-Family Homes Sold 2,500 2,400 2,300 2,200 2,100 2,000 1,900 1,800 1,700 1,600 1,500 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 Source: Census Bureau, Merrill Lynch 8 Persons Per Household At a Record Low (persons per household) 3.4 Record High! 3.3 3.2 3.1 3.0 2.9 2.8 2.7 2.6 2.5 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 Backdrop In The Housing Market Remains Negative 1) Nearly 24% of homes sold in the past year were sold at a loss 2) Of those who purchased a home in the past five years, 29% are “upside down” (negative net equity) 3) Median home values are down a record 10% over the past year 4) Home values are now deflating in 85% of the country 5) Almost 15% of housing sales are now foreclosed transactions Source: Zillow, Merrill Lynch 9 Chapter 2: The End of the House Price Boom Real Estate Price Bubble Pops In 2007 Q1 Case Shiller Home Price Index (Composite 10) (year/year % change) 25 20 15 10 5 0 -5 -10 -15 -20 88 90 92 94 96 98 00 02 04 06 08 11 peak A record low! Source: S&P, MacroMarkets LLC, Merrill Lynch More Real Estate Deflation Ahead Home Price to Rent Ratio * 160 150 140 130 120 110 100 90 80 70 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 Source: Merrill Lynch, S&P Case Shiller, Bureau of Labor Statistics * 2000 = 100; Home price = Case Shiller; rent = CPI rent of shelter 12 Scenarios for home prices to restore equilibrium ** Annual rent (%) # Years 1 2 3 4 5 1% 2% 3% 4% 5% -18.1% -9.0% -5.8% -4.2% -3.1% -17.3% -8.1% -4.9% -3.2% -2.2% -16.5% -7.2% -3.9% -2.3% -1.2% -15.6% -6.3% -3.0% -1.3% -0.3% -14.8% -5.4% -2.1% -0.4% 0.7% ** Annual average home price growth. Long-run equilibrium Mean Reverting This Chart Points To A 30% Decline In Home Prices Household Real Estate Assets to Nominal GDP 2.0 1.9 1.8 1.7 1.6 1.5 1.4 1.3 1.2 1.1 1.0 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 # Years 1 2 3 4 5 Scenario for home prices to restore equilibrium Nominal GDP (%) 1% -30.5% -16.2% -10.8% -8.0% -6.3% 2% -29.8% -15.4% -9.9% -7.1% -5.3% 3% -29.1% -14.5% -9.1% -6.2% -4.4% 4% -28.4% -13.7% -8.2% -5.3% -3.5% 5% -27.7% -12.9% -7.3% -4.4% -2.6% Household real estate assets using Case-Shiller valuation Source: Case-Shiller, Bureau of Economic Analysis, Merrill Lynch 13 House Price Bubble Of Historic Proportions Case-Shiller Real Home Price Index (index level, 100 = 1890) 210 190 170 150 130 110 90 70 50 1890 1898 1906 1914 1922 1930 1938 1946 1954 1962 1970 1978 1986 1994 2002 Source: Robert Shiller, MacroMarkets LLC, Merrill Lynch 14 Chapter 3: The Employment Cycle Ends Employment Cycle Ends In December 2007 Total Nonfarm Payrolls Month-to-month Change (thousands) 400 350 300 250 200 150 100 50 0 -50 -100 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 605,000 Jobs Lost So Far This Year Source: Bureau of Labor Statistics, Merrill Lynch 16 Unemployment Surges To A 16-Year High Unemployment Level 13000 12000 11000 10000 9000 8000 7000 6000 5000 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% -10.0% -20.0% -30.0% 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 Year-over-year % change Shaded region represents period of US recession Source: Bureau of Labor Statistics, Merrill Lynch 17 Leading Employment Indicators Head South Aggregate Hours Worked (year-over-year % change) 10.0% 8.0% 6.0% 20 4.0% 2.0% 0.0% -2.0% 5 -4.0% -6.0% -8.0% 65 68 71 74 77 80 83 86 89 92 95 98 01 04 07 0 -5 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 15 10 30 25 Manpower Hiring Intentions (index level) Shaded region represents period of US recession Source: Bureau of Labor Statistics, Haver Analytics, Merrill Lynch 18 Chapter 4: The End of the Credit Cycle Credit Cycle Ends In August 2007 Baa Spread Baa Corporate bond yield minus 10-year yield (basis points) 3.70 3.45 3.20 2.95 2.70 2.45 2.20 1.95 1.70 1.45 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 trough Source: Federal Reserve Board, Merrill Lynch 20 US Debt-to-Income Ratio Rose As Much In The Past 7 Years As It Did In The Previous 39 Years Household Debt-to-Income Ratio (percent) 150 130 2001 = 101% 110 90 70 50 30 52 56 60 1962 = 63% 64 68 72 76 80 84 88 92 96 00 04 08 21 Peak = 139% Source: Federal Reserve Board, Merrill Lynch Residential Real Estate Delinquency Rate At An All-Time High Loan Delinquency Rate: Residential Real Estate Loans (percent) 4.50 4.25 4.00 3.75 3.50 3.25 3.00 2.75 2.50 2.25 2.00 1.75 1.50 1.25 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 The highest level on record! Source: Federal Reserve Board, Merrill Lynch 22 Delinquencies in Prime and Subprime Mortgages At Record Highs Mortgage Delinquency Rates (percent) Prime 4.0 3.8 3.6 3.4 3.2 3.0 2.8 2.6 2.4 2.2 2.0 98 99 00 01 02 03 04 05 06 07 08 Record high! Subprime 19.0 18.0 17.0 16.0 15.0 14.0 13.0 12.0 11.0 10.0 98 99 00 01 02 03 04 05 06 07 08 Record high! Source: Mortgage Bankers Association, Merrill Lynch 23 Almost 1 in 10 Households In Foreclosure Or Arrears (percent) 10.0 9.0 Record high 8.0 7.0 6.0 5.0 4.0 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 Source: Mortgage Bankers Association, Merrill Lynch 24 Will Credit Cards Be The Next Shoe To Drop? Loan Delinquency Rate: Credit Cards (percent) 5.5 5.0 4.5 4.0 3.5 3.0 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 Source: Federal Reserve Board, Merrill Lynch 25 Tightest Mortgage Standards On Record Fed Sr Loan Officer Survey: Bank tightening standards for mortgages to individuals (percent) 70 60 50 40 30 20 10 0 -10 -20 91 92 93 Easier Easier Tighter Tighter Tighter lending standards Tightest lending standards on record! Easier lending standards 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 *In the latest survey, the residential mortgages lending standard was separated into 3 questions: prime (which came in at 74.0%), nontraditional (at 84.4%), and subprime (at 85.7%). Total is weighted sum of lending policy and demand responses for Prime, Nontraditional and Subprime loans, combined according to the share of banks reporting each characteristic. Source: Federal Reserve Board, Haver Analytics, Merrill Lynch 26 A Record Number of Banks Tightening Consumer Credit Guidelines Bank Tightening Consumer Loan Approvals (banks) 35 30 25 20 15 10 5 0 97 98 99 00 01 02 03 04 05 06 07 08 Shaded areas represent period of US recession Source: Federal Reserve Board, Merrill Lynch 27 Consumer Credit Volume Is Now Contracting Consumer Credit Adjusted For Inflation (year-over-year % change) 15.0 12.5 10.0 7.5 5.0 2.5 0.0 -2.5 -5.0 -7.5 -10.0 59 62 65 68 71 74 77 80 83 86 89 92 95 98 01 04 07 Shaded region represents period of US recession Source: Federal Reserve Board, Bureau of Labor Statistics, Merrill Lynch 28 Households Cutting Back On Credit Demand Banks Reporting Stronger Demand (4-quarter moving average, percent) Consumer Loans 25 23 40.0 60.0 Residential Mortgages 21 19 17 0.0 20.0 15 13 11 -40.0 -20.0 9 7 98 99 00 01 02 03 04 05 06 07 08 -60.0 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 Source: Federal Reserve Senior Loan Officer Survey, Merrill Lynch 29 Chapter 5: The End of the Consumer Cycle Consumer Cycle Ended In 2008 Q3 Real Personal Consumption Expenditures (six-month percent change annualized) 8.0% 6.0% 4.0% 2.0% 0.0% -2.0% -4.0% 89 91 93 95 97 99 01 03 05 07 Shaded region represents period of US recession Source: Bureau of Economic Analysis, Merrill Lynch 31 What Consumers Budget For In A Real Recession Real Spending (1974-75, % change from nearby peak) Hospitals/Nursing Homes Utilities Physicians Pharmaceuticals Clothing/Shoes Restaurants Airlines Gasoline Magazines/Newspapers Furniture Home Improvements Household Appliances Spectator Sports Admissions Salons/Health Clubs Automotive Dry Cleaning Maid Services -23.7% -26.6% -25% -20% -15% -10% -5% 0% 5% 10% -14.3% -17.1% -7.3% -7.5% -8.4% -10% -4.9% -6.1% -1.4% -1.7% -2.4% 0.6% 3.0% 6.1% 5.6% -30% Source: Bureau of Economic Analysis, Merrill Lynch 32 The Real Consumer Picture (% change from nearby peak at an annual rate, July) -2.1% -3.7% -5.3% -6.0% -8.5% -11.8% -11.9% -12.9% -13.4% -14.4% -18% -15% -12% -9% -6% -3% 0% Appliances (Jan/07) Restaurants (Oct/07) Jew elry (Sept/07) Sporting Eqpt (Nov /07) Casinos (July /07) Air Trav el (Sept/07) Clothing (May /08) Furniture (May /08) Boats & Aircraft (Aug/07) Autos (May /07) Source: Bureau of Economic Analysis, Merrill Lynch 33 Credit Sensitive Spending Intentions Rolling Over (12-month moving average) Plans to Buy A Home Within 6 Months (Conference Board, percent) 4.5 160.0 150.0 Vehicle Buying Conditions (U of M Consumer Sentiment, index level) 4.0 140.0 3.5 130.0 120.0 25-year low 25-year low 3.0 110.0 2.5 100.0 2.0 83 85 87 89 91 93 95 97 99 01 03 05 07 90.0 83 85 87 89 91 93 95 97 99 01 03 05 07 Source: Conference Board, University of Michigan, Merrill Lynch 34 Vacation Intentions Falling Sharply Vacation Intended in Six Months (percent) 48 46.4 46.4 46 44 41.9 42 40.1 40.1 40 38 36 34 Apr May Jun Aug Sep Oct Dec Feb Mar Apr Jun Aug Oct Dec Feb Apr Aug 2006 2006 2006 2006 2006 2006 2006 2007 2007 2007 2007 2007 2007 2007 2008 2008 2008 Source: Conference Board, Merrill Lynch 35 46.0 45.8 44.5 43.3 41.7 41.7 40.6 42.2 41.7 43.0 39.6 37.4 The Impact on the Global Economy This Slowdown Has Been A One-Trick Pony Known As Housing (year/year % change) Real GDP minus Real private residential investment 10.0 Real private residential investment 60 50 40 30 20 10 0 -10 -20 -30 -40 56 59 62 65 68 71 74 77 80 83 86 89 92 95 98 01 04 07 Shaded areas represent periods of US recessions Source: Bureau of Economic Analysis, Merrill Lynch 7.5 5.0 2.5 0.0 -2.5 56 59 62 65 68 71 74 77 80 83 86 89 92 95 98 01 04 07 37 The US Does Not Import Houses (2007 US imports, $ billions) 350 300 250 200 150 100 50 0 Transportation Household G oods Com puters E lectronics M etals/Chem icals B uilding M aterials P harm aceuticals A gricultural A pparel E quipm ent* Consum er P roducts 112 293 104 94 89 72 62 48 30 *Aircraft plus autos Source: Census Bureau, Merrill Lynch 38 The US Consumer In Perspective: The Biggest Economy In The World (percent share of global GDP: 2007) US Consumer Japan Germany China UK France Italy Canada Brazil Russia India S. Korea Australia Mexico 0 2.6 2.4 2.3 2.0 1.8 1.7 1.7 2 4 6 8 10 12 14 16 18 3.9 5.2 4.7 6.1 6.1 8.1 18.2 20 Source: Bureau of Economic Analysis, IMF, Merrill Lynch 39 US Consumer More Important To Global Economy, Not Less US Consumer as a share of World GDP (percent) 18.5 18.0 17.5 17.0 16.5 16.0 15.5 15.0 14.5 14.0 1980 Source: International Monetary Fund, Bureau of Economic Analysis, Merrill Lynch 40 18.2 16.8 14.9 1990 2007 US Import Growth Weakening Sharply = Global Export Turndown Real Imports of Goods and Services (bars = quarter-over-quarter annualized % change; lines = year-over-year % change) 40.0% 30.0% 20.0% 10.0% 0.0% -10.0% -20.0% 82 84 86 88 90 92 94 96 98 00 02 04 06 Shaded region represents period of US recession Source: Bureau of Economic Analysis, Merrill Lynch 41 Net Exports Contributed 1.7 ppts To 2.2% GDP Growth In Past Year Net Exports: Contribution to Real GDP Growth (four-quarter moving average, percent) 3.00 2.50 2.00 1.50 1.00 0.50 0.00 -0.50 -1.00 -1.50 -2.00 -2.50 55 58 61 64 67 70 73 76 79 82 85 88 91 94 97 00 03 06 Shaded region represents period of US recession Source: Bureau of Economic Analysis, Merrill Lynch 42 OECD Leading Indicators Running at a Seven-Year Low ... This is a Global Boom? OECD Composite Leading Indicators (6-month % change annualized) 8 6 4 2 0 -2 -4 -6 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 Shaded region represents period of US recession Source: Datastream, Merrill Lynch 43 Profits Recession ... No End In Sight If Not for the Rest of the World, US Profit Growth Would be Negative Corporate Profits with IVA & CC Adjustments (year/year % change) Domestic 50 40 30 20 10 0 -10 -20 82 84 86 88 90 92 94 96 98 00 02 04 06 08 -14% Rest of World 50 40 30 20 10 0 -10 -20 82 84 86 88 90 92 94 96 98 00 02 04 06 08 26% Source: Bureau of Economic Analysis, Merrill Lynch 45 Plenty Of Air Under Profits (percent) Profits as a share of GDP 15% 14% 13% 12% 11% 10% 9% 8% 7% 6% 5% 47 50 53 56 59 62 65 68 71 74 77 80 83 86 89 92 95 98 01 04 07 8% 84 86 88 90 92 94 96 98 00 02 04 06 08 18% 23% peak Financial Profits as a share of Total Pre-tax Profits 38% peak 33% peak 28% 13% Source: Bureau of Economic Analysis, Merrill Lynch 46 Deflation, Not Inflation, The Next Macro Theme The Front Cover Effect – The Great Contrary Indicator Source: The Economist (May 2008) 48 Inflation Rates In A Historical Perspective (year/year % change) Headline Inflation Rate – Is It Really the 70s? (Total CPI) 16% 14% 12% 10% 8% 6% 4% Look where it goes post-recession (Core CPI) 14% 12% 10% 8% 6% 4% 2% 0% -2% 50 53 56 59 62 65 68 71 74 77 80 83 86 89 92 95 98 01 04 07 Shaded areas represent US recession Source: Bureau of Labor Statistics, Merrill Lynch 49 2% 0% 58 61 64 67 70 73 76 79 82 85 88 91 94 97 00 03 06 Inflation Expectations Skewed by High Frequency Items CPI Components (year/year % change, August 2008) High Frequency Items Gasoline Air Fares Bread Utilities Vegetables Fruits Coffee Eggs Chicken Milk 0% 7.3% 6.9% 4.6% 2.2% 5% 10% 15% 20% 25% 30% 35% 40% -14.7% -16% -14% -12% -10% -8% -6% -4% -2% 0% -12.9% 10.5% 16.1% 15.4% 14.2% -4.5% -4.9% -5.2% 20.9% 35.6% Low Frequency Items -0.6% -0.8% -1.3% -1.5% -1.9% Tools Furniture New Vehicles Household Eqpt Floor Coverings Info Tech Audio Eqpt Toys Video Eqpt Televisions Source: Bureau of Labor Statistics, Merrill Lynch 50 Chinese Equities Lead Commodity Prices 6500 6000 5500 5000 4500 4000 3500 3000 2500 2000 1500 Aug-06 Nov -06 Feb-07 May -07 Aug-07 Nov -07 Feb-08 May -08 Aug-08 WTI Crude Oil ($/barrel, lagged 7 months, RHS) r = 0.95 Shanghai Composite Index (index level, LHS) 150 140 130 120 110 100 90 80 70 60 Source: Bloomberg, Merrill Lynch 51 52 The Last $30 Run-Up In The Oil Price Was The Straw That Broke The Camel’s Back Crude Oil ($ per barrel) 150 135 120 105 90 75 60 45 30 15 0 01 02 03 04 05 06 07 08 Dec ’01 3.0%* Mar ’08 2.9%* May ’08 3.4%* July(P) ’08 3.4%* 5-10 Year Median Inflation Expectations (percent) 3.5 3.4 3.3 3.2 3.1 3.0 2.9 2.8 2.7 2.6 2.5 01 02 03 04 05 06 07 08 Mar ’08 = $100/bbl** Dec ’01 = $20/bbl** July(P) ’08 = $145/bbl** May ’08 = $130/bbl** *University of Michigan 5-10 year median inflation expectations; **Price of crude oil Source: Bloomberg, University of Michigan, Merrill Lynch 53 Driving Less ... A Lot Less Vehicle Miles Traveled (year-over-year % change) 15.0% 10.0% 5.0% 0.0% -5.0% -10.0% 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 Shaded region represents period of US recession Source: Federal Highway Administration, Merrill Lynch 54 Vehicle Sales Down To A Seventeen-Year Low Vehicle Sales (million units) 23.0 21.0 19.0 17.0 15.0 13.0 11.0 9.0 7.0 5.0 67 69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 Shaded region represents period of US recession Source: Bureau of Economic Analysis, Merrill Lynch 55 Too Many Vehicles? Ratio of Vehicles To Licensed Drivers 1.20 1.18 1.16 1.14 1.12 1.10 1.08 1.06 1.04 1.02 1.00 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 Source: Haver Analytics, Merrill Lynch 56 Wage Growth Has Peaked Average Weekly Earnings (year/year % change, 3-month moving average) 10 9 8 7 6 5 4 3 2 1 peak peak peak peak peak peak peak peak 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 Shaded areas represent periods of US recessions Source: Bureau of Labor Statistics, Merrill Lynch 57 No Worker Backlash Work Stoppages (number) 450 400 350 300 250 200 150 100 50 0 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 Source: Bureau of Labor Statistics, Merrill Lynch 58 A Less Unionized Workforce Union Membership as a Share of Total Employment (Percent) 28% 26% 24% 22% 20% 18% 16% 14% 12% 10% 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 Source: Bureau of Labor Statistics, Merrill Lynch 59 Aggregate Demand < Aggregate Supply = Lower Core Inflation 4% 3% 2% 1% 0% -1% -2% -3% -4% 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 Aggregate demand – Aggregate supply Gap* (LHS) Core CPI (lagged six quarters, RHS) 3.2% 2.8% 2.4% 2.0% 1.6% 1.2% 0.8% *The difference between aggregate demand (real final sales) and aggregate supply (productivity growth + labor force growth) Source: Bureau of Labor Statistics, Bureau of Economic Analysis, Merrill Lynch 60 Market-Based Inflation Expectations Are Collapsing (percent) 5-Year TIPS Breakeven 2.8 2.7 2.6 2.5 2.4 2.3 2.2 2.1 2.0 1.9 1.8 1.7 1.6 1.5 1.4 1.3 Jan-07 May -07 Sep-07 Jan-08 May -08 Sep-08 10-Year TIPS Breakeven 2.7 2.6 2.5 2.4 2.3 2.2 2.1 2.0 Lowest since 2002 Lowest since January 2003 1.9 Jan-07 May -07 Sep-07 Jan-08 May -08 Sep-08 Source: Bloomberg, Merrill Lynch 61 TIPS Market Pricing In Deflation Over The Next Two Years? Two-Year TIPS Breakeven (percent) 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 -0.5 Dec-04 May -05 Oct-05 Mar-06 Aug-06 Jan-07 Jun-07 Nov -07 Apr-08 Sep-08 Source: Bloomberg, Merrill Lynch 62 Early Stages Of Treasuries Going The Way Of The JGB (Percent) 6.0 5.0 JGB 10-y ear y ield 4.0 (May 1992 - Present) 3.0 US 10-y ear y ield 2.0 (June 2007 - Present) 1.0 0.0 Source: Bloomberg, Merrill Lynch 63 What Goes Around Comes Around: Bond Yields In A Historical Perspective 10-Year Treasury Note Yield (percent) 14 12 10 8 Steady State? 6 4 2 0 1875 1900 1925 1950 1975 2000 Source: Global Financial Data, Federal Reserve Board, Merrill Lynch 64 What’s The Fed To Do? Replacing Bubbles With Choppers 66 In Asset Cycles, the Fed Cut Rates Long After Recession Ended Fed Funds Rate (percent) (January 1988 – December 1992) 10 9 8 7 6 (January 1999 – December 2003) 7 6 5 4 3 Recession ended here 5 4 3 2 1988 1989 Recession ended here 2 1 0 1990 1991 1992 1999 2000 2001 2002 2003 Source: Federal Reserve Board, Merrill Lynch 67 Who knew he would have to cut rates another 400 basis points? Source: The Economist (21 April 2001) 68 The Fed Pushing On A String Spreads Current PDCF announcement Start of Fed easing cycle (as of Sep. 15, 2008) (March 17, 2008) (September 18, 2007) (option adjusted spread, unless otherwise noted: bps) 467 360 166 485 348 180 395 320 136 380 352 186 905 862 446 124 102 87 ML US Aggregate Bank Spread 5-10 years duration 10-15 years duration ML US BBB Corporate Bond Spread ML US High Yield Bond Spread Jumbo mortgage minus 30-year FRM* Yields Current (as of Sep. 15, 2008) ML US Aggregate Bank Rate 5-10 years duration 10-15 years duration ML US BBB Corporate Bond ML US High Yield Bond Jumbo mortgage rate Private Sector Interest Rate** 7.53 8.07 7.65 6.86 11.81 7.17 6.78 PDCF announcement Start of Fed easing cycle (March 17, 2008) (September 18, 2007) (yields, percent) 6.19 5.97 6.45 6.17 6.74 5.97 6.34 6.25 11.12 8.76 6.70 7.18 6.39 6.87 *30-year fixed mortgage rate is weekly data (not option adjusted spread) ** An equal weighting of jumbo mortgage rates, new car loan rate, home equity loan rate, 5-year ARM, 3-month LIBOR rate, high yield bond rate, and bank rate (5-10 year duration) Source: Bloomberg, Haver Analytics, Merrill Lynch 69 Three Things That Will Turn Us More Positive Item #1: Below 8 Months’ Supply Of Unsold Housing Inventory (months’ supply) Existing Single Family Homes on the Market 11.0 10.0 9.0 8.0 7.0 7.0 A 23-year high! New Single Family Homes for Sale 12.0 11.0 10.0 9.0 8.0 A 27-year high! 6.0 5.0 4.0 3.0 98 99 00 01 02 03 04 05 06 07 08 6.0 5.0 4.0 3.0 98 99 00 01 02 03 04 05 06 07 08 Source: National Association of Realtors, Census Bureau, Merrill Lynch 71 Item #2: A Savings Rate That Heads To The Pre-Bubbles level Personal Saving Rate (percent) NIPA Measure 12 10 60 80 70 Flow of Funds Measure 4-quarter moving total-annualized 8 6 4 2 50 40 30 20 10 0 -2 85 87 89 91 93 95 97 99 01 03 05 07 0 -10 85 87 89 91 93 95 97 99 01 03 05 07 Source: Bureau of Economic Analysis, Federal Reserve Board, Merrill Lynch 72 Item #3: Ditto For The Debt-Service Ratio (as a % of personal disposable income) Total Debt-Service Ratio 15.0 14.5 14.0 13.5 13.0 17.5 19.5 Household Financial Obligation Ratio All time high! All time high! 19.0 18.5 18.0 12.5 12.0 11.5 11.0 10.5 10.0 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 17.0 16.5 16.0 15.5 15.0 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 Financial obligations payments, which include recurring obligations like rent, auto leasing, homeowners insurance and property taxes. Source: Federal Reserve Board, Merrill Lynch 73 Bob Farrell’s 10 Market Rules to Remember 1) Markets tend to return to the mean over time. 2) Excesses in one direction will lead to an opposite excess in the other direction. 3) There are no new eras – excesses are never permanent. 4) Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways. 5) The public buys the most at the top and the least at the bottom. 6) Fear and greed are stronger than long-term resolve. 7) Markets are strongest when they are broad and weakest when they narrow to a handful of blue chip names. 8) Bear markets have three stages – sharp down – reflexive rebound – a drawnout fundamental downtrend. 9) When all the experts and forecasts agree – something else is going to happen. 10) Bull markets are more fun than bear markets. Source: Merrill Lynch 74 Other Important Disclosures UK readers: MLPF&S or an affiliate is a liquidity provider for the securities discussed in this report. 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