Five Preconceptions

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					[1] “European sovereign debt auctions are going well”
At first glance, 43 bn EUR of sovereign debt issuance in May and June went better than expected, with no country forcing the
new bilateral borrowing mechanism into action. However, consider the support these auctions received from the ECB, either
through increased ECB lending to banks in each country (much of which we believe is used to finance government bonds), or
51 bn in ECB debt purchases . The bottom line from the table: Italy is doing fine, but Ireland and Portugal are joining
Greece in becoming effective wards of the state. As for Spain, they are going through a Cyrano de Bergerac moment: with no
ECB debt purchases, it looks like the private sector is buying Spanish debt on its own terms. But the increase in ECB lending to
Spanish banks of almost the same amount suggests someone is behind the scenes making it happen.
ECB support for sovereign debt issuance                              Banking system reliance on short term funding
May & June MTD 2010, bn €                                            Funding gap as % of assets
             Sovereign    Repo funding                 ECB debt      30%
 Country    debt issued    from ECB                   purchases      25%
    Italy            21.7              3.9                -          20%
    Ireland          3.3               14.5       Part of 51 bn      15%
    Portugal         3.9               23.3       Part of 51 bn      10%
    Spain            14.0              14.0             -             5%
    Greece           0.0               (5.4)      Part of 51 bn       0%
                                                                        1998       2000      2002      2004      2006          2008    2010
                                                                     Source: Bridgewater Associates.

European banks and corporations have greater funding needs than US counterparts. One reason: after the events of 2008, the
US banking system reduced its reliance on short-term funding to zero (“the funding gap”), through a combination of more
deposits, more longer-term debt and smaller balance sheets. But in Europe, the short-term funding gap is unchanged from
its 2007 level (see highlighted area in the chart). Europe is undergoing the same cyclical manufacturing bounce as other
regions, but the debt and overall growth dynamics remain a huge concern to us.
[2] “The S&P 500 is trading at an 11.5x price/earnings multiple on 2011 earnings, which is extremely cheap”
The 11.5x multiple is based on $95 of consensus analyst estimates. How accurate are these estimates? In some years, analysts
under-estimate earnings; the recovery of 2004-2007 is one example. But in most years, analyst estimates dropped a lot by the
time the year ended (first chart). Some independent research groups are targeting $85 for 2011 instead (the larger differences
tend to be lower estimates for consumer discretionary stocks). If earnings end up at $85, that would be an 11% miss vs
consensus, which is consistent with history. Earnings of $85 implies a 12.9x P/E multiple for 2011, which is still reasonable
value for US equities. But suggestions that equities are trading at exceptional value assume exceptional accurancy by analysts.
In the second chart, some additional context on the optimism often inherent in sell side forecasts.
    Beginning of year vs. End of year earnings estimates                     Percent of S&P 500 stocks with mean analyst rating of
    % change, S&P 500 universe                                               "Sell" or "Hold/Sell"
    15%                                                                      100%
      5%                                                                      70%
      0%                                                                      60%         Enactment of
     -5%                                                                      50%
    -10%                                                                      40%
    -25%                                                                       0%
         1986 1989       1992   1995    1998   2001    2004   2007   2010        1996      1998      2000    2002    2004       2006   2008   2010
    Source: FirstCall.                                                       Source: FirstCall, Wolfe Trahan Research.

  The ECB discloses the amount of its securities purchases, but does not disclose them by country or by issuer. Consensus among our
research and trading contacts is that debt purchases are confined so far to Ireland, Portugal and Greece government bonds.
[3] “The Chinese RMB revaluation is a very important marker in the rebalancing of the global economy”
China dominated financial headlines over the weekend. I don’t think I ever received so many emails about a country resuming
a crawling peg that they said they never abandoned in the first place (0.5% a day). This policy change may amount to little
more than 3% annual appreciation, which is less than the rate which prevailed from 2005 to 2008. With Chinese growth
slowing and its trade surplus declining (3% in Q1 2010 from 11% in 2007), a more aggressive move is unlikely. The
magnitude of Chinese reserve accumulation has no parallel in economic history. The announcement by the People’s Bank of
China appears to be mostly about G-20 politics, and leaves outstanding all the question marks around what happens after
Chinese currency intervention ends.

    Chinese reserve accumulation: unprecedented                           Chinese renminbi spot price
    Percent of GDP                                                        Renminbi per dollar
    12%                                                                   8.50
                      China (1990-2009)                                                        2.0% one-time
    10%                                                                   8.25                  appreciation
                      Germany (1955-1975)
                      Japan (1955-1975)                                   8.00                                                   5.7%
     8%                                                                                                                       annualized
                                                                          7.75                                               appreciation
     2%                                                                   7.00

     0%                                                                   6.75
           1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21            Oct-04    Aug-05    Jun-06    Apr-07    Feb-08   Dec-08   Oct-09
    Source: IMF- IFS, Ferguson and Schularick, HBS, October 2009.         Source: Bloomberg. As of June 22, 2010.

[4] “The low return on cash will continue to drive money into risky assets”
This line of thinking worked in 2009, when capital fled money market funds and went (primarily) into riskier bond funds. And
it looks like low rates will be with us a while longer: a recent report by the Federal Reserve Bank of San Francisco 2 claimed that
based on current inflation and unemployment trends, the Fed does not need to raise rates until 2012, and that the theoretical Fed
Funds rate should be -2.9% But at some point, the epiphany of permanently low interest rates may no longer drive investors
into risky assets, and result in risk aversion instead (“zerophobia”). As shown on the right, we may already be there, as flows
into equity and credit funds have slowed markedly this year, despite a continuation of low rates.
                                                                    Flows into global equity and bond funds
                                                                    Average monthly flow, billions
                                                                    $17                Last 12 months
                                                                    $15                2010 YTD
          Source: Federal Reserve Bank of San Francisco
                                                                                         Equity                              Credit
                                                                    Source: EPFR Inc, AMG Data Services. Data as of May 2010.

If the need for more monetary stimulus implied by the Fed study results in “QE2” (more securities purchases by the Fed), it
would further amplify concerns about monetary stability. Gold would likely be the primary beneficiary. We have already
shelved our price targets for gold. Given the need for easier monetary policy across the developed world and little
opportunity cost for holding gold, we are struggling to figure out what prevents gold prices from rising further. With
industrial production and hours worked as the lone bright spots in June U.S. economic data, and with the UK and Europe
kicking off a period of global fiscal tightening, the world may require more ongoing monetary stimulus than people think.

    “The Fed’s Exit Strategy for Monetary Policy”, Glenn D. Rudebusch, Federal Reserve Bank of San Francisco, June 14, 2010
[5] “A return to more affordable housing will result in a housing market recovery”
Many strategists argued in 2009 that lower interest rates and lower home prices would trigger a sharp housing rebound (these
two components drive the National Association of Realtors Home Affordability Index). Such an approach is seriously flawed,
since it assumes throughout time a constant 20% down-payment. Tighter underwriting criteria and higher downpayments, for
many borrowers, offset the benefit of lower home prices and mortgage rates. As shown in the chart on the right, the home price
recovery has been tepid, given the more than $1 trillion in Fed mortgage and agency purchases, mortgage modification
programs, FHA refinancing programs, relaxation of deficiency judgment rules and homebuyer tax credits. We do not
see a housing recovery on the horizon just yet.
 Theoretical home affordability close to all-time highs...               ...but the housing recovery is a weak one
 Ability of renters to qualify for a mortgage on a starter home, index   Index, January 2000 = 100
 200                                                                     225

 180                                                                                                                           FHFA house
                                                                         200                                                   price index
 160                                                                                     Case Shiller 20
                                                                         175             city composite

 120                                                                     150
                                                                         125                               NAR median sales price
  80                                                                                                       of existing homes sold
  60                                                                     100
    1981     1985     1989       1993      1997   2001   2005     2009      2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
 Source: National Association of Realtors.                               Source: Case-Shiller, FHFA, National Association of Realtors.

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