june 2, 2010 a rocky balboa stock market: june 2010 update · a rocky balboa stock market: june...

All relevant disclosures and certifications appear on pages 38 - 39 of this report.

June 2, 2010

A Rocky Balboa stock market: June 2010 update

Barry B. Bannister, CFA (443) 224-1317 [email protected]

Elizabeth A. Lintner (443) 224-1360 [email protected]

• Equities are positioned in the middle of a secular bear range; we expect the S&P 500 may peak at $1,250 in2010, $1,350 in 2011 and head much lower 2012/14.

• At this point, investors may be entering the Rocky Balboa style home stretch of "punch drunk" volatilitywithin the secular bear market of 2000 to ~2014E.

• Watch policy: it is a bull market in government globally. Deflation risks still outweigh inflation, increasingthe hand of government.

• The “Paper vs. Hard Assets” trade is quite mature, but now is the time for (over)investment in commoditycapacity.

• As a key commodity driver watch out for negative surprises (i.e., high y/y growth) in Chinese CPI inflation(all items, especially food & energy) and further policy tightening resolve.

We believe the S&P 500 around $1,100 is positioned almost exactly in the middle of a “secular bear market” tradingrange, which we expect to exist for the period 2000-14. At this point, investors may be entering the Rocky Balboahome stretch of "punch drunk" volatility. In a short cycle sense, U.S. stocks may now be a “mid-bull,” e.g. volatile, witha less steep rise to 2010/11 in which the S&P 500 may peak at $1,250 in 2010, $1,350 in 2011. Difficult policy choicesand outcomes may pressure 2012/13; however, and though we believe the nominal S&P 500 low point for this secularbear market was seen at $666 in March 2009, the inflation-adjusted “real” low for the S&P 500 may lie ahead,occurring 2012-14. The plausible wide band S&P 500 trading range we see is $1,360 ($80 EPS x P/E 17x) at lowinflation, and $880 ($80 EPS x P/E 11x) at high inflation (or deflationary backsliding).

Competitive devaluations occurred in Asia (late 1990s) and the U.S. (early 2000s), naturally boosting GDP growth forthe first and second to devalue; Europe was late to devalue in 2010, and as a result EU GDP growth may suffer. Still,we believe the ECB has instituted an equilibrium (game theory) beneath the euro as well as eurozone sovereigns. Inthe U.S., public leverage has been offsetting private de-leveraging, but that has questionable longer term efficacy. TheU.S. Fed and Treasury are less well positioned to assist than they were in 2008-09, but conversely our view is thatFed and Treasury intervention thus far has been extraordinary but not untenable given low borrowing costs and thelow starting point for the Fed balance sheet in terms of size. We see U.S. per capita GDP stagnating, with obviouspolitical consequences, but overall U.S. real GDP should grow around 3.5%, in our view. Deflation risks still outweighinflation in our opinion, and liquidity preferences argue against a run on banks. Longer term, taxation, protectionism,xenophobia, and affording entitlements are extraordinary long-term issues affecting markets.

Commodity relative strength drives our Heavy Machinery and Energy Engineering & Construction coverage, which areat their heart commodity and economic “momentum plays.” We observe that the rolling return of commodities iscoming off historic highs, whereas the rolling total return of the S&P 500 is coming off historic lows. After 10 years ofsecular bear market, a great deal of "bad news" is priced into equities, and a great deal of hope resides incommodities. We also believe commodities relative to the S&P 500 are entering a mature, oscillating phase. The U.S.dollar increase in 2010 is, in our view, just part of unwinding Bretton Woods I, signed after W.W. II.

We foresee rising interest in late cycle energy E&C, whereas China mineral plays appear to be petering out. In asense, investors see a bridge they have not yet reached for E&C, and see a pier for what they thought was a bridge toa “V” shaped cycle in machinery. Chinese policy tightening in mid 2010 may worsen as the China CPI (all items)negatively surprises. We see $65-$85/bbl. as the oil price range, adding ~$2-3/bbl. each year. Resilient oil prices,which have confounded skeptics, are probably due to the U.S. dollar, low interest rates (opportunity cost and cost ofcarry) and Emerging market (EM) demand. We believe the “job” of the oil price is to drive G7 demand growth to zero,while accommodating non-G7 and especially EM demand growth. Thus, the risk to oil is weak EM demand (more sothan supply). We prefer “oily” plays, including downstream, more so than solid mineral leveraged stocks.

Market Strategy

Barry B. Bannister, CFAManaging Director, Equity Research

Stifel Nicolaus & [email protected]

All relevant disclosures and certifications can be found on page 38-39 of this report and on the research page at stifel.com.

Current Macro-Trends

A Rocky Balboa Stock Market

June 2, 2010

Market Strategy June 2, 2010

Equity overview, seated in the middle of a secular bear range, expect higher 2010-11, then lower 2012-13

– In each of the following we believe:

• Still a “secular bear market” (trading range 2000-14).

• Entering a Rocky Balboa home stretch of “punch drunk” volatility.

• U.S. stocks now “mid-bull:” volatile, less steep up-trend 2010/11.

• S&P 500 unlikely to exceed $1,250 in 2010 or $1,350 in 2011.

• Difficult policy choices and outcomes may pressure 2012/13.

• Nominal S&P 500 low $666 Mar-09, real low may occur 2012-14.

• S&P $1,360 ($80 EPS x P/E 17x) at low inflation, $880 ($80 x 11x) at high inflation.


We suspect that the real fireworks for equity markets begin when the U.S. Federal Reserve and ECB begin to raise rates, thereby attempting to put the "toothpaste" of monetary accommodation "back in the tube." We expect that such an event for the U.S. Fed will commence in about 12 months. As a result, we see the U.S. S&P 500 index the next year as a mildly rising, more volatile up-trend, i.e., a “mid bull.”

Source: Stifel Nicolaus EquityCompass Strategies, Bloomberg.

S&P 500 | 12/31/2002 – 5/28/2010 | Source: EquityCompass Strategies, Bloomberg

Phases of a Stock Market Cycle

Bear Market

Mid Bull

S&P 500 Index

OversoldStocks

DefensiveMomentumAttractive Relative ValueOversold Stocks

Key to Outperformance

Early Bull Bear Market Late Bull Mid Bull Early Bull Market Phase

OversoldStocks

DefensiveMomentumAttractive Relative ValueOversold Stocks

Key to Outperformance

Early Bull Bear Market Late Bull Mid Bull Early Bull Market Phase

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Secular bear markets flatten in nominal terms (but decline in real terms, after inflation) for ~14 years (average of the past cycles below, we explain why shortly), and this secular bear began in 2000. We’ll know the secular bear is over if the S&P 500 decisively pierces the 2000-2010 ~$1,550 S&P 500 high and keep going. In a sense, in true Jesse Livermore fashion, we would like stocks more the higher they go in the primary trend. The nominal low in a secular bear is usually seen ~7-10 years before a new secular bull begins, and we believe 2009 S&P 500 $666 (DJIA $6,443) was the nominal low in this cycle.

Source: Dow Jones, U.S. Census, Stifel Nicolaus format.

Real (Inflation-adjusted) Dow Jones Industrial Average (2008$) versus Nominal Dow Jones Industrial Average - Chart is through most current data

$10

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1907 to 19211929 to 1942

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2000 to ….Inflation-adjusted Dow

Jones Industrial Average

Dow Jones Industrial Average

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1921new

secularbull

market

1932wasthelow

1942new

secularbull

market

1974wasthelow

1982new

secularbull

market

2009wasthe

secular bear

nominallow, in

our view.


We believe secular bear markets end when equity has been de-capitalized as a percentage of GDP and all types of investors have been impacted, e.g., buy and hold loses capital or purchasing power, momentum buys high/sells low several times, and market timers miss increasingly rapid rallies. The reason this market “feels” like it is in the middle of fair value is precisely because it is between two extremes relative to GDP. Since equity today is the junior slice of capital in a leveraged system, it is most at risk/most volatile, in our view.

?

Source: Ned Davis Research.


Source: FactSet prices, St. Louis Federal Reserve, Stifel Nicolaus format.

True to history, the S&P 500 (month-end prices shown below) price bottomed Feb-09, and 10 months later in Dec-09 the employment ratio followed suit, matching the historical lag. Note also the sharp S&P 500 rise before employment turns up, and more moderate market advances thereafter, which we expect 2010-11. Finally, note the increasingly weak turns in employment, which is the cumulative effect of debt deflation. We expect a moderate recovery in the employment ratio (green line below) outside of U.S. Census jobs.

Civilian Non-Institutional* Employment to Population Ratio versus S&P 500 Index (log scale)

Sharp S&P 500 rise before employment turns up, moderate market advances afterward, plus increasingly modest turns in employment (cumulative debt deflation).

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Civilian Employment to Population Ratio (Left Axis)

S&P 500 Index (log Scale, Right Axis)

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*The civilian non-institutional population consists of persons 16 years of age and older residing in the50 States and the District of Columbia who are not inmates of institutions (for example, penal and mental facilities and homes for the aged) and who are not on active duty in the Armed Forces.

10mos.


Source: Bank Credit Analyst May 14, 2010.

The current cycle is progressing like an exaggerated version of a “normal” recession, mimicking the past six recessions in terms of real retail sales (up strongly, pace to moderate), real wages & salary growth (to rise further, but taper off), and real income from government transfers (cresting, perhaps no longer needed). Maybe $2.5 trillion of Fed and Treasury assistance has created the illusion of a normal cycle. Or perhaps the authorities have been successful. Until the consumer and investment foundation shakes (or credit rafters break), we believe it still pays to play along.


Credit growth created excessive liquidity (M3, left chart), but velocity of that money has collapsed, reducing inflation pressures. The inflation vs. disinflation questions shapes the S&P 500 P/E (right chart). If, for example, S&P 500 EPS are $80 in 2010/11 (bottom-up estimates are invariably too optimistic vis-à-vis top-down S&P 500 EPS estimates), that may be worth ~$1,360 ($80 EPS x P/E 17x) at low inflation or $880 ($80 x 11) at high inflation. Bear in mind that deflation is also destructive to capital, and since deflation is the response to asset or price inflation P/E lows are often seen during deflationary busts.

Source: U.S. Federal Reserve, U.S. Federal Reserve for M3 (SA) 1959 to 2005. For M3 2006 forward we use: M2 + Large time deposits + Money Mkt. Balance + Fed Funds & Reverse repos with non-banks + Interbank loans + Eurodollars (regress historical levels versus levels of M3 excluding Eurodollars), Stifel Nicolaus format.

Growth of Components of U.S. M3 Money Supply ($ bil.)

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Institutional MoneyFunds

Eurodollars

Repos

Large-TimeDeposits

Retail MoneyFunds

Small Denom.Time Deposits

Savings Deposits

Demand & OtherCheck Deposits

Currency &Travelers Checks

M2 = Below

Sum = M3

M1 = Below

Mexican Peso & Asian debt crises.

A combination of importing the

savings of emerging markets and using leverage (money

multiplier) to grow money supply.

The multiplier has subsided, hence

fiscal stimulus and quantitative easing.

Collapsing inflation lowers interest rates,

increasing debt capacity.

6X7X8X9X

10X11X12X13X14X15X

16X17X18X19X20X21X22X

23X24X25X26X

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P/E of the S&P 500, 5-Yr. Moving Average (Left Axis)U.S. Consumer Inflation, Y/Y % Change, 5-Year Moving Average (Right Axis)

U.S. Consumer Price Inflation (Inverted, Right Axis) vs. S&P 500 P/E Ratio (Left Axis)


Watch policy, it is a “bull market in government”– In each of the following we believe:

• Asia (late 1990s), U.S. (early 2000s) competitive devaluations.

• Europe late to devalue 2010, to grow less robustly as a result.

• Public offsetting private deleveraging has questionable efficacy.

• U.S. Fed/Treasury were positioned to assist. Not as much now.

• U.S. per capita GDP may stagnate, versus overall GDP ~3.5%.

• Deflation risks still outweigh inflation, liquidity preferences argue against a run on banks.


Similar to the U.K. devaluation and rapid take-off for growth in 1931, Asia (led by China) undervalued their FX after the late 1990s EM debt crisis. As expected, the first to devalue achieves very strong growth, and Asian GDP soared.

On the heels of Asia around 2001 the U.S. followed a currency devaluation strategy and GDP rose accordingly. This was similar to the way in which the U.S. in 1933 followed the 1931 U.K. devaluation. As expected, the second to devalue achieved strong growth.

Who wants to be the last strong currency? Apparently Western Europe. Just as France held on for too long to a strong currency and suffered a weak recovery in 1936, euro was the last strong FX in our era, and probably suffers a weaker recovery having finally acquiesced to devaluation.

“The Americans get the toys, the Chinese get the Treasuries, and we get screwed.” – Unnamed European official. The competitive devaluations that began in the late 1990s have finally come around to Europe. We expect weak EU GDP, Greece to go the way of Lehman (sacrificial lamb bailed out and kicked out) and the zone to limp along for years like the U.S. financials. Perhaps this debacle will finally bury French pan-European nationalism and end German guilt, since giving up the beloved DM has proved to be a mistake.

Source: Bank Credit Analyst , Stifel Nicolaus commentary.


Debt as a Percentage of U.S. GDP, by Category

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Financial Debt / US GDPPublic Nonfinancial Debt / US GDPPrivate Nonfinancial Household Debt / US GDPPrivate Nonfinancial Business Debt / US GDP

Change in debt since the peak as a % of GDP (bps):

Financial debt Peak: 1Q09 Change: -970 bpsPrivate household Peak: 2Q09 Change: -333 bpsPrivate business Peak: 2Q09 Change: -380 bpsPublic debt Bottom: 2Q08 Change: +1,074 bps= Total debt/GDP up from 354% (2Q08) to 362% (4Q09)

Source: FactSet prices, St. Louis Federal Reserve, Stifel Nicolaus format.

Thus far, increased government debt has

offset decreasing private debt, hardly a test of de-leveraging, in our view.

Since we believe many jobs dependent upon consumption and asset inflation (ex., finance and retail) are gone for good, and government debt is being used to forestall the effects of private sector debt default (brown line rising, below), we foresee at best a weak full cycle jobs recovery, with unemployment unlikely to fall much below 6% (roughly the 50-year average), as well as sporadic difficulties unwinding the consumer debt bubble. Stepping in, the U.S. government hasplausibly been able to borrow the gap because demand for U.S. paper is strong, with low rates (avg. maturity ~4 years).


U.S. Federal Reserve Bank Assets & Liabilities

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Liquidity Facilities

Other

Repurchase Agreements

Term Auction Credit

Securities Held Outright

Reserve Balances withFederal Reserve Banks

Treasury SupplementaryFinancing Program (SPF)

Other

Currency in Circulation

Assets

Liabilities

$ Bill ion

In a similar sense the U.S. Fed was able to double its balance sheet (left chart) because as a percentage of GDP when the crisis began (right chart) the Fed balance sheet was quite small in 2007. So, in a sense, the U.S. Fed and U.S. Treasury have expended their bullets short of outright monetization of Federal debt as a means to restart growth.

Total Financial Assets of the Monetary Authority as a Percentage of U.S. GDP

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Source: U.S. Fed and government data, Stifel Nicolaus format.


Concurrent with an age of thrift beginning, debt appears to be losing its ability to “kick-start” growth. The charts below show that the incremental dollars of nominal U.S. GDP per dollar of incremental U.S. non-financial debt, which we have long termed “Zero Hour,” recently dipped below zero due to recession. These charts may help explain why the cycles of employment growth shown two pages earlier are growing more shallow. Cumulative indebtedness is the “cause,” and the “effect” is poor employment growth.

Source: Federal Reserve Flow of Funds, Stifel Nicolaus format.

Zero-Hour? Diminishing U.S. GDP Returns from Each $1 of New Non-Financial U.S. Debt, 1Q 1954 to 4Q 2009

(Not smoothed)

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Dollar change y/y in U.S. Nominal GDP divided by dollar change y/y in Non-Financial U.S. Debt equals the

dollar increase in GDP per $1.00 increase in Non-Financial U.S. Debt.

U.S. Total Non-Financial Debt Growth y/y%, 4Q54 to 4Q09 (Red) vs. U.S. nominal GDP growth y/y% 4Q54 to 4Q09

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Source: Bank Credit Analyst

Tangible evidence of the deflationary impact of cumulative debt leverage:

Each chart on this page clearly shows a decline in growth since the early 1980s when leveraging began in earnest.

The degree to which corporate profits are “manufactured” by leverage, combined with the way in which leverage has diminishing returns (Zero Hour, discussed previously), argue for a deflationary backdrop to policy.

This trend does not argue for a strong rebound in U.S. economic activity beyond ~3 ½% U.S. GDP, in our view.


Source: Historical Statistics of the United States, Millennial Edition, U.S. Census.

U.S. GDP per capita for 209 years has grown at 1.6%/year, with population growth of 2.0%, producing real GDP growth of 3.6%. Recent trends have supported ~2.5% growth in productivity, and for the past decade the U.S. population has grown at a fairly consistent 1.0%. This indicates that ~3.5% (2.5% + 1%) U.S. real GDP growth potential, no different than the historical trend. What worries us is that an abnormal credit environment pushed growth above trend in recent decades (shown in the chart below). If de-leveraging the consumption side of the U.S. economy causes U.S. per capita real GDP to converge on the long-term trend shown in the chart below, such a process would be a deflationary headwind.

Log of U.S. Real GDP per Capita, 1800 to 1Q2010Trend growth since 1800 of 1.6%, with population growth of 2.0% and U.S. real GDP growth of 3.6%

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Trend 1.6%U.S. GDP/capita

growth

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GDP would have to

decline 12% (twelve

percent) at once, or

somewhat less over

time.


Source: “A Monetary History of the United States”, Friedman and Schwartz, NBER, Federal Reserve.

One argument supportive of deflation is that there is a scarcity of physical paper dollars in bank vaults relative to all time and demand deposits. This is especially true given that around 30% of physical U.S. currency supply is “circulating”overseas. Sudden withdrawal of deposits would shrink bank reserves one-for-one, a situation similar to the banking failures of the 1930s. As the chart below shows, the public’s liquidity preference is such that there is a century high record amount ($139) of dollars on deposit for every dollar held inside banks. With the Fed’s nearly $1 trillion injection of excess reserves last year we believe the risk of a bank run has been substantially reduced, but that still begs the question of what to do with the excess reserves created. Idle reserves and a dearth of cash relative to deposits is deflationary, in our view.

Dollars of Total Time & Demand Deposits per Dollar of Total Vault CashSeasonally adjusted prior to 1946, Not seasonally adjusted after 1945

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Of greater concern to us than Fed asset quality or rising Federal debt and guarantees is the outlook for social program costs.



The historian Will Durant wrote in the late 1960s that "Since practical ability differs from person to person, the majority of such abilities, in nearly all societies, is gathered in a minority of men. The concentration of wealth is a natural result of the concentration of ability and regularly occurs in history” (left chart). Currently, the top 20% receive half the income, and we know from other research sources that the bottom 50% pay no net income tax (only payroll taxes). That seems to us a level of disenfranchisement(1) not seen since imperial, plutocratic Rome. As a result, U.S. government deficits (right chart) may reflect poor tax base dynamics. Concentration of wealth due to the concentration of ability produces systemic instability, which then leads to "…redistribution of wealth through taxation, or redistribution of poverty through revolution," according to Durant. The U.S. has historically chosen taxation (including bracket creep) and inflation (1930s-1940s, 1960s-1970s) as forms of confiscation rather than revolution. The end result is similar, in our view, the former just gives investors more time to prepare.

(1) As the Roman Empire progressed from being farmers/citizens/soldiers with a stake in the affairs of state to a disenfranchised citizenry on a dole funded by the plutocrats, the Empire began to rot from the core.


“Paper vs. Hard Assets,” the hard asset trade is mature, now is the time for (over)investment in commodity capacity –

In each of the following we believe:

• Commodity rel. strength drives our coverage (momentum plays).

• Rolling return of commodities at historic highs, S&P 500 at lows.

• Commodities rel. to S&P 500 now in a mature, oscillating phase.

• U.S.$ 2010 jump is part of unwinding the post-W.W. II bubble.

• May 2010 ECB action did establish a Club Med rate and € floor.

• Tax, protectionism, xenophobia, entitlements long-term issues.


U.S. Commodity Price Index*, y/y% change, 1912 to 2010 latest, 5-yr. M.A. versus Deere relative to the S&P 500 1927 to Present

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%,

5-yr

. mov

. avg

.

0%

1%

2%

3%

4%

5%

6%

7%

Dee

re s

tock

div

ided

by

the

S&P

500

Commodity Price Index, y/y % change, 5-yr. moving average, left axisDeere stock relative to the S&P 500 (S&P Composite in earliest periods), right axis

* Producer Price Index fo r Commodities 1907-56, CRB Futures 1957-present

Crude oil and FLR stock relative strength versus the S&P 500, 1965 to 2010 latest

0%

5%

10%

15%

20%

25%

30%

35%

40%

Dec-65

Dec-67

Dec-69

Dec-71

Dec-73

Dec-75

Dec-77

Dec-79

Dec-81

Dec-83

Dec-85

Dec-87

Dec-89

Dec-91

Dec-93

Dec-95

Dec-97

Dec-99

Dec-01

Dec-03

Dec-05

Dec-07

Dec-09

WTI

oil

pric

e re

lativ

e to

the

S&P

500

0%

3%

5%

8%

10%

13%

15%

18%

20%

23%

25%

28%

FLR

pric

e re

lativ

e to

the

S&P

500

WTI oil price relative to the S&P 500 FLR price relative to the S&P 500

Commodity prices are of great interest to us because we shaped our coverage to benefit from commodities about 10 years ago. The left chart shows that the relative strength versus the S&P 500 of farm equipment maker Deere & Co. since 1927 tracks commodity prices, as does the relative strength of global engineer Fluor Corp., shown in the right chart since 1965.

Source: FactSet prices, Moody’s / Merchant Manual prices split-adjusted, EIA oil prices, Stifel Nicolaus format.


S&P Stock Market Composite 10-Year Compound Annual Total Return (Incl. Reinvested Dividends),

Data 1830 to June-1, 2010

-2.5%

0.0%

2.5%

5.0%

7.5%

10.0%

12.5%

15.0%

17.5%

20.0%

22.5%

1839

1849

1859

1869

1879

1889

1899

1909

1919

1929

1939

1949

1959

1969

1979

1989

1999

2009

Commodity prices are cyclical and move in unisonCommodities by category, data 1795 to April-2010, 10-yr. M.A.

-12%

-10%

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

22%

1805

1815

1825

1835

1845

1855

1865

1875

1885

1895

1905

1915

1925

1935

1945

1955

1965

1975

1985

1995

2005

All Commodities Fuels & Lighting

Cold War/OPEC

War of

1812

W.W. I I &Korean Conflict

W.W. I

CivilWar

U.S. industrial

revolution & overheating / gold surplus.

Easy credit speculative

boom.

Commodity price momentum appears to be coming off a cyclical high (left chart), while the S&P 500 total return (price change + dividend) momentum appears to be coming off a cyclical low (right chart). A great deal of currency debasement and default risk appears to us already priced into the S&P 500.

Source: Stifel Nicolaus format, data Historical Statistics of the United States, a U.S. Census publication.


The 140-year chart below measures the relative performance of the U.S. stock market (S&P) index relative to commodities. Note that the 1932 to 1942 as well as the 1974 to 1982 periods featured multiple bottoms before a sustained bull market for equities began. We believe a bottoming process/oscillation has begun for the period 2010 to 2015.

Source: Standard & Poor’s (S&P composite joined to S&P 500), U.S. government (PPI for Commodities joined to the CRB spot then the CRB futures).

0.0

0.1

1.0

10.0

100.0

1870

1875

1880

1885

1890

1895

1900

1905

1910

1915

1920

1925

1930

1935

1940

1945

1950

1955

1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

2010

E

2015

E

Rel

ativ

e pr

ice

stre

ngth

, sto

cks

vs. c

omm

oditi

es, l

og s

cale

U.S. stock market composite relative to the U.S. commodity market, 1870 to present

Key: When the line is rising, the S&P stock market index beats the commodity price index and inflation eventually falls. When the line is falling, the opposite occurs.

U.S. Stock Market Relative to The Commodity Market, 1870 to June 1, 2010.

Post-Civil War Reconstruction ends in

1877, gold standard begins 1879,

deflationary boom, stocks rally.

Pearl Harbor, WW2

1939-45

Gold nationalized

U.S.$ devalued in 1933. FDR's "New Deal" &

reflation begins.

'29 Crash

Post-WW 1 commodity

bubble bursts, deflation ensues

in 1920, bull market begins.

WW11914 to

1918

OPEC '73 embargo; 1973-74

Bear Market, Iran

fell '79.

LBJ's Great Society + Vietnam

1960s; Nixon closed gold

window 1971, all inflationary.

Post-WW 2 commodity &

inflation bubble bursts ca. 1950,

disinflation ensues,

Eisenhower bull market begins.

OPEC overplays hand and oil prices collapse 1981, Volcker stops

inflation 1981-82, then Reagan tax cuts, long Soviet

collapse, disinflation & bull market begin.

Tech Bubble 2000, 9/11, U.S. $ weak, commodity bull begins, Mid-East wars,

Asian oil use, strong global dollar demand after the

1990s emerging markets debt crisis, credit crisis in

U.S.

Populism in U.S. politics.

Panic of 1907, a banking crisis &

stock market crash.

`


Nominal Trade-Weighted U.S.$ Major Currency Index, 1935 to May-2010 (Left) versus U.S. GDP as a share of global GDP expressed in U.S. $, 1950 to 2010E (Right)

30

40

50

60

70

80

90

100

110

120

1935

1940

1945

1950

1955

1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

2010

E

2015

E

Nom

inal

trad

e-w

eigh

ted

U.S

. $

12%

14%

16%

18%

20%

22%

24%

26%

28%

U.S

. GD

P sh

are

of g

loba

l GD

P (e

xpre

ssed

in

U.S

. $)

Bretton WoodsAgreement

began U.S. dollar bubble; U.S. share

of world GDP dominates. Vietnam, social

programs, EU and Japan recovery weigh on dollar resulting is

gold outflows.

Emerging markets reserves increase,

dollar rallies.

Fed tightens 1969, dollar rallies, Martin > Burns Fed transition 1970 then Bretton

Woods abandoned 1971

Fed's Volcker hikes rates sharply.

Source: U.S. GDP with a base year 1990 links the OECD Geary-Khamis 1950 to 1979 series to the IMF World Economic Outlook 1980 to present series, including 2009 & 2010 estimates. U.S. dollar data is from the U.S. Federal Reserve 1971 to present, for 1970 and prior we use R.L. Bidwell - “Currency Conversion Tables - 100 Years of Change,” Rex Collins, London, 1970, and B.R. Mitchell - British Historical Statistics - Cambridge Press, pp. 700-703. For trade weightings pre-1971 we use “Historical Statistics of the United States, Colonial Times to 1970,” a U.S. Census publication.

Why did the U.S. choose leverage? Probably because it was just too tempting given the status of the U.S. dollar as the world reserve currency, itself a fringe benefit of defeating the fascists (WW2) and collectivists (Cold War). The U.S. could afford to defend the free world and support a rising welfare (entitlements) state. Note below that the dollar surged after WW2 with the Bretton Woods Agreement in which the U.S. dollar tied to gold and the world’s currencies floated (usually down) versus the dollar. Ending the gold standard in the late 1960s to 1971 enabled reserve accumulation, and the U.S. logically chose to accumulate debt as well as gradually inflate. The long downtrend has been interrupted by short squeezes for the dollar, shown in the blue line below as spikes post-1969. We are not impressed by the EU or Chinese model, and believe another such spike in the dollar could be in the offing.


Source: U.S. Federal Reserve, FactSet, Stifel Nicolaus.

After “bursting a bubble” in oil following a “standard” disbelief, belief and euphoria 3-stage bubble 1999-2008 (left chart), we see oil as range bound unless inflation takes hold in the U.S. economy. Oil continues to track the U.S. dollar, and the DXY dollar index equates to an oil price ~$70/bbl. currently (right chart).

$0/bbl.

$10/bbl.

$20/bbl.

$30/bbl.

$40/bbl.

$50/bbl.

$60/bbl.

$70/bbl.

$80/bbl.

$90/bbl.

$100/bbl.

$110/bbl.

$120/bbl.

$130/bbl.

$140/bbl.

$150/bbl. Jan-03A

pr-03Jul-03O

ct-03Jan-04A

pr-04Jul-04O

ct-04Jan-05A

pr-05Jul-05O

ct-05Jan-06A

pr-06Jul-06O

ct-06Jan-07A

pr-07Jul-07O

ct-07Jan-08A

pr-08Jul-08O

ct-08Jan-09A

pr-09Jul-09O

ct-09Jan-10A

pr-10

WTI

, $ p

er b

bl.,

inve

rted

axis

60

65

70

75

80

85

90

95

100

105

DXY

Dol

lar I

ndex

WTI, $ per bbl

U.S. Dollar Index DXY

Correlation Coefficient = 0.81

DXY Dollar index (right axis) versus WTI Crude Oil price

(inverted, left axis)

Crude oil price, $/bbl. (month-end prices)depicting the "typical" bubble 3-stage bull market

that breaks and segues to a trading range

$0

$10

$20

$30

$40

$50

$60

$70

$80

$90

$100

$110

$120

$130

$140

$150

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

Disbelief~$11 to $34

= ~3x

Euphoria ~$55 to $147 (high)

= ~3x

Belief~$24 to $74

= ~3x


Contrary to what many euro shorts believe, Central Banks can easily peg interest rates with minimal purchases of sovereign issues.

The precedent is the pre-Treasury Accord of 1942-51. A probable “miscalculation” may occur, however, when one of the Club Med attempts to issue 90-day paper and the ECB has to backstop the whole issue.

The successful precedent for sovereign debt prices being pegged for prolonged periods was the Treasury Accord, referenced by Ben Bernanke in 2002 in his famous "Helicopter Speech (See Note 1)."

"Historical experience tends to support the proposition that a sufficiently determined Fed can peg or cap Treasury bond prices and yields at other than the shortest maturities. The most striking episode of bond-price pegging occurred during [1942 to 1951, see Note (2), when]...the Fed was able to achieve these low interest rates [2.50% long-term Treasury bonds, 0.875% to 1.25% twelve-month Treasury certificates, 0.375% 90-day Treasury bills, four of those years to finance W.W. II] despite a level of outstanding government debt (relative to GDP) significantly greater than we have today, as well as inflation rates substantially more variable. At times, in order to enforce these low rates, the Fed had actually to purchase the bulk of outstanding 90-day bills. Interestingly, though, the Fed enforced the 2.50% ceiling on long-term bond yields for nearly a decade without ever holding a substantial share of long-maturity bonds outstanding. For example, the Fed held 7.0% of outstanding Treasury securities in 1945 and 9.2% in 1951 (the year of the Accord), almost entirely in the form of 90-day bills. For comparison, in 2001 the Fed held 9.7% of the stock of outstanding Treasury debt."

(Note 1) http://www.federalreserve.gov/BOARDDOCS/SPEECHES/2002/20021121/default.htm(Note 2) http://www.richmondfed.org/publications/research/economic_quarterly/2001/winter/pdf/hetzel.pdf


Market price for fiat sovereigns before the

central bank instituted a price floor… Mayhem.

Market price for fiat sovereigns after the central bank institutes a price floor.

Speculators rush to

arbitrage the low

seller out of existence.

Market price for fiat sovereigns if a rogue seller offers sovereigns below the

central bank price floor.

When the ECB backed the Club Med debt, we believe the central bank effectively instituted a price floor for EU sovereigns and the currency by creating a Nash Equilibrium that we expect will hold.

Speculators compete with one

another to be the first to tender

bonds to a buyer who is implicitly backed by the ECB.

Source: Microsoft Clip Art images, Stifel Nicolaus format.


Source: Factset prices, Stifel Nicolaus format.

Month-end gold price (left axis) vs. inflation-adj. month-end S&P 500 price (right),

1972 to 1987

$0

$100

$200

$300

$400

$500

$600

$700

Jan-

72

Jan-

73

Jan-

74

Jan-

75

Jan-

76

Jan-

77

Jan-

78

Jan-

79

Jan-

80

Jan-

81

Jan-

82

Jan-

83

Jan-

84

Jan-

85

Jan-

86

Jan-

87

Gol

d /$

oz.

$100

$125

$150

$175

$200

$225

$250

$275

$300

Infla

tion-

adju

sted

S&

P 50

0

Gold/$oz. (left) Inflation-adjusted S&P 500 price (right)

1 23

Month-end gold price (left axis) vs. inflation-adj. month-end S&P 500 price (right),

1999 to present

$100

$200

$300

$400

$500

$600

$700

$800

$900

$1,000

$1,100

$1,200

$1,300

Jan-

99

Jan-

00

Jan-

01

Jan-

02

Jan-

03

Jan-

04

Jan-

05

Jan-

06

Jan-

07

Jan-

08

Jan-

09

Jan-

10

Jan-

11

Jan-

12

Jan-

13

Jan-

14

Jan-

15

Gol

d /$

oz.

$300

$400

$500

$600

$700

$800

$900

$1,000

Infla

tion-

adju

sted

S&

P 50

0

Gold/$oz. (left) Inflation-adjusted S&P 500 price (right)

1 2 3?

Left chart: Tight policy choices to combat price inflation led to both the S&P 500 and gold plunging 1980-82 (Point 1, chart below), however gold plunged more since it was hobbled by policy. Both gold and the S&P 500 recovered and corrected fitfully 1982-84 conforming to policy moves (2), but a new “regime” of tighter policy caused gold and the S&P 500 to diverge post-1984 (3), with the S&P 500 leading for ~15 years.

Right chart: Loose monetary and fiscal policy responses to combat debt deflation resulted after both gold and the S&P 500 corrected 2008-09 (1), however the S&P 500 fell more sharply as it was disadvantaged by debt deflation. Both gold and the S&P 500 recovered 2009-10 as policy gained traction (2), but we expect both gold and the S&P 500 to correct by 2011-12 when authorities attempt to tighten. After that, we expect one asset to prevail (3).


Commodity drivers, watch out for Summer 2010 China CPI and tightening – In each of the following we believe:

• Rising interest in energy E&C, China mineral plays petering out.

• See $65-85/bbl. as oil price range, adding ~$2-3/bbl. each year.

• Resilient oil price due to U.S.$, interest rates and EM demand.

• The “job” of oil price is to drive G7 demand growth to zero.

• The risk to oil is thus weak EM demand (more so than supply).

• Chinese tightening June-July 2010 may worsen as CPI surprises.

• Prefer “oily” plays, incl. downstream, more than solid minerals.


Our mood swings the past few years: We rode the commodity wave for over 100% out-performance versus the S&P 500 from Nov-06 to Jul-08 with mostly Buy ratings on our commodity-geared universe (we chose commodity stocks to cover in 2002, anticipating a commodity boom). But we were slammed in the financial crisis of Aug-08 to Nov-08 when we failed to appreciate the reserve currency appreciation (and thus commodity depreciation) associated with debt deflation. We redoubled our historical analysis efforts, and did pick some of the best performing E&C and Machinery stocks from Dec-08 to Aug-09, but switched prematurely from mid-cycle Machinery to late cycle E&C in Sep-09 and have since watched Machinery beat our E&C picks by a large margin. We sense a growing appetite for late cycle E&C, and believe China-dependent mining/coal/steel machinery-exposed plays are petering out.

Source: FactSet prices, Stifel Nicolaus format.

Our E&C vs. Machinery equal-weighted universe up to and after the bubble11/16/06 = 100, relative to the S&P 500

75

100

125

150

175

200

225

250

Nov-

06

Jan-

07

Mar

-07

May

-07

Jul-0

7

Sep

-07

Nov-

07

Jan-

08

Mar

-08

May

-08

Jul-0

8

Sep

-08

Nov-

08

Jan-

09

Mar

-09

May

-09

Jul-0

9

Sep

-09

Nov-

09

Jan-

10

Mar

-10

May

-10

E&C Equal Weighted Avg rel. to S&P 500 (11/16/2006=100)Machinery Equal Weighted Avg rel. to S&P 500 (11/16/2006=100)

Machinery surged ahead on China minerals demand but that theme is tiring, while E&C just

consolidate awaiting better petroleum capex(especially downstream).


Real Crude Oil prices (left axis, solid area) vs. y/y GDP converted to monthly (right axis)

$0.00

$10.00

$20.00

$30.00

$40.00

$50.00

$60.00

$70.00

$80.00

$90.00

$100.00

$110.00

$120.00

$130.00

$140.00

Jan-

73Ja

n-74

Jan-

75Ja

n-76

Jan-

77Ja

n-78

Jan-

79Ja

n-80

Jan-

81Ja

n-82

Jan-

83Ja

n-84

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85Ja

n-86

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87Ja

n-88

Jan-

89Ja

n-90

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91Ja

n-92

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93Ja

n-94

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95Ja

n-96

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97Ja

n-98

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99Ja

n-00

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01Ja

n-02

Jan-

03Ja

n-04

Jan-

05Ja

n-06

Jan-

07Ja

n-08

Jan-

09Ja

n-10

-6.0%

-5.0%-4.0%

-3.0%

-2.0%

-1.0%0.0%

1.0%

2.0%

3.0%4.0%

5.0%

6.0%

7.0%8.0%

9.0%

10.0%

Inflation- adjusted Crude Oil $ per bbl U.S. Real GDP Monthly y/y % chng (left)

If oil doesn’t actually cause a recession, we believe it certainly renders the coup de grâce by causing already slowing GDP to “go negative.” As a result, following oil is critical for any industrial analyst. This chart also shows that particularly deepU.S. recessions occur at ~$85/bbl. and higher (in inflation-adjusted terms), consistent with our earlier charts.

Source: U.S. Department of Commerce, BEA, NYMEX.


Source: U.S. DOE and government data, Stifel Nicolaus format.

U.S. consumer use of gasoline has historically plunged when inflation-adjusted retail gasoline prices have broken through $2.85/gallon, equivalent to inflation-adjusted crude oil prices of ~$85/bbl. at more “normal” crack spreads. We see $85/bbl. as a ceiling for inflation-adjusted crude oil prices for the foreseeable future. Nominal crude oil prices would thus only exceed $85/bbl. when/if U.S. inflation accelerates.

US Oil Demand vs. Inflation adjusted Retail Gasoline

$1.00

$1.50

$2.00

$2.50

$3.00

$3.50

$4.00

$4.50Ja

n-73

Jan-

75

Jan-

77

Jan-

79

Jan-

81

Jan-

83

Jan-

85

Jan-

87

Jan-

89

Jan-

91

Jan-

93

Jan-

95

Jan-

97

Jan-

99

Jan-

01

Jan-

03

Jan-

05

Jan-

07

Jan-

09

Infla

tion

adj.

U.S

. All

Gra

des

Ret

ail

Gas

olin

e Pr

ices

($/g

allo

n)

14

15

16

17

18

19

20

21

22

23

US

Oil

Dem

and

(mil

b/d)

Inflation adjusted U.S All Grades Retail Gasoline Prices ($ per Gallon) US Oil Demand (mil b/d)


Source: EIA, BP Statistical Review of World Energy, United Nations, IEA, Stifel Nicolaus format.The G7 is the U.S., U.K., Japan, Germany, France, Italy, and Canada.

Will oil demand growth be “supernormal” due to EM demand growth? No. The “job” of the oil price is to rise just to the point that the G7 consumption growth = 0%. The G7 (U.S., U.K., Japan, Germany, France, Italy, and Canada) is 11% of global population and 38% of annual world oil demand, with a long-term demand declining trend of ~(0.33)%/year (red regression line, left chart), indicative of demand destruction, not demand deferral. In contrast, non-G7 is 89% of the world population and 62% of world oil demand, with +2.85%/year usage growth (red regression line, right chart), indicative of demand creation. The resulting average is [0.38 x (0.33)% + .62 x 2.85%] = +1.6%/yr. world oil demand growth.

Non-G7 oil demand (bars), y/y % demand growth (line), 1981 to 2010E: The trend supports +2.85%/year growth

(line) for 89% of the world population that currently uses 62% of the world's oil.

20,000

25,000

30,000

35,000

40,000

45,000

50,000

55,000

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

Oil

cons

umpt

ion

(000

bbl

/d)

-9.0%-8.0%-7.0%-6.0%-5.0%-4.0%-3.0%-2.0%-1.0%0.0%1.0%2.0%3.0%4.0%5.0%6.0%7.0%8.0%9.0%10.0%

Non

-G7

oil c

onsu

mpt

ion,

y/y

%

Non-G7 oil consumption thous. b/dNon-G7 oil consumption Y/Y%Linear (Non-G7 oil consumption Y/Y%)

G7 oil demand (bars) and y/y % demand growth (line), 1981 to 2010E: The trend supports

-0.33% growth (line) for 11% of the world population that currently uses 38%

of the world's oil

20,000

25,000

30,000

35,000

40,000

45,000

50,000

55,000

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

Oil

cons

umpt

ion

(000

bbl

/d)

-7.0%-6.0%-5.0%-4.0%-3.0%-2.0%-1.0%0.0%1.0%2.0%3.0%4.0%5.0%6.0%7.0%8.0%9.0%10.0%

G7

oil c

onsu

mpt

ion,

y/y

%

G7 oil consumption thous. b/dG7 oil consumption Y/Y%Linear (G7 oil consumption Y/Y%)


As we showed on the previous page, [0.38 x (0.33)% + .62 x 2.85%] = +1.6%/yr. world oil demand growth, which is close to the historical average of 1.5% shown in the top chart. With OPEC spare oil producing capacity of ~6mb/d and Saudi Arabia only wishing to retain ~2mb/d of spare capacity, and with Manifa in Saudi Arabia and rising Iraq production only enhancing future OPEC capacity, we believe that “excess spare” capacity of 4mb/d (6 minus 2) already exists to cover 3 years of world oil demand growth [1.5% x 85 mb/d world oil demand = 1.275 mb/d (on average, 2010 should be higher, 2011 lower, etc.), which divided by 4 mb/d is ~3 years].

Source: EIA, BP Statistical Review of World Energy, United Nations, IEA, Stifel Nicolaus format.

Y/Y growth of oil demand 1981 to 2010EHistorical growth of ~+1.5% +/- 1.5% (e.g. 0% to 3%) outside of deep recessions

Future growth of [0.38 G7 demand x (0.33)% + .62 non-G7 demand x 2.85%] = +1.6%/yr.

-4.5%-4.0%-3.5%-3.0%-2.5%-2.0%-1.5%-1.0%-0.5%0.0%0.5%1.0%1.5%2.0%2.5%3.0%3.5%4.0%4.5%

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

E

Wor

ld o

il co

nsum

ptio

n y/

y %


China bank loans (bil. yuan/month, bars, left axis) vs. China oil usage (LTM, mil. bbls./day, line, right axis)

12,500B Yuan

15,000B Yuan

17,500B Yuan

20,000B Yuan

22,500B Yuan

25,000B Yuan

27,500B Yuan

30,000B Yuan

32,500B Yuan

35,000B Yuan

37,500B Yuan

40,000B Yuan

42,500B Yuan

45,000B Yuan

Jan-

04M

ay-0

4Se

p-04

Jan-

05M

ay-0

5Se

p-05

Jan-

06M

ay-0

6Se

p-06

Jan-

07M

ay-0

7Se

p-07

Jan-

08M

ay-0

8Se

p-08

Jan-

09M

ay-0

9Se

p-09

Jan-

10

5.5mb/d

5.8mb/d

6.0mb/d

6.3mb/d

6.5mb/d

6.8mb/d

7.0mb/d

7.3mb/d

7.5mb/d

7.8mb/d

8.0mb/d

8.3mb/d

8.5mb/d

8.8mb/d

9.0mb/d

9.3mb/d

9.5mb/d

China bank loans (billion yuan, bars, left axis) vs. China net coal* imports (LTM tons, mil., line, right axis)

12,500B Yuan

15,000B Yuan

17,500B Yuan

20,000B Yuan

22,500B Yuan

25,000B Yuan

27,500B Yuan

30,000B Yuan

32,500B Yuan

35,000B Yuan

37,500B Yuan

40,000B Yuan

42,500B Yuan

45,000B Yuan

Jan-

04M

ay-0

4Se

p-04

Jan-

05M

ay-0

5Se

p-05

Jan-

06M

ay-0

6Se

p-06

Jan-

07M

ay-0

7Se

p-07

Jan-

08M

ay-0

8Se

p-08

Jan-

09M

ay-0

9Se

p-09

Jan-

10

-100.0mt/y

-90.0mt/y

-80.0mt/y

-70.0mt/y

-60.0mt/y

-50.0mt/y

-40.0mt/y

-30.0mt/y

-20.0mt/y

-10.0mt/y

0.0mt/y

10.0mt/y

20.0mt/y

30.0mt/y

40.0mt/y

50.0mt/y

60.0mt/y

70.0mt/y

80.0mt/y

90.0mt/y

100.0mt/y

110.0mt/y

120.0mt/y

*Met coal + anthracite + steam coal

China bank loans (billion yuan, bars, left axis) vs. China iron ore imports (LTM tons, mil., line, right axis)

12,500B Yuan

15,000B Yuan

17,500B Yuan

20,000B Yuan

22,500B Yuan

25,000B Yuan

27,500B Yuan

30,000B Yuan

32,500B Yuan

35,000B Yuan

37,500B Yuan

40,000B Yuan

42,500B Yuan

45,000B Yuan

Jan-

04M

ay-0

4Se

p-04

Jan-

05M

ay-0

5Se

p-05

Jan-

06M

ay-0

6Se

p-06

Jan-

07M

ay-0

7Se

p-07

Jan-

08M

ay-0

8Se

p-08

Jan-

09M

ay-0

9Se

p-09

Jan-

105.0mt/y

10.0mt/y

15.0mt/y

20.0mt/y

25.0mt/y

30.0mt/y

35.0mt/y

40.0mt/y

45.0mt/y

50.0mt/y

55.0mt/y

60.0mt/y

65.0mt/y

70.0mt/y

China transitioning to net coal imports coincided exactly with the record surge in Chinese bank loans (left chart). Iron ore (middle chart) is similar, and (not shown) Chinese copper inventories are now at a record. China has had less of an effect on oil demand (right chart), which suggests that the large increases in the other commodities are stimulus-driven, since oil was not part of the Chinese stimulus via construction plan. This is also evident in the way China under-prices electric power, leading to waste of power and, probably, over-building. Perhaps that is why 23 of the 30 largest Chinese power producer’s stocks have failed to recover to the 2007-08 average highs. Given the importance of Chinese construction and power markets on other Asian nations and commodity exporters such as Brazil, Russia, Australia and so on, we believe the problem with a loan-driven strategy is that ever larger amounts of lending are required to achieve the same stimulating effect.

Surge in lending post-

January 2009

coincides with surge in net coal imports.

Source: People’s Bank of China, National Bureau of Statistics of China, FactSet, Stifel Nicolaus Metals & Mining research.

No such surge in oil usage,

because the lending program

was geared toward

“infrastructure.”

Surge in lending post-January 2009

coincides with surge in net coal imports.


-4%

-2%

0%

2%

4%

6%

8%

10%

12%

14%

Jan-

00

Jan-

01

Jan-

02

Jan-

03

Jan-

04

Jan-

05

Jan-

06

Jan-

07

Jan-

08

Jan-

09

Jan-

10

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

22%

24%

26%

28%

30%

32%

34%

36%

38%

40%

China CPI All Items y/y% (Left Axis)M1 y/y% (Right Axis)

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

22%

24%

26%

28%

30%

32%

34%

36%

38%

40%

Jan-

00

Jan-

01

Jan-

02

Jan-

03

Jan-

04

Jan-

05

Jan-

06

Jan-

07

Jan-

08

Jan-

09

Jan-

10

China M1 money supply y/y%Chinese total bank loans y/y%

As has been widely reported, China began the current lending cycle from a low level of credit as a percentage of GDP, enabling a strong 2009 surge in lending (left chart). So, while the U.S. is liquidating land, labor & capital and floating the U.S. dollar, the Chinese are employing massive expansion of bank loans and fixing their currency to avoid such medicine. The U.S. approach is far more sound, in our view. Chinese bank lending ($1.4 trillion in 2009, 29% of GDP) and currency policies are driving Chinese M1 growth (middle chart), and besides fixed investment or asset bubbles, China risks inflation (right chart), so policy is already tightening.

Source: BCA, People’s Bank of China, National Bureau of Statistics of China, FactSet.

China began this crisis with a fully loaded cannon, able

to lend.

Chinese bank loans (and currency policy)

are driving extraordinary M1

money supply growth…

…and despite claims of an output gap, extraordinary

M1 growth is historically inflationary.


There is a 5 or 6-month lead between Chinese M1 growth and Chinese CPI inflation. Though food & energy are the most volatile components of Chinese CPI, they are nonetheless important in a developing economy. Based on the 39% M1 growth and rising velocity in China, we prefer to take a wait-and-see approach to a possible China inflation spike circa June/July 2010. If CPI exceeds the PRC ceiling of 4% y/y, which we expect, further tightening measures would ensue, in our view.

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

11%

Jan-

00

May

-00

Sep-

00

Jan-

01

May

-01

Sep-

01

Jan-

02

May

-02

Sep-

02

Jan-

03

May

-03

Sep-

03

Jan-

04

May

-04

Sep-

04

Jan-

05

May

-05

Sep-

05

Jan-

06

May

-06

Sep-

06

Jan-

07

May

-07

Sep-

07

Jan-

08

May

-08

Sep-

08

Jan-

09

May

-09

Sep-

09

Jan-

10

May

-10

2%4%6%8%10%12%14%16%18%20%22%24%26%28%30%32%34%36%38%40%

China CPI All Items y/y% (Left Axis) M1 y/y% (Right Axis)

6 Mos.

5 Mos.

Jan-2010 +39% y/y M1

Chinese M1 growth leads CPI All Items (Food & Energy most volatile) by 5-6 months.

Source: BCA, People’s Bank of China, National Bureau of Statistics of China, FactSet.


Important Disclosures and Certifications

I, Barry B. Bannister, certify that the views expressed in this research report accurately reflect my personalviews about the subject securities or issuers; and I, Barry B. Bannister, certify that no part of mycompensation was, is, or will be directly or indirectly related to the specific recommendation or viewscontained in this research report.

Stifel, Nicolaus & Company, Inc.'s research analysts receive compensation that is based upon (among other factors)Stifel Nicolaus' overall investment banking revenues.

Our investment rating system is three tiered, defined as follows:

BUY -We expect this stock to outperform the S&P 500 by more than 10% over the next 12 months. For higher-yieldingequities such as REITs and Utilities, we expect a total return in excess of 12% over the next 12 months.

HOLD -We expect this stock to perform within 10% (plus or minus) of the S&P 500 over the next 12 months. A Holdrating is also used for those higher-yielding securities where we are comfortable with the safety of the dividend, butbelieve that upside in the share price is limited.

SELL -We expect this stock to underperform the S&P 500 by more than 10% over the next 12 months and believe thestock could decline in value.

Of the securities we rate, 38% are rated Buy, 58% are rated Hold, and 4% are rated Sell.

Within the last 12 months, Stifel, Nicolaus & Company, Inc. or an affiliate has provided investment banking services for13%, 10% and 6% of the companies whose shares are rated Buy, Hold and Sell, respectively.

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Please visit the Research Page at www.stifel.com for the current research disclosures applicable to the companiesmentioned in this publication that are within Stifel Nicolaus' coverage universe. For a discussion of risks to target priceplease see our stand-alone company reports and notes for all Buy-rated stocks.

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These materials have been approved by Stifel Nicolaus Limited, authorized and regulated by the Financial ServicesAuthority (UK), in connection with its distribution to professional clients and eligible counterparties in the EuropeanEconomic Area. (Stifel Nicolaus Limited home office: London +44 20 7557 6030.) No investments or servicesmentioned are available in the European Economic Area to retail clients or to anyone in Canada other than aDesignated Institution. This investment research report is classified as objective for the purposes of the FSA rules.Please contact a Stifel Nicolaus entity in your jurisdiction if you require additional information.

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