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Portfolio Strategy Update: May 2011

For the past several weeks, I have been altering the composition of client portfolios, transitioning
them to a more defensive posture. This piece discusses the reasons for the changes and details
the specific investment decisions.
Issues / Concerns
1) The broader economy and the stock markets may lose momentum with U.S. fiscal
and monetary stimulus being scaled back.
In developed economies such as the United States, the economic recovery from the Great
Recession has been mediocre at best. One would expect this weaker growth following a financial
crisis. For the past year and a half, I have cited empirical data from studies performed by
McKinsey Global Institute and Reinhardt/Rogoff (in their book This Time is Different, to what
some have referred as “The Bible for analyzing financial crises”). The data indicate how a lengthy
deleveraging (i.e., debt reduction) period nearly always follows a banking crisis, creating a
significant headwind to vibrant economic growth.
Since almost every financial crisis results from an excessive build-up of debt, it is common to
observe declining credit growth after a crisis because: i) debtors are unable to borrow against less
valuable assets (think home prices), and ii) banks are unwilling and/or unable to lend because
their balance sheets contain a higher proportion of delinquent loans.
In the United States, negative private sector credit growth has constrained the strength of the
economic recovery. As Table 1 illustrates, this post-recession credit growth is in stark contrast to
that during the typical post-World War II recovery, during which time borrowers and banks were
in much better financial shape.
Table 1
The Role of Private Sector Credit Growth in Post-WW II Recoveries
GDP DECLINE GDP GROWTH PRIVATE SECTOR
DURING IN RECOVERY CREDIT GROWTH
RECESSION PERIOD RECESSION (FIRST 18 MONTHS) (FIRST 18 MONTHS)
Q4 1969 Q4 1970 -0.2% 8.8% 15.4%
Q1 2001 Q4 2001 -0.3% 2.7% 12.7%
Q2 1960 Q1 1961 -0.5% 9.7% 13.6%
Q3 1990 Q1 1991 -1.4% 4.8% 5.5%
Q4 1948 Q4 1949 -1.6% 16.7% 23.4%
Q1 1980 Q3 1980 -2.2% 1.4% 17.0%
Q2 1953 Q2 1954 -2.5% 9.9% 19.5%
Q3 1981 Q4 1982 -2.6% 11.7% 18.6%
Q3 1957 Q2 1958 -3.1% 9.8% 16.7%
Q4 1973 Q1 1975 -3.2% 7.5% 11.9%

Q4 2007 Q2 2009 -4.1% 4.5% -6.2%

Data Sources: U.S. Bureau of Economic Analysis and U.S. Federal Reserve 1
 To try and counteract the private sector credit decline, the federal government has increased
spending by nearly 25% since early 2007. However, because of lower tax revenues due to the
more-sluggish economic conditions, the higher spending has led to sizable fiscal deficits and a
run-up in the national debt.
At the same time, the Federal Reserve (Fed) has attempted to stimulate more credit growth by:
i) cutting its short-term target interest rate to virtually zero and ii) expanding its balance sheet at
an unprecedented scale via two rounds of “quantitative easing (QE),” where it has created
additional reserves out of thin air (essentially printing money) and purchased U.S. Treasury and
mortgage-backed debt securities in an effort to drive down longer-term interest rates.
Figure 1
Fed Balance Sheet & Federal Government Spending: Q1 2007 – Q1 2011
$3,000 $6,000

An unprecedented amount of
monetary and fiscal stimulus
F
$2,500 have been deployed to offset the
E F
private sector deleveraging.
D E
$5,500
D
B $2,000
A G
L O
A V
N $1,500 $5,000 T
C
E S
P
$1,000
S E
H N
$4,500
E D
E $500 I
T N
G

$0 $4,000
Q107

Q207

Q307

Q407

Q108

Q208

Q308

Q408

Q109

Q209

Q309

Q409

Q110

Q210

Q310

Q410

Q111

Federal Reserve Bank Credit (LHS) Federal Government Spending (RHS)

Figure 2
Current Economic Recovery vs. Average of Prior Post-WW II Recoveries
110

Even with the huge doses of Avg Post-WW II

stimulus, the current recovery Recovery
105 has lagged the average post-WW
II recovery by a wide margin.

100
Current
Recovery

95
Q-4

Q-3

Q-2

Q-1

End

Q+1

Q+2

Q+3

Q+4

Q+5

Q+6

Q+7

Data Sources: U.S. Bureau of Economic Analysis and U.S. Federal Reserve 2
 Despite the flood of fiscal and monetary stimulus, the economic recovery has been
mediocre at best (see Figure 2 on previous page), with unemployment remaining stubbornly
high and the housing market still well off 2007 levels.

Figure 3
Housing Prices & Unemployment: 2007 - Present
220 12

The flood of monetary and

C
fiscal stimulus has done little 11
U
A
200 to improve U.S. housing N
S E
prices and unemployment.
E M
10
P P
S L
R 180
H O
I 9
I Y
C
L M
E
L
160 8 E
E N
I
R T
N
D 7
H
E 140 R
O A
X
U 6 T
S E
I 120
N 5

(
%
G

)
100 4
May-07

May-08

May-09

May-10
Jan-07
Mar-07

Nov-07
Jan-08
Mar-08

Nov-08
Jan-09
Mar-09

Nov-09
Jan-10
Mar-10

Nov-10
Jan-11
Mar-11
Jul-07
Sep-07

Jul-08
Sep-08

Jul-09
Sep-09

Jul-10
Sep-10

Case-Shiller Housing Price Index (LHS) U.S. Unemployment Rate (RHS)

Data Sources: U.S. Bureau of Labor Statistics and Standard & Poor’s
While the Fed’s highly accommodative monetary policy has been unsuccessful driving down
unemployment and increasing housing prices, it has helped spur a dramatic rise in commodity
prices, particularly food and energy prices. As a result, inflationary expectations have risen since
the implementation of QE2 last November (see Figure 4 on next page).
Although the Fed does not appear eager to raise interest rates to address the risk of rising
inflation, Chairman Bernanke has signaled an end to QE2 in June, with the program expected to
completely wind down toward the end of the year. In addition, Bernanke has explicitly said the
risks of implementing QE3 outweigh the potential benefits at this time. The bottom line is that
a major source of monetary stimulus is ending within the next few months.
Meanwhile, federal, state, and local government spending will either have to be cut and/or taxes
will have to be raised if lawmakers want to avoid a looming fiscal debt crisis. When Standard &
Poor’s placed U.S. sovereign debt on negative watch last month, it was a painful reminder that
fiscal austerity measures may have to be enacted in short order. Since U.S. government
expenditures (including transfer payments) currently comprise roughly one-third of U.S. GDP,
cutbacks and/or higher taxes will likely create a near-term drag on economic growth.
3
 Figure 4
Inflation Expectations Since Announcement of QE2
5.0%

4.5%
4.4%
Inflationary expectations have
4.0% risen across the board since
the announcement of QE2.
3.5%

3.0% 3.0%
2.8%

2.5%
2.2%
2.2%
2.0%

1.5% 1.2%

1.0%
Dec-10

May-11
Apr-11
Aug-10

Oct-10

Nov-10

Jan-11

Mar-11
Sep-10

Feb-11
5-Year TIPS Spread UMich 5-Year UMich 1-Year
Data Sources: U.S. Treasury Department and University of Michigan Consumer Sentiment Survey
A big debate right now is whether the fragile U.S. economy is healthy enough to stand on its own
once the Fed and federal/state/local governments scale back their huge doses of stimulus. I do
not believe that it is, and some signs in the bond market would appear to support this view.
2) Ominous signs in the bond market raise doubts about the sustainability of the
economic recovery.
At the outset of QE2, the Fed indicated that it would purchase $600 billion of U.S. Treasury
bonds in monthly installments between November 2010 and June 2011. Since the beginning of
QE2, the Fed has gobbled up 96% of net new Treasury issuance.
With the Fed now about to exit the picture, many predict that interest rates will have to increase
in order to attract new Treasury buyers to fill the gap left by the Fed. Indeed, PIMCO, a
behemoth, globally renowned, bond fund manager, has publicly declared that it has sold all U.S.
Treasuries in its flagship bond funds due to concerns about rising Treasury yields (and falling
bond prices since prices and yields move inversely) once QE2 is over.
The end of QE2, coupled with the rising inflation expectations mentioned previously, has
drastically reduced sentiment for Treasury bonds. After huge demand for bonds throughout
2009 and late into 2010 (even as stocks were outperforming bonds by a large margin), bond fund
flows have slowed substantially during the past six months.
One would think that these developments (not to mention the long-term fiscal deficit situation)
would have started to drive Treasury rates higher in anticipation of QE2 ending. However, it has
been quite the contrary. Intermediate- and long-term Treasury rates have actually been declining
for the past several months. I view these rate moves as a potentially ominous sign for the
economy (and hence riskier asset classes) because the bond market has traditionally been a fairly
4
accurate predictor of economic weakness.
 Figure 5
Ominous Signs in the Bond Market?

5.0% INFLATION EXPECTATIONS SINCE QE2

4.5%
With inflation
4.0% expectations on
3.5%
the rise…

3.0%

2.5%

2.0%

1.5%

1.0%
Dec-10

May-11
Apr-11
Aug-10

Oct-10

Nov-10

Jan-11

Mar-11
Sep-10

5-Year TIPS Spread UMich 5-Year Feb-11 UMich 1-Year

Data Sources: U.S. Treasury Department and University of Michigan Consumer Sentiment Survey

TOTAL NET BOND FUND FLOWS* SINCE 2009

50,000
45,000
bond buyers have
40,000
largely disappeared.
35,000
30,000
25,000
20,000
Millions
$s in

15,000
10,000
5,000
0
-5,000
-10,000
-15,000
-20,000 * Bond fund inflows, net of stock fund inflows
-25,000
May-09

May-10
Jan-09

Mar-09

Nov-09

Jan-10

Mar-10

Nov-10

Jan-11

Mar-11
Jul-09

Sep-09

Jul-10

Sep-10

Data Source: Investment Company Institute 5

 Figure 5 (Cont.)

FEDERAL RESERVE U.S. TREASURY PURCHASES (IN AGGREGATE BY MONTH) SINCE QE2

Net Change in Federal Reserve U.S. Treasury Holdings Net Change in U.S. Treasuries Outstanding

Nov-10

But the Fed has

Dec-10 stepped in to purchase
96% of the net Treasury
Jan-11
issuance since QE2.

Feb-11

Mar-11

Apr-11 96%

$0 $100 $200 $300 $400 $500 $600

($s in billions)
Data Sources: U.S. Treasury Department and Federal Reserve

However, with the Fed about to start winding

down its Treasury purchases, and with U.S.
structural deficit and sovereign debt issues…

U.S. FEDERAL DEFICIT AS A % OF GDP SINCE Q1 07 U.S. GOVERNMENT DEBT-TO-GDP RATIOS SINCE Q1 07

0% 140%

-2% 120%

-4% 100%

-6% 80%

-8% 60%

-10% 40%

-12% 20%

-14% 0%
Q107

Q207

Q307

Q407

Q108

Q208

Q308

Q408

Q109

Q209

Q309

Q409

Q110

Q210

Q310

Q410

Q107

Q207

Q307

Q407

Q108

Q208

Q308

Q408

Q109

Q209

Q309

Q409

Q110

Q210

Q310

Q410

Federal State & Local GSE

Data Sources: U.S. Bureau of Economic Analysis and U.S. Federal Reserve
6
 Figure 5 (Cont.)

one would have expected longer-term interest

rates to have risen more recently.

10- AND 30-YEAR U.S. TREASURY RATES SINCE ANNOUNCEMENT OF QE2

5.00

4.50

30-Year
Treasury
4.00 Rate

3.50

10-Year
3.00
Treasury
Rate The fact they have been
declining may be a
2.50
precursor to slowing
economic g rowth.
2.00
10/22/10

11/19/10

12/17/10

12/31/10

4/8/11

5/6/11
8/27/10

9/10/10

9/24/10

10/8/10

11/5/10

12/3/10

1/14/11

1/28/11

2/11/11

2/25/11

3/11/11

3/25/11

4/22/11
Data Source: Yahoo! Finance

CATCHING UP ON CURRENT EVENTS?

Did you happen to read

this story in the March
issue of Time magazine?

March 1972 that is

7
 3) Strong economic g rowth in emerging markets (EMs) is likely to decelerate as EM
policymakers take measures to slow rising inflation in their countries.
Besides the headwinds from the incremental withdrawal of U.S. monetary and fiscal stimulus,
decelerating growth in EM economies may present challenges for riskier asset classes. Since late
2009, robust economic growth across most EMs has fueled the global economic recovery,
outpacing growth in developed markets by a wide margin (see Figure 6). However, most EM
economies are now in danger of overheating, and measures to slow rising inflation will no doubt
lead to decelerating EM economic growth.

Figure 6
9
GDP Growth (Annualized by Quarter): Q4 2009 – Q4 2010

Data Source: Trading Economics

-1

-3
Q4 2009 Q1 2010 Q2 2010 Q3 2010 Q4 2010

U.S. Euro Area Japan EMs {EM figures are a weighted average for
countries in the MSCI EM Index}.

QE and Its Impact on Emerging Markets

To keep their exports more competitive on the global stage, mercantilist EM countries
(particularly China) depend a great deal on lower currency exchange rates. During the past
several years, though, the Fed’s QE programs (and lesser-discussed QE programs in Europe and
Japan) have created some significant challenges for EM policymakers trying to stave off
currency appreciation. Since the Fed’s extremely loose monetary policy has created a huge
tailwind for U.S. dollar depreciation, EM countries have had to either increase their own money
supplies and/or “recycle” reserves back into the United States via U.S. Treasury purchases to
prevent their currencies from rising too much.

8
 Because most EM economies exited the Great Recession in much better financial shape (e.g.,
lower unemployment, modest debt levels, and healthy banking systems) relative to the overly
indebted developed-market economies, the increased money supply/higher excess reserves in
reaction to the Fed’s QE programs have functioned like an inflationary tinder box. Figure 7
illustrates how inflation in EM countries has been much higher relative to that in the United
States, Euro Area, and Japan since QE2 was implemented.
Figure 7
Year / Year Inflation Rate (by Month) Since Announcement of QE2

6
Extremely accommodative monetary policies in developed markets
have led to higher inflation levels across most EM economies.

5 5.1%

4.1%
4

3.2%
3
2.8%

2 1.8%

1.1%
1

0.0%
0

Data Source: Trading Economics

-0.6%
-1
Dec-10

Apr-11
Oct-10

Nov-10

Jan-11

Mar-11
Sep-10

Feb-11

U.S. Euro Area Japan EMs {EM figures are a weighted average for
countries in the MSCI EM Index}.

Thus far, most EM policymakers have taken their time addressing the rising inflation because
efforts to combat rapidly escalating prices would ultimately lead to exchange-rate appreciation,
which would adversely impact export growth. Figure 8 (top of the next page) illustrates how
“real” interest rates across most EMs are either negative or barely positive – arguably not high
enough to curtail the inflationary pressures.
However, because policymakers understand that rising inflation can spur social unrest (it is not a
coincidence that the Middle East uprisings started after food prices jumped considerably), they are starting to
confront the issue by raising interest rates and/or allowing their exchange rates to rise. These
tightening measures are almost certain to slow the rate of growth in EM economies.
As one can observe from Figure 9 (bottom of next page), EM stocks have lagged those in
developed markets since late November, plausibly in anticipation of slower economic growth.
These slowing EM economies may lead to a deceleration in global growth later this year.
9
 Figure 8
“Real” Interest Rates* Across Emerging Markets
BRAZIL 5.3%
TURKEY 2.0%
SOUTH AFRICA 1.4%
HUNGARY 1.3%
PERU 1.2%
MEXICO 1.1%
CHINA 1.0%
CHILE 0.8%
INDONESIA 0.6% Most EM countries will almost
TAIWAN 0.4%
certainly need to tighten
monetary policies during the
MALAYSIA 0.2%
next few months to address
COLOMBIA 0.1% inflationary pressures.
PHILIPPINES 0.0%
POLAND -0.3%
THAILAND -0.5% * Real interest rate defined as the
CZECH REPUBLIC -0.9% benchmark interest rate, less the
KOREA
12-month change in inflation.
-1.2%
RUSSIA -1.4%
INDIA -2.6%
EGYPT -4.0% Data Source: Trading Economics

Figure 9
120 MSCI EM Index vs Russell 3000 Index (Nov. 2010 – Present)
EM stock market underperformance since
R November may be a precursor to slower Russell 3000
E 115 EM economic growth later this year. 15.2%
L
A
T
I 110
V
E

R 105 MSCI EM Index

E
T 2.5%
U
R 100
N

95
10/29/10

11/12/10
11/19/10
11/26/10

12/10/10
12/17/10
12/24/10
12/31/10
1/7/11

2/4/11

3/4/11

4/1/11
4/8/11

5/6/11
11/5/10

12/3/10

1/14/11
1/21/11
1/28/11

2/11/11
2/18/11
2/25/11

3/11/11
3/18/11
3/25/11

4/15/11
4/22/11
4/29/11

5/13/11

10
 4) Historical trends do not bode well for the second half of 2011.
In addition to the economic headwinds noted thus far, historical trends are not supportive for
riskier asset prices later this year. As I noted in the Lederer PWM 2011 Outlook, almost every
short-term (cyclical) bull market within a longer-term (secular) bear market has fizzled out
before reaching 9 quarters. Since the most-recent cyclical bull started in early March 2009, early
June would mark the 9-quarter mark.
Moreover, the Ned Davis Research S&P 500 Cycle Composite for 2011, which the stock market
has generally followed this year (other than the short-term pullback caused by the Japan
earthquake), exhibits weakness during the second half of the year (see Figure 10).

Figure 10
The Ned Davis Research (NDR) S&P 500 Cycle Composite for 2011
112

Should the stock market continue to follow

the NDR Cycle Composite for 2011, a
second-half correction would occur.
110

108

106

Cycle Composite
Equal-weighted Average of
One-, Four-, and 10-year Cycles
104 2011
YTD

102

Japan
Earthquake

100
31-Jan

2-Mar

1-May
1-Jan

30-Aug

28-Nov
1-Apr

31-May

30-Jun

31-Jul

29-Oct

29-Dec
29-Sep

Data Source: Ned Davis Research

11
 Investment Actions
This section details the specific investment decisions made to reduce portfolio risk.
1) Sold U.S. small- and mid-cap stocks
These traditionally riskier asset classes have benefitted disproportionately from the Fed’s
exceptionally loose monetary policy, which has not only increased liquidity in the financial
system, but also provided greater incentive to take risk (since holding cash earning less than
inflation is not an attractive long-term option – investors are thus forced to go out on the risk
spectrum). As Figure 11 shows, small-cap stocks have outperformed larger-cap names by a wide
margin during the past decade, when the Fed frequently held rates below the rate of inflation.

Figure 11
Relative Return of U.S. Small-* vs. Large-Cap* Stocks: Aug. 2000 – April 2011
300%

Shaded areas represent

280% periods of negative
U.S. real interest rates
260%

240%

220%

200%
U.S. small-cap stocks have outperformed
large-caps by a wide margin during the past
180%
decade, during which time the Fed kept
monetary policy highly accommodative.
160%

140%

120%

100%
Dec-00

Dec-01

Dec-02

Dec-03

Dec-04

Dec-05

Dec-06

Dec-07

Dec-08

Dec-09

Dec-10
Aug-00

Apr-01
Aug-01

Apr-02
Aug-02

Apr-03
Aug-03

Apr-04
Aug-04

Apr-05
Aug-05

Apr-06
Aug-06

Apr-07
Aug-07

Apr-08
Aug-08

Apr-09
Aug-09

Apr-10
Aug-10

Apr-11

Data Source: Yahoo! Finance

* S&P 600 Index used to represent small-cap stocks; S&P 100 used to represent large-cap stocks.

Now, after a long period of outperformance, small- and mid-cap valuations are significantly
richer than those of larger-cap stocks. And, with liquidity likely to be scaled back (due to the end
of QE2) and almost every central bank (particularly EM central banks) tightening their
monetary policies, I think small- and mid-cap asset classes may underperform given their already
lofty valuations (relative to larger-cap names).

12
2) Cut EM equity positions
Although I am bullish on EMs longer-term, I am concerned that they could experience greater
declines should the stock market sell off during the next 3-6 months. For example, during the
vicious bear market from late 2007 through early 2009, the MSCI EM Index declined nearly
70%, while the S&P 500 fell by 55%. This underperformance occurred despite the fact EM
economic fundamentals were more favorable to those in most developed-market economies.
While a global growth slowdown would relieve some of the inflation pressures in the EMs
(reducing the need to tighten monetary policies as rigorously), I believe it would still be a net
negative for EMs because many rely upon larger industrialized countries to purchase their
exports, a huge growth driver in many EM economies. If the larger developed-market
economies are in worse shape, the ripple effects would almost certainly be felt in the EMs.

3) Purchased long-term bonds (anticipated 3-6 month holding period)

Given my concerns about slowing economic growth, I purchased positions in two exchange-
traded funds that hold long-term bonds (the PIMCO 25-year Zero Coupon U.S. Treasury Index
ETF and the Vanguard Long-Term Corporate Bond ETF). I think that these positions would
likely perform well should riskier asset class prices decline.
Obviously, there are risks to holding long-term bonds in the current environment. The biggest,
in my opinion, would be if U.S. inflation started to really accelerate. Though I believe higher
inflation will ultimately result from this country’s profligate policies, I do not think it will
become a problem during the next 3-6 months.
Despite the Fed expanding its balance sheet (a potentially harmful inflationary risk because
banks have significantly more reserves against which to lend), inflation has yet to pick up
because credit growth has been virtually nonexistent. Again, the lack of loan demand is not
surprising on the heels of a financial crisis, when cutting debt is a top priority for an over-
leveraged consumer facing an environment consisting of high unemployment and lackluster
wage growth. Thus, the reserves created by the Fed have remained trapped in the banking
system and are not flowing out into the economy. To quote BCA Research, the Fed is pushing
on a string trying to stimulate the economy via strong private sector credit growth (see Figure 12
on next page).
Of course, if loan demand was to pick up and if banks were to start deploying their reserves by
lending en masse, then the tinder box created by the Fed when it expanded banking reserves at
an exponential rate would be ignited, and inflation would certainly follow. However, given the
historical post-crisis precedents, coupled with still-weak real estate markets (both residential and
commercial) and an over-indebted consumer worried about the employment situation, I view
this risk as remote through the end of this year.
In light of current Fed policy, rising commodity prices, particularly food and energy prices,
could also drive underlying inflation higher, negatively impacting long-term bond prices. When
one looks at recent inflationary expectations (refer back to Figure 5), the risk would appear to be
legitimate. Yet, I think rising near-term inflation is unlikely to become a problem because of the
current employment climate, where workers have little bargaining power to ask for higher wages.
As Gluskin Sheff ’s David Rosenberg has shown, wages are a key determinant of consumer price
inflation (see Figure 13 on page 15).

13
 Figure 12
The Fed Pushing on a String?
$1,600 U.S. EXCESS BANK RESERVES: 2008 - PRESENT

$1,400
Though banks are sitting
on a boatload of excess
$1,200 reserves (against which
they can lend)…
$1,000
Billions
$s in

$800

$600

$400

$200

$0
May-08

Dec-08

May-09

Dec-09

May-10

Dec-10
Apr-08

Jun-08

Apr-09

Apr-11
Jun-09

Apr-10
Jan-08

Mar-08

Oct-08
Nov-08

Jan-09

Aug-09

Oct-09

Jan-10

Mar-10

Jun-10
Aug-10

Oct-10
Nov-10

Jan-11
Mar-11
Feb-08

Jul-08
Sep-08

Feb-09

Jul-09

Sep-09

Feb-10

Sep-10
Data Source: U.S. Federal Reserve

YEAR / YEAR BANK LOAN GROWTH: 2008-2010

10%

8%

6%
…loan g rowth has
4%
remained sluggish...

2%

0%

-2%

-4%

-6%

-8%
Q108

Q208

Q308

Q408

Q109

Q209

Q309

Q409

Q110

Q210

Q310

Q410

Data Source: FDIC

14
 Figure 12 (Cont.)
2.1x VELOCITY OF MONEY IN THE UNITED STATES: 2001-2010

2.0x

1.9x

1.8x
…while the velocity of
money* remains well
below pre-crisis levels.
1.7x

1.6x
Q400
Q101
Q201
Q301
Q401
Q102
Q202
Q302
Q402
Q103
Q203
Q303
Q403
Q104
Q204
Q304
Q404
Q105
Q205
Q305
Q405
Q106
Q206
Q306
Q406
Q107
Q207
Q307
Q407
Q108
Q208
Q308
Q408
Q109
Q209
Q309
Q409
Q110
Q210
Q310
Q410
* Velocity of money is the rate of turnover in the money supply. Data Source: St. Louis Fed

Figure 13
4.0
Relationship Between Private Sector Wages and Core CPI: 2001-2011

3.5

3.0
Y
/
Y
2.5

%
2.0
C
H
1.6%
A 1.5 Wage growth appears to be a key
N
determinant of “core” consumer
G
E 1.0
price inflation. In an environment
of tepid wage growth, it would
seem difficult for underlying
0.5 inflation to rise dramatically.
Correlation = 72%
0.0
Q101
Q201
Q301
Q401
Q102
Q202
Q302
Q402
Q103
Q203
Q303
Q403
Q104
Q204
Q304
Q404
Q105
Q205
Q305
Q405
Q106
Q206
Q306
Q406
Q107
Q207
Q307
Q407
Q108
Q208
Q308
Q408
Q109
Q209
Q309
Q409
Q110
Q210
Q310
Q410
Q111

Private Sector Wages & Salaries Core CPI 15

 David Rosenberg has also made an incredibly astute observation regarding inflationary
expectations in recent years. Specifically, during the past several decades, whenever consumers
have anticipated inflationary spikes, the subsequent 12-month inflation rates have turned out to
be substantially below the expectations. Considering the “jobless recoveries” of the past two
decades (where workers have had less-and-less bargaining power to demand higher wages
because of an increasing labor pool from EM countries), it is not a huge surprise that surging
commodity prices, which almost always trigger higher inflationary expectations, have eaten into
consumer purchasing power because the higher food and energy prices function like a tax. With
the S&P GSCI Commodity Index up nearly 30% in the six months since QE2 was unveiled, I
would not be surprised to see commodity prices drop from current levels, decreasing inflation
pressures and helping bond prices.

Figure 14
Univ. of Michigan Consumer Survey: 12-Month Inflation Expectations vs. Actual
6

-2.0%
2.8%
5
1.4% ?
1
2 Actual 12-Month
- Change in Inflation
M
E 4
O
X
N
P
T
E
H
C
T 3
I
A
N
T
F
I
L
O
A
N 2
T
I Whenever inflation expectations have
O spiked up during the past two decades
N
(mostly because of rising commodity
1
prices), actual inflation has been
significantly less than expected.

0
May-92
Dec-92

May-99
Dec-99

May-06
Dec-06
Apr-95

Apr-02
Aug-90

Jun-96

Jun-03

Apr-09

Jun-10
Jan-90

Mar-91
Oct-91

Nov-95

Jan-97
Aug-97
Mar-98
Oct-98

Nov-02

Jan-04
Aug-04
Mar-05
Oct-05

Nov-09

Jan-11
Jul-93
Feb-94
Sep-94

Jul-00
Feb-01
Sep-01

Jul-07
Feb-08
Sep-08

Data Sources: University of Michigan and U.S. Bureau of Labor Statistics

Another big risk to holding long-term bonds during the next 3-6 months would be if the bond
markets reach a riot point where investors refuse to lend to the U.S. government at such low
rates because of increasing default risk. Though I think this concern is certainly a credible one, it
would appear to be a longer-term risk, especially considering the fact U.S. Treasury rates have
fallen since Standard & Poor’s put U.S. sovereign debt on negative watch.

16
 Then there is the risk that Fed Chairman Bernanke comes out and signals QE3. However, given
the increasing criticism the QE policies have invoked, I do not believe the Fed would announce
QE3 unless the stock markets suffered a 15%+ decline from current levels. Should such a
scenario play out, bond prices would likely benefit in the interim.
I am including several pieces of anecdotal evidence to support the long-term bond purchases.
First, when I attended a presentation by the aforementioned David Rosenberg several weeks
ago, he opened his talk by asking the audience of 500 investment managers how many thought
interest rates would increase during the next 12 months. Practically everyone in the room raised
their hand. When asked how many thought rates would decline, only a handful responded. I
found this scene quite indicative of how virtually every investment manager has followed in the
footsteps of PIMCO, positioning for higher rates. I quickly recalled legendary former Merrill
Lynch equity strategist Bob Farrell’s “10 Market Rules to Remember,” one of which says that
“when all the experts and forecasts agree, something else is going to happen.” Moreover, this
past week while at the CFA Institute’s annual conference, which is attended by investment
professionals from around the world, people responded with great surprise whenever I told
them I recently purchased long-term U.S. bonds.

Figure 15
Net Inflows Into Bonds & Bond Returns Relative to Stocks: Feb. 2009 – April 2011
$60,000 100%

$50,000

90%
BOND INFLOWS, NET OF STOCK INFLOWS ($s in Millions)

$40,000

BOND RETURNS RELATIVE TO STOCK RETURNS

$30,000

80%
$20,000

$10,000
70%

$0

($10,000) Investors piled into bonds from early

2009 through late 2010 as bonds 60%
underperformed stocks by a wide margin.
($20,000) Now, sentiment toward bonds is low.

($30,000) 50%
May-09

Dec-09

May-10

Dec-10
Apr-09

Apr-10

Apr-11
Mar-09

Jun-09

Aug-09

Oct-09
Nov-09

Jan-10

Mar-10

Jun-10

Aug-10

Oct-10
Nov-10

Jan-11

Mar-11
Feb-09

Jul-09

Sep-09

Feb-10

Jul-10

Sep-10

Feb-11

Bond Inflows, net of Stock Inflows Bond Returns Relative to Stock Returns
Data Sources: Investment Company Institute and Yahoo! Finance 17
 Analyzing fund flows since the stock market rally began in March 2009, one can observe how
sentiment toward bonds has decreased significantly since late last year (see Figure 15 on the
previous page). One will also notice how bonds underperformed stocks by a wide margin as the
public piled into bonds. Now, with the opposite phenomenon occurring, will bonds outperform
stocks during the next six months?
4) Added to Long U.S. Dollar Positions
With the Fed essentially printing money and leaving its target interest rate at zero, the trade-
weighted dollar has been shellacked since the start of QE1 (see Figure 16). With other central
banks raising rates, investors have been flocking away from the dollar and into higher yielding
currencies and precious metals.
Figure 16
120
Trade-Weighted Dollar and Gold Prices: 2009 – Present $16

$15

The U.S. dollar has been devalued

115
substantially since the Fed began its $14
quantitative easing programs.

$13
110

iSHARES COMEX GOLD ETF PRICE

BROAD U.S. DOLLAR INDEX

$12

105 $11

$10

100
$9

$8
95

$7

90 $6
May-09
Apr-09

Dec-09

May-10

May-11
Jan-09

Mar-09

Jun-09

Aug-09

Apr-10

Dec-10
Oct-09

Nov-09

Jan-10

Mar-10

Jun-10

Aug-10

Apr-11
Feb-09

Jul-09

Oct-10

Nov-10

Jan-11

Mar-11
Sep-09

Feb-10

Jul-10

Sep-10

Feb-11

Broad U.S. Dollar Index iShares Comex Gold ETF

Data Sources: U.S. Federal Reserve and Yahoo! Finance

18
The negative dollar sentiment has been widespread following such a large decline. And although
I am bearish on the greenback long-term as long as Ben Bernanke is Fed Chairman and Timothy
Geitner is U.S. Treasury Secretary, I think there is a more-than-likely chance the dollar could rally
shorter-term in anticipation of the Fed starting to wind down QE2. Furthermore, should the
global economy begin to slow, investors may decide to seek safe haven in the dollar, which is still
the world’s reserve currency.
Additionally, I believe there is a fairly strong chance the European Central Bank (ECB) and Bank
of Japan (BOJ) may start to increase their money supplies at a faster pace than the United States
during the next 3-6 months. The ECB is probably going to have to print more euros in order to
purchase the debt of the profligate PIIGS countries (Portugal, Italy, Ireland, Greece, and Spain)
to prevent a European banking crisis (many undercapitalized European banks hold PIIGS debt
– this is why the inevitable PIIGS sovereign debt defaults have been delayed). Meanwhile, the
BOJ may continue to inject liquidity as Japan rebuilds from its devastating earthquake.
Similar to owning long-term U.S. bonds, being long the greenback could backfire if foreign
investors lose faith in the government’s ability to rein in deficit spending and/or the Fed’s ability
to tighten monetary policy. However, I view these risks as unlikely during the next 3-6 months,
especially if the global economy was to slow.

Lederer PWM cannot guarantee

any of the forecasts discussed in
this portfolio strategy update

19