Issue 83 | September 2010

Welcome to the latest edition of the First Equity Investment Newsletter. Over
the summer months we have adopted a new format and are delighted
to announce that Andy Hartwill has taken over as the author. We offer our
sincere thanks to the previous author, Ray Jones, who has retired after the
previous 82 issues.

Caught between Armageddon and Irrational Exuberance

Financial markets have summered well. Although economic data were weaker than those for the first
quarter, expectations are still that the world will avoid the dreaded double-dip recession. But most
valuation measures are inconclusive. We take an old one and turn it on its head. From that
perspective we still see labels saying “Consumed In China”.

Key Points
Financial markets have travelled hopefully through the summer doldrums. The FTSE Global
Index (equities) is up by almost 5% since the end of June and bond yields have dropped by
some 50bp.

In our Spotlight section we look more closely at the challenges ahead presented by consumer
retrenchment in the USA and fiscal consolidation in the UK and Europe.
Much of the expected slow-down may already be discounted. Recent valuation indicators are
stuck in neutral with one, the earnings yield gap, caught somewhere between Armageddon and
“irrational exuberance”.

We take a new perspective on an old valuation tool, the gold/ oil ratio, by literally turning it on its
head. The resulting indicator suggests that even if a double-dip recession can be avoided, the
risks and opportunities for equities generally lie in your view of China.

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First Equity Limited

Salisbury House, London Wall, London EC2M 5QQ
Tel: 020 7374 2212 Fax: 020 7374 2336
Website: www.firstequity.ltd.uk
Paul Henry Andy Hartwill
email: paul.henry@firstequity.ltd.uk andy.hartwill@firstequity.ltd.uk
No double-dip and a lot of corporate cash: perfect recipe for an
Indian summer
Equities have summered well as they used to say at the time of The Great Gatsby. Global equities have rallied
by some 5% so far this quarter with a definite bias towards cyclical counters. In the UK there was a similar
pattern with Oil&Gas, Financials and Utilities to the fore (see the table below). The Telecom sector joined the
party spurred on by Telefonica’s raised bid for its Portuguese neighbour’s stake in its Brazilian joint venture.

Although economic data have generally been weaker over the period, that was almost inevitable after the 5%
growth of the first quarter, pumped up by fiscal stimulus and re-stocking. More importantly they still point to
global growth averaging between 3% and 3.5% over the next 3 to 5 years. That’s well below the almost 5%
in the early/ mid-noughties - but it’s not double-dip.

Coming weeks will be dominated by anticipation of the UK’s Spending Review on October 20th and the US
Congressional mid-term elections on November 2nd in both of which there may be the opportunity for a relief
rally. Elsewhere we expect corporate M&A activity to remain a strong feature: while consumers and
governments struggle to cut debt, companies have amassed record cash levels (net financial balance to be
accurate) equivalent to some 6% of GDP in the UK according to the ONS!

FTSE Actuaries
UK Series (£)
Index / group 30 Jun 2010 27 Aug 2010 Performance

FTSE100 4916.9 5201.6 5.8%

FTSE250 9366.1 9779.9 4.4%
FTSE Small Cap 2690.9 2770.8 3.0%

Oil & Gas 6638.9 7237.1 9.0%

Basic Materials 5824 5201.6 5.8%
Industrials 2552.3 2564.5 0.5%
Consumer Goods 9230.2 9341.7 1.2%
Health Care 6140.5 6382.4 3.9%
Consumer Service 2981.9 3098.5 3.9%
Telecommunications 2167.7 2336.7 7.8%
Utilities 5742.7 6295.4 9.6%
Financials 3503.6 3767.2 7.5%
Technology 560.4 586.3 4.6%
Source: Bloomberg

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Spotlight: Caught between Armageddon and Irrational Exuberance
In our last edition we highlighted the sharp reductions in growth forecasts for the UK. As investors return from
the holiday season they confront the next set of challenges: the UK’s Spending Review, to be published on
October 20th, and the US Congressional mid-term elections on November 2nd. The first will reveal the speed
and depth of the cuts in UK public spending deemed necessary to pay for the excesses that led to the credit
crunch; the second will serve effectively as a referendum on the equivalent US plans.

In both cases the cuts will be deep: chopping 5% of GDP is the equivalent of shutting down the entire military
defence force in each country – and in the UK the civil defence force also. No more NATO or Scotland Yard.

And while public spending is cut back, banks continue to restrict lending. In the USA, the July reading
showed that bank lending contracted by over 15%, a modest improvement on the almost 20% contraction
earlier this year but still the lowest on record before this year’s readings. In the UK, the August Bank of
England report showed lending to business contracting at an annualised rate of 8% in June (negative 15%
outside the property sector) and secured lending to individuals growing at a rather limp 0.9% - a far cry from
the 11% growth recorded in 2007.

Little wonder that consumers are increasing their savings. In the UK, households have increased their savings
rate from less than 2% at times between 2006 and 2008 to 5.6% in 2009 Q2 (latest data) – still a long way
short of the 10% rates that were typical in the early 1990s. In the US there is a similar picture – and McKinsey
has estimated that every 1% increase takes $100bn out of the tills in the USA. Retailers on both sides of the
pond have a mountain of debt de-leveraging still to climb – to mix a few metaphors.

But how much is already discounted?

There is, as always, a difference between the real economy and the financial markets. The difficulty of course
is agreeing on how much is already discounted. Historic Price Earnings Ratios (admittedly of limited
informational value on their own) of 15x in the US and 13.6x in the UK equity markets do not automatically
ring alarm bells – but nor are they screaming out “Buy” signals.

Even the yield gap between earnings (100/PER) and bonds (a measure preferred by the Fed) is inconclusive.
With 10year bonds on both sides of the pond below 3%, the gap is negative 4.1% in the USA and negative
4.4% in the UK. Those values have improved dramatically from the Armageddon levels of March 2009 when
the gaps were negative 7% and 10.3% respectively. Even so they are still a long way below the positive 2%
gap at the time of Greenspan’s infamous warning against “irrational exuberance” as far back as December
1996. Where does that leave investors? On this evidence, about half way between Armageddon and
“irrational exuberance”.

There may be another tool with which to help break the log-jam. Many readers will be familiar with the Gold/
Oil ratio which calculateshow many barrels of oil could be bought with one ounce of gold. Back in the 80s
and 90s the mean level was some 20 barrels (albeit with considerable volatility). That dropped to around 10
barrels in the early noughties with the surge in the oil price and more recently has risen to around 15 barrels.

But there may be another way that the ratio can be used - by turning it upside down! The intriguing result
can be seen in the chart on the next page.
Oil/ Gold Ratio [or Demand per Unit Risk]

Source: Bloomberg; First Equity

Let’s agree that the gold price is driven by some combination of perceived risk and inflation and that
perceptions of (long run) inflation are themselves a function of demand. Let’s say also that the oil price is
driven by perceptions of net demand. So, inverting the traditional gold/ oil ratio should give some measure of
perceived demand relative to risk.

Back in the 90s it hovered around 5 (i.e. 100 x the inverse of 20 barrels) when global growth was motoring
along at above 3%. The emergence of China spurred the ratio almost to double in the early noughties
suggesting that investors may have allowed themselves to see Chinese growth as purely additive i.e. that it
simply added to the growth of the developed western economies.

Subsequent events have shown that not to be the case. If anything, and possibly at best over the next 3 to
5 years, Chinese (and other emerging) growth may be substitutive i.e. they take up the slack left behind by
indebted western consumers trying hard to restore their balance sheets by de-leveraging.

In that case global growth over the next few years may do no better than in the mid-90s when the engines
of global growth were motoring along at between 3% and 4%. The valuation risk would be see further falls
in the gold/ oil ratio to the levels of the mid-90s, with gold outperforming oil as it did so. The difference this
time will be that those engines will have “Consumed in China” stamped all over them.

The information in the newsletter is taken from publicly available sources and the newsletter is distributed for information purposes
only. Whilst reasonable steps have been taken to ensure the fairness of any views expressed, First Equity Limited does not offer any
guarantee as to the accuracy or completeness of the information. The newsletter is not intended as a solicitation to buy or sell any
securities or investments which may be mentioned. First Equity Limited is regulated and authorised by the Financial Services Authority
and is a member of the London Stock Exchange and the PLUS Market.