Sixth Man Research: The World We See

March 15, 2013

Mark O. Lapolla, CFA

770.363.2142
Mark@SixthManResearch.com
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 March 15, 2013

This presentation has four parts:

I. Our Views In Brief

II. Supporting Charts
III. The Potential earthquake in Fund Flows
IV. Fiscal sustainability & monetary theory

Sixth Man Research | Sixth Man Research: The World We See 2

Section One: Our Views In Brief

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 March 15, 2013

What Long Strange Trip It’s Been...

THE ULTIMATE FALLACY

U.S.A.

Europe

China

Four years ago this March, the world generally believed that the US was finally finished,
Europe would have the last laugh, and that China would reign supreme. Somehow,
thoughtful investors forgot about the power of free markets and democracy. The only
stronghold left is the debate over fiscal sustainability.

Sixth Man Research | Section One: Our Views In Brief 4

 March 15, 2013

The History of Our World

hh In the 1980’s, a massive acceleration in the development
of IP, coupled with maturing emerging countries, caused a
Ricardian value shift of epochal proportions.
hh The simple perception that US manufacturing had declined
and that American jobs were “being shipped overseas”,
is painfully mistaken. More correctly, US manufacturing
productivity exploded (the US is still the largest producer of
“value-add” in the world”) while the Keyensian concept of
“technological unemployment” began to ravish the broad
labor market.
hh Although measured unemployment was low, marginal
employment skyrocketed as jobs were created to staff the
supply of excess services or facilitate the growth in the
housing bubble.
hh At the heart of it, the Economic Value Add (EVA) of
US labor has been eviscerated by the rapid ascent and
development of our IP-based society.
hh Whether by design or change, the deregulation of the
financial markets and the reckless and irresponsible
behavior of the Fed and system regulators, fueled the
disintermediation of the commercial banking system
enabling the biggest the entitlement program in history:
The conveyance of wealth to the middle class through
home equity.
hh Although most analysts are now in sync with this part of
the story, developing a congruent view of the future has
proven more problematic.

Sixth Man Research | Section One: Our Views In Brief 5


Secular Themes
hh Labor markets in the developed world are structurally
broken. Until—and unless—some-type of sweeping
technological or political change unleashes new, or
dilapidated! frontiers, the EVA of non-IP labor will remain in
secular decline.
hh Monetary policy is generally impotent. The mortgage
market is the only direct transmission mechanism the
Fed has to stimulate Main Street and the system remains
structurally broken.
hh Credit creation will necessarily remain anemic because
mortgage finance—both residential and commercial—
dominates the landscape. Moreover, there is simply no
collateral; +/-30% of homeowner’s have no debt and the
marginal buyer has no equity—even if they have income.
hh Over the intermediate and long-term, fiscal stimulus
will continue to have a negative multiplier; tax payers
understand the inverse relationship between what they get
now and what they will “pay for” later.
hh The hegemonic position of the US will continue to grow
stronger.
hh Stable and/or accelerating profit growth will be
concentrated in companies with oligopolistic-type market
positions and IP; the rest will continue to weaken.
hh Stock are rising because cash flow stability/earnings and
dividend yield is compelling on a risk-adjusted basis.
Sixth Man Research | Section One: Our Views In Brief
March 15, 2013
hh The European Union, pardon the pun, is lying in “State”.
It will survive because political and practical reality
demand it, not because it should.
hh China is extraordinarily vulnerable, much more so
than even tempered expectations believe. A major
restructuring of virtually all their social and financial
systems will happen under this new ruling class.
hh The commodity super-cycle is over; this is bullish for
some and quite bearish for others.
hh The global “elites” present the greatest systemic risk to
the capital markets.
hh The US is fiscally sustainable. (See Appendix)
hh Bretton Woods “forever”, but the euro must secularly
decline or the EU will fail.
hh Japan; a brave new world, and we don’t know exactly
what it means yet. But Southeast Asia will NOT look the
same in 3 years.
hh Say goodbye to my little friend elastic, economic
cyclicality.
6
 March 15, 2013

Structural Capital Market Themes

hh Capital flows trump ALL; don’t get too caught up in hh US fiscal policy is a major drag currently and the
discrete positions. prospect of tighter spending is actually worse.
hh “Normalization” of European rates will continue; there will hh Asset managers will rise relative to investment
be a European Redemption Fund to “solve” their Sovereign banks.
debt crisis. (sinking fund for Sovereign debt >60% GDP). hh The Euro needs to stay down or self-destruct.
hh Fed’s folly will continue fueling unintended consequences hh Excess credit in China is largely denominated in $USD;
until the mortgage market rebalances. The Taylor Rule is a a deflationary-type collapse would crush the Yuan.
preposterous concept.
hh IP, IP, IP
hh Forward looking asset returns spell trouble for investors
who massively de-risked at the equity market lows.
hh Commodities are a masquerade ball. Supply and demand is
dominated by synthetic uses such as: trade finance, political
leverage and military hedging. The big bull is over.
hh Germany is the weakest relative player on the board in
Europe; they will continue to blink.
hh Brazil and Australia are skating on the edge of a
precipice.
hh India, very corrupt, very bad neighbors; but maybe not so
bad overall?

Sixth Man Research | Section One: Our Views In Brief 7

 March 15, 2013

Trading Concepts & Ideas

hh Always know what the BIGGEST guy in the room is doing
(i.e. Flows) and what his motivations are.
hh Always know who are the weakest players on the board
and what they fear most.
hh The lowest risk points of entry occur when flawed theory
and/or misconceptions of structural forces is most in focus
and linked to open market prices.
hh The Euro must work below 1.25, then towards 1.0.
hh Crude oil has 3:1 downside risk (aggressively fade Middle
East panic).
hh The Yuan should be much lower versus the dollar.
hh Investors are afraid of stocks; the bid side of the bond
markets should firm hard on equity corrections—if they
don’t—flows are accelerating out of bonds.
hh Learn how to best hedge fixed income with equity
instruments. Spread risk is much greater than rate risk.
hh It would be healthy/great to see the 10-Yr move towards
2.5%
hh Fade every momentum move into inflation hedges.
hh Trade the entire commodity complex from the short-side;
copper will collapse.
hh Fade the Euro with impunity.
hh Stay/get short AUD, CAD.

Sixth Man Research | Section One: Our Views In Brief 8

Section Two: Supporting Charts

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 March 15, 2013

Labor eroded, productivity ramped, and the effect of debt weakened

10-Year Payroll Growth Non-Farm Payroll Components as Percent of Total
60%
70% Non-Farm Payroll 40%

50%
35%
65%

40%
30%
60%
30%
25%

55%
20%
20%

10% 50%
15%

0%
45%
10%

-10%
1959 1962 1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 40% 5%
US Employees on Nonfarm Payrolls Total SA 120-Month % Change 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
US Employees On Nonfarm Payrolls Total Government SA 120-Month % Change Private Service as Percent of Total (LS) Govt as Percent of Total (RS)
US Employees on Nonfarm Payrolls Total Private SA 120-Month % Change Manufacturing as Percent of Total (RS)
Source: Bureau of Labor Statistics, Sixth Man Research Source: Bureau of Labor Statistics, Sixth Man Research

US Manufacturing Output Growth vs. Average annual percentage point increase, (cycle-by-cycle)
Manufacturing Labor Decline 1950-2010
Non-financial Household
900
Total Economy Private economy Nonfarm Debt
800 y = 50e0.6931x Business Debt as a Debt as a % of Corporate Debt as as a
R² = 1 Cycle % of GDP Private Sector GDP a % of New Worth % of PDI
700
2Q58-1Q60 -1.0 0.2 0.2 2.3
1Q61-3Q69 -0.3 2.0 1.2 0.6
600
4Q70-3Q73 -0.1 0.8 0.7 0.3
500
1Q75-4Q79 1.2 0.2 0.2 1.6
4Q82-2Q90 7.4 6.6 3.3 2.4
400 1Q91-4Q00 3.7 5.1 -2.5 1.7
Average 1.8 2.5 0.5 1.5
300 4Q01-Current 10.0 10.1 -1.2 5.6

200 y = -33x + 133

R² = 1
100

0
1950 1980 2010
"US Manufacturing Output (1950=100) "US Manufacturing Workers (1950=100)
Expon. ("US Manufacturing Output (1950=100)) Linear ("US Manufacturing Workers (1950=100))

Sixth Man Research | Section Two: Supporting Charts 10

 March 15, 2013

The largest entitlement program in history led to the collapse

THE CONSUMPTION BUBBLE Over Valued Homes
$300,000
Q2 2006

LIFESTYLE

Existing One Family Home Sales Average Price

$250,000
Q2 2010 Q3 2010
Q4 2010 Q4 2008
Q4 2009
$200,000

$150,000
CONSUMER CREDIT / LEVERAGE

$100,000

$50,000

$0
0 50 100 150 200 250 300 350 400 450 500
ECONOMIC VALUE ADD Diaposable Income / 10-Treasury
Source: National Assoc. of Realtors, Federal Reserve, Bureau of Economic Analysis, Bloomberg, KSR

MEW / GDP US Nominal Dollars SAAR Debt Growth vs. GDP Growth
3,000

4.5%
2,500
4.0%

3.5% 2,000

3.0%
1,500

2.5%

1,000
2.0%

1.5% 500

1.0%
0

0.5%

-500
0.0% 1961 1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005 2009
Jun-95 Aug-96 Oct-97 Nov-98 Jan-00 Mar-01 May-02 Jul-03 Sep-04 Nov-05 Jan-07 Mar-08 Annual $ Change US Non-Financial Debt Annual $ Change US GDP
Source: Bloomberg, KSR Source: Federal Reserve, , Bureau of Economic Analysis, Sixth Man Research

Sixth Man Research | Section Two: Supporting Charts 11

 March 15, 2013

Traditional policy doesn’t work under these conditions

SHOW ME THE COLLATERAL!

EQUITY

LENDER COLLATERAL BORROWER

DEBT SERVICE INPUT COSTS

LABOR

Spending on Food & Gas as a % of Retail Sales RETIREMENT CALCULUS

23%

22%
LIFE EXPECTANCY

21%
BASE EQUITY
20%
SAVINGS
EXPECTED RETURNS INVESTMENTS
19%

18%
WAGE
EXPECTATIONS
CONSUMPTION
17%

SAFETY NETS
16%

LIKELY
15% DEPENDENTS
Jan-92 Oct-93 Jul-95 Apr-97 Jan-99 Oct-00 Jul-02 Apr-04 Jan-06 Oct-07 Jul-09 Apr-11
Source: U.S. Census Bureau, Sixth Man Research

Sixth Man Research | Section Two: Supporting Charts 12

 March 15, 2013

So Labor’s anemia will continue...for a long time...

US Nominal GDP Per Capita YoY % Change US Personal Income versus Transfer Payments
SAAR (Indexed 100=1-31-1999
21% 240
+4 Stdev
18%
220
+3 Stdev
15%

200
12% +2 Stdev

9% +1 Stdev 180

6%
Mean 160

3%
-1 Stdev
140
0%
-2 Stdev
120
-3%
-3 Stdev
-6% 100
Jan-99 Mar-00 May-01 Jul-02 Sep-03 Nov-04 Jan-06 Mar-07 May-08 Jul-09 Sep-10 Nov-11
-4 Stdev
-9% US Personal Income SAAR Indexed 100=1-31-1999
1950 1954 1958 1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010 Personal Income Transfer Payments to Persons SA Indexed 100=1-31-1999
Source: Bloomberg, Sixth Man Research Source: Bureau of Economic Analysis, Sixth Man Research

US Jobs Lost and Months to Recover Peak Unemployment Rate (%) vs

Aligned at Maximum Loss Duration of Unemployment Number of Weeks SA
1%
45

0% 40
Dec. 2012
Non-Farm Payroll as a Percent of Peak NFP

Avg Duration of Uneployment Number of Weeks

-1% 35

-2% 30

25
-3%

20
Current
-4%

15
-5%

10
-6%
5

-7%
(28) (26) (24) (22) (20) (18) (16) (14) (12) (10) (8) (6) (4) (2) 0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 0
Number of Months Before to After Maximum Job Loss 0 1 2 3 4 5 6 7 8 9 10 11 12
1948 1953 1957 1960 1970 1974 1980 1981 1990 2001 2007 Unemployment Rate (%)
23 24 25 21 19 20 11 29 33 49 55 1948 to Dec 2008 Jan 2009 - Dec 2009 Jan 2010 - Dec 2012 Linear (1948 to Dec 2008)
Source: Bureau of Labor Statistics, Sixth Man Research Source: Bureau of Labor Statistics, Sixth Man Research

Sixth Man Research | Section Two: Supporting Charts 13

 March 15, 2013

But profitability is great for the strong and the “smart”

MAIN STREET LOSSES ARE LARGE COMPANY’S GAINS US Corp Profits With IVA (billions)
vs. Number Employed (thousands)
1,800
CAPACITY SHRINK
1,600
Q3 2012

WEAK COMPETITION 1,400

POORLY FINANCED 1,200

OVER-LEVERAGED
ANEMIC NOMINAL GDP

NON-COMPETITIVE 1,000

CREDIT CONTRACTION
800
SHARE GAINS
600
FLAT REVENUE
400

200
WELL FINANCED; STABLE/GROWING
MARKET SHARE; COMPETITIVE ADVANTAGE 0
40,000 50,000 60,000 70,000 80,000 90,000 100,000 110,000 120,000 130,000 140,000
US Corp Profits With IVA and CCA Domestic Industries Total SA 1950 to 2008
US Corp Profits With IVA and CCA Domestic Industries Total SA 2009 to Q2 2012
Source: Bureau of Economic Analysis, Sixth Man Research

Relative Strength of US Corporate Net Cash Flow Nominal Hourly Wage Growth
SA versus US Nominal GDP (SAAR) 10.0

14%
9.0

13% 8.0

12% 7.0

6.0
11%

5.0
10%

4.0
9%
3.0

8%
2.0

7%
1.0

6% 0.0
1959 1962 1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 2012
Source: Bureau of Economic Analysis, Sixth Man Research Source: Bureau of Labor Statistics, Sixth Man Research

Sixth Man Research | Section Two: Supporting Charts 14

 March 15, 2013

Profits and transfer payments explode and the strong recover slowly
US Corporate Profits vs. Household Net Worth Government Transfers as Pct of Personal Income
Indexed 100=3-31-1960 20%

5,000
19%

4,500
18%
4,000

17%
3,500

3,000 16%

2,500 15%

2,000
14%
1,500
13%
1,000

12%
500

0 11%
1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011
US Corporate Profits With IVA and CCA Net Cash Flow SA Indexed 100=3-31-1960
10%
FOF Federal Reserve US Households & NPO Net Worth Nominal $ Value Indexed 100=3-31-1960
1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011
Source: Bureau of Economic Analysis, Federal Reserve, SMR Source: Bureau of Economic Analysis, Sixth Man Research

Net financial investment / 5-Yr Growth Household Net Worth

20%
Personal Income vs. Personal Savings Rate 15
120% +4 Stdev

15%
10 +3 Stdev
100%

10% +2 Stdev
80%
5

5% +1 Stdev
60%

0
Median
0% 40%

-5 20%
-1 Stdev
-5%

-2 Stdev
0%
-10
-10%
-3 Stdev
-20%

-15% -15
1969 1972 1975 1977 1980 1982 1985 1988 1990 1993 1995 1998 2000 2003 2006 2008 2011 -4 Stdev
-40%
Net financial investment / Disposable Personal Income US Personal Saving as a % of Disposable Income (RS) 1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010
Source: Federal Reserve, Sixth Man Research Source: Federal Reserve, Bloomberg, SMR

Sixth Man Research | Section Two: Supporting Charts 15

 March 15, 2013

Deflation is moving East and without MEW the economy can’t purr
Nominal$ YoY US Disposable Income vs.
Annualized Cash-Out Mortgage Refis
900 900

700 700

500 500

300 300

100 100

-100 -100

-300 -300

-500 -500
Dec-99 Jan-01 Feb-02 Mar-03 Apr-04 May-05 Jun-06 Jul-07 Aug-08 Sep-09 Oct-10 Nov-11
Disposable Personal Income From The GDP Report US$ SAAR YoY Net Change
U.S. Net Home Equity Extraction Active Mortgage Equity Withdrawal
Source: Bureau of Economic Analysis, Sixth Man Research

30-Year Mortgage Rates (inverted) vs Mortgage Refi Index GDP US Nominal Dollars SAAR / Monetary Base
9,000 3.0
17

8,000 3.5

15
7,000
4.0

6,000
4.5 13

5,000
5.0
4,000 11

5.5
3,000
9
6.0
2,000

1,000 6.5 7

0 7.0
Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 5
MBA Refinancing Index SA Mortgage Bankers FRM 30-Year Contract (RS) Dec-99 Jun-01 Dec-02 Jun-04 Dec-05 Jun-07 Dec-08 Jun-10 Dec-11
Source: Mortgage Bankers Association, Sixth Man Research Source: Bloomberg, Sixth Man Research

Sixth Man Research | Section Two: Supporting Charts 16

 March 15, 2013

Auto strength not surprising, but what else is there?

GDP US Nominal Dollars SAAR 8-Quarter % Change US Capacity Utilization % of Total Capacity SA
90
30%

25%
85

20%

80
15%

10% 75

5%

70

0%

-5% 65
1950 1953 1956 1959 1962 1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 2012
US Recession GDP US Nominal Dollars SAAR 8-Quarter % Change US Recession US Capacity Utilization % of Total Capacity SA
Source: NBER, Bureau of Economic Anal, Sixth Man Research Source: NBER, Federal Reserve, Sixth Man Research

US Auto Sales Total Annualized SA NFIB Small Business Good Time to Expand
22

26
20

18 21

16
16

14

11
12

10 6

8
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
1
US Recession US Auto Sales Total Annualized SA Jan-99 Mar-00 May-01 Jul-02 Sep-03 Nov-04 Jan-06 Mar-07 May-08 Jul-09 Sep-10 Nov-11
Source: NBER, Bloomberg Indices, Sixth Man Research Source: Nat'l Fed. of Ind. Business, Sixth Man Research

Sixth Man Research | Section Two: Supporting Charts 17

 March 15, 2013

Europe lies in “state” and China faces enormous challenges

Italy & Spain Intensity and Duration of Capex Booms
10-Yr Sovereign Bond Yields (Fixed Asset Investment / GDP and Years)
8.0 75%
China 2010 71%

70% China 2011 67%

7.0
65%

6.0 60%

55%

5.0
China (96-2009) 50%
50%

45% Maylaysia (90-97)

4.0 Thialand (89-97)

South Korea (90-97)

40%
Singapore (91-99)
3.0 Japan (68-74)
Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 35%
Italy Buoni Poliennali Del Tesoro Spain Government Bond 5.00 6.00 7.00 8.00 9.00 10.00 11.00 12.00 13.00 14.00
Source: BLOOMBERG GENERIC, Sixth Man Research Source: IMF, Sixth Man Research

PBOC Mumulative Net Open Market Infusion into

Deflationary Impact of Fiscal Spending Chinese Interbank Market (RMB bn)
Given Trend Toward Austerity 5,000

4,000

Fiscal stimulus through deficit spending anchors forward

expectations of expense cuts and/or tax increases. 3,000

Past patterns of Government behavior strongly favor tax increases. 2,000

 1%  Income Taxes  3%  Personal Consumption Expenditures 1,000


0


Economic Benefit Net Present Liability of
from Expected Future Tax
-1,000
Fiscal Spending Increases
-2,000
May-08 Oct-08 Mar-09 Aug-09 Jan-10 Jun-10 Nov-10 Apr-11 Sep-11 Feb-12 Jul-12 Dec-12
Source: The People's Bank of China, Sixth Man Research

Sixth Man Research | Section Two: Supporting Charts 18

 March 15, 2013

Jobs aren’t better and housing is just okay

Number of Persons Collecting an Unemployment Benefit Real Estate Loans as % of Total Bank Loans
14 60%
Millions

12

50%
10

8
40%

4 30%

20%
0
Oct-10 Dec-10 Feb-11 Apr-11 Jun-11 Aug-11 Oct-11 Dec-11 Feb-12 Apr-12 Jun-12 Aug-12 Oct-12 Dec-12
Persons Claiming Emergency Unemployment Compensation Benefits
Persons Claiming Extended Unemployment Insurance Benefits
10%
US Continuing Jobless Claims NSA
1947 1951 1955 1959 1963 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003 2007 2011
Source: Department of Labor, Sixth Man Research Source: Federal Reserve, Sixth Man Research

Home Sales vs. Transaction Dollar Volume US Commercial Bank Assets Loans & Leases
7.5 1,700
Commercial & Industrial SA 13-Week % Change

7.0 7%
1,500

6.5
5%
1,300
6.0
3%
$ Billions SAAR

5.5 1,100
1%

5.0
900
-1%
4.5

700 -3%
4.0

-5%
3.5 500
Jan-00 Feb-01 Mar-02 Apr-03 May-04 Jun-05 Jul-06 Aug-07 Sep-08 Oct-09 Nov-10 Dec-11
US Existing Homes Sales Millions SAAR -7%
Existing Home Sales Transaction Value (Sales * Median Price) (RS) Apr-05 Dec-05 Aug-06 Apr-07 Dec-07 Aug-08 Apr-09 Dec-09 Aug-10 Apr-11 Dec-11 Aug-12
Source: National Assoc. of Realtors, Sixth Man Research Source: Federal Reserve, Sixth Man Research

Sixth Man Research | Section Two: Supporting Charts 19

 March 15, 2013

Reality bites when you are trying to force good times

SUSTAINABLE HOME PRICE MODEL Mortgage Origination Profitability
(Bankrate Avg 30Yr - FNMA 30Yr Current Coupon)
1.7

EQUIVALENT
RENT
1.2
COST OF CAPITAL

TAX INCENTIVES 0.7

LOCATION PREMIUM
(e.g. PROPERTY TAXES, SCHOOLS, ETC 0.2

COMMUNITY LEVEL
SUSTAINABLE CASH FLOWS
-0.3
Jan-99 Mar-00 May-01 Jul-02 Sep-03 Nov-04 Jan-06 Mar-07 May-08 Jul-09 Sep-10 Nov-11 Jan-13
Source: Bloomberg, Sixth Man Research

National Association of Home Builders Market Index SA Commercial Paper Outstanding

80 240

1,200
70 220

200
60 1,000

180
50
800
160
40

600 140
30
120

20 400
100

10
200 80
Oct-07 Mar-08 Aug-08 Jan-09 Jun-09 Nov-09 Apr-10 Sep-10 Feb-11 Jul-11 Dec-11 May-12 Oct-12
0 Commercial Paper Outstanding Financial Seasonally Adjusted
1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 Commercial Paper Outstanding for Special Categories Asset Backed-Seasonally Adj
US Recession National Association of Home Builders Market Index SA Commercial Paper Outstanding Non Financial Seasonally Adjusted (RS)
Source: NBER, National Association of Home Builders, Sixth Man Research Source: Federal Reserve, Sixth Man Research

Sixth Man Research | Section Two: Supporting Charts 20

 March 15, 2013

Commodities are done, political uncertainty isn’t, and we are getting old
US Stock Prices Relative to Commodity Prices Figure 1: Index of Economic Policy Uncertainty
(Jan 1985 – Nov 2012) Debt Ceiling Dispute;
102.4
Four Periods of Commodity Outperformance Euro Debt
Ongoing

Fiscal Cliff
Obama
Election Banking
51.2 Crisis
Lehman

200
Black and
Monday Gulf 9/11
TARP

Policy Uncertainty Index

25.6
War I Gulf
Balanced Clinton Bush War II
Election Election Large
12.8 Budget
interest

150
Act
Logarithmic Scale

rate cuts,
Russian
Stimulus
6.4 Crisis/LTCM

2010

100
3.2 Midterm
Elections

1.6

50
0.8

Notes: Index of Policy-Related Economic Uncertainty composed of 4 series: monthly news articles containing uncertain or uncertainty, economic or economy,
and policy relevant terms (scaled by the smoothed number of articles containing ‘today’); the number of tax laws expiring in coming years, and a composite of IQ
0.4 ranges for quarterly forecasts of federal, state, and local government expenditures and 1-year CPI from the Phil. Fed Survey of Forecasters. Weights: 1/2 News-
1871 1881 1891 1901 1911 1921 1931 1941 1951 1961 1971 1981 1991 2001 2011 based, 1/6 tax expirations, 1/6 CPI disagreement, 1/6 expenditures disagreement after each index normalized to have a standard-deviation of 1. Data from Jan
1985-Nov 2012. Index normalized mean 100 from 1985-2009. Data at www.policyuncertainty.com
Source: Shiller, US Census Bureau, Bloomberg, KSR

US Employment Population Ratio Total in Labor Force SA

66

64

62

60

58

56

54

52
1950 1953 1956 1959 1962 1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010
Source: Bureau of Labor Statistics, Sixth Man Research

Sixth Man Research | Section Two: Supporting Charts 21

Section Three: The Big Shift?

S���� M�� R�������

 March 15, 2013

The Footsteps of Yield Hungry Investors Has Been LOUD

Moody's BAA Less 10Y vs. US Corp HY Avg YTM Less 10Y 17-Jan
380 800

US 10 & 30-Year Treasury Yields versus

750
S&P Dividend Yield & Investment Grade Average YTM 360

700
10 340

650
320

8 600
300
550

6 280
500

260
450
4
240 400

2 220 350
Aug-11 Sep-11 Nov-11 Dec-11 Feb-12 Apr-12 May-12 Jul-12 Aug-12 Oct-12 Nov-12 Jan-13
Moody's BAA Less 10Y US Corp HY Avg YTM Less 10Y

0
Jan-04 Oct-04 Jul-05 Apr-06 Jan-07 Oct-07 Jul-08 Apr-09 Jan-10 Oct-10 Jul-11 Apr-12 Jan-13
S&P 500 Index Equity Dividend Yield 12M
FINRA - BLP Active Investment Grade US Corporate Bond Average Yield to Maturity
US 10-Year Yield
US 30-Year Yield
Source: Standard & Poor's, FINRA-BLOOMBERG, Bloomberg Indices, Sixth Man Research S&P 500 Dividends Aristocrats TR / S&P 500 Index

With 10-year rates at 1.8% and long bond marginally above 3%, the S&P 80%

dividend yield of 2.16% looks pretty good.

75%

Thus, with investment grate corporate bond yields averaging 3.3%,

despite ongoing economic malaise, it isn’t surprising to see junk bond 70%

yields fall sharply as of late (see chart upper right).

65%

And despite lofty arguments to the contrary, the high-quality, cash-flow/

dividend theme we have been emphasizing for two years, continues to 60%

significantly outperform the broad market. (see chart lower right).

55%

50%
Jan-04 Oct-04 Jul-05 Apr-06 Jan-07 Oct-07 Jul-08 Apr-09 Jan-10 Oct-10 Jul-11 Apr-12 Jan-13
Source: Bloomberg, Sixth Man Research

Sixth Man Research | Section Three: The Big Shift? 23

 March 15, 2013

Bonds, Bonds, and Liability Driven Investing

US 10-Year Yield Moody's Bond Indices Corporate BAA vs US 10-Year Yield

17
15

15
13
13

11
11

9 9

7
7

5
5

3
1
1962 1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010
1
Moody's Bond Indices Corporate BAA US 10-Year Yield
1962 1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010
Source: Bloomberg Indices, Sixth Man Research Source: Moody's Investors Service, Bloomberg Indices, Sixth Man Research

In this report, we will not address our heterodox views on the U.S.
monetary system, the real effects of Federal Reserve policy, and
our shocking belief that U.S. Government interest rates are set and
bounded by Fed policy and arbitrage—not the free markets.
However, everyone agrees that bonds have been in a 30+ year secular
bull market which, as Mark Twain might say, has persevered despite
many claims that it was dead.
The simple fact is that bond yields reflect the relative cost and
demand for safety, the availability of investment capital, the credit
worthiness of the lender and, of course, inflation expectations.
One might believe that the Fed’s QE programs have substantively
suppressed Treasury yields, but the data only suggest about a 20 bp
impact on 10-year bonds.
In October of 2008, back in the early days of Sixth Man Research,
we published “Corporate Bonds: The Best Equity”. In that piece we
asserted that the markets did not understand the likely path of the
global recovery and that the world was short both unencumbered
collateral with stable values, and consumers with predictable cash
flows and “excess” equity margin.
Since then, the flood of both institutional and retail money flowing
into bonds has been spectacular, catalyzing a major shift in
portfolio weights.
As discussed in “Savor the ‘Saviors’, pension funds and their
consultants validated this shift through a concept called “Liability
Driven Investing.”

Factually, the demand for Treasuries has reflected a rational shift in

investor demand for safety amidst the greatest threat of deflation
since the Great Depression.

Sixth Man Research | Section Three: The Big Shift? 24

 March 15, 2013

And For Those Underweight Stocks; the Pain Increases

Value Line Index Arithmetic Average Financial Select Sector SPDR Fund

36

2,900
31

26
2,400

21

1,900

16

1,400 11

6
900 Jan-02 Mar-03 May-04 Jul-05 Sep-06 Nov-07 Jan-09 Mar-10 May-11 Jul-12
Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11 Jan-12 May-12 Sep-12 Jan-13 Financial Select Sector SPDR Fund Weekly Financial Select Sector SPDR Fund 200-Week SMA
Source: Bloomberg, Sixth Man Research Source: US, Bloomberg, Sixth Man Research

The Value Line arithmetic index is an equal weighted Dodd-Frank is a joke and so is Basel. The mega-banks are
basket of 1650 stocks will always be too big to fail and they will always receive
regulatory and capital market forbearance
Dow Jones Transportation Average Industrial Select Sector SPDR Fund
6,500 45

6,000

5,500
40
5,000

4,500

4,000 35

3,500

3,000
30
2,500

2,000

1,500 25
Jan-00 Feb-01 Mar-02 Apr-03 May-04 Jun-05 Jul-06 Aug-07 Sep-08 Oct-09 Nov-10 Dec-11 Jan-13 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13
Source: Dow Jones, Sixth Man Research Source: US, Sixth Man Research

The DJ transport index has “finally” confirmed Shale gas is a big deal; sophisticated engineering
resources and weaker labor unions are making “made in
the USA” a really attractive thing

Sixth Man Research | Section Three: The Big Shift? 25

 March 15, 2013

“This is a fine mess you have gotten us into, Ollie!”

U.S. Pension Fund Asset Allocation Defined-Benefit Pension Plan Asset Allocation
(Towers Watson Global Pension Survey 2012)
60%
100% 2%
5%
17%
90%
25%
50%
80% 28%

23%
70%
40%
60% 31%

50%
30%
40%

65%
30% 60%
20%
44%
20%

10%
10%
1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010
0%
2001 2006 2011 Stocks as a Percent of Total Credit Market Instruments as Percent of Assets
Equities Bonds Other Cash
Source: Towers Watson Global Pension Survey 20120; Sixth Man Research Source: Federal Reserve, Sixth Man Research

Although pension fund allocations are materially more
“sophisticated” (as supported by the quintupling of “Other” assets;
e.g. Hedge Funds, PE Funds, timber, etc.), we believe many portfolios
are have become dangerously uncorrelated to the equity markets
and increasingly dependent upon private equity for outsized, long-
term alpha.
Moreover, by heartily embracing a duration matching strategy after
the most of the meltdown in global equities was complete, many
institutions have essentially de-risked at the bottom of the market.
So here it is graphically. For those pension plans who are required
to fund their retiree pool from operations, the pain of falling stocks,
falling interest rates, and rising obligations was just too much.
And although this strategic shift might have deadened the
pain, U.S. corporate pension plans remain, on average, ~25%
underfunded.

By effecting this strategy when they did, pension funds immunized

their liabilities from the risk of falling interest rates (rising future
obligations due to lower discount rate), but they also became very
exposed to principal losses on bond investments when/if rates rise.

Sixth Man Research | Section Three: The Big Shift? 26

 March 15, 2013

And “It” Begins?

Source: “ Chart of the Day”

Just a week after publishing Savor the “Saviors”, we were pleasantly surprised to see data confirming
our rotation thesis. Although one week of flows does not make a trend and we can’t yet verify that
US institutions have begun shifting their $16 trillion asset pool, we can confidently assert two critical
points:
1. The consensus is wrong. The lift in equities—despite rising sentiment indicators—is not being
fueled by confidence or complacency; it’s just the opposite. The market is fearful of bonds.
2. Capital flows must never be confused with trading capital; they are the stuff of rising tides,
breached levees, and flood waters.

Sixth Man Research | Section Three: The Big Shift? 27

 March 15, 2013

How Bad Is It?

Portfolio Weight Expected Return Contribution

Bonds 31% 6.5% 2.0%
Stocks 44% 1.5% 0.7%
Other 25% 10% 2.5%
100% 5%

We graciously thank Grantham Mayo (GMO) for publicly sharing
their rolling 7-Year asset class return forecasts. In our experience,
their work has been remarkably accurate and, directionally, we have
little disagreement with this table.
However, we do believe that the US equity returns will likely be
higher—and emerging returns lower—than their expectations; but
of most import to this note, are their shocking forecasts for bond
returns.
We would suggest that negative bond returns would be more
consistent with higher equity returns, but the key takeaway is the
spread: some ~600+ bps.
As shown in the table above, institutional portfolios have become
wholly dependent upon “other” assets to drive plan returns.
As is patently obvious from the fund raising success private equity
firms have had throughout the past several years, it is clear that
pension fund CIOs have been lured—and essentially trapped—by
the high-return promises of these funds, despite the very poor
returns realized in recent vintages.
Of course, as always, there is game-theory at play. Private equity
funds have a nice habit of not marking assets to market along
the way; ergo, pension funds and their consultants can plug their
returns in a variety of creative ways.

Sixth Man Research | Section Three: The Big Shift? 28

 March 15, 2013

Of Course John Q. Has Played Right Along

Net New Equity vs. Bond & Hybrid Fund Flows Cumulative Equity Less Bond & Hybrid Flows
ICI Mutual Fund Data (1990 - November 2012)
ICI Mutual Fund Data (1990 - November 2012) 1,600,000
2,500,000
1,400,000

1,200,000

2,000,000
1,000,000

800,000

$USD Billions
600,000
1,500,000
$USD Billions

400,000

200,000

1,000,000
0

-200,000

500,000 -400,000
Jan-90 Dec-91 Nov-93 Oct-95 Sep-97 Aug-99 Jul-01 Jun-03 May-05 Apr-07 Mar-09 Feb-11
Source: Bloomberg, Sixth Man Research

0
Jan-90 Dec-91 Nov-93 Oct-95 Sep-97 Aug-99 Jul-01 Jun-03 May-05 Apr-07 Mar-09 Feb-11
Cumulative Equity Bond & Hypbrid Flows
Source: Sixth Man Research

Balance Equity vs. Bond Mutual Fund Holdings

No surprises here. Retail flows have been moving aggressively into bonds 80% ICI Data (1990 - November 2012)
and, as shown in the upper right chart, the cumulative spread has reached 70%
~$1.7 trillion.
60%

Also, quite predictably, the retail equity/bond balance hit a peak of 70% at 50%
the top of the 2000 internet bubble, had a resurgence into the top of the
housing bubble (60%), and has now fallen to 30%. 40%

30%
With 10-year Treasury rates at 1.8% and corporate bond prices pegged,
what can the retail investor do? 20%

10%

0%

-10%
Dec-91 Sep-93 Jun-95 Mar-97 Dec-98 Sep-00 Jun-02 Mar-04 Dec-05 Sep-07 Jun-09 Mar-11
Source: Bloomberg, Sixth Man Research

Sixth Man Research | Section Three: The Big Shift? 29

 March 15, 2013

Who are the weakest players on the board?

HFRX Equity Hedge Index vs. SPX Percent of HFRX Strategies Beating the SPX
180 (Indexed 100=12-31-2006) (Relative to Trailing 6-Months)
100%

160
90%

80%
140
70%

60%
120

50%

100 40%

30%

80
20%

10%
60
Dec-08 Apr-09 Aug-09 Dec-09 Apr-10 Aug-10 Dec-10 Apr-11 Aug-11 Dec-11 Apr-12 Aug-12 0%
HFRX Equity Hedge Index Indexed 100=12-31-2006 S&P 500 Index Indexed 100=12-31-2006 Jan-06 Aug-06 Mar-07 Oct-07 May-08 Dec-08 Jul-09 Feb-10 Sep-10 Apr-11 Nov-11 Jun-12
Source: Hedge Fund Research, Standard & Poor's, Sixth Man Research Source: Sixth Man Research

Sixth Man Research | Section Three: The Big Shift? 30

Section Four: Fiscal Sustainability

S���� M�� R�������

 March 15, 2013

Don’t Trust the Orthodoxy

The Orthodox View of Fiscal Sustainability

“The government’s total fiscal policy may be
considered balanced if today’s publicly held debt
plus the present value of projected non-interest
spending is equal to the present value of projected
government receipts. For the entire federal
government’s policy to be sustainable, its fiscal
imbalance must be zero.”
The government cannot spend and owe more than
it will receive as revenue in present value.”
Fiscal Present Value Present Value Net National
Imbalance Expenditures Revenues Debt

Sixth Man Research | Section Four: Fiscal Sustainability 32


Heretical Challenge to Convention
The Shocking Truth About Money
1. Money is the most basic form of credit; it has “no value” in and
of itself.
2. Thus, “fiat”—derived from the Latin origin “let it be done”—is
not “backed” by the tangible wealth of the issuing Sovereign;
but rather, by the “full faith” of the issuing government to
uphold the laws and regulations which support its transaction
value.
3. Moreover, it is the Sovereign herself—through the collection of
taxes and the payment of obligations with government issued
fiat currency—that serves as the foundation for its credit
“worthiness”.
4. And as a “reserve” credit, the utility of any “money” is directly
related to the breadth of its use and the scope of its acceptance
around the world.
5. Despite popular folklore to the contrary, money systems utilizing
stores of value (such as gold, beads, etc.) have always failed and
given way money representing standard units of credit.
Monetary System Basics
1. Central banks operating target is necessarily an interest rate target.
2. Modern, currency issuing sovereigns with free-floating FX spend via
the crediting of reserves.
a. “Printing money” vs. “financing” spending is a false dichotomy.
b. Present value of liabilities or “prefunding” makes no sense since
“user” and “issuer” of the currency are one and the same.
3. Bond sales and tax collections are interest rate maintenance
operations, NOT financing operations.
4. Deficits with or without bond sales—whether to the Fed or to the
private sector—has no effect other than overnight rate.
a. It is the size of the deficits themselves, not whether bonds are
sold, that matter for aggregate demand, as government deficits
necessarily increase private savings.
b. Whether deficits actually raise aggregate demand and
potentially create inflation depends upon the private sector’s
relative proclivity to save or spend.
Sixth Man Research | Section Four: Fiscal Sustainability
March 15, 2013
Interest Rates are Monetary, Not Real Phenomena
1. Central Bank targeted rate anchors other rates.
2. With interest payment on reserves and no bond
sales, rate on national debt is rate paid on reserves.
3. If short-term bonds are issued, these rates are set via
arbitrage with Fed’s target.
4. If long-term bonds are issued, these rates are set via
arbitrage with current and expected Fed target AND
premium attached to debt of increasing maturity.
5. Long end of term structure is set mostly by
expectations of short-term rates.
6. Monetary sovereignty within a free-floating
exchange regime means government debt NOT
subject to loanable funds paradigm.
Fiscal Sustainability
1. Long-term Fiscal Sustainability results when nominal
interest rates are kept below nominal GDP growth; it is a
mathematical reality.
2. Furthermore, the Federal Reserve anchors the yield curve
by maintaining a targeted rate and paying reserves on
unused balances. And if the Fed’s policy stays firm,
arbitrage will reverse any attempt by speculators to drive
yields past what is defined by the coupon roll down the
term structure.
3. And the degree to which deficits might cause inflation is a
function of their size and the private sector’s proclivity to
save or spend; and/or in cases where capacity utilization is
high and resources are scarce, the government’s excess
liabilities can trigger inflation. (But this is highly
improbable in an IP-centric economy.)
33
S���� M�� R�������

Disclosures
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the securities mentioned herein, nor does it constitute an opinion of the suitability and appropriateness of investing in any financial instrument.

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