Napier

Equity Valuation
Inflation, deflation and mean

reversion
Russell Napier
Strategist
Conclusions
Key to mean reversion of CAPE- changing inflationary
expectations
CAPE and Q drive capital creation and are reflexive
Technology is key but it is never as positive for noninflationary growth as it seems
Deflation or inflation rising through 4% will reduce
valuations
Equities can adjust more rapidly than bonds
Deflation comes next and sharply lower equity prices
Page 2
The mean reversion of CAPE

CAPE
46
44
42
40
38
36
34
32
30
28
26
24
22
20
18
16
14
12
10
8
6
4
Page 3
Slide 4. US Stock Market Value q and CAPE.

q and CAPE to their own averages (log numbers).
1.2
1.2
1
1
q
0.8
CAPE
0.8
0.6
0.6
0.4
0.4
0.2
0.2
-0.2
-0.2
-0.4
-0.4
-0.6
-0.6
-0.8
-0.8
-1
-1
-1.2
-1.2
1900
1910
1920
1930
1940
1950
1960
1970
1980
1990
2000
2010
Data Sources: Stephen Wright (1900 - 1952) and Federal Reserve Z1 Table B.102 (1952 - Q2 2013)
for q, and Robert Shiller (updated) from Standard & Poor's for CAPE.
Page 4
But beware inflation near 4%

US inflation and Dow Jones Industrial Average, 1966-1978
1,050
14
1,000
12
950
10
900
850
800
6
750
700
650
2
CPI (LHS)
Dow Jones Industrials - Price Index
66
67
68
69
70
71
72
73
74
600
75
76
77
Source: Datastream
Page 5
78
550

5.0
4.5
2,800
CPI (LHS)
2,600
2,400
4.0
2,200
3.5
2,000
3.0
1,800
2.5
1,600
2.0
1,400
1.5
1.0
1985
1,200
1986
1987
1,000
1988
Source: Datastream
Page 6

('000)
4.0
12.0
11.5
3.5
11.0
10.5
3.0
10.0
9.5
2.5
9.0
2.0
8.5
8.0
1.5
1.0
1998
CPI F(LHS)
1999
2000
2001
7.5
2002
2003
Source: Datastream
Page 7
7.0

('000)
6
CPI (LHS)
15
14
13
12
3
11
2
10
1
8
(1)
2002
Source: Datastream
2003
2004
2005
2006
2007
2008
2009
Source: DATASTREAM
Page 8
40
35
38
30
36
25
34
32
20
30
15
28
10
26
Gross
24
22
1929
Net
0
1935
1941
1947
1953
1959
1965
1971
1977
1983
1989
1995
2001
2007
Data Source: NIPA Table 1.14.

Page 9
2013
Profits, after depreciation, but before interest and tax, as

% of net output.
Profits, before depreciation, interest and tax, as % of gross

output.
Slide 63. US Profit Margins 1929 - Q2 2013.
Stability of long term return from equities
% p.a. real return.
Slide 13. The First Remarkable Feature 30 Year Rolling

Returns.
12
12
10
10
0
Bonds
-2
-4
1831
Equities
Cash
-2
-4
1851
1871
1891
1911
1931
1951
1971
1991
Data Sources: 1801 - 1899 Jeremy Siegel , then Elroy Dimson, Paul Marsh & Mike Staunton
1900 - 2012 via Morningstar.
Page 10
2011
Stability of long term return from equities
% p.a. real return.
Slide 13. The First Remarkable Feature 30 Year Rolling

Returns.
12
12
10
10
0
Bonds
-2
-4
1831
Equities
Cash
-2
-4
1851
1871
1891
1911
1931
1951
1971
1991
Data Sources: 1801 - 1899 Jeremy Siegel , then Elroy Dimson, Paul Marsh & Mike Staunton
1900 - 2012 via Morningstar.
Page 11
2011
Deflation in the age of QE

Inflation is always and everywhere a monetary
phenomenon- Friedman
We do not live in a fiat system as so many countries
manage/fix their currencies to others
For EMs external surpluses dictate monetary policy
In fiat systems money is created by commercial banks
and not by central banks
Demographic trends mitigate against credit and money
creation by central banks
Page 12
Smaller US deficits and EM deflation

For almost two decades a widening US current account
deficit was the basis for Bretton Woods II
Earned surpluses allowed liquidity creation and stable
exchange rates in EMs
Since 2009, EMs have borrowed surpluses they did not
earn
The round trip of capital creates liquidity in EMs
A country with insufficient surplus and liquidity can
deflate or devalue and China is particularly vulnerable
Page 13
Source: Datastream
Page 14
1Q14
1Q13
1Q12
1Q11
1Q10
1Q09
1Q08
1Q07
1Q06
1Q05
1Q04
1Q03
1Q02
1Q01
1Q00
1Q99
1Q98
1Q97
1Q96
1Q95
1Q94
1Q93
1Q92
50
1Q91
1Q90
US current-account deficit
(US$bn)
(50)
(100)
(150)
(200)
(250)
6/1/67
5/1/68
4/1/69
3/1/70
2/1/71
1/1/72
12/1/72
11/1/73
10/1/74
9/1/75
8/1/76
7/1/77
6/1/78
5/1/79
4/1/80
3/1/81
2/1/82
1/1/83
12/1/83
11/1/84
10/1/85
9/1/86
8/1/87
7/1/88
6/1/89
5/1/90
4/1/91
3/1/92
2/1/93
1/1/94
12/1/94
11/1/95
10/1/96
9/1/97
8/1/98
7/1/99
6/1/00
5/1/01
4/1/02
3/1/03
2/1/04
1/1/05
12/1/05
11/1/06
10/1/07
9/1/08
8/1/09
7/1/10
6/1/11
5/1/12
4/1/13
When does money printing begin?

GDP DEFLATOR (ANNUAL %) : Global World International
18
16
14
12
10
Source: Datastream
Page 15
Source: Datastream
Page 16
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
US current-account deficit as % of GDP - A new era

(%)
(1)
(2)
(3)
(4)
(5)
(6)
(7)
The shrinkage in the deficit is structural

The shale oil and gas revolution means fewer US dollars
in the hands of foreigners
Chinese manufacturing wages have risen 3x since end2007 in US$ terms, US hourly wages just 12%
The baby-boom generation is degearing and saving; and
this means less consumption and fewer imports
If the US is to run structurally smaller deficits. then
Bretton Woods II is unfit for purpose
EMs will deflate or devalue; either will bring a global
deflation
Page 17
US visible trade deficit with China (% of GDP) - Shrinking

0.0
(%)
(0.5)
(1.0)
(1.5)
(2.0)
(2.5)
90
91
92
93
94
95
96
97
98
99
Source: Datastream
Page 18
10
11
12
13
Chinas capital inflows and outflows (US$bn)

9000
8000
7000
6000
5000
Pane 1 BOP - CAPITAL & FINANCIAL ACCOUNT

(DEBIT) : China ex Hong Kong and Macau
(Country)
4000
Pane 1 BOP - CAPITAL & FINANCIAL ACCOUNT

(CREDIT) : China ex Hong Kong and Macau
(Country)
3000
2000
1000
8/1/14
2/1/14
8/1/13
2/1/13
8/1/12
2/1/12
8/1/11
2/1/11
8/1/10
2/1/10
8/1/09
2/1/09
8/1/08
2/1/08
8/1/07
2/1/07
8/1/06
2/1/06
8/1/05
2/1/05
8/1/04
2/1/04
8/1/03
2/1/03
8/1/02
2/1/02
8/1/01
2/1/01
8/1/00
2/1/00
Source: Thomson Reuters Datastream
Page 19
Chinas gross external indebtedness

900
(US$bn)
800
700
600
500
400
300
200
100
0
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Source: Thomson Reuters Datastream
Page 20
2012
2013
Family holdings of debt by age of head, 2007 and 2010 surveys
Family
characteristic
Age of head (years)
Less than 35
35-44
45-54
55-64
65-74
75 or more
Secured by resi property

Primary
Other
residence
37.3
59.5
65.5
55.3
42.9
13.9
3.3
6.5
8.0
7.8
5.0
0.6
Instalment
loans
Credit-card
balances
Credit lines not

secured by resi
property
Other
Any debt
65.2
56.2
51.9
44.6
26.1
7.0
48.5
51.7
53.6
49.9
37.0
18.8
2.1
2.2
1.9
1.2
1.5
-
5.9
7.5
9.8
8.7
4.4
1.3
83.6
86.2
86.8
81.8
65.5
31.4
Source: Federal Reserve Survey of Consumer Finances
Page 21
US personal savings as a % of disposable income
Source: Datastream
Page 22
Five-year-TIPS-implied inflation versus MSCI EM Index (US$)

2.6
(%)
Five-year-TIPS-implied inflation
MSCI Emerging Markets Index (RHS)
2.4
1,300
1,200
2.2
1,100
2.0
1,000
1.8
900
1.6
800
1.4
700
1.2
1.0
1 Jan 10
12 Oct 10
23 Jul 11
2 May 12
10 Feb 13
21 Nov 13
Source: Datastream
Page 23
600
1 Sep 14
Gross External Debt Table

Gross External Indebtedness 3Q 2014
(US$bn)
Source: Joint External Debt Hub and World Bank
Argentina
Belarus
Brazil
Bulgaria
China
Chile
Columbia
Croatia
Czech Republic
Ecuador
Georgia
Hungary
India
Indonesia
Kazakshtan*
Korea
Malaysia
148
41
540
49
874
137
98
58
127
19
13
190
456
292
155
429
213
28%
53%
24%
90%
8%
52%
25%
100%
64%
19%
81%
147%
22%
22%
34%
28%
68%
Macedonia
Mexico
Mongolia
Pakistan
Peru
Phillipines
Poland
Romania
Russia*
Serbia
South
Africa
Thailand
Turkey
Ukraine
Uruguay
Venezula
7
419
19
56
61
58
370
120
679
36
73%
32%
158%
24%
29%
20%
67%
59%
33%
80%
142
143
397
136
24
119
42%
38%
49%
101%
44%
27%
* exchange rate movements since end September 2014 will have pushed external debt to GDP ratios well about 35%
Page 24
Conclusions
The size of the US current account deficit is a key driver
of global liquidity but it is not growing
Structural reasons - shale oil and gas, rising Chinese
wages, baby boom degearing - stop the deficit growing
The de-gearing of the baby boom generation restricts the
effectiveness of monetary policy
EMs, particularly in Eastern Europe, have borrowed too
much in foreign currency.
Six years after the launch of QE we get deflation anyway
and a move to government action
Page 25

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Equity Valuation

Inflation, deflation and mean

The mean reversion of CAPE

Slide 4. US Stock Market Value q and CAPE.

But beware inflation near 4%

But beware inflation near 4%

But beware inflation near 4%

But beware inflation near 4%

Data Source: NIPA Table 1.14.

Profits, after depreciation, but before interest and tax, as

Profits, before depreciation, interest and tax, as % of gross

Slide 63. US Profit Margins 1929 - Q2 2013.

Stability of long term return from equities

% p.a. real return.

Slide 13. The First Remarkable Feature 30 Year Rolling

Stability of long term return from equities

% p.a. real return.

Slide 13. The First Remarkable Feature 30 Year Rolling

Deflation in the age of QE

Smaller US deficits and EM deflation

When does money printing begin?

US current-account deficit as % of GDP - A new era

The shrinkage in the deficit is structural

US visible trade deficit with China (% of GDP) - Shrinking

Chinas capital inflows and outflows (US$bn)

Pane 1 BOP - CAPITAL & FINANCIAL ACCOUNT

Pane 1 BOP - CAPITAL & FINANCIAL ACCOUNT

Source: Thomson Reuters Datastream

Chinas gross external indebtedness

Source: Thomson Reuters Datastream

Family holdings of debt by age of head, 2007 and 2010 surveys

Secured by resi property

Credit lines not

Source: Federal Reserve Survey of Consumer Finances

US personal savings as a % of disposable income

Five-year-TIPS-implied inflation versus MSCI EM Index (US$)

MSCI Emerging Markets Index (RHS)

Gross External Debt Table

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