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As with other investment-driven “economic miracles” — Germany in the 1930, the Soviet Union in the
Global
1950s and 1960s, and Japan in the 1970s and 1980s — “you started seeing this Macro Strategy:
unsustainable Mayup
build 2011
in
debt,” Pettis said. “In the early stages…building the first road is profitable, but what happens when you’ve

Current edition contains:

MORE THOUGHTS ON GOLD
1
Last time it did not work out. We tried harder to analyze what is driving gold.

SMALL CAPS VS. LARGE CAPS

2
Large caps offer about 20% discount compared to small stocks.

DOES COPPER STILL HOLD IT’S PHD IN ECONOMICS OR HAS IT FALLEN VICTIM TO CHINESE
3 FINANCING SHENANIGANISM?
Data on Chinese copper stockpiles are ambiguous like Chinese accounting.

DEVELOPMENT ECONOMICS – CASE STUDY ON INDIA

4
Network statistics give us some clues on the path for development of India.

© ATWEL International, s.r.o. www.atwel.com Page 1

1) MORE THOUGHTS ON GOLD

Late last year, we were trying to short gold on the movement in world real rates. We had a beautiful chart, great
correlation and a trade that should have performed magnificently (Chart 1). Yet, it did not. True, gold fell from 1400
to 1300, but nowhere near 1150 as we expected. As you can see on Chart 2, the correlations did not really break up,
but the gold got boosted by some special alpha.

Chart 1 Chart 2
Gold, World 10Y Real rates
left axis - World 10Y Real rates; right axis - price of gold in USD/oz
0,1 1600

0,3
1500
0,5
1400
0,7

0,9 1300

1,1
1200
1,3

1100
1,5

1,7 1000

1,9
900

06/09 08/09 10/09 12/09 02/10 04/10 06/10 08/10 10/10 12/10 02/11 04/11

We do not like being treated by markets like that and had get into some more research what is driving gold price. We
do know that marginal cost of production is around 600 USD/oz and there is very limited demand for industrial
production, thus in fact, there must be about 900 USD put on the Fed and other central banks.

In order to keep things simple, we will not pay attention just to Fed, as it is still the main reserve central bank and
besides, ECB is more hawkish, thus any strength in gold should be stemming primarily from Fed. The Asian central
banks are also behind the curve, but have been hiking lately and are also partially dependent on Fed.

So what are the variables we are looking at that may drive gold? First, we naturally looked at real short term rates. If
people are not compensated in the bank in real terms, they will start searching for other stores of value. Naturally,
we could have tested different segments of yield curve or their combinations, not just real 3M T-Bill yields, but as we
work with old-school excel to test our hypothesis, there is simply not enough will to do all the permutations by hand.
We think 3M real yields as sufficient proxy to measure strength of debasement. We also work with historical CPI as
we not buy into rational expectations theory.

On Chart 3, we regressed monthly CAGR of gold prices over 12 months against 12M average real rate. Our recent
experience tells us, that people were buying into gold as they knew Fed would remain on hold for long time (their
QE2 program told in October that they will basically stay on hold for next 8 months and people like David Tepper
would famously go "balls to the wall", flying on the money printing wave. Thus we also tested, if we can make our
regression any better based on some kind of expectation proxy - here we used a small trick and pushed forward the
real rates by couple of months, with 7 months lead giving us the best fit.

© ATWEL International, s.r.o. www.atwel.com Page 2

 Chart 3 Chart 4
Gold and US Real Rates Correlation
Gold and US Real Rates Correlation Test x axis - Monthly CAGR in gold price over 12M; y axis - 12M avg. real rates pushed
x axis - R2; y axis - 12 M avg. real rates push forward by T+X months forward by 7 months in %
7
T : T+11
R² = 0,2947
T-1 : T+10 5

T-2 : T+9
3
T-3 : T+8

T-4 : T+7
1

T-5 : T+6
-1
T-6 : T+5

T-7 : T+4
-3

T-8 : T+3

-5
22,00% 23,00% 24,00% 25,00% 26,00% 27,00% 28,00% 29,00% 30,00%
-6,00% -4,00% -2,00% 0,00% 2,00% 4,00% 6,00% 8,00% 10,00%

When we look at residuals and do the same correlation testing, we find strongest links between 12M absolute CPI
change (probably due to the fact that everyone likes to look at annual changes), which means basically taking into
account whether inflation is accelerating or decelerating and also , we find some minor, yet explanatory, relationship
with broad trade-weighted USD. The reason why it is minor, is due to the fact that real rates and CPI moves drive
currencies as well. What the model does not account for is any speculative positioning in the commodity exchanges,
Asian factors, etc. We will try to upgrade the model by taking account these two into account, but for now, we need
2
to get satisfied with overall R =46%. The final regression equation for monthly CAGR of gold price over one year is :
Monthly CAGR of gold price over 1 year = 1.12% - 0.261% * (3M T-Bill - Headline CPI y/y)12M average of 7 months forward and 4

months historical + 0.299% * ( CPIT - CPIT-1) - 0.678 * 12M CAGR in Trade weighted US Dollar

Before we start judging our model, we will have a look how gold did over certain major time periods. From 1973 to
1979 Keynesianism was in full swing and central banks helped to accommodate fiscal policy. 1980 was the period
when Volcker came into office, yet gold and inflation mania was so entrenched, that despite hiking rates like crazy,
not much really happened to price. 1981-1991 and 1991-2001 were periods when real rates were kept positive and
gold corrected. Since 2000, Greenspan put and later Bernanke put were put into effect and you can see what the
price did by yourself.

Chart 5

Gold price by periods

USD/oz
1 600

800 1974-79

1980 - Volcker
400
1981-1990

1991-2001
200
2002-2011

100

50
73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11

© ATWEL International, s.r.o. www.atwel.com Page 3

Now let us give you a hint how gold price has been evolving over time with respect to the model.

Chart 6

Gold price and model, 1974-1979

x axis - theoretical monthly CAGR in gold price over 12M; y axis - actual monthly CAGR in gold price over 12M

10%

Inflation getting out of

8%
control. Fed losing credibility
1974-2011
6%
1974-1979
y = 1,0046x - 1E-04
4% R² = 0,4669

2%

0%
-3% -2% -1% 0% 1% 2% 3% 4%
-2%

-4%

-6%

Chart 7

Gold price and model, 1980 - Volcker breaking neck of inflation

x axis - theoretical monthly CAGR in gold price over 12M; y axis - actual monthly CAGR in gold price over 12M

10%

8%
1974-2011

6%
1980
y = 1,0046x - 1E-04
4% R² = 0,4669

2%

0%
-3% -2% -1% 0% 1% 2% 3% 4%
-2%

-4%

-6%

© ATWEL International, s.r.o. www.atwel.com Page 4

 Chart 8

Gold price and model, 1981-1990

x axis - theoretical monthly CAGR in gold price over 12M; y axis - actual monthly CAGR in gold price over 12M

10%

8%
1974-2011
6%
1981-1990
y = 1,0046x - 1E-04
4% R² = 0,4669

2%

0%
-3% -2% -1% 0% 1% 2% 3% 4%
-2%

-4%

-6%

Chart 9

Gold price and model, 1991-2001

x axis - theoretical monthly CAGR in gold price over 12M; y axis - actual monthly CAGR in gold price over 12M

10%

8%
1974-2011
6%
1991-2001
y = 1,0046x - 1E-04
4% R² = 0,4669

2%

0%
-3% -2% -1% 0% 1% 2% 3% 4%
-2%

-4%

-6%

Chart 8 and 9 shows very good fit of the model, gold is doing exactly what it should as real rates were positive. On
chart 10, we see some flattening of the 10 year linear regression and upward shift. That shows some tentative signs
that markets are losing patience with US central bank.

© ATWEL International, s.r.o. www.atwel.com Page 5

 Chart 10

Gold price and model, 2002-2011

x axis - theoretical monthly CAGR in gold price over 12M; y axis - actual monthly CAGR in gold price over 12M

10%

8%

1974-2011
6%
2002-2011
y = 1,0046x - 1E-04
4% R² = 0,4669

2%

0%
-3% -2% -1% 0% 1% 2% 3% 4%
-2%

-4%

-6%

Conclusion: We believe there will be continuous CPI increases in US stemming primarily from commodities and
import price pressures from China. Let us assume for a while that we will get CPI stabilized at 2%, we will have stable
USD and Fed will remain at zero yields for next year and half. With real rates at negative 2%, the equation is quite
simple. Monthly price appreciation of gold should reach : 1.1% - 0.26% * (-2) = 1.1% + 0.52% = 1.62% p.m. = 21% p.a.
over next year. Another scenario is to apply current yield curve which points to slow rate hikes early next year and
reaching real rates equal to zero by early 2013. With broad USD dropping at the pace of just 2% due to rise of Asian
currencies and CPI stable, we come down to our 1 year return on gold of 10-14% p.a.

It may look truly crazy to expect 10-21% p.a. appreciation in gold with just 2% CPI, but as gold has no physical impact
on economy like oil, it can move quite freely. Also we think gold has little memory (little return-to-the-mean
tendency and its returns are driven dominantly by real rates, CPI and USD) . If oil went up by 50% y/y today, it would
crush world economy. On the other hand, if gold trades like a currency, it won't affect competitiveness of any nation.
Gold is just a subject to demand with the supply being pretty stable.

Should we get continuous negative -2% real rates while economy grows at 2% p.a. in real terms, then more and more
people will ask themselves why should I be a subject of continuous devaluation? There is a clear robbing of the saver
going on. In case real rates start going up, we will get much more cautious on gold. But as of now, we would remain
cautious buyers.

© ATWEL International, s.r.o. www.atwel.com Page 6

2) SMALL CAPS VS. LARGE CAPS

We have noticed that both our Hong Kong friends in GaveKal and GMO’s Jeremy Grantham pointed out to a gross
overvaluation of US Small Caps compared to their large cap peers. In order to test the claims, we took a look at the
valuations of both groups.

As of today, small caps measured by Russell 2000 (ETF:IWM) are valued at 22x next year earnings, while S&P500
(ETF:SPX) stands at 13,5x next year earnings. Two reasons could potentially stand behind the divergence in
valuations: a) different constitution, and b) different growth expectations.

Looking at the mix of both, it is hard for us to identify a meaningful skew of fast growing sectors within one and
missing in the other. S&P 500 is heavier loaded in consumer staples, but lacks the positioning in crippled financial
sector. The beauty does lie in the eye of beholder, but we would argue there is little evidence that would justify a 5%
spread in estimated growth rates.

Chart 1

Sector weightings
%

Utilities

Telco

Info Technology

Financials

Health Care

Cons. Staples

Cons. Discretionary Russell 2000

Industrials
S&P 500
Materials

Energy

0,00% 5,00% 10,00% 15,00% 20,00% 25,00%

Analyst estimates are telling us, that Russell should grow at 15.7% p.a. over next 3-5 year cycle and S&P at 10.7% p.a.
Well, first, we are not sure of both in absolute terms, given the US government has to start tackling its deficit really
soon (both seem too high to us), and second, we see little historical evidence over past ten years that small caps
would do any better than large caps.

© ATWEL International, s.r.o. www.atwel.com Page 7

 Chart 2

Long term geometric growth rate of Earnings, starting from 1997

%
20%

15%
Russell 2000
S&P 500
10%

5%

0%

-5%
1.1.1999 1.1.2000 1.1.2001 1.1.2002 1.1.2003 1.1.2004 1.1.2005 1.1.2006 1.1.2007 1.1.2008 1.1.2009 1.1.2010 1.1.2011

Rather than believing the analysts and Bloomberg median estimates, we prefer our own judgments. We think there
should be a strong correlation between return on equity and the premium one is willing to pay for the asset. In terms
of premium, we mean how many times the book value one really wants to pay. In simplistic terms, if one company is
able to earn twice as much with the same bunch of assets, one should be willing to pay roughly twice as much for
that company. Of course, things are more complicated (large companies tend to pay lower taxes from their overseas
operations and have inflated ROEs, their book value is more skewed towards unreported intangible value like the
value of brands, capitalized R&D, etc.). But all in all, we see a pretty strong relationship between ROE and P/B. On
this metric, S&P is roughly 28% undervalued, whilst Russell is just 3% undervalued.

Chart 3

Return on equity and Price to book relationship

x axis - ROE, y axis - P/B

3
y = 1,5830e0,0290x
R² = 0,4892
2

0
0 5 10 15 20 25 30

Small Caps Small Caps Current Large Caps Large Caps Current

Our intention was to show how the premium in Russell evolved over time, unfortunately, our data for ROE of S&P
500 go back only as far as year 2000. As you can see in the chart, year 2000 was a period of Nasdaq bubble and also a
© ATWEL International, s.r.o. www.atwel.com Page 8
period of serious S&P overvaluation (P/B too high). To get a longer history (although without valuation perspective),
please see pure S&P 500 and Russell 2000 price chart. If things were to normalize, one should be able to grab a 20%
arbitrage.

Chart 4

Russell - S&P 500 premium

%
30%

20%

10%

0%

-10%

-20%

-30%

-40%

-50%
25.2.2000 25.2.2001 25.2.2002 25.2.2003 25.2.2004 25.2.2005 25.2.2006 25.2.2007 25.2.2008 25.2.2009 25.2.2010 25.2.2011

Chart 5 Chart 6

© ATWEL International, s.r.o. www.atwel.com Page 9

3) DOES COPPER STILL HOLD IT’S PHD IN ECONOMICS OR HAS IT FALLEN VICTIM TO CHINESE
FINANCING SHENANIGANISM?

As copper is a widely used material for all kinds of infrastructure projects and as it feeds into many consumption
products, it has been a long held view that copper is a real-time indicator of activity in the world. If copper prices are
rising, it is sensible to expect a booming economy. From here comes the PhD. in economics.

Well, unless you start reading in the press, that Chinese developers have been using copper as collateral for their
shady financing deals. The Chinese government has decided to start pushing hard against raising property prices in
the high end market. Via raising lending rates and tightening loan conditions, it makes a financing for developers
much harder. But the smart Chinese found a way around and through borrowing money from a bank on a L/C basis
for the purpose of copper procurement. Banks were quite happy to do this kind of deal as nobody scrutinizes this
kind of financing as it is classified as a standard L/C note. And such approach goes well in hand with unofficial or
indirect lending, that reached as much as 46% of all new financing in Q1 2011 – here, we are talking about all the
trust loans, bank acceptance bills, insurers funding, etc.

Basically, what has been going on is that some developers got credit for purchase of copper which helped them
finance their real estate projects. This costs the buyer 30 bps for 90 days and around 70 bps if they defer repayment
to 180 days. The process stopped a month ago because the PBoC intervened to prevent more copper-based
financing and apparently it was the start of the bearish sentiment in copper. Some traders say that on a cash basis,
imports of copper to China were nil in April. The only imports that were recorded in the official statistics were
related to purchases of copper from the tariff-protected warehouses by developers on the scheme we described
above. – only when copper is bought and copper paid for, it gets regarded as an import. Some are estimating that
the level of unreported holdings of copper can be as much as 700.000MT of copper (40% of China refined copper
demand).

What is the possible endgame? The developer eventually finds himself with a long position in the real estate project,
a long position in copper and a short position in USD due in six months. If developers will not be able to sell the new
apartments within next few months quickly enough, they will have to liquidate their copper stocks as soon as
possible at low prices. It is quite interesting to watch how these developers, stripped of cheap financing, run to Hong
Kong to issue some USD denominated high-yielding bonds.

We suppose there will be more pain among developers and in copper ahead of us over next few months. Market
positioning would approve this conclusion as net long positions of speculators fell to 6.000 contracts down from
30.000, which would correlate with price target of around 300c/lb. Long term, copper should remain well bid due to
constraints in new resource developments and falling grade quality. Also on a marginal cost basis, copper has a lot of
th
room to fall – to around 250c/lb, which is 90 percentile of real cash costs curve.

© ATWEL International, s.r.o. www.atwel.com Page 10

 Chart 1

© ATWEL International, s.r.o. www.atwel.com Page 11

4) DEVELOPMENT ECONOMICS – CASE STUDY ON INDIA

We have recently published a short research piece on development outlook of India. We see little purpose rewriting
all the slides into text here and think it as more straightforward to place a link on this publication.

Please, feel free to download here: http://www.atwel.com/download/Long_India.pdf

Also, we are quite aware that India has been a poor performer for the past two months, but do not forget that Rome
was not built in a day either. For us, India remains a good structural story. As we discussed with our clients during
the recent seminar sessions, the best way to play India is to have some hedges on commodity prices in place as India
is a net importer of commodities (while still in early stage of development and thus having still to do a lot of
infrastructure spending – that is why it is even more vulnerable to high commodity prices than developed net
importers). Be also aware of rolling commodity futures due to contango, we urge you to consider owning commodity
miners or producers that pay dividends as a more suitable and cheaper hedge.

Disclaimer

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Company provides this document for educational purposes only and does not advise or suggest to its clients or other subjects to buy or sell any
security traded at financial markets, despite the fact such security may be mentioned in this material. Company is not liable for any actions of a
client or other party that are based on the opinions of the Company mentioned in this material.

Trading and investing into financial instruments bears a high degree of risk and any decision to invest or to trade is a personal responsibility of
each individual. Client or a reader understands that any investment or trading decisions that he or she makes is a decision based on his or her will
and he or she bears responsibility for such action.

Educational methods of the Company do not take into consideration financial situation, investment intentions or needs of other persons and
therefore do not guarantee specific results. Company and its employees may purchase, sell or keep positions in shares or other financial
instruments mentioned in this material and use strategies that may not correspond to strategies mentioned in this material.

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