Peering Through the Mist Strategic Investor Conference - La Jolla April 22-24, 2004 Peering Through the Mist Martin Barnes Managing Editor The Bank Credit Analyst

KEY MESSAGES The U.S. economic expansion is sustainable. The Fed is falling behind the curve: inflation will pick up in the coming year. The trends in domestic debt are unsustainable, but do not pose any immediate threat to the economic and financial outlook. No major asset class offers compelling value right now. However, stocks should outperform both bonds and cash this year and next.

REFLATION TRADES (Part I) STOCK-TO-BOND TOTAL RETURN RATIO* 1.0 1.0 .9 .9 .8 .8 .7 .7 .6 .6 BPs BPs CORPORATES MINUS TREASURYS (OAS)** 240 240 200 200 160 160 120 120 © BCA Research 2004 2001 2002 2003 *INDEXED TO JANUARY 2001 = 1 **SOURCE: MERRILL LYNCH; OPTION-ADJUSTED SPREAD

REFLATION TRADES (Part II) S&P CYCLICAL STOCKS/NON-CYCLICAL STOCKS 1.0 1.0 .9 .9 .8 .8 .7 .7 .6 .6 320 CRB* RAW INDUSTRIALS INDEX 320 300 300 40-WEEK MOVING AVERAGE 280 280 260 260 240 240 220 220 © BCA Research 2004 2001 2002 2003 *CRB = COMMODITY RESEARCH BUREAU

MASSIVE MONETARY STIMULUS % % FED FUNDS TARGET RATE 10 GDP GROWTH 10 8 8 6 6 4 4 2 2 © BCA Research 2004 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

STRONG REVIVAL IN BUSINESS CONFIDENCE % % AVERAGE OF ISM MANUFACTURING AND NON-MANUFACTURING INDEXES* 60 60 55 55 50 50 45 45 40 40 CONFERENCE BOARD BUSINESS CONFIDENCE INDEX 70 70 60 60 50 50 40 40 30 30 © BCA Research 2004 1998 1999 2000 2001 2002 2003 2004 *SOURCE: INSTITUTE FOR SUPPLY MANAGEMENT

CONSUMER SPENDING SUPPORTED BY INCOMES Ann% Chg Ann% Chg REAL PERSONAL DISPOSABLE INCOME* REAL CONSUMER SPENDING* 6 6 4 4 2 2 % % PERSONAL SAVING RATE* 4 4 3 3 2 2 1 1 © BCA Research 2004 1996 1998 2000 2002 2004 *SHOWN AS A 3-MONTH MOVING AVERAGE

HEALTHY TREND IN CONSUMER INCOMES Ann% Chg Ann% Chg DISPOSABLE INCOME 8 PERSONAL INCOME 8 6 6 4 4 2 2 % % AVERAGE EFFECTIVE TAX RATE 14 14 12 12 10 10 © BCA Research 2004 1998 2000 2002 2004 NOTE: ALL SERIES ARE SHOWN AS A 3-MONTH MOVING AVERAGE

A GLOBAL RECOVERY Ann% Chg U.S.: LEADING ECONOMIC INDICATOR (LS) INDUSTRIAL PRODUCTION (RS) 102 4 101 100 -4 99 BCA GLOBAL LEADING ECONOMIC INDICATOR EX. U.S. (LS) GLOBAL INDUSTRIAL PRODUCTION EX. U.S. (RS) .4 8 4 -.4 -.8 © BCA Research 2004 -4 1994 1996 1998 2000 2002 2004

RECESSIONS USUALLY TRIGGERED BY TIGHT MONEY Ann% Chg Ann% Chg REAL GDP 6 6 4 4 2 2 -2 -2 % % 10-YEAR MINUS 3-MONTH TREASURY YIELD 4 4 2 2 -2 -2 © BCA Research 2004 1960 1965 1970 1975 1980 1985 1990 1995 2000 NOTE: SHADED AREAS CORRESPOND TO NBER-DESIGNATED PERIODS OF RECESSION

A STUNNING REBOUND IN PROFITS % % TOTAL CORPORATE AFTER-TAX PROFITS AS A % OF GDP 8 8 7 7 6 6 5 5 4 4 % NON-FINANCIAL CORPORATE SECTOR: % WEIGHTED AVERAGE REAL COST OF CAPITAL 9 9 AVERAGE RETURN ON CAPITAL 8 8 7 7 6 6 5 5 4 4 3 3 © BCA Research 2004 1960 1965 1970 1975 1980 1985 1990 1995 2000

INFLATION TURNS THE CORNER Ann% Chg Ann% Chg CORE* CPI 2.5 2.5 2.0 2.0 1.5 1.5 Ann% Chg CORE* PPI FINISHED GOODS Ann% Chg 2 2 1 1 Ann% Chg Ann% Chg IMPORT PRICES FOR CONSUMER GOODS & AUTOS 2 2 1 1 -1 -1 © BCA Research 2004 1994 1996 1998 2000 2002 2004 *CORE EXCLUDES FOOD AND ENERGY

THE TWO SIDES OF INFLATION Ann% Chg Ann% Chg CORE* CPI GOODS -2 -2 Ann% Chg CORE* CPI SERVICES EXCLUDING RENT OF SHELTER Ann% Chg 4 4 3 3 © BCA Research 2004 1994 1996 1998 2000 2002 2004 *CORE EXCLUDES FOOD AND ENERGY

IS HOUSING IN A BUBBLE? HOUSE PRICES* / EMPLOYEE COMPENSATION RATIO 2.0 2.0 1.9 1.9 1.8 1.8 1.3 HOUSE PRICES* / CPI RENT OF SHELTER 1.3 1.2 1.2 1.1 1.1 © BCA Research 2004 1984 1988 1992 1996 2000 2004 *SOURCE: OFFICE OF FEDERAL HOUSING ENTERPRISE OVERSIGHT

IS HOUSING IN A BUBBLE? HOUSE PRICES* 8 8 6 6 4 4 2 2 140 Ann% Chg Ann% Chg HOUSE PRICES* 8 8 6 6 4 4 2 2 140 HOUSING AFFORDABILITY INDEX** 140 120 120 100 100 80 80 © BCA Research 2004 1982 1986 1990 1994 1998 2002 *SOURCE: OFFICE OF FEDERAL HOUSING ENTERPRISE OVERSIGHT **SOURCE: NATIONAL ASSOCIATION OF REALTORS

IS CONSUMER DEBT A PROBLEM? % % HOUSEHOLD DEBT AS A % OF PERSONAL DISPOSABLE INCOME 100 100 90 90 80 80 70 70 60 60 50 50 © BCA Research 2004 1960 1970 1980 1990 2000

“Consumer short term debt… is approaching a historical turning point “Consumer short term debt… is approaching a historical turning point. Having risen at an abnormally fast rate for ten years, it must soon adjust itself to the nation’s capacity for going into hock… which is not limitless. Whether the rate of growth in consumer debt will slow down is no longer the question…it must slow down.” Fortune Magazine March 1956 “Federal Reserve Chairman G. William Miller said the average American buyer is getting dangerously deep in debt, and warned that the trend could have serious consequences… Several of the nation’s business leaders said they share Miller’s alarm over the level to which consumer debts have climbed.” Washington Post October 1978

CONSUMERS NOT IN FINANCIAL STRESS % % BANK LOAN DELINQUENCY RATES: 3.2 3.2 2.8 RESIDENTIAL REAL ESTATE LOANS 2.8 2.4 2.4 2.0 2.0 % % 4.2 4.2 ALL CONSUMER LOANS 3.8 3.8 3.4 3.4 3.0 3.0 2.6 2.6 © BCA Research 2004 1990 1992 1994 1996 1998 2000 2002 2004

TREASURYS ARE OVERVALUED % % 10-YEAR TREASURY YIELD 9 9 FAIR VALUE PROJECTED BY BCA BOND MODEL 8 8 7 7 6 6 5 5 4 4 BCA 10-YEAR TREASURY VALUATION INDEX Bonds Extremely Undervalued 1 1 -1 -1 Bonds Extremely Overvalued -2 -2 © BCA Research 2004 1990 1992 1994 1996 1998 2000 2002 2004

STOCKS ARE NOT CHEAP 25 25 S&P 500 FORWARD P/E RATIO* 20 20 15 15 10 10 5 5 NONFINANCIAL CORPORATE SECTOR EQUITIES TO REPLACEMENT COST BOOK VALUE 1.6 1.6 1.2 1.2 .8 .8 % % S&P 500 DIVIDEND YIELD MINUS 3-MONTH TREASURY BILL YIELD -4 -4 -8 -8 -12 -12 © BCA Research 2004 1980 1984 1988 1992 1996 2000 2004 *BASED ON 12-MONTH FORWARD EARNINGS

STILL LOTS OF CASH ON THE SIDELINES % % 60 60 CASH MOUNTAIN* AS A % OF PERSONAL DISPOSABLE INCOME 50 50 40 40 30 30 Bn$ Bn$ INTEREST INCOME FROM CASH MOUNTAIN* (IN 2003 PRICES) 220 220 180 180 140 140 100 100 60 60 © BCA Research 2004 1982 1986 1990 1994 1998 2002 *INCLUDES MONEY MARKET FUNDS AND SAVINGS DEPOSITS

Mean- Reversion Scenario** DECOMPOSING EQUITY MARKET RETURNS Mean- Reversion Scenario** Historical Average 1950-95 Bubble Years Bear Market 2000-02 Optimistic Scenario Bear Scenario*** 1996-2000* 2004-14 2004-14 2004-14 Nominal GDP Earnings +Valuation change =Growth in S&P 500 +Reinvested dividends =Total equity returns Inflation (CPI) Real returns 7.6 7.6 1.4 9.0 4.3 13.3 4.2 8.7 5.9 9.3 13.7 23.0 2.0 25.0 2.2 22.3 3.2 -8.7 -5.9 -14.6 1.7 -12.9 2.4 -14.9 5.0 5.0 0.0 5.0 1.7 6.7 2.0 5.7 5.0 5.0 -1.8 3.2 1.7 4.9 2.0 4.1 5.0 5.0 -4.0 1.0 1.7 2.7 2.0 1.8 *Bull market ended in 2000 Q3, based on quarterly data. ** Assumes that the price-earnings ratio falls to 15 over the period. ***Assumes that the price-earnings ratio falls to 12 over the period. © BCA Research 2004

THE DOLLAR MOVES IN LONG CYCLES REAL TRADE-WEIGHTED DOLLAR 130 130 120 120 110 110 100 100 90 90 © BCA Research 2004 1975 1980 1985 1990 1995 2000 SOURCE: THE FEDERAL RESERVE

WHY THE DOLLAR HAS FURTHER TO FALL % % CURRENT ACCOUNT DEFICIT AS A % OF GDP 5 5 NET LONG-TERM CAPITAL FLOWS AS A % OF GDP (PORTFOLIO PLUS DIRECT INVESTMENT)* 4 4 3 3 2 2 1 1 -1 -1 © BCA Research 2004 1980 1984 1988 1992 1996 2000 2004 *SHOWN AS A 4-QUARTER MOVING AVERAGE

GOLD AS A LONG-TERM INVESTMENT 4000 4000 REAL RETURN ON: 2000 2000 STOCKS 1000 1000 BONDS 500 GOLD 500 100 100 10 10 © BCA Research 2004 1880 1900 1920 1940 1960 1980 2000