Stagflation Versus Valuation

Lehman Brothers | Global Strategy Weekly
Global Equity Research 27 June 2008
Investment Strategy & Macro

Portfolio Strategy
Global Strategy Weekly

MARKET SELECTOR
Stagflation versus valuation 2-5

Ian Scott
• The phenomenon that could have undermined our bullish call has undermined it.
Stagflation is not just a journalistic debating point, but its effects are reflected in
equity valuations. As much as we might protest that the environment is very
different from 1974 and 1978, relative equity valuations are at those historic levels.
Regulars • With oil at $140 per barrel, global oil consumption accounts for nearly 7% of
world GDP, a similar proportion to the peak reached in the early 1980s.
Recommended Portfolio 6
• Returning to that era, the equity market consequences of the tripling in oil prices
Global Index Targets 7 and subsequent global recession, while not good, were heavily mitigated by the
Recommended Weightings 8 extremely low valuations that stocks traded on during that period.
On-going Stylistic Themes 9
• We believe the same can be said for the current period.
Databank
• While our in-house forecasts indicate a fall in crude prices is likely which should
Market Performance 10
prompt a rally in the market, even without a large drop in prices, some stability,
Sector Performance 10 coupled with the extreme valuations on offer, should be enough to allow equities to
Style Performance 10 recover.
Valuation and Profitability 11
Research Library 13
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27 June has been prepared in whole or in part by research analysts that are not registered/qualified as research analysts with FINRA. 1
PLEASE SEE ANALYST(S) CERTIFICATION(S) AND IMPORTANT DISCLOSURES INCLUDING FOREIGN AFFILIATE DISCLOSURES BEGINNING ON PAGE 15
MARKET SELECTOR
Stagflation versus valuation

Ian Scott The one combination of factors that could have undermined our positive outlook for
Tel: +44 (0)20 7102 2959 stocks in 2008 has undermined it. While we might argue that the current environment is
iscott@lehman.com a world away from that which prevailed in 1974 or indeed 1978, market prices tell a
different story. Stocks are as cheaply priced now as they were then, relative to “risk-free”
rates, which suggests that “stagflation” is no longer viewed as a possibility, but a
probability by equity investors.
Figure 1: Global Earnings Yield Gap1
Yield Gap (% Points)

6
4
Stagflation fears are behind
equities’ de-rating.... 2
-2
-4
70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08
1
Trailing Earnings Yield less 10 year Global Treasury Yield (equity market cap weighted)
Source: MSCI, Datastream, Lehman Brothers
Oil is, of course, the main issue. Crude price movements have been responsible for large
equity de-ratings in the past, and the same factor would appear to be happening now.
... and oil prices are behind With oil demand inelastic to price, at least in the short term, and the importance of oil as
those stagflation fears both an input into the production process and as a consumer good, we believe it is the
one commodity with the capacity to derail the global economy unilaterally, and within it,
corporate profitability.
Figure 2: Global Oil Consumption as % of World GDP1
%
7
6
If crude were to stay at $140,
oil consumption would once 5
again account for almost 7 %
4
of world GDP
3
0
1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006
1
2008 plot takes current spot rate of $140 as basis for calculation
Source: BP Statistical Review of World Energy 2008, IMF, Datastream
27 June 2008 2
Certainly, with crude at $140 per barrel, the world will once again spend nearly 7% of
aggregate GDP on oil: a return to the peak levels of expenditure seen in the early 1980s.
This was responsible for subsequent severe recessions in most developed economies, but
it is also true to say that the extreme levels of “value” on offer during the period were
followed by strong stock market performance. This environment of extreme valuation
coupled with extreme economic conditions meant that market dynamics were key.
Figure 3: Global Equity Prices and Crude Prices, Jan 78 to Dec 84
Jan 1978 = 100 $ per barrel

210 45
Crude Price (RHS) 40
190
Global equities rose between
35
1978 and 1980 despite crude 170
prices going up threefold (in 30
150
real terms they flat-lined) 25
130
20
110
Equity Price (LHS) 15
90 10
70 5
78 79 80 81 82 83 84
Source: FTSE, Datastream
If we examine the 1980s’ analogue, given that the overall effect of higher crude prices
(as a percentage of global GDP) is on a par with the current environment, then it is clear
to us that the rise in crude between 1978 and 1980 was accompanied by higher stock
markets, but once growth slowed, stocks fell by 17% (peak to trough), between April
1981 and March 1982, subsequently recovering as growth resumed.
Figure 4: Global Equity Prices and Industrial Output Growth, Jan 78 to Dec 84
Jan 1978 = 100 year-on-year

10
190
8
Equity Price (LHS)
170 6
Despite a protracted 150 4

recession the largest decline 2
130
during the period was 17%
0
between April 1981 and 110
March 1982 -2
Industrial Output
90 Growth (RHS) -4
70 -6
78 79 80 81 82 83 84
Source: FTSE, OECD
Interest rates did not determine the turning point for stocks in 1982; bond yields had
already been falling for a year.
27 June 2008 3
Figure 5: Global Equity Prices and Short Rate Movements, Jan 78 – Dec 84
Jan 1978 = 100 % yield

210 15
Equity Price (LHS) 14
190
Our conclusion is that 13
170
valuations protected stocks
12
from the worst ravages of the 150
11
1978 – 1982 oil price shock 130
and subsequent recession 10
110
9
90 8
70 Global 10 year yield (RHS) 7
50 6
78 79 80 81 82 83 84
Source: FTSE, Lehman Brothers
But, despite the similarities in terms of valuation and the link to crude, underlying
inflation is much lower now and labour markets more flexible. As we have demonstrated
before, US unit labour cost growth has been quick to adjust to the weakening demand for
labour.
Figure 6: US Unit Labour Cost Growth
% year-on-year
12
10
-2
71 76 81 86 91 96 01 06
Source: BLS
Core inflation has not demonstrated, so far, the feared second-round effects of higher
food and energy prices. In prior cycles, both unit labour costs and core inflation were
faster to respond to the higher oil prices.
27 June 2008 4
Figure 7: US and Euro Area Headline Inflation
y/y%
18
16
14
12 OECD Europe
10
8 US
6
4
2
0
1970 1975 1980 1985 1990 1995 2000 2005
Source: OECD
So, while it is easy to see why the market is so fearful of higher crude prices – as history
has shown us – this time round, it is hard to argue that things are as bad as they were in
either the mid 1970s or early 1980s. Yet relative valuations are as extreme.
We believe the best catalyst for stocks right now is a drop in crude. Our in-house
forecast suggests prices will decline to $110 by the year-end and average $93 next year.
If this comes to pass, then the currently attractive valuations on offer will translate into a
significant rally, in our view. The more challenging question is whether the current
value, alone, is enough. As the analysis above suggests, in the past, value has been
enough.
27 June 2008 5
GLOBAL RECOMMENDED PORTFOLIO

Price/ Rel Perf. Rel Perf.
Price ($) Mkt Cap Calendarised EPS y/e Dec earnings Date since Over Analyst Sector
Sector Stock Currency 25 Jun 08 US$m 2007e 2008e 2009e Dec 08 (x) Added Added4 week4 Rating1 Rating2
North America Overweight Recommended Weight 52% Benchmark Weigh 47%
Consumer Cyclicals COACH INC USD 30.5 10423.3 1.7 2.2 2.6 13.7 11 Dec 06 -32 -4 1-OW 2
DOLLAR TREE INC USD 34.3 3083.1 2.1 2.4 2.6 14.6 10 Dec 07 28 -2 1-OW 2
WAL-MART STORES INC USD 58.1 172374.8 3.1 3.4 3.8 16.9 31 Mar 08 10 3 1-OW 2
Energy CHEVRON CORP USD 99.4 205514.9 8.4 11.6 11.7 8.6 11 Dec 06 38 2 1-OW 2
Financials & Insurance CHUBB CORP USD 51.1 18665.5 6.4 6.1 5.9 8.4 11 Dec 06 -2 0 1-OW 2
CITIGROUP INC USD 18.9 101495.9 0.7 0.4 2.7 53.9 20 Aug 07 -58 -6 1-OW 1
JPMORGAN CHASE & CO USD 37.9 128315.2 4.4 2.9 3.8 13.0 11 Dec 06 -20 0 1-OW 1
METLIFE INC USD 56.4 39961.6 6.3 6.2 6.9 9.1 14 Jan 08 -1 1 1-OW 2
WACHOVIA CORP USD 17.9 38592.5 3.4 1.6 2.8 11.2 6 Nov 06 -71 8 1-OW 1
Health Care THERMO FISHER SCIENTIF USD 55.8 23452.2 2.7 3.2 3.7 17.7 11 Dec 06 22 -2 1-OW 1
BRISTOL-MYERS SQUIBB C USD 20.3 39955.5 1.5 1.7 2.0 12.2 10 Dec 07 -17 5 1-OW 1
CELGENE CORP USD 62.0 27003.7 1.1 1.5 2.3 41.3 14 Jan 08 20 5 1-OW 2
MEDCO HEALTH SOLUTIONS USD 46.4 23488.7 1.8 2.3 2.7 20.2 14 Jan 08 -4 3 1-OW 2
Technology CISCO SYSTEMS INC USD 24.7 147236.6 1.3 1.6 1.8 15.3 10 Dec 07 1 0 1-OW 1
COMMSCOPE INC USD 53.8 3758.3 2.8 3.4 4.1 16.0 10 Dec 07 24 1 1-OW 2
HEWLETT-PACKARD CO USD 45.6 112417.6 2.9 3.6 4.1 12.5 4 Sep 00 -2 0 NR 2
INTL BUSINESS MACHINES USD 124.6 171665.7 7.1 8.5 9.6 14.6 9 Jun 08 6 1 1-OW 2
JUNIPER NETWORKS INC USD 23.3 12168.9 0.9 1.1 1.4 20.6 11 Dec 06 12 5 1-OW 1
MICROSOFT CORP USD 28.4 265795.2 1.5 2.0 2.3 14.0 9 Jun 08 0 2 2-EW 1
ORACLE CORP USD 22.6 115926.5 1.3 1.4 1.6 16.1 3 Apr 06 49 2 1-OW 1
Media DIRECTV GROUP INC USD 26.3 22627.5 1.2 1.5 1.9 17.7 14 Jan 08 29 -1 1-OW 2
YAHOO INC USD 22.0 22711.6 0.5 0.5 0.6 45.9 11 Dec 06 -20 -2 2-EW 2
OMNICOM GROUP USD 46.4 14875.8 3.0 3.4 3.7 13.7 14 Jan 08 10 2 1-OW 2
Telecoms AMERICAN TOWER CORP USD 42.7 16899.9 0.1 0.5 0.7 90.8 11 Dec 06 10 -1 1-OW 1
AT&T INC USD 34.5 204786.3 2.8 3.0 3.4 11.4 11 Dec 06 1 0 1-OW 1
Europe Ex UK Underweight Recommended Weight 12% Benchmark Weigh 21%
Consumer Cyclicals DAIMLER AG EUR 66.1 68063.9 7.3 9.2 10.4 7.2 25 Feb 08 -15 -3 2-EW 2
LVMH MOET HENNESSY EUR 105.8 38857.6 6.6 7.2 8.0 14.7 11 Dec 06 3 -3 1-OW 3
PEUGEOT SA EUR 55.0 9662.8 6.0 9.6 11.2 5.7 25 Feb 08 -24 -1 1-OW 2
RENAULT SA EUR 87.3 18035.8 16.1 16.2 19.8 5.4 25 Feb 08 -11 1 1-OW 2
Energy MAIRE TECNIMONT SP EUR 7.2 2326.7 0.4 0.5 0.5 15.0 7 Apr 08 52 7 1-OW 1
TOTAL EUR 81.4 194772.6 8.4 9.8 10.3 8.3 14 Jan 08 2 4 1-OW 1
Financials & Insurance ALLIED IRISH BANKS EUR 15.5 13630.2 3.2 3.2 3.2 4.8 20 Aug 07 -35 -5 1-OW 1
AXA EUR 32.0 66029.4 4.3 4.3 4.7 7.5 11 Jan 99 -42 0 1-OW 1
BBVA(BILB-VIZ-ARG) EUR 20.2 75570.0 2.3 2.6 2.9 7.8 10 Dec 07 -7 1 1-OW 1
BNP PARIBAS EUR 95.1 86066.3 13.2 12.5 13.6 7.6 30 Aug 07 -3 1 1-OW 1
CREDIT SUISSE GRP CHF 46.9 54471.2 7.8 2.3 6.3 20.1 7 Apr 08 -22 0 2-EW 1
INTESA SANPAOLO EUR 5.8 51146.5 0.5 0.7 0.8 8.4 20 Aug 07 -15 1 NR NR
NATL BK OF GREECE EUR 45.6 22634.0 4.8 5.6 6.7 8.2 20 Aug 07 -10 -4 1-OW 1
UNICREDIT SPA EUR 6.4 63880.0 0.8 0.8 0.9 8.1 20 Aug 07 -17 4 1-OW 1
Health Care ROCHE HLDGS AG CHF 169.1 118795.8 10.9 11.3 12.7 15.0 24 Jul 07 4 3 1-OW 2
Technology CAP GEMINI EUR 60.7 8752.3 4.7 5.4 5.8 11.3 30 Oct 06 6 -3 1-OW 2
Media PUBLICIS GROUPE SA EUR 34.2 4986.2 3.4 3.4 3.6 10.0 26 Mar 07 -27 -1 1-OW 1
VIVENDI SA EUR 38.5 44848.7 3.8 4.0 4.5 9.7 19 Jan 04 15 -1 1-OW 1
Telecoms EUTELSAT COMMUNICA EUR 28.9 6345.4 1.1 1.3 1.4 21.8 7 Apr 08 7 1 1-OW 3
TELE2 AB SEK 19.1 7759.5 0.4 1.2 1.4 16.6 10 Dec 07 4 -1 1-OW 3
United Kingdom Underweight Recommended Weight 7% Benchmark Weigh 9%
Consumer Cyclicals MARKS & SPENCER GP GBP 6.9 10936.3 0.9 0.8 0.8 8.6 10 Dec 07 -30 5 1-OW 1
NEXT GBP 20.2 4048.6 3.3 3.1 3.2 6.5 28 Jan 08 -23 5 1-OW 1
PERSIMMON GBP 6.7 2016.7 2.7 1.4 1.2 4.7 28 Jan 08 -56 -8 NR NR
Consumer Stables TESCO GBP 7.5 59020.8 0.5 0.6 0.6 13.6 7 Apr 08 -2 2 1-OW 2
Financials & Insurance BARCLAYS GBP 6.3 42623.9 1.3 1.2 1.3 5.5 04 Jul 05 -60 4 2-EW 1
MAN GROUP GBP 12.3 21010.5 0.9 0.9 0.9 13.5 13 Dec 04 149 4 1-OW 1
OLD MUTUAL PLC GBP 1.9 10090.6 0.4 0.4 0.4 5.0 7 Apr 08 -18 -8 1-OW 2
PRUDENTIAL GBP 11.6 28758.4 1.5 1.5 1.7 7.5 23 Oct 00 -22 -1 1-OW 2
STANDARD CHARTERED GBP 30.9 43858.8 2.0 2.3 2.7 13.3 20 Aug 07 6 4 1-OW 1
Media WPP GROUP GBP 9.9 11722.0 0.9 1.0 1.1 9.9 10 Dec 07 -9 -6 1-OW 1
Japan Overweight Recommended Weight 14% Benchmark Weigh 9%
Capital Goods DAIKIN INDUSTRIES JPY 52.2 11484.2 2.4 2.6 2.9 20.2 10 Dec 07 11 -3 2-EW 2
TADANO LTD JPY 10.8 1399.7 0.8 0.8 0.9 13.0 10 Dec 07 6 -1 1-OW 2
Consumer Cyclicals MITSUBISHI MOTOR C JPY 1.8 7501.9 0.1 0.0 0.0 45.3 10 Dec 07 12 -3 3-UW 2
MITSUI O.S.K.LINES JPY 13.9 12555.1 1.5 1.6 1.6 8.8 10 Dec 07 16 1 NR NR
KONICA MINOLTA HLD JPY 17.3 6898.0 1.2 1.2 1.3 14.2 10 Dec 07 3 -7 2-EW 2
Financials & Insurance MITSUI FUDOSAN CO JPY 21.7 19151.7 0.9 1.0 1.1 21.8 10 Dec 05 -3 -3 NR NR
MIZUHO FINL GP JPY 4835.7 41331.3 234.6 396.0 461.6 12.2 28 Nov 05 -56 -7 2-EW 3
NOMURA HOLDINGS JPY 15.2 29783.6 -0.3 0.6 1.0 24.3 14 Mar 05 -27 -5 1-OW 1
SUMITOMO TRUST&BKG JPY 7.0 8801.0 0.5 0.5 0.6 13.1 8 Oct 07 -2 -10 2-EW 3
Health Care DAIICHI SANKYO COM JPY 26.2 14449.8 1.3 1.2 1.3 22.8 14 Jan 08 -12 -2 1-OW 3
TERUMO CORP JPY 50.9 8057.4 2.0 2.2 2.4 23.6 10 Dec 07 8 2 NR NR
Technology SONY CORP JPY 45.5 45363.4 3.4 2.9 3.1 15.8 11 Dec 06 11 -7 NR NR
Asia Ex Japan Overweight Recommended Weight 12% Benchmark Weigh 9%
Capital Goods CHEUNG KONG INFSTR HKD 4.3 1957.7 0.3 0.3 0.3 14.7 10 Dec 07 28 5 1-OW 1
Energy SINOPEC S/PETROCHE HKD 0.4 5880.0 0.0 0.0 0.0 50.1 11 Dec 06 -26 -10 2-EW 2
PETROCHINA CO HKD 1.3 399924.6 0.1 0.1 0.1 11.8 14 Jan 08 -15 0 2-EW 2
Financials & Insurance HANG SENG BANK HKD 20.6 15781.2 1.2 1.2 1.3 17.8 10 Dec 07 14 6 NR NR
IND & COM BK CHINA HKD 0.7 251845.8 0.0 0.1 0.1 14.1 11 Dec 06 35 1 1-OW 1
PUNJAB NATL BANK INR 9.9 3125.4 NA NA 2.0 NA 10 Dec 07 -27 -5 1-OW 1
SUN HUNG KAI CO HKD 0.8 1362.1 0.2 0.1 0.1 7.2 10 Dec 07 -29 1 1-OW 1
Telecoms DIGI.COM.BERHAD MYR 7.5 5631.3 0.4 0.5 0.5 16.0 10 Dec 07 15 4 1-OW 1
SINGAPORE TELECOMM SGD 2.7 17408.0 0.2 0.2 0.2 15.0 14 Jan 08 3 2 1-OW 1
Latin America / Other EMG Underweight Recommended Weight 1% Benchmark Weigh 4%
Financials & Insurance BK PEKAO PLN 78.9 20670.2 5.7 6.9 7.6 11.4 10 Dec 07 -9 5 1-OW 1
T IS BANKASI TRY 3.7 10195.3 0.5 0.6 0.7 6.2 14 Jan 08 -31 -3 1-OW 1
Source: I/B/E/S, XShare, FactSet
Portfolio perf. (US$ terms, %) YTD Last Week 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997
LB Strategy Recommend Portfolio -8.32 -1.91 6.90 12.92 11.10 11.87 33.69 -23.80 -13.80 -2.80 40.80 35.7 20.1
FTSE-World Index -8.85 -1.92 11.74 18.82 8.87 13.66 30.97 -20.60 -17.50 -12.20 24.20 22.8 13.6
1
Analyst rating refers to Lehman Brothers research dept rating: "1 - OW" = Overweight; "2 - EW" = Equal Weight; "3 - UW" = Underweight, "NR" = Not Rated, "RS" = Rating Suspended.
2
Sector rating refers to Lehman Brothers research dept sub sector rating: "1" = Positive; "2" = Neutral; "3" = Negative.
3
Return history presented as price return in US$ Terms from before 2006. Returns from 2007 to present are on a Total Return basis.
4
Relative performance shown as total return performance less performance of FTSE World total return index.
Please turn to the back cover for an explanation of Lehman Brothers' rating system.
Past performance is not a guarantee of future results.
27 June 2008 6
GLOBAL INDEX TARGETS
Global Index Forecasts
Price Indices* Dividend Price Return Total return Total return

• We think the hawkish stance of the ECB is likely to
Current** End 2008 Yield Local Local $ terms
result in underperformance of Continental Europe
US 1322 1630 1.0% 23% 24% 24% relative to the UK.
Europe ex UK 355 425 1.5% 20% 21% 17%
Japan
UK
1346
5666
1713
7300
0.5%
1.5%
27%
29%
28%
30%
42%
27%
• We have reduced our targets for Europe, but still see
Asia ex Japan 363 536 1.0% 48% 49% 46% significant upside potential for Continental Europe. We
Global 331 415 1.0% 26% 27% 27%
think the UK offers better prospects in several sectors.
*S&P500, FTSE W Europe ex UK, Topix, FTSE100, FT SE W Asia Pacific ex Ja pan, FTSE W World
** As of 26- Jun-2008
• Though there are concerns about the effect on equities
from tightening policy, real interest rates remain low
globally and are still below levels at which higher rates
have historically affected equities negatively.
• Valuations are as attractive as they have been in 30
years and the rate of earnings downgrades has slowed
down, both of which should lead markets to rally, in our
opinion.
• Net issuance from the corporate sector is still at low
levels which is supportive for equities.
• Investors have been selling equities in unprecedented
quantities, while the corporate sector has been retiring a
similarly large amount of stock. A large proportion of
this capital seems to have flowed into money market
funds and the high levels of cash holdings should be
bullish for equities.
Source: Lehman Brothers research
Earnings Growth Forecasts
• We expect earnings growth to decline by 5% in the US.

2006 2007 2008
% % % • We expect earnings growth in Continental Europe to be
flat this year, impacted by slowing top lines and rising
US 16 3 -5
9 2 -10
cost pressures.
UK
Europe ex UK 15 8 0 • We expect earnings growth in Asia to be strong at 16%.
Japan 14 15 10
Asia ex Japan 12 21 16 • In Japan, too, despite slow nominal growth, we believe
earnings growth ought to exceed that in Europe and the
Global 14 7 0
US.
Source: Worldscope, Lehman Brothers research
27 June 2008 7
RECOMMENDED WEIGHTINGS
Recommended Asset Allocation
Benchmark
Recommended
Weighting Recommendation • The subprime crisis and resulting credit crunch have
injected a high level of volatility into the markets,
Equities 60 72 Overweight compounding ‘late-cycle’ effects. Over a 12-month
Bonds 35 24 Underweight
horizon, we expect equity markets to recover and to
Cash 5 4 Underweight
outperform bonds, supported by the combined effects of
what we perceive to be attractive valuations and
aggressive policy actions from central banks
Source: Lehman Brothers research and FTSE World.
Recommended Market Allocation
Benchmark
Recommended
Weighting Recommendation • We have moved to an underweight stance on
Continental European stocks and increased our
North America 47 52 Overweight exposure to the US.
Europe Ex-UK 21 12 Underweight
UK 9 7 Underweight
• We think the hawkish stance of the ECB is likely to
Japan 9 14 Overweight result in underperformance of Continental Europe.
Asia Ex-Japan 9 12 Overweight
Latin America / Other EMG 4 1 Underweight • Labour costs in Continental Europe are increasing faster
than in the US, while earnings revisions and valuations
are moving in favour of the US.
• We recommend overweighting Asian and Japanese
stocks. These markets should enjoy better earnings
growth and benefit from Fed easing, in our view.
Benchmark: FTSE W World Index.
Source: Lehman Brothers research and FTSE World.
Recommended Global Sector Allocation
Recommended • We believe that the market will reward companies and

Benchmark Weighting Recommendation
sectors that are able to increase earnings in this
challenging profits environment.
Basic Industries 9 0 Underweight
Capital Goods 10 6 Underweight • We advocate an overweight position in Global Tech
Consumer Cyclicals 10 13 Overweight
and to a lesser extent in Telecoms.
Energy 11 13 Neutral
• We think Financials are oversold and should benefit
Financials
Banks
21
11
31
16
Overweight
Overweight
from a steeper yield curve.
Insurance 5 9 Overweight • We have increased our weighting in the Consumer
Other 5 6 Overweight
Cyclicals sector where earnings revisions have moved
Consumer Staples 8 0 Underweight sharply negative.
Healthcare 8 8 Neutral
Utilities 5 0 Underweight • We think Consumer Staples and Utilities are
“expensive defensives” and are underweight these.
Technology 10 17 Overweight
Telecoms 5 6 Overweight • We are also underweight cyclical businesses where we
Media 2 5 Overweight
think current valuations pay insufficient attention to the
prospects of slower economic growth: Capital Goods
and Materials.
• We are neutral on Energy as the sector is attractively
priced but without the growth of some sectors.
Benchmark: FTSE World Index. Source: Lehman Brothers research and FTSE
World.
27 June 2008 8
ONGOING STYLISTIC THEMES*
Emerging Market exposed basket rel to European Market
Index • We believe that European stocks with emerging market

86 exposure are likely to be re-rated relative to those with
85
84 high exposure to the US market, based on increasing
83 divergence between growth prospects in the two
82
81 regions, as well as the former’s reasonable valuations.
80
79 • In our piece entitled Going for Growth in the European
78 Strategy Weekly from 3 September 2007, we built
77
76 baskets of top-20 stocks that fall into both these
Aug- Sep- Oct- Nov- Dec- Jan- Feb- Mar- Apr- May- categories.
07 07 07 07 07 08 08 08 08 08
• The emerging-market-exposed basket has outperformed
its US-exposed equivalent since September.
Chart shows the relative performance of a basket of emerging-market-exposed For a full description of screening characteristics and hit ratios of the strategy,
stocks relative to US-exposed stocks on an equal-weighted basis. Portfolios please refer to ‘Going for Growth’, European Strategy, 3 September 2007.
have been rebalanced quarterly. Source: FTSE, Datastream, Lehman Brothers Figures will reflect a rebalance as of 31 August 2007 based on the European
Strategy piece ‘Going for Growth’.
Large Cap Versus Mid Cap
• We believe that in an environment of declining earnings

Index
115 momentum, large caps should outperform small caps.
110
• Large-cap stocks are currently ‘cheap’ relative to their
105
history, while small-cap stocks are ‘expensive’.
100
• Although the broader trend globally over recent years
95
has been toward small-cap outperformance, we have
90
begun to see a turn in fortunes. Specifically, we have
85 seen large-cap stocks outperforming their smaller peers
Dec- Jun- Dec- Jun- Dec- Jun- Dec-
since February of this year.
04 05 05 06 06 07 07
Chart shows the relative performance of highest/lowest quartile stocks Please click here for the latest daily update and more history on our website
screened size on an equal-weighted basis. Source: Lehman Brothers, FTSE
World, Worldscope, Exshare For a full discussion of this investment theme, please refer to "Style Selector”,
16 August 2007
Composite Value
Index • Although we have had a long-standing bias for growth

130
stocks, we now believe there is a strong case for
125 overweighting deep-value stocks in relation to growth.
120
• Earnings revisions of value stocks have reached an all-
115 time low relative to growth stocks.
110
• Value has become synonymous with Financials, which
105
we think are set to outperform.
100
Dec- Jun- Dec- Jun- Dec- Jun- Dec- • Growth as a style can no longer be considered cheap.
04 05 05 06 06 07 07
Chart shows the relative performance of highest/lowest quartile stocks Please click here for the latest daily update and more history on our website
screened on 12-month forward P/E, Dividend Yield, and Price to Book Value
on an equal weighted basis. Portfolios have been rebalanced quarterly. The For a full discussion of this investment theme, please refer to "A Tactical Case
benchmark universe is the 500 largest stocks in the FTSE World index. for Deep Value”, Global Strategy, 14 April 2007.
Source: Lehman Brothers, FTSE World, IBES, Exshare
* Themes referred to here are those that have been featured in recent Global Weekly Strategy reports, and where the advice is not captured in either the asset,
regional or sector recommendations shown on the prior page.
27 June 2008 9
GLOBAL PERFORMANCE
Global Market Performance1 (%)
Regions 1 Week 1 Month 1 Year YTD

• Global stock markets sold-off sharply amid continued
US -1.2 -3.5 -8.9 -8.4 stagflation fears.
Europe ex UK -2.0 -7.2 -20.1 -16.5
UK -1.6 -6.8 -10.9 -10.3 • Japan gave back some of its recent strong performance
Japan -4.7 -2.1 -22.2 -8.0
Asia ex Japan -3.5 -8.8 -7.8 -17.5 this week on concerns of weak economic growth at
-2.1 -5.0 -12.1 -10.5
World
home and abroad.
as of 25 Jun 2008
• The growth-sensitive Asian region was another notable

weak performer.
• The relatively defensive US market held up relatively
well compared to its global counterparts.
1
Performance is calculated on a local currency total return basis.
Source: FTSE World, Lehman Brothers research Please click here for the latest daily update and more history on our website
Global Sector Performance1 (%)
Sectors 1 Week 1 Month 1 Year YTD

• Defensives outperformed cyclicals across the board, as
Basic Industries -3.0 -4.0 6.4 2.9 investors worries broadened-out beyond the financial
Capital Goods -2.9 -5.9 -13.8 -12.2
Consumer Cyclicals -2.7 -4.5 -18.7 -10.9
sector.
Consumer Staples -1.7 -5.4 -3.8 -11.6
Energy -1.8 -3.7 15.8 4.9 • Basic Industries, led by the Miners, underperformed on
-3.0 -8.7 -30.0 -19.8
Financials
the back of a flare-up in global growth concerns.
of which: Banks -2.7 -10.1 -33.2 -21.0
Insurance -3.1 -6.6 -22.8 -17.2
Healthcare 1.0 -1.1 -11.5 -10.7
• Financials were the other notable underperformer,
Technology -1.5 -2.1 -4.7 -9.0 weighed down on credit quality and inflation concerns.
Media -2.4 -7.2 -18.9 -8.3
Telecoms -1.3 -6.7 -9.2 -17.3 • Healthcare was the lone bright spot on the week as
Utilities -1.2 -1.4 0.5 -7.5
Market -2.1 -5.0 -12.1 -10.5 investors showed renewed interest in what had been
as of 25 Jun 2008
previously regarded as an unattractive sector.
1
Performance is calculated on a local currency total return basis. Please click here for the latest daily update and more history on our website.
Benchmark: FTSE W World Index.
Source: FTSE World, Lehman Brothers research
Global Style Performance1 (%)
Styles 1 Week 1 Month 1 Year YTD

• Value, led by the P/E style, underperformed.
Value (Cheap / Expensive) -1.3 -5.0 -26.0 -9.1
Dividend Yield (High / Low) 0.2 -6.3 -16.9 -11.9
• Large caps outperformed their small cap counterparts
FCF Yield (High / Low) 1.4 -2.3 -7.9 -6.6 as growth fears heated up.
PE (Cheap / Expensive) -1.1 -6.0 -15.2 -3.7
FCF Dividend Cover (High/Low)
Profitability (High / Low)
0.7
1.0
1.9
0.6
-2.6
15.4
-1.6
5.6
• The High Cash return style was another notable strong
Cash Return (High / Low) 1.8 0.6 5.8 -2.8 performer.
Risk (High / Low) -1.9 -2.5 -0.1 3.1
Gearing (High / Low) 0.5 -1.3 -10.8 -8.3
Size (Large / Small) 1.6 3.4 15.8 3.5
Earnings Momentum (High / Low) 0.5 3.4 15.3 4.3
Long Term f'cast Growth (High / Low) 0.7 4.3 12.4 7.5
Internal Growth (High/Low) 0.3 2.3 18.3 9.8
Composite Growth (High/Low) 0.5 3.8 20.1 8.9
as of 25 Jun 2008
1
Performance is calculated on a local currency total return basis. Please click here for the latest daily update and more history on our website
Benchmark: FTSE W World Index
Source: FTSE World, Lehman Brothers research
27 June 2008 10
GLOBAL VALUATION AND PROFITABILITY
12 month Forward PE
Current Values Post 1990 Average

US Eur ex UK UK Japan Asia ex Jp3 World US1 Eur ex UK6 UK6 Japan Asia ex Jp3 World
Basic Industries 14.7 10.8 10.2 12.8 11.0 11.5 Basic Industries 15.6 13.0 12.4 58.5 12.8 15.2
Capital Goods 12.7 11.7 11.5 13.4 14.8 12.6 Capital Goods 16.2 16.1 11.9 31.7 17.0 17.5
Consumer Cyclicals 16.2 9.9 10.1 13.5 12.4 13.0 Consumer Cyclicals 16.1 15.4 12.7 30.7 13.3 16.4
Consumer Staples 15.3 14.1 13.8 21.8 14.5 15.0 Consumer Staples 19.3 17.4 12.8 33.0 16.2 17.8
Energy 10.2 8.8 9.2 13.6 17.6 10.0 Energy 16.0 14.7 15.1 31.9 15.0 15.8
2 2
Financials 11.7 7.7 7.4 14.5 11.5 9.7 Financials 12.5 13.8 12.5 43.9 12.6 16.0
of which: Banks 10.9 7.8 7.3 13.3 10.6 9.0 of which: Banks 11.6 12.1 11.1 49.8 12.4 15.8
Insurance 9.6 6.9 6.6 27.7 11.4 8.5 Insurance 13.7 17.9 16.4 37.3 12.8 16.0
Healthcare 13.0 13.3 10.9 19.4 20.9 13.0 Healthcare 19.3 19.2 18.4 26.2 20.8 19.8
Technology 16.3 12.2 11.8 20.4 15.8 15.3 Technology 22.7 22.8 19.4 89.2 3.7 23.7
Media 15.2 9.9 10.1 17.7 13.2 13.1 Media 28.2 19.2 19.8 24.0 18.5 24.3
Telecoms 12.5 10.5 10.3 12.4 14.7 11.8 Telecoms 17.4 21.3 17.1 40.4 17.3 17.2
Utilities 15.4 13.9 12.6 44.7 18.1 15.3 Utilities 13.1 15.1 10.0 31.0 13.3 14.3
Market 13.3 10.1 9.8 15.0 12.7 11.9 Market 16.8 14.9 13.1 35.1 14.1 17.2
Enterprise Value / Sales

3 3
US Eur ex UK UK Japan Asia ex Jp World US Eur ex UK UK Japan Asia ex Jp World
Energy 1.6 1.0 0.9 0.4 5.4 1.2 Energy 1.3 1.1 1.2 0.6 3.1 1.1
Financials2 NA NA NA NA NA NA Financials2 NA NA NA NA NA NA
of which: Banks NA NA NA NA NA NA of which: Banks NA NA NA NA NA NA
Insurance NA NA NA NA NA NA Insurance NA NA NA NA NA NA
Media 2.3 1.3 1.7 0.6 3.4 1.8 Media 2.6 1.8 2.3 1.1 3.3 2.1
Market ex Financials 1.7 1.3 1.5 0.9 2.5 1.5 Market ex Financials 1.8 1.1 1.4 0.9 2.5 1.4
Enterprise Value / EBITDA

3 3
Energy 7.1 3.9 4.9 5.6 11.8 5.9 Energy 7.9 5.7 7.5 9.8 7.8 7.1
Media 7.4 5.6 7.8 5.7 10.2 7.1 Media 11.1 8.4 10.8 7.5 14.0 10.0
1 Ratios reflect Earnings Before Goodwill Amortization,

2 Financials excluding Real Estate
3 Asia ex Japan = Australia, Hong Kong, New Zealand and Singapore
Source: Worldscope, Factset, IBES, FTSE, Lehman Brothers.
27 June 2008 11
Return on Capital Employed4 (ROE4 Financials)

US1 Eur ex UK4 UK4 Japan Asia ex Jp World5 US1 Eur ex UK6 UK6 Japan Asia ex Jp World
Energy 19.6 20.1 20.7 6.7 19.4 19.0 Energy 12.2 12.1 12.1 4.0 12.8 11.4
1 ,2 1 ,2
2 2
of which: Banks 11.2 15.4 18.3 12.6 18.8 14.9 of which: Banks 16.2 9.7 15.7 -2.7 14.7 10.4
2 2
Media 7.7 14.2 12.4 5.2 8.4 9.0 Media 7.6 11.9 16.9 5.7 7.0 7.9
Enterprise Value / Capital Employed (P/BV Financials)

US1 Eur ex UK4 UK4 Japan Asia ex Jp World5 US1 Eur ex UK6 UK6 Japan Asia ex Jp World
Energy 2.6 1.9 2.0 1.2 3.7 2.2 Energy 2.1 1.7 2.0 1.1 1.9 1.9
1 ,3 1 ,3
3 3
of which: Banks 1.0 1.1 1.0 1.3 2.0 1.2 of which: Banks 2.2 1.8 2.2 2.3 2.1 2.1
3 3
Media 1.3 1.3 1.1 0.9 1.3 1.3 Media 1.9 2.2 3.0 1.2 1.5 1.7
Free Cash Flow Yield

Capital Goods 7.5 2.9 8.2 3.1 4.6 4.9 Capital Goods 5.1 2.6 4.9 -0.3 2.8 3.0
Consumer Cyclicals 4.2 4.6 5.3 0.9 4.4 3.5 Consumer Cyclicals 2.3 -0.1 1.7 -1.0 0.8 0.7
Consumer Staples 4.2 4.1 3.8 4.1 -0.5 3.9 Consumer Staples 3.6 3.4 3.8 1.3 3.1 3.3
Energy 3.8 5.5 3.6 4.1 1.4 3.6 Energy 4.4 4.7 2.9 0.4 3.1 3.9
Technology 4.6 6.9 7.2 4.5 1.6 4.5 Technology 2.9 2.2 5.4 -0.2 2.0 2.2
Media 5.9 13.9 7.8 3.3 5.1 6.9 Media 3.6 5.2 4.1 2.6 0.5 3.4
Utilities -1.0 3.6 5.3 10.4 4.4 2.8 Utilities 3.7 4.5 2.2 -4.5 3.0 1.0
Market ex Financials 4.7 5.4 4.9 3.5 3.3 4.5 Market ex Financials 3.6 3.0 3.3 -0.3 3.5 2.7
1 Financials excluding Real Estate,

2 Return on Equity used for Financials,
3 Price to Book Value used for Financials;
4 ROE and RoCE calculated pre goodwill and pre exceptionals
Source: Worldscope, Factset, FTSE, Lehman Brothers.
27 June 2008 12
RESEARCH LIBRARY
Details of our regular research products are listed below.

Asset Selector
th
Bond Yield Back-up Bullish for Stocks 30 May 2008
th
Discerning Earnings 25 April 2008
th
An Unprecedented Exit from Equities 4 April 2008
th
Recessions, Earnings and the Market 28 March 2008
st
Stocks, Bonds and Commodities – A Single-Sector Perspective 21 March 2008
th
Policy Should Provide a Panacea 18 March 2008
th
Stocks have Decoupled from Credit 15 February 2008
st
Trendy Valuations 1 February 2008
Market Selector
th
US Versus Europe: The Valuation Debate 13 June 2008
th
Downgrading Continental European Equities 6 June 2008
Is Issuance an Issue? 23 May 2008
th
Japanese Judgement 9 May 2008
nd
Equities and an End to Easing 2 May 2008
th
Can Japan De-Couple? 14 March 2008
th
US Recession Reality? 7 March 2008
Sector Selector
th
Sectors across the Pond 13 June 2008
th
Global Tech Stocks: Powering Up? 6 June 2008
th
Not All Commodity Stocks Are Equal 16 May 2008
th
Hong Kong Property: On Solid Ground 18 April 2008
th
US General Retailers Are On Sale 28 March 2008
th
US and European Banks 8 February 2008
Style Selector
th
Languishing Leverage Factor 20 June 2008
th
A Tactical Case for Deep Value 11 April 2008
th
Style Rotation 29 February 2008
nd
Staying with the Large Caps 22 February 2008
th
Large Cap Growth Does Exist 11 January 2008
th
Styles, Sectors and Regions for 2008 4 January 2008
Stock Selector
th
When Disagreement is Good 25 April 2008
th
Quality Companies for the Coming Quarter 18 April 2008
th
Update of Growth Stock Selection Model 4 April 2008
th
What Happens When Dividend Yield>P/E? 29 February 2008
th
Quantitative Selection of Growth Stocks 18 January 2008
th
Quality Companies for the Coming Quarter 18 January 2008
nd
Quality Candidates for the Earnings Season 22 October 2007
Fund Flow Research
th
Retail Starts to Return 11 April 2008
th
Buybacks Say More than M&A 14 December 2007
th
Comfort in Money Market Funds? 26 November 2007
th
Buybacks Continue in Strength 26 November 2007
th
A Postscript on the Flows 24 September 2007
th
Figuring Out the Flows 27 August 2007
th
Global Fund Flow Report Q1 2007 5 March 2007
27 June 2008 13
27 June 2008 14
Analyst Certification:
I, Ian Scott, hereby certify (1) that the views expressed in this research report accurately reflect my personal views about any
or all of the subject securities or issuers referred to in this report and (2) no part of my compensation was, is or will be directly
or indirectly related to the specific recommendations or views contained in this report.
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rating, 21% of companies with this rating are investment banking clients of the Firm.
27 June 2008 15
GLOBAL EQUITY RESEARCH
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27 June 2008 16

Stagflation Versus Valuation

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Global Equity Research 27 June 2008

Investment Strategy & Macro

Global Strategy Weekly

Stagflation versus valuation 2-5

Valuation and Profitability 11

Please see our website at

Stagflation versus valuation

Figure 1: Global Earnings Yield Gap1

Yield Gap (% Points)

Figure 2: Global Oil Consumption as % of World GDP1

Figure 3: Global Equity Prices and Crude Prices, Jan 78 to Dec 84

Jan 1978 = 100 $ per barrel

Source: FTSE, Datastream

Jan 1978 = 100 year-on-year

Despite a protracted 150 4

Source: FTSE, OECD

Jan 1978 = 100 % yield

Source: FTSE, Lehman Brothers

Figure 6: US Unit Labour Cost Growth

Figure 7: US and Euro Area Headline Inflation

GLOBAL RECOMMENDED PORTFOLIO

Source: I/B/E/S, XShare, FactSet

Past performance is not a guarantee of future results.

GLOBAL INDEX TARGETS

Global Index Forecasts

Price Indices* Dividend Price Return Total return Total return

Earnings Growth Forecasts

• We expect earnings growth to decline by 5% in the US.

Source: Worldscope, Lehman Brothers research

Recommended Asset Allocation

Recommended Market Allocation

Recommended Global Sector Allocation

Recommended • We believe that the market will reward companies and

ONGOING STYLISTIC THEMES*

Emerging Market exposed basket rel to European Market

Index • We believe that European stocks with emerging market

Large Cap Versus Mid Cap

• We believe that in an environment of declining earnings

Index • Although we have had a long-standing bias for growth

Global Market Performance1 (%)

Regions 1 Week 1 Month 1 Year YTD

• The growth-sensitive Asian region was another notable

Global Sector Performance1 (%)

Sectors 1 Week 1 Month 1 Year YTD

Global Style Performance1 (%)

Styles 1 Week 1 Month 1 Year YTD

GLOBAL VALUATION AND PROFITABILITY

Current Values Post 1990 Average

Enterprise Value / Sales

Current Values Post 1990 Average

Enterprise Value / EBITDA

Current Values Post 1990 Average

1 Ratios reflect Earnings Before Goodwill Amortization,

Return on Capital Employed4 (ROE4 Financials)

Current Values Post 1990 Average

Enterprise Value / Capital Employed (P/BV Financials)

Current Values Post 1990 Average

Free Cash Flow Yield

Current Values Post 1990 Average

1 Financials excluding Real Estate,

Details of our regular research products are listed below.

FOR CURRENT IMPORTANT DISCLOSURES REGARDING COMPANIES THAT