Variant Perception’s Framework:

Asset Allocation, Trading and Leading Indicators

Tools for Understanding and Profiting from the Business Cycle

Background

Variant Perception helps clients protect and increase their trading capital by

providing forward-looking research.

Who we are:

Variant Perception is an independent global macroeconomic research service

enabling leading and contrarian investment decision making. Former traders

and economists created all the tools we use.

Our Approach: Candid - Data Driven - Easy to Digest

Our global macro research is written with the money manager and decision

maker in mind. We keep our reports succinct and let the data tell the story.

Our Clients

Our clients are some of the world’s most successful, forward-looking asset

managers. They include bank prop desks, hedge funds, family offices, public

corporations and trusts.

2

Developing a Variant Perception

3

“Successful investing is anticipating the anticipations of others.”

John Maynard Keynes

The only way to make money in financial markets is to have a Variant

Perception and to be ahead of other investors.

Variant Perception finds trading ideas focusing on sentiment, positioning,

valuation and economic fundamentals. Variant Perception identifies outliers:

• Hated asset classes where investors are short but where fundamental

leading indicators are turning up.

• Popular asset classes where investors are long but fundamental leading

indicators are turning down.

Developing a Variant Perception

4

Variant Perception is extremely data-driven. Our only goal is to identify good

trades. Variant Perception has built a framework to identify extremes in key

drivers of asset prices:

• Sentiment: Daily Sentiment Index, premiums/discounts to NAV,

put/call ratios, option skew, etc.

• Positioning: Commitment of Traders, ETF AuMs, Fund Flows from

EPFR, manager surveys, etc.

• Valuation: VP proprietary leading valuation scores (P/B, P/Sales,

P/E, margins, etc).

• Economic fundamentals (leading indicators): VP has built dozens

of leading indicators for key economies, asset classes, volatility

levels and credit spreads.

• Predicting debt and currency crises: VP has developed very

accurate tools to predict which countries are vulnerable to crises

Turning Points in the Economy Are Hard to Predict

The best trades are almost always at turning points. But most analysts merely extrapolate recent trends and miss turning points in economic activity. That is why economic forecasts are generally useless precisely when you need them most.

Variant Perception’s tools allow investors to spot turning points.

5

Variant Views Lead to the Most Profitable Trades

6

From VP Monthly January 2008: “The

US is already in a recession, and the

UK, Spain, Ireland are about to enter

one. Asia and the rest of Europe will

soon feel the aftershocks.”

From VP Monthly June 2009: “We are

likely to have a very sharp upturn that

people are not counting on or

expecting. For a few quarters, we'll

most likely have above trend growth.”

Traditional Approaches Often Miss Key Risks

“Quite simply, the record of failure to predict

recessions is virtually unblemished. Only two

of the 60 recessions that occurred around the

world during the 1990s were predicted a year

in advance”

Prakash Loungani, Assistant to the Director

External Relations Department, IMF

7

In the past four US recessions consensus economic forecasts did not

recognize the recessions even when recessions had already started.

2001 Recession: Dotcom Bust

“In a survey in March 2001 95% of American economists said there would

not be a recession.” The Economist (Jan. 2005)

The recession had already started that month, and industrial production had

already been contracting for five months.

8

2001 Recession: Dotcom Bust

9

“Moreover, with all our concerns about the next

several quarters, there is still, in my judgment,

ample evidence that we are experiencing only a

pause in the investment in a broad set of

innovations that has elevated the underlying

growth rate in productivity to a level significantly

above that of the two decades preceding 1995.”

Remarks by Chairman Alan Greenspan

Economic developments

Before the Economic Club of New York

May 24, 2001

The recession started in March 2001. The NASDAQ had already fallen 50%.

2008 Recession: Subprime Bust, Banking Crisis

10

The 2008 recession started in December 2007.

A majority of Wall Street economists did not recognize it had started until March

2008. Even then almost 30% of economists still expected the economy to avoid

contraction.

“The risk that the economy has entered a

substantial downturn appears to have

diminished over the past month or so.”

Ben Bernanke, Boston Federal Reserve’s 52nd

annual economic conference

October 2008

Traditional Approaches Focus on the Wrong Things

The two main reasons traditional approaches fail to forecast recessions:

1) Focus on lagging indicators – Traditional approaches focus on the wrong

things, such as inflation and employment. Inflation typically reaches its peak

in the middle of a recession and troughs when an expansion is strongest.

Unemployment is always at its lowest point when a recessions starts and is

in fact highly misleading.

2) Vintage Data – Almost all economic data is revised 3 and 12 months later.

Making decisions based on incomplete data or worse, data that will tell a

completely different story upon revision, is a recipe for disaster.

The only sensible way to understand economic changes is to focus on the

relationships between leading, coincident and lagging data.

11

Not All Economic and Financial Data is Created Equal

Traditional approaches place almost equal weight on all data and analyze

changes in great detail. At Variant Perception, we look at data in a logical,

sequential order.

Sequential changes in leading indicators confirm turns in the business cycle.

12

Leading Indicators Show Turning Points In Growth

Variant Perception Focuses on Leading Economic Indicators, unlike consensus

approaches which focus on coincident and lagging indicators.

We build all our own leading indices based on unrevised data.

13

Vintage Data: Making Predictions With Bad Data

Almost all economic data is revised (inflation, unemployment, GDP, savings

rates, industrial output, trade, etc). This makes for greater historical accuracy,

but it doesn’t help inform investors and decision makers in real time.

Variant Perception focuses on economic data and prices that are not revised

(ISM survey, yield curve, policy rates, credit spreads, initial unemployment

claims, etc).

14

Real Time Recession Signals Protect Capital

It is possible to call recessions before they start and when they end in real time based on the use of leading indicators. Variant Perception did that in December 2007 and June 2009.

Variant Perception’s tools flag recessions in real time and provide a good advanced warning to industrial companies and asset managers. Recessions typically lead towards falls in industrial production, retail sales, commodity prices, etc.

15

Leading Indicators Predict Economic Turning Points

16

The best way to track the business cycle is to 1) follow leading indicators, and

2) follow the sequential interaction between leading, coincident and lagging

indicators.

Variant Perception Leading Indices give advance warning, allowing investors to

protect their capital, hedge and/or go short the market.

Financial Conditions Business Cycle Driven

17

The business cycle is primarily controlled by central banks’ policies that a)

tighten when inflation is too high and/or rising uncomfortably because there is

little slack in the economy and credit growth is strong; and b) ease when the

reverse conditions exist.

Business Cycles Drive Commodity Prices

18

Global monetary policy moves provide a good lead of commodity price changes

with a 9 month lead.

In the long run commodities are driven by end demand and the marginal cost of

production. However, in the short run commodity prices fluctuate in line with

changes in available liquidity. With a lead of 9-12 months, less money means

lower prices, while more money means higher prices.

Real Money Growth Drives the Business Cycle

19

Real money growth drives the business cycle. Real Money growth leads

towards higher inflation. Higher inflation acts as a tax on growth and real

spending.

Excess liquidity drives stock market returns

20

Excess liquidity measures money growth in excess of what the real economy

needs. Stock market returns are best when industrial activity is low, money

growth is rising and inflation is falling, e.g. 1992, 2003, 2009.

Leading Indicators Point to Turns in Pricing and

Inflation

21

Leading indicators provide an advanced read on inflation for core and headline

inflation.

Sectoral Leading Indicators

22

Variant Perception provides not only country indices, but industrial sector

leading indices.

VP sector indices include:

- Manufacturing

- Car sales

- Durable goods consumption

- Shipping

- Construction

- Commodities

Leading Indicators Show the Direction of Retail Sales

Retail companies should pay close attention to Variant Perception’s Leading

Consumption Index to gauge the direction of retail sales.

23

Asset Allocation and Trade Ideas

Research providers for asset managers need to provide concrete input into asset allocation decisions. At Variant Perception, we take this task very seriously

VP provides trading ideas and investment themes for all major asset classes

- Global equities and equity sectors

- Credit

- FX

- Sovereign debt and fixed income

- Volatility

- Commodities and precious metals

24

VP Long-term Equity Signals

VP long-term equity indicators provide strong signals to trade and rotate

between equities and bonds. Our models incorporate valuation measures,

technical measures as well as our leading economic indicators.

25

VP Tactical Equity Signals

VP tactical equity indicators provide strong short-term trading and rotation

signals. Our models incorporate technical measures, inter-market analysis and

fund flows.

26

Fixed income fair value models

A crucial question for long run asset allocation and valuation models is whether

benchmark interest rates are over- or undervalued. Our models can help

answer that question.

27

FX valuation: Fade extremes

Purchasing Power Parity and uncovered interest rate parity models only work

on very long timeframes and often not at all. By far the best way to trade FX is

to fade extremes and let fundamental leading indicators lead the way.

28

Debt Creates Capital Market Volatility

Lending leads changes in equity and capital market volatility. Variant

Perception’s credit indicators provide a long lead on changes in volatility in

capital markets.

29

Excessive Foreign Financing Creates Crises

30

Variant Perception tracks current account imbalances and debt growth. Our tools

consistently flag countries that run the highest risk of currency and debt

problems. For example:

• The European periphery countries were top of the list from 2007-2010.

Europe had a debt crisis.

• Today, Turkey and South Africa are amongst the worst and they have hit

new lows against the dollar.

VP Value Added: European Periphery Cycles

Leading economic indicators kept Variant Perception ahead of curve

From December 2009 VP Monthly

• Analysis: “We believe that the crisis in Eastern Europe and Spain is ahead

of us, not behind. We foresee prolonged deflation in Ireland, the Baltics, and

Spain in particular. Spain is our highest conviction short.”

• Result: Many periphery stock markets declined over 50%

From August 2012 VP Monthly,

• Analysis: “One of the more bullish developments after Draghi’s speech was

the steepening of peripheral bond curves. The steepness of the yield curve

in the periphery has been a good precursor to equity rallies and increases in

industrial production.”

• Result: European periphery equity markets rallied 30-50%.

31

VP Value Added: Avoiding Growth Scares

After the “Flash Crash” of 2010, most investors were scared and selling their

stocks. Variant Perception was bullish based on leading indicators.

32

From July 2010 VP Monthly

• Analysis: “Double-dip recession

and deflation fears are now

consensus, but both risks are

vastly overstated – A wide

variety of recession indicators do

not point towards a recession in

the next six to nine months.”

• Result: Despite massive pessimism, the S&P bottomed in July and rallied

the rest of the year.

VP Value Added: Chinese Slowdown 2012-13

From March 2012 VP Monthly

• Analysis: “Our leading indicators for China have pointed down for some time and the incoming data for January confirms a significant slowdown ahead. Both exports and domestic demand have slumped. While the ensuing move towards monetary easing has been taken positively by the market, the underlying story is one of a severe slowdown ahead.”

33

• Result: The Chinese stock market fell over 20% over the following year.

Variant Perception’s China leading index accurately forecast the Chinese

slowdown.

Contact Us

If you would like a colleague to receive Variant Perception research, please email us at

subscribe@variantperception.com

Tom Sheehan, Head of Sales USA

tom@variantperception.com

+1 (646) 737 1602

Kali Huff, Institutional Sales USA

kali@variantperception.com

+1 (646) 737 1606

34

© Copyright by Variant Perception® LLC

VARIANT PERCEPTION is a federally registered trademark of Variant Perception LLC

www.variantperception.com - All rights reserved

It is a violation of US federal and international copyright laws to reproduce all or part of this publication by email, xerography, facsimile or any other means. The Copyright Act

imposes liability of $100,000 per issue for such infringement. The publications of Variant Perception are provided to subscribers on a paid subscription basis. If you are not a paid

subscriber of the reports sent out by Variant Perception and receive emailed, faxed or copied versions of the reports from a source other than Variant Perception you are violating

the Copyright Act. This document is not for attribution in any publication, and should not be disseminated, distributed or copied without the explicit written consent of Variant

Perception.

Disclaimer: Variant Perception’s publications are prepared for and are the property of Variant Perception and are circulated for informational and educational purposes only. The

content of this report is intended for institutions and professional advisers only. This report is not intended for use by private clients. Recipients should consult their own financial

and tax advisors before making any investment decisions. This report is not an offer to sell or a solicitation to buy any investment security. Variant Perception’s reports are based

on proprietary analysis and public information that is believed to be accurate, but no representations are made concerning the accuracy of the data. The views herein are solely

those of Variant Perception and are subject to change without notice. Variant Perception’s principals may have a position in any security mentioned in this report. All data is

sourced from Bloomberg unless otherwise stated.