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North America Equity Research10 December 2010
2011 OutlookYE 2011 Target 1425; Raise '11E EPS to $94 from$91; Introduce '12E EPS of $102
US Equity Strategy
Thomas J Lee, CFAAC
(1-212) 622-6505
Daniel M McElligott(1-212) 622-5598
J.P. Morgan Securities LLC
See page 70 for analyst certification and important disclosures.J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm mhave a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making thinvestment decision.
Year-End 2011 S&P 500 Price Target: 14
S&P EPS EstimatesJPM Bottom
Strategy St
2010E $85.50 $84
2011E $94.45 +10% $95
2012E $102.00 +8% $108
Sector Weightings
Overweight: FinancialsIndustrialsEnergyMaterialsTechnologyDiscretionary
Neutral: HealthcareTelecom
Underweight: StaplesUtilities
Strategy View
Third year of expansion and third year ofpresidential cycle
Credit eases in 2011 and labor grows175k/month Sector rotation greatest in third year of bumarket; best window is 4-mo intervals
Favor Cyclicals early in 11 and Defensive
later in year Domestic Cyclicals over Intl
We see the S&P 500 delivering at least a 15% gain 2011, driven more by valuation
expansion (risk premium falling) than EPS beats. Our YE2011 S&P 500 target is
1425, based on 14x 2012E EPS of $102. History (see below) suggests an even stronger
20%-plus gain, and history also suggests there should be more rapid industry rotation
in 2011 (year 3) than any prior year. Thus, for the portfolio manager, 2011 represents
some daunting challengesa 15-20% bogey to beat along with even greater group
rotation than in 2010. Thus far, this market has been textbook in staging
leadership, and we introduce some tools in this report to target alpha generation.
US GDP growth is forecast to accelerate to 3.5% (4Q/4Q) from 2.6% in 2010 (see
Figure 9) aided by expansionary behavior by business and consumer, rehabilitation
of consumer balance sheets, and accommodative fiscal and monetary policy. We see
labor picking up, adding 175k/month. Inflation remains muted due to resource slack.
History strongly argues for an even stronger year in equities. This is the 3rd year
of a business expansion AND the 3rd year of a presidential term. There were only 5
periods (see Figure 10) in the 111 years of Dow history when both occurred and
markets rose in each instance posting an average gain of 21%. The risks of a bear
market in 2011 appear low given (i) low recession risk; (ii) low inflation;
(iii) positive real rates; and (iv) higher EY vs. BAA BY. These 4 items were key
determinants (of 20 we examined) of longer (vs. shorter) bull markets (Figure 14).
Finally, relative value should strongly support stocks in 2011. Equity risk premium
remains at 50-year high at 6.2% (see Figure 15) (our 14x assumes premium drops to
5.7%, well above 10-yr avg. of 3.56%). Moreover, forecast returns in 2011 for fixed
income markets are meaningfully weakerwith treasuries negative (see Figure 17),
high grade +2%against double-digit increases seen for commodities and equities.
Sector correlations historically have fallen to cycle lows during the 3rd year of a bull
market suggesting a drop in correlation from 90% (see Figure 21).
MARKET STRATEGY: GROUP LEADERSHIP LIKELY ROTATES MORE
RAPIDLY IN 2011, ARGUING FOR STAGING MARKETS. We compared the
price performance of 30 industries at each point in the bull market cycle (thus,
staging) and found top-quartile leadership shifted rapidly in Year 3 compared to
Years 1 and 2 (see Figure 26). This seems logical to us as a fall in correlation leads
to divergences and business cycle dynamics dominate. This bull market, as we
noted, has been a textbook example thus far. The top 8 groups which history
indicated should outperform in 2010 indeed outperformed by 1,000bp while the
expected worst 8 (based on history) underperformed by 400bp. For 2011, staging
analysis suggests best groups in the first 4 months of 2011 should be: Asset
Managers, Insurance, Construction Materials, Restaurants, Retail, Gaming,and oddly Telecom Services, and Utilities (see Figure 25).
18 IDEAS. We identified 18 names expected to outperform in early 2011, using the
following criteria: (i) top quartile of staging (above); (ii) top style factor of high-beta
which is attractive on institutional ownership and relative P/E (vs. LT avg.); and
(iii) rated OW. The tickers are: ODP, OZM, IVZ, ALL, NIHD, OMX, OC, LVS,
LTD, MW, AFL, GPI, BEN, PNK, HIG, M, MET, and AXP.
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Thomas J Lee, CFA(1-212) [email protected]
Table of Contents#1: Solid GDP Growth Expected in 2011 ................................3
#2: History Argues for 20%-Plus Year ....................................9
#3: Relative Return of Equities Should Outperform RiskyAssets......................................................................................13
Setting Target of 1425 ............................................................17
Market Strategy: Staging as Correlation Falls .....................19
Staging in 2011: The Year in 3 Phases..............................25
STOCKS: 18 Names for 1st Third of 2011 ............................29
Special: Still See Housing Bottom in 2011...........................31Risk: P/E Volatility ..................................................................35
Risk: Sovereign Concerns Real ............................................37
Risk: Municipal DebtBudget Deficits Helped by Recoveryin Revenue ..............................................................................39
2011 Sector Outlook...............................................................43
Basic Materials: Overweight..................................................45
Industrials: Overweight..........................................................47
Consumer Discretionary: Overweight ..................................49
Technology: Overweight........................................................51
Energy: Overweight................................................................53
Financials: Overweight ..........................................................55
Healthcare: Neutral.................................................................57
Telecom: Neutral ....................................................................59
Consumer Staples: Underweight ..........................................61
Utilities: Underweight.............................................................63
Appendix: Bull Market Metrics in Months 22-34 After Startof Bull Market ..........................................................................65
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Thomas J Lee, CFA(1-212) [email protected]
#1: Solid GDP Growth Expected in 2011
J.P. Morgan Economic Outlook Above Consensus
J.P. Morgan economists see a fragile recovery but with enough cyclical lift to
overcome fiscal drags (see Figure 9) resulting in growth above Street consensus. This
above-consensus outlook is evident in Figure 1 and Figure 2.
What is notable is that J.P. Morgans US GDP forecasts are above Street consensus
in 1H (and below consensus in 4Q), while our Euro-area forecast calls for upside to
Consensus later in the year (2H).
The US forecast assumes passage of the compromise tax package offered by the
White House and Congress. What is notable in the compromise plan is the reduction
in Social Security withholding taxes. Previously, Kasman and team had expectedwithholding taxes to be a drag on income growth in 2011, but now they stand to
support income growth. Thus, our economics team sees GDP growth of 3.5-4.0% in
1H11, which is 110-130bp above that seen by Consensus.
Figure 1: JPM US GDP vs. Consensus
%q/q saar
2.50
3.50 4.00 3.503.00
JPM Consensus
0.30 . . .
-0.20
4Q10 1Q11 2Q11 3Q11 4Q11
Source: JPM Economics Research and Bloomberg.
Figure 2: JPM Euro GDP vs. Consensus
%oya saar
2.10 2.00
1.40 1.401.60
JPM
Consensus
0.10 0.100.20 0.30 0.30
4Q10 1Q11 2Q11 3Q11 4Q11 Source: JPM Economics Research and Bloomberg.
Washington Moving to the CenterBoosting Small Biz
The White House is moving to the center, which should provide a boost for business
confidence and, in our view, a particular boost to small/medium biz confidence. We
think small and medium business confidence has been hampered by bleak
fundamentals and tight credit, but also concerns about taxes, regulatory creep, and
the general anti-business sentiment from Washington.
Thus, we believe small and medium business confidence should improve in 2011,
which should engender hiring. Granted, this is circular (as hiring in the past has been
driven by better business conditions). But the point of this is that an improving
outlook from Washington, particularly towards the center, should at least help sustain
some of the improvements we are seeing in small and medium business conditions.
Consider the two charts below:
Upside seen in 1H
More upside seen in 2H
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Thomas J Lee, CFA(1-212) [email protected]
The NFIB small business optimism index (see Figure 3) has nearly recovered tocycle highs as of October and, again, we see reasons for the rise to be sustained.
After all, this survey was completed before the mid-term elections and before therecent strengthening in labor market conditions.
In addition, NFIB hiring plans have similarly improved as shown in Figure 4 withthe employment index continuing its move above the zero line. Granted, we are
still a long way from reaching the 8.5 long-term level, but, by the same token,
this survey was taken as of October, before recent incremental improvements.
Figure 3: NFIB Small Business Optimism Improving
Business conditions
Source: Bloomberg.
Figure 4: NFIB Small Business Employment Plans Are Turning Positive
Hiring plans
Source: Bloomberg.
Consumer Balance SheetsCredit Better than Mortgages
Household balance sheet repair progressed substantially in the past few years. We
realize that debt reduction has been driven both by charge-offs as well as a higher
savings rate. Still, one needs to remember that a 5% savings rate equates to about
$550 billion annually in debt reduction.
Balance sheet repair can be seen most clearly in credit card balances, which havefallen 14% from a peak of $866 billion in 4Q08. Figure 5 shows that this credit
card reduction may have potentially overshot equilibrium, as the balance of
6.6% is below the 7.3% level seen at the start of the decade. An increase of 0.7%
(to get to 2000 levels) would represent $79.0 billion of incremental credit card
balances, or potential upside to spending in 2011.
On the other hand, mortgage debt likely has further to fall. At $8.7 trillion, itstands at 76.7% of Disposable Income (see Figure 6). While this is down from
85.5% at the peak in March 2008, it is well above the 50.1% at the start of the
decade and would need to fall a further $3.0 trillion to reach 50%. We actually do
not expect it to fall to 50% of disposable income, as low interest rates mitigate the
debt burden. But we do anticipate further declines in this balance.
ZERO line
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Thomas J Lee, CFA(1-212) [email protected]
Figure 5: FIXED HEREConsumer Credit as % Disposable Income
% of Nominal Disposable Income
Source: Federal Reserve.
Figure 6: IN PROCESSMortgage Debt as % Disposable Income
% of Nominal Disposable Income
Source: Federal Reserve.
KEY TO REMEMBER, Excess Leverage in Housing IsConcentrated in 8% of Households
But, wait, isnt there too much mortgage debt? Arent many Americans underwater
in their mortgages? We think it is important to remember that only a fraction of US
households today have negative equity. Take a look at Figure 7 below. We have
stratified the homeowner market into: (i) Positive Equity; (ii) Borderline (Loan-to-
Value (LTV) between 100% and 130%); and (iii) Seriously Negative (LTV>130%).
The data was provided by our ABS team.
As shown below, 80mm households today have positive equity, including 32mm
with no mortgage. There are also another 38mm or so renters with no mortgage.There are 3.9mm households that are seriously delinquent, representing
$1.0 trillion in mortgages (negative equity is $372 billion).
Figure 7: Distribution of Mortgages Based on Loan-to-Value
Households in thousands, $ billions; from Matt Jozoff/John Sim, MBS Strategist
31,859
16,117
7,69911,022
8,0374,3822,4191,7281,8401,348589486400420242148303
HH with
NO
mortgage
200
# of Households
0
$1,693
$1,070
$1,965$1,620
$995
$578$417$401
$226$199$163$119$119$69$43$85
HHwith
NO
mortgage
200
Mortgage balance outstanding ($ billions)
Source: J.P. Morgan ABS/MBS Research.
SERIOUS NEG EQ (LTV > 130%)3.9mm Households
SERIOUS NEG EQ (LTV > 130%)$1.0 Trillion, $372 billion NEG EQUITY
POSITIVE EQUITY$7.3 Trillion
BORDERLINE6.0mm Homeowners
BORDERLINE$1.4 Trillion
POSITIVE EQUITY79mm Households
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Thomas J Lee, CFA(1-212) [email protected]
Labor Tracking Like Jobless Recoveries of 91/01Suggesting 150-200k Jobs in 11
Kasman and team forecast payrolls to grow by 175k/month in 2011.
This would be consistent with the trajectory of labor markets during the jobless
recoveries of 91 and 01. As shown in Figure 8 below, the recovery in labor markets
looks a lot like the jobless recoveries of 91 and 01. In those precedent periods,
stronger hiring did not take place until 18 months after the labor market began to
growthink of it as a rolling start.
And similar dynamics are at work currently even if the drivers differbusinesseshave chosen to defer hiring, meeting rising demand with increased hours worked,
temporary hires, and eventually full-time hiring. What is different this cycle is
regulatory and tax uncertainty coupled with tight credit inhibiting hiring. But
eventually businesses should need to hire as shown in Figure 8 below.
Figure 8: 2011 Payrolls Should Grow 150-200k per Month, Similar to Past Jobless Recoveries of 1991/2001
Six-month average of monthly payroll gains (Private Payrolls)
1/10
2003
9/03
6/91
1991
-300
-200
-100
0
100
200
6/09 9/09 12/09 3/10 6/10 9/10 12/10 3/11 6/11 9/11 12/11
Monthly
inpriva
tepayroll(trailing6m
avg)
2011
2/03 5/03 8/03 11/03 2/04 5/04 8/04 11/04 2/05 5/05 8/05
11/90 2/91 5/91 8/91 11/91 2/92 5/92 8/92 11/92 2/93 5/931991
2003
2010
Source: J.P. Morgan and Bloomberg.
91/03 Jobs grew 150k-200k/ month
Date laborgrowth turnedpositive.
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Thomas J Lee, CFA(1-212) [email protected]
Figure 9: J.P. Morgan Economic Forecast Summary
Saar
2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 2010 2011 2012 2010 2011 2012
Gross domestic product
Real GDP 1.7 2.5 2.5 3.5 4.0 3.5 3.0 2.6 3.5 3.0 2.8 3.1 3.0
Final sales 0.9 1.2 4.1 3.8 3.9 3.8 2.9 1.8 3.6 3.0 1.3 3.3 2.9
Domestic 4.3 2.9 2.7 3.3 3.7 4.1 3.3 2.8 3.6 3.0 1.9 3.4 3.1
Consumer spending 2.2 2.8 2.5 3.5 3.5 4.0 3.0 2.3 3.5 2.6 1.7 3.2 2.7
Business investment 17.2 10.3 7.0 7.8 10.6 11.5 10.1 10.5 10.0 8.9 5.7 9.6 9.7
Equipment 24.8 16.8 10.0 10.0 12.0 12.0 10.0 17.9 11.0 8.5 15.6 12.3 9.6
Structures -0.5 -5.8 -3.0 0.0 5.0 9.0 10.0 -7.0 5.9 10.0 -14.5 1.3 9.6
Residential investment 25.6 -27.5 5.0 10.0 20.0 15.0 10.0 -4.3 13.7 13.7 -2.9 6.7 13.1
Government 3.9 4.0 1.1 -0.6 -1.0 -1.0 -0.1 1.8 -0.7 -0.5 1.2 0.5 -0.5
Net exports ($bn, chained $2005) -449 -507 -467 -454 -453 -468 -487 - - - - - -
Exports (goods and services) 9.1 6.3 7.0 7.0 8.0 9.0 8.0 8.4 8.0 8.0 11.6 7.5 8.1
Imports (goods and services) 33.5 16.8 -2.0 3.0 6.0 10.0 10.0 14.2 7.2 6.7 13.5 7.2 8.2Inventories (ch $bn, chained $2005) 68.8 111.5 61.2 51.6 55.3 47.2 52.4 - - - - - -
Contribution to real GDP growth (% pts):
Domestic final sales 4.4 3.0 2.7 3.3 3.7 4.1 3.3 2.8 3.6 3.0 1.9 3.4 3.1
Housing 0.6 -0.8 0.1 0.2 0.4 0.3 0.2 -0.1 0.3 0.3 -0.1 0.1 0.3
Consumer Spending 1.5 2.0 1.8 2.5 2.5 2.8 2.1 1.6 2.4 1.8 1.2 2.2 1.9
Net exports -3.5 -1.8 1.3 0.5 0.2 -0.3 -0.5 -1.0 0.0 0.0 -0.6 -0.1 -0.2
Inventories 0.8 1.3 -1.6 -0.3 0.1 -0.3 0.1 0.8 -0.1 0.0 1.4 -0.2 0.0
Income and profits (NIPA basis)
Adjusted corp profits 12.7 11.5 8.0 8.0 10.0 8.0 7.0 19.2 8.2 5.5 29.8 9.0 5.9
Real disposable personal income 5.6 0.9 1.0 4.5 3.5 3.0 3.0 2.2 3.5 2.4 1.3 3.0 2.3
Saving rate1 6.2 5.8 5.4 5.7 5.7 5.4 5.4 - - - 5.7 5.6 5.2
Prices and labor cost
Consumer price index -0.7 1.5 2.3 1.8 1.0 1.1 1.1 1.1 1.2 1.3 1.6 1.4 1.2
Core 0.9 1.2 0.4 0.6 0.6 0.7 0.8 0.6 0.7 1.1 1.0 0.7 0.9Producer price index -0.5 0.9 4.0 1.0 0.7 0.8 1.3 3.2 0.9 1.4 4.1 1.4 1.3
Core 1.7 2.2 1.0 0.6 0.5 0.5 1.0 1.8 0.6 1.1 1.3 0.9 1.0
GDP chain-type price index 1.9 2.3 1.3 1.0 1.0 1.0 1.1 1.6 1.0 1.2 1.0 1.3 1.2
Core PCE deflator 1.0 0.8 0.5 0.6 0.6 0.7 0.8 0.9 0.7 1.0 1.4 0.7 0.9
S&P/C-S house price index (%oya) 3.6 -1.2 -2.1 -2.5 -1.0 1.0 2.0 -2.1 2.0 2.0 0.6 -0.1 2.0
Productivity -1.8 1.9 1.0 2.0 2.5 2.0 2.0 1.2 2.1 1.6 3.4 1.7 1.7
Other indicators
Housing starts (mn units, saar)1 0.602 0.584 0.550 0.600 0.650 0.675 0.700 - - - 0.588 0.656 0.781
Industrial production, mfg. 9.3 3.7 4.0 4.5 5.0 4.5 3.5 5.8 4.4 3.5 6.0 4.6 3.7
Capacity utilization, mfg. (%)1 71.6 72.3 73.0 73.7 74.4 75.0 75.5 - - - 71.7 74.6 76.2
Light vehicle sales (mn units, saar)1 11.3 11.6 12.2 12.4 12.6 12.8 12.9 - - - 11.5 12.7 13.2
Unemployment rate1 9.7 9.6 9.7 9.6 9.4 9.2 9.0 - - - 9.7 9.3 8.7
Nominal GDP 3.7 4.8 3.8 4.5 5.0 4.5 4.1 4.3 4.6 4.3 3.9 4.5 4.2
%q/q, saar %q4/q4 %y/y
Source: J.P. Morgan Economic Research.
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Thomas J Lee, CFA(1-212) [email protected]
#2: History Argues for 20%-Plus Year
Markets Gained Each Time in the 3rd Year of ExpansionAND 3rd Year of Presidential Term
We have found substantial relevance in using historical analysis and cycle analysis as
key elements of framing our forecast. (Of course, the challenge is to explore the
differences in the current context.) We believe this provides us with a baseline
context to examine how market reaction is likely to evolve. Moreover, basic
decision-making instincts by investors are assumed to be similar over periods.
Based on 111 years of Dow history, 2011 looks to be an extremely favorable
combination of (i) 3rd year of an expansion and (ii) 3rd year of a presidential term:
This combination has only occurred 5 times since 1900 and the average returnhas been 20.6% with the market rising in each instance (see Figure 11).
On a standalone basis, performance of the Dow in the 3rd year of a Presidentialterm has been superior to that in other years (13.3% vs. 7.2% for all years). And,
of course, in such periods Senators are aiming for re-election as well. The
prevailing theory is that re-election dynamics drive fiscal spending. But it could
also be due to a President ultimately shifting toward the center.
And, on a standalone basis, performance in the 3rd year of an expansion hastypically been decent, with gains of 7.2% vs. declines of 6.7% seen during
recessions.
Figure 10: Annual Performance of S&P 500 During Expansion/Contraction and Presidential Cycles
Annual % change
AllYears
Contraction
Expansion
3rdYearof
Expansion
AllYears
Contraction
Expansion
3rdYearof
Expansion
AllYears
Contraction
Expansion
3rdYearof
Expansion
All Years 7.2% -6.7% 11.4% 7.2% 111 26 85 14 66% 42% 72% 71%
Presidential Election Years 8.2% 1.2% 11.1% 0.1% 28 8 20 5 71% 50% 80% 60%
Non-Presidential Election Years 6.8% -10.2% 11.5% 11.1% 83 18 65 9 63% 39% 69% 78%
3rd Year of Presidential Term 13.3% -13.9% 21.0% 20.6% 27 6 21 5 81% 33% 95% 100%
% Annual Gain Number of Instances % t imes Instances >=0%
Source: J.P. Morgan and FactSet.
Figure 11: Years that Were Both3rd Year of Presidential Term
and 3rd Year of ExpansionAnnual % change
41.4%
26.4%
18.9%
16.3%
0.0%
0% 20% 40% 60%
1935
2003
1963
1951
1947
during 2-yr of bear
market which
started in 05/46
Source: J.P. Morgan and FactSet.
Should it be any different in 2011? We dont think soThe naysayers will no doubt argue that it is different this time. Take the White
Housebecause of large deficits and midterm turmoil, skeptics are likely to argue
that there is little the White House can do in this 3rd year in terms of policy action.
But consider that split chambers of Congress and/or split Congress/White Househave been the norm in history, yet, 81% of the time the market has recorded
positive performance in the 3rd year of a Presidential term.
Wow Wow
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But Havent Half of All Bull Markets Ended by Year 3? Yes
There is another wrinkle in the historical analysis.
Of the 19 Bull markets that lasted at least 22 months (which is the current age of the
2009 bull market), 9 turned into bear markets before the 34th month (equivalent to
December 2011). In fact, 7 of the 9 would indicate an end to this bull market by
June 2011 (see below in Figure 12).
Figure 12: Duration of Bull Markets (Lasting at Least 22 Months)
Since 1900
1 1 2 2 2 4 510 11
21 22 24 27 28
34 38 39
7592
19191916197919761909196819051972198919511964 195519441959 193420041984 19231992
Lifespanbe
yondmonth22
Lifespan of bull beyond month 22
9 of 19 bull markets
did not last thru month
34
Source: J.P. Morgan and Bloomberg.
But even in those years the market gained 3% to 30% before peaking...Interestingly, as shown below in Figure 13, even in those 9 years in which a bear
market ensued (between months 22 and 34), intra-year gains ranged from 3% to 30%
(in 1909 and 1979, respectively).
Figure 13: Maximum % Gain from Month 22 to Month 34 (Best Intra-Year Gain)...
Since 1900, sorted by duration of bull market (see chart above)
5%9%
30%
4% 3%
11%
29%
11%
7%
14%10%
15%
19%
2%0%
13%
23%
7% 7%
0%
10%
20%
30%
40%
191919161979197619091968190519721989195119641955 19441959193420041984 19231992%G
ainMo22toPeakinMo22-34
9 of 19 bull markets did
not last thru month 34
Source: J.P. Morgan and Bloomberg.
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Thomas J Lee, CFA(1-212) [email protected]
Analysis of Long vs. Short Bull Points to Longer Variety
We looked at 20 discrete metrics to understand what distinguishes a short vs.
long bull market (see Appendix and Figure 91 to Figure 94). Of these 20 metrics,we found 4 that had strong intuitive and explanatory powers for what distinguishes a
long vs. short bull market. Those are summarized in Figure 14:
Figure 14: Factors that Differentiate Longer vs. Shorter Bull Markets
As indicated
Time to next recession
40
16
Longer bull
markets
Short bulls (end
by 34th month)
Inflation
3.1%
7.8%
today
1.1%
Longer bull
markets
Short bulls (end by
34th month)
Real 10-year rates
1.7%
-1.1%
today
1.4%
Longer bull
markets
Short bulls (end
by 34th month)
S&P 500 EY vs. BAA Yields
1.6%
-0.6%
today
1.7%
Longer bull
markets
Short bulls (end
by 34th month)
Source: J.P. Morgan, Bloomberg, and FactSet.
#1: Time to next recessionForemost, it was the proximity to the next recession. Shorter bull markets saw a
recession start within 16 months. (In the current context, that would mean a recession
starting in 2012). On the other hand, longer bull markets saw a recession start only
within 40 months. This makes sense. Recessions bring bear markets. Bruce Kasman and team do not see a recession in 2012.
#2: Inflation was a big differentiatorInflation at Month 22 was a key differentiator as well. Shorter bull markets suffered
from higher inflation of around 8%, compared to longer bull markets with 3%
inflation. In our past work, we showed that inflation rates above 6% have driven P/E
compression, so this again is logical.
Inflation is running at about 1% today, again indicating a longer bull market.
#3: Real 10-year ratesReal 10-year rates (10-year less inflation) were POSITIVE during longer bull
markets whereas in Month 22 of shorter bull markets rates were negative. This is
somewhat less intuitive, but we think it speaks to rate-of-return opportunities for
businesses. Higher real rates imply positive expected returns for risky assets and
therefore capital investment.
Today, real rates, at positive 140bp, again clearly indicate a longer bull market.
#4: Equity relative value vs. BAA bond yieldsFinally, relative value was positive in longer bull markets with EY (1/P/E) higher
than bond yields (lowest investment grade). This again is intuitivestocks were
cheaper and therefore did well.
Today, EY is 170bp above the BAA bond yield.
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#3: Relative Return of Equities Should
Outperform Risky Assets
#1: 50-Year High in Equity Risk Premia...
Our global asset allocation team recently produced a 50-year time series of equity
risk premia shown below in Figure 15. They calculated these by comparing the
earnings yield of equities against the real yield on the 10-year, which is basically
the 10-year bond yield less inflation.
As shown below, the current equity risk premium of 620bp is the highest ever,higher even than that during the 1974 bear market trough and definitely well
above the level at which it settled at the 2002 bear market low.
This high risk premium obviously raises a few questions. Foremost is thatinvestors are showing little trust in equities, which may not be entirely surprising
given the awful performance of stocks over the past decade.
But it also may reflect a general fear of capital investment, both physical andfinancial. After all, many investors and companies still question the durability of
this recovery and thus have been reluctant to invest in longer-duration assets.
Equities, after all, are infinite-duration assets.
Figure 15: Equity Risk Premia
Calculated as Earnings Yield less Real 10Y Yield (10Y Less Inflation)
12/02
4.12
9/10
6.2112/74
5.56
10-year average
3.56
(2.0)
(1.0)
-
1.0
2.0
3.0
4.0
5.0
6.07.0
'57 '59 '62 '64 '67 '69 '72 '74 '77 '79 '82 '84 '87 '89 '92 '94 '97 '99 '02 '04 '07 '09
Equity Risk Premia 10-year average
Source: J.P. Morgan Global Asset Allocation Strategy.
The implication though is risk/reward for equities is attractiveThe key takeaway, in our view, is that risk/reward appears favorable for stocksthat
is, the margin for error is lower for equities when the equity risk premium is high.
Even if one were to argue that the equity risk premium has been rising, which hasbeen the case over the past decade, it is well above the 10-year average.
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North America Equity Research10 December 2010
Thomas J Lee, CFA(1-212) [email protected]
#2: Equities Offer Attractive Return Potential vs. OtherRisky Assets
Equities did not outperform other risky assets in 2010 as shown in Figure 16 below.
In fact, most fixed income markets and commodities saw gains of 11-25%. Most of
these were above the 11.5% gain of the S&P 500 YTD (2.0% from dividends).
But 2011 forecast returns point to better relative performance for equitiesWe have compared our 2011 Target of 1425 for the S&P 500 to J.P. Morgans
projected returns for other risky assets. These are shown below in Figure 17.
The forecast return for Equities of 18.5% matches the expected return forcommodities (oil up 26% and commodities broadly up 19%) and is higher than
that for fixed income assets. Of this, the majority consists of capital gains (EPS
growth and P/E expansion) rather than dividend yield.
Our fixed income teams expect the rally in fixed income to end, with Treasuriesprojected to be flat (down 0.9%), high-grade returns a mere 2%, and high-yield
delivering an 8% total return. This is quite a contrast to 2010 when CMBS
returned 25% and high-yield 13%.
Figure 16: 2010 Comparative Returns for Risky Assets
% change, YTD as of 12/02/10
25.8
25.0
13.2
12.8
12.1
11.5
10
7.1
7.1
5.7
Gold (S&P GSCI)
CMBS (AAA)
High Yield
Emerging Markets Bonds
Treasury (10y)
Equities (S&P500)
Investment Grade Corporates
Commodities (JPMCCI)
Oil (S&P GSCI Brent)
MBS
Source: J.P. Morgan.
Figure 17: 2011 FORECASTED Comparative Returns of Risky Assets
% change
26.0
19.0
18.5
17.0
8.0
6.5
4.5
2.0
1.0
-0.9
Oil (S&P GSCI Brent)
Commodities (JPMCCI)
Equities (S&P500)
Gold (S&P GSCI)
High Yield
CMBS (AAA)
Emerging Markets Bonds
Investment Grade Corporates
MBS
Treasury (10y)
Source: J.P. Morgan estimates.
Fixed incomeforecasted returnsare substantiallymore modest thanthose for equitiesor commodities
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North America Equity Research10 December 2010
Thomas J Lee, CFA(1-212) [email protected]
#3: JPM Client Survey Indicates Allocation into Equities
In J.P. Morgans Fixed Income Survey, investors were asked about expected changes
in portfolio allocation over the next six months (see US Fixed Income Markets 2011Outlook dated 11/24/10 by Srini Ramaswamy). The survey is broad-based, but this
particular question has only been asked this year. The survey was based on a clients
intended changes in asset allocation. If a respondent had a desire to add exposure,
they were asked to indicate +1, with -1 representing a desire to reduce exposure.
As shown below in Figure 18, respondents expressed the strongest desire to addexposure for Equities, followed by TIPS and Emerging Markets.
On the other end of the spectrum, respondents expressed modest preferences toreduce exposure to Non-Agency MBS and High-Yield.
Broadly, our interpretation is that macro funds and institutional managers are
likely to add to equity exposure in 2011Our takeaway is that institutional investors are likely to add to equity exposure in
2011. The nagging question remains whether retail investors will add to exposure.
What we do know is that retail investors tend to follow outperformance. Thus, ifthe outperformance of equities continues into 2011, we believe investors will
make a pronounced allocation into equities.
Figure 18: Client Survey Indicates Planned Move into EquitiesScale: +1 desire to add; -1 desire to reduce
-0.2 -0.1 -0.1-0.1
0.00.1 0.3 0.3
0.4 0.5
-0.2-0.5
0.0
0.5
1.0
Non-
Agy
MBS
High
Yield
CMBS Agy
debt
Agy
MBS
Dur'n
risk
ABS IG EM TIPS Equities
Source: J.P. Morgan Fixed Income Strategy.
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North America Equity Research10 December 2010
Thomas J Lee, CFA(1-212) [email protected]
Setting Target of 1425
S&P 500 to Reach 1425 in 2011Debate Will Be on P/E
We believe the S&P 500 can reach 1425 in 2011 (see Figure 19). Consensus is
centered about 100 points lower with a top-down Strategist consensus (NI WGT
) of 1337. Michael Krauss, J.P. Morgan Technical Strategist, sees 1300-
1350. So, for reasons discussed in prior sections, we are more bullish than consensus
for 2011.
2011 should be more about valuation expansion rather than EPS upside...The composition of market return in 2010 was more about EPS upside, as top-down
forecasts rose about 7% in 2010 (2010E EPS started the year at $74 and is now $83).
For 2011, we see less potential for upward revisions to estimates, but rather see the
shift in market performance toward a decline in the risk premiumresulting in P/Eexpansion. Specifically, our target is based on the following:
Figure 19: Comparative S&P 500 Price Levels Based on EPS and P/E Ratios
Index level
Range of 2012 EPS.
Implied '12 GDP gth 2.25% 2.50% 2.75% 3.00% 3.25%
EPS $98.00 $100.00 $102.00 $104.00 $106.00
Applied
P/E
Implied Equity Risk
Premia YE '11
EY vs BAA
Yield
(EY less {10Y less
inflation})
12.5x 6.57% 2.02% 1,222 1,247 1,272 1,297 1,322
13.0x 6.26% 1.71% 1,271 1,297 1,323 1,349 1,375
13.5x 5.97% 1.42% 1,320 1,347 1,374 1,401 1,428
14.0x 5.71% 1.16% 1,369 1,397 1,425 1,453 1,481
14.5x 5.46% 0.91% 1,418 1,447 1,476 1,505 1,534
15.0x 5.23% 0.68% 1,467 1,497 1,527 1,557 1,587
15.5x 5.01% 0.46% 1,516 1,547 1,578 1,609 1,640 Source: J.P. Morgan estimates.
#1: Raise 2011E to $94 from $91 and New 2012E EPS of $102
The global cyclical recovery should enable S&P 500 companies to generate at least
high-single-digit EPS growth in 2011/2012. Our estimates are basically built around
2.5-3.0% GDP growth (in line with Kasmans US GDP view), but we see upside to
our 2011 estimates in the context of an accelerating cyclical outlook which ispossible if Europes sovereign issues do not damage the economy.
We are raising our 2011 EPS estimate to $94 from $91 (see details in Figure 20),principally reflecting higher anticipated EPS contributions from Financials and
Industrials.
Our 2012 EPS estimate of $102 anticipates that the prior EPS peak (in 2Q07 at$92) will be surpassed. This is consistent with prior earnings cycles.
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North America Equity Research10 December 2010
Thomas J Lee, CFA(1-212) [email protected]
#2: Forward P/E Ratio Should Creep to 14.0x 2012E
While there are considerable countervailing forces acting on asset values (hence
P/E), we believe the primary drivers of P/E expansion will be:
1. Contracting relative value relationship of equities vs. corporate credit, in whichrisk premium for stocks narrows from record-high to normalized levels. As
shown in Figure 19, our target risk premium is 5.43%, down from 6.21%
currently (see Figure 15) but still well above 10-year average of 3.56%; and
2. Positive impact on asset prices from LSAP (Feds large-scale asset purchases, orQE2).
EPS Driven by Cyclicals
The drivers of earnings growth in 2011 and 2012 should basically be the
economically sensitive stocksCyclicals and near-Cyclicals account for $8 of the $9
in incremental EPS we forecast for 2011. We highlight forecasts by Sector in Figure20 below.
We are revising our 2011 EPS estimate up slightly to $94 (from $91) to reflectthe expected re-acceleration of the economic recovery in 2011. Our estimate of
$94 does implicitly assume meaningful GDP growth as the 4Q10E EPS run-rate
is $88 ($22 x 4 = $88).
We forecast that Financials will be the largest contributor of incremental EPSyear-over-year ($3.13) and report the fastest growth on a % basis.
Figure 20: S&P 500 EPS Forecast
$ per share
JPM Strategy Estimates
2011E EPS 2012E EPS
Strategy
Rating FY 2008 FY 2009
FY
2010E 1Q11E 2Q11E 3Q11E 4Q11E
FY
2011E $ chg % chg
Bottom-Up
Consensus FY 2012E $ chg % chg
Bottom-Up
Consensus
Cyclicals
Materials OW $2.57 $1.31 $2.40 $0.71 $0.78 $0.70 $0.65 $2.85 $0.45 19% $2.88 $2.93 $0.08 3% $3.13
Industrials OW 9.41 6.41 7.68 1.98 2.29 2.35 2.38 9.00 1.32 17% 9.23 9.62 0.62 7% 10.28
Discretionary OW 3.07 5.02 8.28 2.04 2.25 2.32 2.54 9.15 0.87 11% 9.33 10.45 1.30 14% 11.17
Technology OW 11.62 11.83 16.45 4.03 4.20 4.46 5.06 17.75 1.30 8% 18.56 19.43 1.68 9% 20.76
Near-Cyclicals
Energy OW $16.11 $6.81 $10.07 $2.63 $2.76 $2.88 $2.97 $11.25 $1.18 12% $11.07 $13.26 $2.01 18% $14.17
Financials OW (6.84) 4.91 13.37 3.59 4.13 4.21 4.58 16.50 3.13 23% 16.63 19.55 3.05 19% 20.89
DefensivesStaples UW $8.97 $9.20 $9.61 $2.33 $2.55 $2.62 $2.75 $10.25 $0.64 7% $10.41 $10.04 ($0.21) -2% $10.72
HealthCare N 11.10 11.17 11.77 3.06 3.08 3.06 2.99 12.20 0.43 4% 12.28 11.61 (0.59) -5% 12.40
Telecom N 2.91 2.25 2.18 0.58 0.61 0.61 0.60 2.40 0.22 10% 2.41 2.26 (0.14) -6% 2.41
Utilities UW 2.93 3.12 3.71 0.78 0.67 0.95 0.70 3.10 (0.61) -16% 3.08 2.85 (0.25) -8% 3.04
S&P 500 $61.85 $62.02 $85.52 $21.74 $23.33 $24.16 $25.22 $94.45 $8.93 10% $95.88 $102.00 $7.55 8% $108.97
S&P ex-Fin 68.69 57.11 72.15 18.15 19.20 19.95 20.65 77.95 5.80 8% 79.25 82.45 4.50 6% 88.08
Cyclicals $26.67 $24.56 $34.81 $8.77 $9.52 $9.82 $10.64 $38.75 $3.94 11% $40.00 $42.43 $3.68 10% $45.34
Defensives $25.91 $25.73 $27.27 $6.75 $6.91 $7.25 $7.04 $27.95 $0.68 2% $28.18 $26.75 ($1.20) -4% $28.58 Source: J.P. Morgan and FactSet.
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North America Equity Research10 December 2010
Thomas J Lee, CFA(1-212) [email protected]
STAGING: Using Prior Bull Markets to Pick Groups Today
We have derived substantial insight with staging markets which is the basis for our
Circle of Life analysis, and we decided to further enhance this analysis by stagingprior bull markets across time. We also did similar work in our Guide to Stock
Bottoms Part I and Part II.
The idea here is that industry groups generally gain favor over time as a bull market
progresses, reflecting the combination of fundamental developments (earnings
power, employment, etc.) against changes in market behavior (valuation sensitivity
or M&A, etc.).
One can visually see such prior shifting of leadership in Figure 22 below indicating
the shifts in the composition of the top quartile of groups as bull markets aged:
Note, for instance, that in the Year -1 period (prior to market bottom), the leaderswere mostly Defensives (personal products, food, etc.).
But moving through Year 2 (now), leadership in the past has shifted more heavilyto Cyclicals.
Certainly this is the case today and we have compiled some analysis in thefollowing section discussing this.
Figure 22: Top Quartile Industry Groups as Bull Markets Aged
All bull markets since '74. Top quartile identified in DARK GREEN based on 6-month relative performanceAverage '74 to '02 YEAR -1 YEAR 1 YEAR 2 YEAR 3 YEAR 4
Date
Months into Bull market -11 -9 -7 -5 -3 -1 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49
S&P 500 % chg next 6-months (r (1) 3 (9) (16 ) (12 ) 5 19 17 11 7 7 9 8 6 1 3 3 6 5 2 1 (1) 3 7 8 7 8 7 4 4 7
Personal products 6 10 9 7 3 5 0 -2 -5 -4 1 2 5 0 2 1 1 -1 -1 0 -2 3 3 6 1 3 3 3 3 2 -1
Health Care Eq &Svcs 7 6 5 8 5 10 -1 -1 -4 -4 0 -4 -4 -7 -2 1 -4 -3 -2 5 5 7 6 10 1 4 2 7 0 -2 -4
Food & Beverages 6 9 8 8 2 4 -4 0 -3 0 3 3 3 1 3 3 -1 -1 -1 3 3 6 3 2 -1 5 5 9 2 0 -4
Homebuilders 6 10 9 7 3 5 0 -2 -5 -4 1 2 5 0 2 1 1 -1 -1 0 -2 3 3 6 1 3 3 3 3 2 -1
Biotech 18 0 8 7 18 32 28 31 18 15 -2 -10 -5 -8 -3 3 1 -12 0 6 25 23 32 44 20 33 24 19 -4 -18 -10
Pharma 4 6 5 6 5 6 -2 -4 -6 -3 -1 -2 -4 -6 -1 -3 -9 -12 -4 2 4 2 1 3 0 7 9 12 4 0 -5
Software 9 4 -3 -3 -1 8 16 7 5 3 7 2 -5 -9 -5 -1 4 -2 1 -5 -2 2 11 14 6 4 9 11 13 6 7
PC 5 3 0 -2 0 10 2 1 -6 3 1 1 -5 -6 -9 -8 -4 2 2 -3 -7 0 8 12 0 -7 -6 -2 4 3 6
Semis 12 8 -4 -9 -8 7 35 19 7 2 7 16 0 -4 -13 -3 7 9 4 -4 -2 -1 4 14 6 0 -7 -6 1 3 16
Telco Eq 3 4 0 -5 -8 -1 14 9 4 2 8 12 7 6 -2 3 5 9 11 4 2 0 -1 9 7 10 2 2 6 2 5
Chemicals 3 6 2 1 -1 -3 2 3 7 -2 4 2 4 -3 -5 -4 -3 -2 -1 -4 -5 -4 1 2 6 4 4 -2 1 3 8
Metals, Paper and Gold 3 -1 -1 -3 -1 -1 6 3 6 -1 2 3 6 1 -6 -4 -3 -1 -1 -3 -7 -5 1 3 7 2 5 -4 3 2 11
Asset Mgrs, Cons. Fin, etc -12 -15 -8 -10 10 41 62 42 21 14 3 6 -3 4 -13 0 2 6 0 -4 1 0 4 1 5 16 13 9 4 5 0 1
Banks 0 -4 -4 -6 1 4 7 6 4 2 -4 0 3 4 0 -4 0 3 3 1 -2 -2 0 4 9 10 7 1 -3 -4 -3
Construction Materials 2 5 -2 -5 -6 4 13 14 5 1 -1 2 5 1 0 -3 6 6 5 0 -2 0 1 6 5 3 0 -8 -5 -4 7
Auto &Auto Parts 2 7 0 -4 -8 -4 0 3 3 3 7 4 7 1 -3 -6 -1 2 1 -3 -5 -4 -5 -5 2 -2 -3 -10 -4 0 9
Hotels -5 -10 -11 -13 -7 11 24 24 11 14 8 10 12 19 8 1 5 3 10 7 2 -1 6 17 10 6 15 9 6 5 16
Gaming 23 31 20 1 -1 6 15 25 37 23 9 2 6 3 1 7 17 17 18 15 12 2 9 18 29 32 56 29 9 2 13
Insurance -4 -4 -3 -3 1 3 2 -2 0 -1 -2 2 2 1 2 6 6 4 3 4 5 5 4 4 2 2 0 0 0 0 -1
REITs -5 2 -2 -11 -9 1 17 16 0 1 8 8 1 -5 -3 3 5 -1 -5 0 1 4 1 17 15 14 6 1 -2 -3 1
Restaurants 4 11 1 -1 -7 -1 4 6 5 3 6 13 10 1 -2 5 8 5 -2 -3 5 6 8 8 6 8 2 2 0 0 -2
Telecom -7 -8 -3 6 8 4 -11 -12 -8 -4 -2 -1 3 1 7 7 8 3 0 1 4 0 -4 -6 -3 -1 -3 1 1 2 -5
Oil &Gas 1 -1 4 2 4 -7 -5 -6 -3 1 -6 -6 -3 5 8 6 3 3 3 7 7 3 -3 -8 -6 -7 -2 -3 2 0 6
E&P 3 -2 2 -6 -1 -8 0 -9 -4 -2 -6 -7 -7 4 8 11 3 -1 2 8 9 1 -4 -9 -7 -3 -2 -4 -7 -4 6
Utes -7 -8 -1 3 6 -2 -10 -7 -4 1 -2 -2 -4 -2 2 4 7 5 3 5 7 4 -3 -9 -8 -4 -5 2 0 1 -3
Retail 8 13 2 -2 -6 6 16 19 13 7 1 -3 -4 -5 -2 1 5 3 -1 -4 -3 1 2 9 4 4 0 0 -4 -4 -5
Transports 3 -1 -3 -4 -1 -1 2 -2 -1 -1 4 3 0 -1 0 1 2 3 7 1 2 1 6 5 7 2 1 -5 -2 0 2
Airlines 1 6 -3 -7 -9 3 9 6 3 -5 0 3 1 6 -2 -5 -10 -5 7 2 -3 -1 8 6 4 0 0 -3 2 0 0
Industrials 0 0 -1 -3 -3 -1 3 3 2 -1 0 1 2 2 0 0 1 1 5 2 0 -2 0 2 5 3 2 -3 -2 0 2
Media 0 -2 -1 -1 -3 2 3 6 -2 -7 -2 -2 1 -6 -5 -5 -3 -4 -3 -6 -2 -2 -1 -5 -3 3 6 3 1 1 2 Source: J.P. Morgan and Datastream.
1. Prior tomarketbottom,Defensivesled
2. But as bullmarket aged,leadershipshifted to other
groups in aconsistentmanner
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North America Equity Research10 December 2010
Thomas J Lee, CFA(1-212) [email protected]
In 2010, Top-Quartile Groups Based on Staging MateriallyOutperformed...
So would staging have identified top groups in 2010?
We have compiled the data in Figure 23 below. We took the 30 largest industry
groups in the S&P 500 (weights of at least 2%) and stratified them by quartile based
on their historical outperformance in Year 2 of a bull market (roughly 2010).
The implied returns are those with the dashed lines around the columns. Forinstance, the top quartile (8 groups) would be expected to outperform by 650bp
(see Figure 24) based on their behavior during bull markets since 74.
The blue column shows the actual outperformance for each of these quartiles. Asnoted, the top quartile outperformed the S&P 500 by 1,030bp this year.
By contrast, the worst quartile underperformed by 400bp.
Overall, in 2010, each group performed roughly in line with expected performance
suggested by historical bull markets. In other words, interestingly, the market this
year has acted in very textbook manner.
Figure 23: Suggested Top Quartile (Based on Staging) Outperformed in 2010
% change relative to S&P 500
6.5
2.70.2
-2.2
10.3
3.9 3.8
-4.0
Quartile 1 Quartile 2 Quartile 3 Quartile 4
Relativeperf.vsS&P500
Predicted 2010 Actual 2010
Source: J.P. Morgan and Datastream.
To give some context on those groups, we have detailed these in Figure 24 below.
For instance, historical staging suggests that Consumer Cyclicals (Auto Parts,
Restaurants, Hotels, Gaming) should have led in 2010 and, as the actual shows
these sectors indeed outperformed.
The top 8 groups expected toperform well based on resultsin past bull markets did infact outperform by 1,030bp in
2010
The bottom 8 groupsunderperformed by400bp
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North America Equity Research10 December 2010
Thomas J Lee, CFA(1-212) [email protected]
Figure 24: 2010 Comparative Performance: What History Would Suggest vs. What Happened
% change (next 6 months)
Good =Top quartile2010 stylized Actual 2010
(based on all bull markets since '73) 1H performance Bad = Bottom quartile
1H10 1H10 Comment
Asset Mgrs, Cons. Fin, etc Asset Mgrs, Cons. Fin, etc Financials did not stand out in 1H as
Banks Banks expected. Although history said REITs
Insurance Insurance should have been top quartile
REITs REITs
Chemicals Chemicals
Metals, Paper and Gold Metals, Paper and Gold Chemicals as expect but Metals better
Oil & Gas Oil & Gas Energy did badly in 1H10 as expected
E&P E&P
Semis Semis
Telco Eq Telco Eq
Construction Materials Construction Materials Corporate-capex plays were as expected
Transports Transports but Airlines rather than Transports outperform
Airlines Airlines in 1H10
Industrials Industrials
Software Software
PC PC
Auto & Auto Parts Auto & Auto Parts
Homebuilders Homebuilders
Restaurants Restaurants Consumer Cyclicals performed like
Retail Retail clockwork.
Hotels Hotels
Gaming Gaming
Media Media
Health Care Eq & Svcs Health Care Eq & Svcs
Biotech Biotech
Pharma Pharma Defensives did poorly as history suggested
Food & Beverages Food & Beverages framework in a near text-book format
Personal products Personal products
Telecom Telecom
Utes Utes Source: J.P. Morgan and Datastream.
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North America Equity Research10 December 2010
Thomas J Lee, CFA(1-212) [email protected]
Analysis: How Do We Stage?
To do our staging analysis, we took multiple steps:
1. First, we examined the five bull markets since 1974 and looked at rolling six-month performance each month from Year -1 to Year +4, or six months in total.
2. Second, we identified the 30 largest industry groups (with at least a 2%weighting) and looked at the relative performance of each of these groups (vs.
S&P 500).
3. Third, we aggregated the performance of each of these groups to establish acomposite performance ranking at each point in the bull market.
4. Using quartiles identified, we now can determine at each month in the life cycleof a bull market what groups outperformed and underperformed.
We then stylized this information by indicating when a particular industry group
started outperforming (labeled Buy) and underperforming (labeled Sell) (see
Figure 26 and Figure 27).
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Thomas J Lee, CFA(1-212) [email protected]
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North America Equity Research10 December 2010
Thomas J Lee, CFA(1-212) [email protected]
Staging in 2011: The Year in 3 Phases
Historical analysis suggests that we should see substantial shifts in industry
leadership in 2011. Based on all bull markets since 1974 (5 in total), the groups
expected to outperform (top quartile) are shaded in Green below in Figure 25 and the
groups expected to underperform are italicized (bottom quartile).
Basically, in the first third of 2011, Consumer Cyclicals along with Insurance andAsset Managers are expected to lead.
As we move into the second third, enterprise/infrastructure Cyclicals should lead.
And by the final third of the year, there is likely to be a more pronounced shiftinto Defensives (Biotech, etc.)
Utilities, Insurance, and Gaming are expected to outperform consistently during
each phase of 2011. We will monitor this in our Circle of Life reports.
Figure 25: Groups Expected to Outperform in 2011 Based on Historical Staging
Top quartile is shaded green; Bottom quartile in italics and red
2011 stylized (based on all bull markets since '73)
1st third (~month 22) 2nd third (~month 26) 3rd third (~month 30)
Credit Sensitive Asset Mgrs, Cons. Fin, etc Asset Mgrs, Cons. Fin, etc Asset Mgrs, Cons. Fin, etc
Banks Banks Banks
Insurance Insurance Insurance
REITs REITs REITs
Resource & Chemicals Chemicals Chemicals
Commodity Metals, Paper and Gold Metals, Paper and Gold Metals, Paper and Gold
Producers Oil & Gas Oil & Gas Oil & Gas
E&P E&P E&P
Corporate Semis Semis Semis
Capex & Telco Eq Telco Eq Telco Eq
Infrastructure Construction Materials Construction Materials Construction Materials
Plays Transports Transports Transports
Airlines Airlines Airlines
Industrials Industrials Industrials
Software Software Software
PC PC PC
Auto & Auto Parts Auto & Auto Parts Auto & Auto Parts
Consumer Homebuilders Homebuilders Homebuilders
Cyclicals Restaurants Restaurants Restaurants
Retail Retail RetailHotels Hotels Hotels
Gaming Gaming Gaming
Media Media Media
Defensives Health Care Eq & Svcs Health Care Eq & Svcs Health Care Eq & Svcs
Biotech Biotech Biotech
Pharma Pharma Pharma
Food & Beverages Food & Beverages Food & Beverages
Personal products Personal products Personal products
Telecom Telecom Telecom
Utes Utes Utes Source: J.P. Morgan and Datastream.
1. Consumer Cyclicalsexpected to outperform inearly 2011, along withFinancials
2. Leadership isexpected to shift towardEnterprise/Capex Sensitives.It makes sense that domesticcyclicals would be expectedto gain
3. Defensives expected togain in the final thirdof 2011
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North America Equity Research10 December 2010
Thomas J Lee, CFA(1-212) [email protected]
Stylized Sorting of Group Outperformance
We present the above analysis in a different format below, in which we show a
sequential ordering of groups based on their historical relative outperformance ateach point in a bull market cycle.
Figure 26: Historical Staging Stylized Timing of Group Outperformance (Buy Indicates Start of Outperformance)***
Based on Top Quartile performance at each month of bull market
Average '74 to '02 YEAR -1 YEAR 1 YEAR 2 YEAR 3 YEAR 4
Date
Months into Bull market -11 -9 -7 -5 -3 -1 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49
S&P 500 % chg next 6-months (rolling) (1) 3 (9) (16) (12) 5 19 17 11 7 7 9 8 6 1 3 3 6 5 2 1 (1) 3 7 8 7 8 7 4 4 7
Auto & Auto Parts BUY
Telecom BUY BUY
Oil & Gas BUY BUY BUY
E&P BUY BU
Utes BUY
Gaming BUY BUY
Hotels BUY BUY
Insurance BUY
Asset Mgrs, Cons. Fin, etc BUY BUY BUY
Banks BUY BUY BUY
Construction Materials BUY BUY
Transports BUY BUY
Health Care Eq & Svcs BUY BUY
Food & Beverages BUY BUY BUY BUY
Restaurants BUY BUY
Biotech BUY BUY
REITs BUY BUY
Retail BUY BUY BUY BUY
Software BUY BUY
Airlines BUY BUY BUY
Industrials BUY BUY BUY
PC BUY BUY BUY
Personal products BUY BUY BUY
Homebuilders BUY BUY BUY
Semis BUY BUY BUY BUY
Telco Eq BUY BUY BUY BUY
Chemicals BUY BUY BUY
Metals, Paper and Gold BUY BUY
Pharma BUY BUY
Media BUY BUY
Source: J.P. Morgan and Datastream.
*** Buy only indicates period in which specific group started to outperform in past bull markets, and does not indicate a J.P. Morgan Strategy sector rating or recommendation. For J.P. Morgan
Strategy sector ratings and analysis, please see 2011 Sector Outlook starting on page 43 of this report.
2011
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Stylized Sorting of Group Underperformance
We present the above analysis in a different format below. We show a sequential
ordering of groups based on their historical relative UNDERperformance at eachpoint in the bull market cycle.
Figure 27: Historical Staging Stylized Timing of Group Underperformance (Sell Indicates Start of Underperformance)***
Based on Bottom Quartile performance at each month of bull market
Average '74 to '02 YEAR -1 YEAR 1 YEAR 2 YEAR 3 YEAR 4
Date
Months into Bull market -11 -9 -7 -5 -3 -1 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49
S&P 500 % chg next 6-months (rolling) (1) 3 (9) (16) (12) 5 19 17 11 7 7 9 8 6 1 3 3 6 5 2 1 (1) 3 7 8 7 8 7 4 4 7
Pharma SEL SEL
Health Care Eq & Svcs SEL SEL
Media SEL SEL
Biotech SEL SELL SEL
PC SELL SEL
Software SEL
Semis SELL SEL SEL
Chemicals SELL
Metals, Paper and Gold SELL
Auto & Auto Parts SELL SELL
Hotels SEL SELL
Telecom SEL SEL SEL
Oil & Gas SEL SEL
E&P SELL SEL
Utes SEL SEL SEL
Insurance SEL SEL
Airlines SELL SELL SELL SEL
Construction Materials SEL SELL
Transports SELL SELL
Banks SEL SEL SELL SELL SEL
REITs SEL SEL
Retail SELL SEL
Gaming
Asset Mgrs, Cons. Fin, etc SEL SEL
Food & Beverages SEL SEL SEL
Restaurants SELL SEL
Industrials SELL SELL
Personal products SEL
Homebuilders SEL
Telco Eq SELL
Source: J.P. Morgan and Datastream.
*** Sell only indicates period in which specific group started to underperform in past bull markets, and does not indicate a J.P. Morgan Strategy sector rating or recommendation. For J.P. Morgan
Strategy sector ratings and analysis, please see 2011 Sector Outlook starting on page 43 of this report.
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STOCKS: 18 Names for 1st Third of 2011
We decided to compile a list of ideas for the first third of 2011, based on our staging
conceptthat is, identify a group of stocks that is expected to outperform in the first
few months of 2011. Again, one of the changes in our thinking about 2011 is that we
believe there could be greater sector rotation than in past years. The criteria we used
are as follows:
In top quartile of industries for 2011, namely: Asset Managers, ConsumerFinance, Insurance, Construction Materials, Restaurants, Retail, Gaming,Telecom, and Utilities;
Style factor of High-Beta, as this style looks attractive on institutional ownershipand relatively cheaper vs. long-term valuations;
Upside implied by J.P. Morgan target price is at least 10%; and
Rated Overweight by J.P. Morgan.
The list of 18 stocks is shown in Figure 28 below. These stocks have an average P/E
(2011E) of only 13.4x and average implied upside of 21% to J.P. Morgan target
prices.
Figure 28: 18 Ideas Expected to Outperform in Early 2011
$ millions
JPM Coverage Sentiment EPS and Valuation
Name Sub-Industry Ticker
Current
Price
Market
Cap Beta
JPM
Rtg JPM Analyst
Target
Price
Implied
Upside
FC Mean
Rating
(1=buy,
5=sell)
Short
Int % of
Float
2011E
EPS
P/E
('11E) P/B1 Office Depot Inc. Specialty Stores ODP $5.03 $1,394 3.30 OW Horvers Christ $8.00 59% 2.90 6.7% $0.07 68.9x 1.72x
2 Och-Ziff Capital Management Asset Management & Custody BankOZM $14.12 $1,281 2.00 OW Worthington K $19.00 35% 1.90 5.7% $1.39 10.1x
3 INVESCO Ltd. Asset Management & Custody Bank IVZ $23.08 $10,664 1.75 OW Worthington K $30.50 32% 2.20 2.3% $1.71 13.5x 1.31x
4 Allstate Corp. Property & Casualty Insurance ALL $30.48 $16,404 1.49 OW Heimermann $40.00 31% 2.20 1.3% $3.88 7.9x 0.85x
5 NII Holdings Inc. Wireless Telecommunication Servic NIHD $41.34 $6,998 2.03 OW Baggio Andre $51.00 23% 1.90 3.1% $2.64 15.7x 2.21x
6 OfficeMax Inc. Specialty Stores OMX $18.07 $1,536 2.83 OW Horvers Christ $22.00 22% 2.20 10.2% $1.07 16.9x 2.85x
7 Owens Corning Building Products OC $28.77 $3,586 8.50 OW Rehaut Michae $34.50 20% 1.90 8.9% $2.16 13.3x 0.94x
8 Las Vegas Sands Corp. Casinos & Gaming LVS $46.04 $31,525 4.09 OW Greff Joseph $55.00 19% 2.00 10.5% $1.69 27.2x 5.18x
9 Limited Brands Inc. Apparel Retail LTD $31.10 $10,031 1.69 OW Tunick Brian $37.00 19% 2.40 3.0% $2.20 14.1x 4.89x
10 Men's Wearhouse Inc. Apparel Retail MW $23.65 $1,246 1.74 OW Tunick Brian $28.00 18% 2.20 9.5% $1.64 14.4x 1.26x
11 AFLAC Inc. Life & Health Insurance AFL $54.92 $25,882 1.75 OW Bhullar Jimmy $65.00 18% 2.10 1.2% $6.18 8.9x 2.32x
12 Group 1 Automotive Inc. Automotive Retail GPI $39.76 $943 1.76 OW Patel Himansh $46.00 16% 2.10 22.7% $3.22 12.3x 1.22x
13 Franklin Resources Inc. Asset Management & Custody BankBEN $118.92 $26,637 1.50 OW Worthington K $136.00 14% 2.20 1.8% $7.81 15.2x 3.45x
14 Pinnacle Entertainment Inc. Casinos & Gaming PNK $14.00 $860 1.94 OW Greff Joseph $16.00 14% 2.00 10.7% $0.17 83.3x 1.67x
15 Hartford Financial Services GrMulti-line Insurance HIG $25.00 $11,114 3.03 OW Bhullar Jimmy $28.00 12% 2.60 4.7% $3.68 6.8x 0.55x
16 Macy's Inc. Department Stores M $25.49 $10,794 1.82 OW Grom Charles $28.00 10% 2.00 4.3% $2.24 11.4x 2.20x
17 MetLife Inc. Life & Health Insurance MET $42.79 $42,159 1.80 OW Bhullar Jimmy $47.00 10% 1.80 2.2% $5.04 8.5x 0.84x
18 American Express Co. Consumer Finance AXP $45.63 $54,928 1.99 OW Shane Richard $50.00 10% 2.00 1.3% $3.75 12.2x 3.45x
Average 2.50 21% 2.14 6.1% 13.4x 1.72x Source: J.P. Morgan and FactSet.
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Special: Still See Housing Bottom in 2011
We still believe US housing markets are likely to see a bottom in mid-2011 (see
Positive on housing food chain dated 4/9/2010) sustained by household formation,
recovery in employment, tightening markets for housing (vacancy rates), and
gradually easing credit conditions.
A sustained recovery in housing provides upside to the GDP outlook. Eachincrement of 500k home starts (from the current 519k) adds 1.5% to GDP growth
and about 2mm jobs.
Thus, if US housing indeed starts to see a recovery in starts, this would addsubstantially to the upside potential for GDP forecasts.
Of course, there is an animal spirits element to the recovery in housing. After all,purchasing a home requires the buyer to accept a large liability and, thus,
expectations of future home prices are key. If one expects rising home prices, one
consequently has an incentive to acquire the liability.
Demand Forecast to Improve in 2011 Leading to GradualRise in Prices
Foremost, demand for housing is forecast to recover. Economists broadly see home
sales rising in 2011 (see Figure 29) with some variance between a 2% and 18% rise
in demand for existing homes (EHS). The drivers for this are noted above.
The gradual improvement in demand (existing homes, not new homes) should
stabilize home prices. The J.P. Morgan Securitized Products Group HPA (homeprice) forecasts are shown below in Figure 30. The relevant one is the Base
case and they see flat home prices in 2011 followed by gradual rises going
forward.
Figure 29: Economists Predict a Recovery in Housing Demand
From 2011 Global Housing Outlook by John Sim
Source: J.P. Morgan. From Home Price Monitor: 2011 Outlook by John Sim dated 11/24/2010.
Figure 30: J.P. Morgan SPG Sees Home Prices Flat in 2011
From 2011 Global Housing Outlook by John Sim
Source: J.P. Morgan. From Home Price Monitor: 2011 Outlook by John Sim dated
11/24/2010.
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Improvement in Employment Should Boost HouseholdFormation1.5mm in 2011 and 1.6mm in 2012
Equally important is a recovery in the labor markets. J.P. Morgan economists see the
US adding 175k per month in payrolls, a major step up from the 100k seen in 2010.
Historically, this bodes well for household formation. One can see below in Figure
31 that household formation varies with labor market conditions. Specifically, it has
plunged during recessions before recovering.
The pace of that recovery is illustrated in Figure 32 on the right. As one can see,Housing formed per net adult change meaningful accelerates as labor market
conditions improve. The result is that by Year +2 and +3 (which equates to 2011
and 2012), this ratio would be expect to rise from a low of 0.19 to 0.7 and this
implies a meaningful step up in demand.
For 2011 and 2012, moving to the average ratio of 0.7 times 2.6mm net new
adults implies 1.9mm-plus formed.
Figure 31: Household Formation vs. Employment Growth
Jobs and Households formed per net adult chg
0.160.22
0.16
0.470.27
0.540.42
0.10
0.30
0.50
0.70
0.90
1.10
1.30
1/59 1/63 1/67 1/71 1/75 1/79 1/83 1/87 1/91 1/95 1/99 1/03 1/07 1/11 1/15
H
H
form
ation
perN
etA
dultChg
(6,000)
(4,000)
(2,000)
0
2,000
4,000
Increase
in
Nonfarm
Payrolls
Recession Increase in Nonfarm Payrolls HHFormation per Net Adult chg
Source: J.P. Morgan and Bloomberg.
Figure 32: Following Labor Trough, HH FormationAccelerates
Jobs and Households formed per net adult chg
From trough HH Formed/ Net Adult chg
Year of Trough
in Ratio 0 1 2 3 4
1962 0.27 0.69 0.92 1.24 0.54 0.
1966 0.54 0.71 0.82 0.53 0.54 0.
1974 0.47 0.60 0.47 0.65 0.43 1.
1982 0.16 0.50 0.70 0.69 0.48 0.
1989 0.22 0.44 0.63 0.36 0.41 1.
1995 0.42 0.67 0.84 0.67 0.55 0.
b Avg All Years 0.35 0.60 0.73 0.69 0.49 0.2009 (today) 0.19 0.38
Implied HHs formed 2011e 2012e 2013e 20
a Incr. Adults 2.6mm 2.6mm 2.6mm 2.6m
b HH/adult (see above) 0.73 0.69 0.49 0.
a*b Implied HHs Formed 1.9mm 1.8mm 1.3mm 2.2m
Source: J.P. Morgan and Bloomberg.
Shadow Inventory Is Peaking
The J.P. Morgan Securitized Product Research (or SPG) team sees shadow inventory
of homes (homes delinquent, plus foreclosure plus REO) as peaking and gradually
dipping going forward (see Figure 33). But as has been apparent in the past fewyears, the pace at which these homes are liquidated plays a big role in home price
movements.
Their base case is for foreclosure liquidations to rise to 2.5mm in 2011 assuminga foreclosure rate of 10% and foreclosures becoming REO (real estate owned,
homes owned by banks) staying at roughly 3.5-4.0%.
In our view, a decline in shadow inventory sets the stage for home prices togradually bottom and that is the forecast of our SPG team which expects home
prices to bottom in 2011 before gradually rising.
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Figure 33: Shadow Inventory Is Peaking
Shadow is all delinquent, foreclosure, and REO loans (millions)
Source: J.P. Morgan. Loan Performance, MBA, and the 2011 Securitized ProductOutlook by Ed Reardon, John Sim, and team.
Figure 34: Liquidations of Foreclosures Are Peaking
Millions
Source: J.P. Morgan. From 2011 Securitized Product Outlook by Ed Reardon, John Sim,
and team.
Vacancy Rates of Housing Are Falling, While ApartmentRents Are Rising
Vacancy rates for both housing and rental use in the meantime are falling
meaningfully. In fact, we believe rental vacancy rates at 10.3% are essentially back
to equilibrium levels seen in the 2003-2004 period (see Figure 36).
But vacancy rates for US housing are still somewhat elevated at 2.5%. A tightermarket would see vacancy rates below 2%. The key for reducing vacancy rates
for US housing is the need for household formation (see above). Again, we see
that accelerating in 2011. The pushback is that one might say more households may become renters. This is
possible, but the issue, in our view, is the limited rental stock available.
Figure 35: Housing Vacancy Rates Are Declining
%
Source: Bloomberg.
Figure 36: Housing Vacancy Rates Are Declining
%
Source: Bloomberg.
Still high
Equilibrium
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Record Affordability, But Credit Needs to Ease
In the meantime, affordability of housing has improved greatly according to our SPG
team. As shown in Figure 37 below, given the combination of falling home price andlower interest rates, payments on a 30-year fixed-rate mortgage today are lower than
those using non-traditional lending products to purchase a home in 2006 and 2008. In
fact, compared to 2008, mortgage payments are 50% lower.
The movement in mortgage payments is illustrated in Figure 38 below whichshows that conforming mortgages (30-year fixed) have a lower payment now
than would ARMs originated in 2004 and prior. In other words, affordability is
very strong.
Figure 37: Affordability Is Better Today than During AnyBoom Time...
Forecasted payments
Source: J.P. Morgan. Loan Performance, MBA, and the 2011 Securitized
Product Outlook by Ed Reardon, John Sim, and team.
Figure 38: Conforming Loans Cheaper Than Option-ARMs of 5 Years Ago
Payment on a given mortgage product
Source: J.P. Morgan. Loan Performance, MBA, and the 2011 Securitized Product Outlook by Ed Reardon,
John Sim, and team. Assumes a $500K home in June 06, with Case-Shiller home price increases/declinesbefore and after. LTV ramps up from 70% to 80% during the boom and then back to 70%. Option ARM
assumes a minimum 1.5% teaser payment.
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Risk: P/E VolatilityExpect Higher Interest Rate and Dollar Volatility
Higher volatility in interest rates and the dollar should be all but certain in 2011, with
the resulting implication being higher P/E volatility (see Figure 39 and Figure 40).
The drivers of this are the combination of Fed monetary easing cycle (QE) against
the backdrop of rising sovereign debt sustainability (EU mostly) and diverging
cyclical momentum:
It should be no surprise that QE coupled with mounting sovereign debtsustainability questions are raising the volatility of interest rates. Similarly, given
the diverging global economic momentum (EM vs. developed), the Feds latest
easing cycle is driving debate about dollar intervention and competitive
devaluation.
Figure 39: Interest Volatility High...
Delivered volatility since 2005
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
1/05 7/05 1/06 7/06 1/07 7/07 1/08 7/08 1/09 7/09 1/10 7/10
DeliveredVolatility
5yr Avg +/- 1std dev
10yr Treasury Delivered Volatility (20Davg)
Trailing 5yr Avg
Source: J.P. Morgan and Bloomberg.
Figure 40: Dollar Volatility High...
Delivered volatility since 2005
0.0%
0.2%
0.4%
0.6%
0.8%
1.0%
1/05 7/05 1/06 7/06 1/07 7/07 1/08 7/08 1/09 7/09 1/10 7/10
DeliveredVolatility
5yr Avg +/- 1std dev DXY Delivered Volatility (20D avg)
Trailing 5yr Avg
Source: J.P. Morgan and Bloomberg.
Higher interest rate and dollar volatility naturally produce higher P/E volNaturally, with higher interest rate and dollar volatility, we should expect higher P/E
volatility. Historical analysis indicates this has been the case (with 90% correlation).
Figure 41: High Rate Volatility Indicates Higher P/E Volatility
Delivered volatility since 1967
y = 0.3596x + 0.1101R2 = 0.9181
(0.60)
(0.40)
(0.20)
0.00
0.20
0.40
0.60
0.80
1.001.20
1.40
(2.00) (1.00) 0.00 1.00 2.00 3.00
10yr Treasury Yield Volatility # std dev from 5yr avg
P/E(NTM)Volatility#stddevfrom5yr
avg
Source: J.P. Morgan and Bloomberg.
Figure 42: Higher FX Volatility Indicates Higher P/E Volatility
Delivered volatility since 1976
y = 0.3058x + 0.0765
R2 = 0.9616
(0.60)
(0.40)
(0.20)
0.00
0.20
0.40
0.60
0.80
1.00
(1.60) (1.10) (0.60) (0.10) 0.40 0.90 1.40 1.90 2.40
DXY Volatility # std dev from 5yr avg
P/E(NTM)Volatility#stddevfrom5yr
avg
Source: J.P. Morgan and Bloomberg.
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Sufficient Funds to Meet Funding Requirements of Irelandand Portugal, and Spain, if Needed, Until 2013
Cumulatively, funds from the EFSF (European Financial Stability Fund), the IMF,
and EU balance of payments facility can provide 565bn of loans to Euro area
sovereigns. From Figure 44, which our European Rates Strategy team put together,
we can see that the cumulative estimated funding requirements of Ireland, Portugal,
and Spain are roughly 140bn below the funding capacity. Although we do
acknowledge concerns that there have only been opaque signs of these liquidity
arrangements being extended beyond 2013, we believe that the existing supports will
be sufficient to allow fiscal consolidation to proceed in the peripheral economies,
even if it only means creating a buffer away from harsher and more difficult
decisions of fiscal transfers, debt restructuring, and fiscal reform.
Figure 44: Ireland, Portugal, and Spain Require 23bn of Funding Until End 2013
Estimated funding requirements* until 2013 for Ireland, Portugal, and Spain
Source: J.P. Morgan European Rates Strategy.
* Excludes T-bills and bank recapitalization from funding requirements. The number for Ireland includes 3bn/yr of promissory notes.
**BoP is the 60bn Extended Balance of Payments facility agreed upon by the EU. The 565bn loans consists of 250bn from the IMF,
255bn from the EFSF, and 60bn from the Balance of Payments facility.
140bn buffer
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Risk: Municipal DebtBudget Deficits
Helped by Recovery in RevenueUS public indebtedness has come under elevated scrutiny in the recent months. If
municipalities begin to make widespread cuts to balance budgets, there would be
impacts on labor and capital spending. The city/state issue is arguably less about debt
given the relatively smaller debt burdens (see below).
Ultimately, though, this is a question of timing. If this does not become an issue in
2011, the US cyclical recovery should boost tax revenues making the overall impact
in future years smaller.
State Budget Deficits Largest Yet...But Revenue Growth
Expected to Help Bridge GapFrom our discussions with our Municipal Finance team, we believe that fears of the
so-called muni crisis are exaggerated and that states and, to a lesser extent, local
governments are able to, and committed to, meet their debt obligations. Although we
expect to see state budget gaps increasing, our Municipal Finance team does not view
this as a catalyst for an increase in muni default/liquidity risk although headline risks
likely will still persist.
In our earlier reports (see Post-Midterm Equity Strategy Call dated 11/3/10), we
discussed how the new Republican-controlled US House of Representatives likely
will herald in a new wave of fiscally conservative measures, which we believe will
reduce the likelihood of ARRA funding renewal. Consequently, FY2012 budget
deficits are expected to be larger than in previous years (ARRA contribution toclosing the gap expected to decrease from $59bn to $6bn).
Figure 45: Next Years Budget Gaps Should Be the Largest Yet
Total states' budget shortfalls, $ billion
Source: J.P. Morgan Municipal Finance Credit Research. Center on Budget and Policy Priorities analysis using data from US
Department of Health and Human Services, US Department of Education, Congressional Budget Office, and state budget documents.
$33bn increase instate responsibility
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There are several reasons why our Muni team remains constructive on the space:
States are constitutionally obligated to meet their debt obligations, whichsimply means that bondholders can sue state governments in the event of adefault. That, coupled with the risk of losing access to the public markets, should
be sufficient deterrent against default. Moreover, states are also constitutionally
obliged to balance their budgets.
State revenue growth has been rebounding, and is expected to continuerecovering into 2011. The best high-frequency gauge would be the weekly initial
jobless claims which J.P. Morgan Economists predict will grind down toward
400k, from which we would expect to see an acceleration in tax receipts six
months later.
Figure 46: State Taxes Are Rebounding
YoY change in real estate and local tax revenue, %
-10%
-8%
-6%
-4%
-2%
0%
2%
4%
6%
20102009200820072006
State Local
Source: US Census Bureau, J.P. Morgan Municipal Finance Credit Research.
Figure 47: And Should Continue to Recover Alongside Initial Jobless Claims
Quarterly state tax receipt growth (%); Weekly initial jobless claims (000s)
-10%
-5%
0%
5%
2006 2007 2008 2009 2010
Statetaxreceiptgrowt
200
300
400
500
600
700
Initialjoblessclaims
State tax receipts
Initial jobless claims
Source: US Census Bureau, US Bureau of Labor Statistics, J.P. Morgan Municipal Finance Credit
Research.
Expected improvements in thelabor markets are a leadingindicator of acceleration instate tax receipts (6mo delay)
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States Have Relatively Small Debt Levels and Are DistinctlyDifferent from Other Sovereigns...
Roever and team expect debt issuance to decline as debt becomes more taboo with
the Republican influence seen to dampen the marginal propensity to borrow. But
how much of this is actually relevant to the already much less indebted states and
local governments?
For starters, munis are distinct from other sovereigns in that they have limitedrollover riskthe debt is long-term, at a fixed rate, and is amortizing.
Moreover, there is much less of it around! States and local governments only owe10% of the total US public bonded debt (Figure 48). Pension and Healthcare
obligations remain daunting but even at current levels, they are estimated to be,
on average, solvent for the next 10 years and do not pose a 2011 risk.
Interest payments for debt obligations also only make up 5-6% of state budgets.
With significant resources, especially in the light of continuous revenue growth,the willingness of states to repay is also bolstered by their continued need for
capital.
Figure 48: Magnitude of State and Local Debt Is Small Relative to Federal Debt
$ in billions
Bonded Debt % of Total Debt
Federal 8,627.7 89.2%
State 373.3 3.9%
County 111.3 1.1%
School district 326.4 3.4%
City 238.0 2.5%
Total 9,676.6 100.0%
Source: J.P. Morgan Municipal Finance Credit Research.
States and localgovernments hold only10% of the total bondeddebt
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2011 Sector Outlook
Our Strategy Sector Overweights and Underweights are explored on the following
pages, as well as some discussion of the views of each of J.P. Morgans fundamental
equity analysts. Figure 49 below summarizes the views of our analysts on the
likelihood of his/her industry outperforming the market in 2011.
For our Strategy Sector ratings, in summary, our sector ratings are as follows:
Overweight: Materials, Industrials, Discretionary, Technology, Energy,andFinancials
Neutral: Telecom and HealthCare
Underweight: Staples and Utilities
Figure 49: J.P. Morgan Fundamental Analyst Conviction Levels on Likelihood of Industry Outperforming Market in 2011
HC = High Conviction, N = Neutral, LC = Low Conviction
CYCLICALS
Materials OW Industrials OW Discretionary OW Technology OW
Gold / Bridges HC Airlines / Baker HC Gaming / Greff HC Communications Equipment / Hall HC
Platinum/Palladium / Bridges HC Business Services / Steinerman HC Lodging / Greff HC LED (Alt Energy) / Blansett HC
Metals & Mining / Gambardella HC Airfreight/Surface Transport / Wadewitz HC Global QSR (Restaurants) / Ivankoe HC IT Hardware / Moskowitz HC
Chemicals / Zekauskas HC Machinery / Duignan N Homebuilders / Rehaut HC Electronic Mfg Services / OBrien HC
Coal / Bridges N Engineering & Construction / Levine N Broadlines & Department Stores / Grom HC Software Technology / Auty HC
Environmental Services / Levine N Food / Grom HC Applied and Emerging Tech / Coster HC
Aerospace & Defense / Nadol N Hardlines / Horvers HC Computer Svcs & IT Consulting / Huang HC
Electrical Equip & Multi-Industry / Tusa N Media / Khan HC SMid Semiconductors / Sur HC
Oil Tankers / Chappell LC Autos, Auto Parts & Tires / Patel HC Software / DiFucci N
Dry Bulk / Chappell LC Advertising & Marketing Svcs / Quadrani HC Enterprise Voice Equipment / OBrien N
Casual Dining (Restaurants) / Ivankoe N Solar Alt Energy) / Blansett LC
Building Products / Rehaut N Semiconductors / Danely LC
Specialty Retail / Tunick N Electronic Components / OBrien LC
Info Svcs/Radio/TV Broadcasting / Meltz N
Education Services / Steinerman N
Internet / Khan LC
NEAR-CYCLICALS
Energy OW Financials OW
Oil Services & Equipment / Anderson HC Life Insurance / Bhullar HC
Integrated Oil & Gas / Minyard HC Asset Managers / Worthington HC
Oil & Gas E&P / Allman N Large Cap Banks / Juneja HC
Energy MLPs / Liu N REITs / Michael Mueller / Paolone HC
Credit card / Shane N
Exchanges / Worthington N
Small/Mid Cap Banks / Alexopoulos N
Non-Life Insurance / Heimermann LC
DEFENSIVES
HealthCare N Telecom N Staples UW Utilities UW
Healthcare Tech & Distribution / Gill HC Tobacco / Maile HC Unregulated Utilities / Smith HC
SMid Biotechnology / Kasimov HC HH & Personal Care Products / Faucher N Regulated Utilities / Smith N
SMid Med/Life Sciences Tech / Peterson HC Packaged Food / Bivens LC
Managed Care / Rex HC Beverages / Faucher LC
Healthcare Facilities / Rex HC
Pharmaceuticals / Schott HC
Healthcare Information Tech / Rahim HC
Biotechnology / Meacham N
Medical Tech & Devices / Weinstein LC Source: J.P. Morgan.
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North America Equity Research10 December 2010
Thomas J Lee, CFA(1-212) [email protected]
Figure 50: Sector Earnings Outlook and ValuationEarnings growth (2011) Valuation. (2012 P/E)
JPM
StrategyRating
JPM Est
EPSGrowth
Consensus
Est EPSGrowth
JPM vs.Consensus Comment
P/E(2012)
P/E (2012)
Relative toS&P 500 Comment
Cyclicals
Materials OW 18.8% 20.2% -144 bp Domestic materials like Paper, Construction
materials and Steels
15.2x 3.2x Valuatons less attractive
Industrials OW 17.2% 20.1% -295 bp Domestic cyclicals still more attractive 13.6x 1.6x Upside to P/E
Discretionary OW 10.5% 12.7% -222 bp 12.7x 0.7x Upside to P/E
Technology OW 7.9% 12.8% -491 bp See some risk to EPS growth due to Europe 12.2x 0.2x Upside to P/E
Near-Cyclicals
Energy OW 11.7% 9.9% 177 bp Above consensus due to higher Oil forecast 10.7x -1.3x See upside here
Financials OW 23.4% 24.4% -98 bp Fastest EPS growth in 2011 and largest
contributor to EPS gains
9.6x -2.4x Some P/E expansion possible
Defensives
HealthCare N 3.7% 4.3% -66 bp Weak EPS growth 11.4x -0.6x Upside to P/E as market trades higher
Telecom N 10.1% 10.5% -41 bp 16.2x 4.2x Expensive
Staples UW 6.7% 8.3% -165 bp Slower EPS 14.0x 2.0x and rel. higher valuatio
Utilities UW -16.4% -16.9% 51 bp 14.2x 2.2x P/E bit high
S&P 500 10.4% 12.1% -167 bp 12.0x Forecast P/E to reach 14x
S&P ex-Fin 8.0% 9