kostin on qe2 and outlook

8/8/2019 Kostin on QE2 and Outlook

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October 15, 2010

United States: Portfolio Strategy

US Equity Views

Updating our price targets as investors focus on 2011S&P 500 has surged 12% in the past 7 weeks. We expect themarket will rise another 2% to reach our year-end 2010 targetof 1200. We anticipate a flat return to stocks during 1Q 2011as economic recovery remains fragile. Despite QE2, firms willspend only after CEO confidence improves. Our 12-monthtarget of 1275 (up from 1250) reflects a 9% price return.

3-Month: 2% upside to 1200 based on conditional return profileImmediate near-term positives include 3Q earnings season, mid-term

Congressional elections on November 2 nd , and FOMC meeting on Nov 3 rd .Our 2% forecast return ranks in the 51th percentile of 3-month returns since1950, conditional on a trailing 1-month return in the 0% to 5% range.

6-Month: The economy is not the market and QE2 is not a panaceaMost investors we meet believe the Feds goal of reflating the economywill drive stock prices higher. QE2 should eventually stimulate economicgrowth but earnings impact will be minimal. Firms will spend cash slowlygiven spare capacity, desire to preserve margins, and low CEO confidence.

12-Month: Our DDM-based valuation suggests fair value of 1275We expect the cost of equity will decline during the course of 2011 as riskaversion recedes and investors turn to the economic prospects for 2012.

Path of the S&P 500: Our 3-month, 6-month and 12-month price targets

Source: Compustat and Goldman Sachs Global ECS Research.

David J. Kostin(212) 902-6781 [email protected] Sachs & Co.

Stuart Kaiser, CFA(212) 357-6308 [email protected] Sachs & Co.

Amanda Sneider, CFA(212) 357-9860 [email protected] Sachs & Co.

Yi Zhang(212) 357-6003 [email protected] Sachs & Co.

The Goldman Sachs Group, Inc. does and seeks to do business with companies covered in its research reports. As a result, investors should beaware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a singlefactor in making their investment decision. For Reg AC certification, see the end of the text. Other important disclosures follow the Reg ACcertification, or go to www.gs.com/research/hedge.html. Analysts employed by non-US affiliates are not registered/qualified as research analystswith FINRA in the U.S.

The Goldman Sachs Group, Inc. Goldman Sachs Global Economics, Commodities and Strategy Research

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S&P 500 Forecasts

3-Month(+2%)

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1200 1200

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October 15, 2010 United States: Portfolio Strategy

Goldman Sachs Global Economics, Commodities and Strategy Research 2

Updating our 3-month, 6-month, 12-month S&P 500 price targets

The S&P 500 has surged 12% in seven weeks and now trades at 13.4x our NTM EPSestimates, in-line with the 35-year average since 1975.

In our view, three unrelated items combined to push US share prices higher :

Septembers batch of positive macroeconomic data surprised to the upside for the firsttime in five months. The Goldman Sachs aggregate monthly US-MAP score measuringthe magnitude and relevance of economic data hit the highest level since June 2009;

Polls indicate the November 2 nd mid-term Congressional elections will likely seeRepublicans gain control of the US House of Representatives and narrow the currentDemocratic majority in the US Senate. A divided government may reduce the policyand regulatory uncertainty that many business leaders claim has hindered capitalspending decision-making; and

Comments from various Fed officials made it increasingly clear that the Fed intends toinitiate a second round of quantitative easing (QE2) following the upcoming FOMCmeeting on November 2 nd and 3 rd . Ten-year US Treasury yields have dropped 20 bp infour weeks to 2.57%. For context, yields peaked this year at 4.0% in early April.

We expect the S&P 500 will rise another 2% to reach our year-end 2010 target of 1200. We anticipate US equities will trade sideways during 1Q 2011 as economic uncertaintyremains high. Our revised 12-month price target of 1275 (from 1250) reflects a potentialprice return of 9% from current levels. The cost of equity should decline slightly as 2011progresses and investors turn their attention to the economic growth prospects for 2012.

Risks to our view include a jump in management confidence leading to acceleration incapital spending; a decision by individual investors or pension funds to re-allocate assetsfrom bonds to domestic equities; a rise in trade protectionism; a US municipal financecrisis, another European sovereign credit market dislocation, and a protracted economicslowdown in emerging markets generally and China in particular.

Exhibit 1: S&P 500 EPS should near prior peak in 2011 but index level will be below Oct 07as of October 14, 2010


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5 0 0 E P

S S & P 5 0 0 P r i c e

S&P 500Price

S&P 500EPS

24-Mar-00Peak = 1527

09-Oct-07New Peak = 1565

Sep-00Peak EPS = $57

Mar-04New Peak EPS

2011 EPSnear

prior peak

Jun-07Peak EPS = $91

Goldman SachsForecasts

$89

1200

Year-end2010

09-Mar-09Low = 678

1275 12-moTarget

Current

SPX1160

6 mo


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Maintaining our 2010 year-end price target of 1200

Our interim price forecasts reflect our view of the likely path toward our 12-monthDDM-based estimate of fair value for the S&P 500. Our three- month target is the mostmarket-driven of our price targets.

We maintain our year-end 2010 target of 1200, reflecting a 2% expected return overthe next three months. Options currently imply a 46% probability the S&P 500 will reachour 3-month target, suggesting we are more bullish about a recovery than marketexpectations. A 3-month return of 2% would rank in the 51 th percentile of 3-month returnssince 1950, conditional on a trailing 1-month return in the 0% to 5% range that we have justexperienced.

Exhibit 2: Distribution of 3-month S&P 500 returns implied by options market, as of October 14, 2010

Source: Goldman Sachs Research Estimates and Goldman Sachs Global ECS Research.

Exhibit 3: Distribution of S&P 500 forward 3-month returns conditional on trailing 1-month returns since 1950


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3-Month Returns

Distribution of 3-month S&P 500

returns implied by options market

Goldman Sachs3-Month Forecast: +2%

Option impliedprobability: 46%

Distribution of Following 3-Month Returns

(15)% to (10)% to (5)% to 0% to 5% to 10% to< (15)% (10)% (5)% 0% 5% 10% 15% > 15%

< (15)% 3 % 10 % 10 % 15 % 30 % 13 % 3 % 16 %

(15)% to (10)% 5 4 7 17 18 21 14 15

(10)% to (5)% 5 7 9 17 27 20 10 6

(5)% to 0% 2 3 8 22 31 22 8 3

0% to 5% 1 3 9 22 33 23 7 2

5% to 10% 2 4 9 20 27 26 11 2

10% to 15% 0 2 6 26 26 24 16 2

> 15% 0 0 11 5 30 16 30 8 T r a

i l i n g

1 - M o n t h

R e t u r n s


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Three topics will drive US equities over the next several months1. Earnings season (October 18th-November 5 th ). The crescendo of quarterly reportingseason is upon us and 395 companies in the S&P 500 (78% of the equity cap) will report 3Qearnings results in the next three weeks (Oct 18 th to Nov 5 th ). As we discussed in ourOctober 8 th report, 3Q 2010 Earnings season preview: We expect positive EPS surprises ,current bottom-up consensus expects 3Q earnings to be below 2Q actual results for theoverall S&P 500 and for six of the 10 sectors (see Exhibit 4).

US economic activity during 3Q was positive, albeit below trend, making it unlikelythat S&P 500 earnings will decline sequentially from 2Q to 3Q. Current consensusexpects 3Q 2010 revenues (ex Financials and Utilities) will rise by 6% year/year while EPSfor the same cohort of companies increases by 19% (30% for the entire S&P 500 includingFinancials and Utilities) (see Exhibit 5).

Exhibit 4: Strong 2Q EPS did not flow through to 3Qas of October 13, 2010

Source: First Call, Compustat, and Goldman Sachs Global ECS Research

Exhibit 5: S&P 500 Bottom-up consensus estimates for 3Q 2010; as of October 13, 2010

Source: Compustat, FirstCall, I/B/E/S and Goldman Sachs Global ECS Research.

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2010 S&P 500 Consensus EPS by Quarter

3QE 2010 Bottom-up Consensus

Sales Margin EPSGrowth Change Growth

$/Share yoy Level yoy $/Share yoy

Info Tech $24 14 % 16.0 % 340 bp $3.85 44 %Industrials 27 8 7.3 137 2.01 33Materials 9 8 6.7 120 0.59 32Energy 35 20 7.1 90 2.46 37Consumer Discretionary 30 3 6.1 78 1.85 18Consumer Staples 34 (0) 6.7 (8) 2.24 (1)Health Care 30 (1) 9.3 (26) 2.78 (4)Telecom Services 8 (1) 6.4 (28) 0.52 (6)Financials NM NM NM NM 3.20 195Utilities NM NM NM NM 1.04 3S&P 500 $20.53 30 %

ex. Financials and Utilities $197 6 % 8.3 % 88 bp 16.29 19


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3. Quantitative Easing (November 3 rd). The widely held consensus view of both buy- andsell-side economists is that the Fed will initiate a second round of quantitative easing (QE2)following the November 2 nd -3 rd FOMC meeting. Various estimates exist regarding thespecific size and form of the asset purchase program. Although it will probably startsmaller, our US Economics Research group believes Fed purchases of US Treasuries willcumulate to $1.0 trillion or more.

The decision to begin QE2 represents an explici t acknowledgement by the Fed that USeconomic growth remains extremely weak and unemployment is likely to remain muchhigher than its policy mandate. Given public statements by Fed officials that inflation isalso running below its target, the Feds upcoming QE2 initiative is a dramatic attempt tocreate inflationor at least inflation expectations and rouse the economy from its torpor.

Reflecting on the client meetings we have hosted during the past few weeks, mostinvestors are optimistic regarding the market impact of the Feds actions. These investorsbelieve the market will continue to rally even after the Feds announcement next month.

There is friction between macro and micro investors interpretation of the impact ofQE on equities. In the broadest terms the affirmative macro case for QE2 rests oneasier financial conditions and the goal of asset price inflation. The skeptical microview is that additional easing is an acknowledgement of the weak US growth outlookand will not drive earnings meaningfully higher in the near-term. We discuss theseviews in more detail below.

Equities and QE2: The Macro AffirmativeWe boil equity investors bull case for QE down to four points (1) the positiverelationship between easier financial conditions and equity returns; (2) reduced risk ofdouble-dip recession in 2011; (3) support for prices of long-dated assets; and (4) lowerrates making equities more attractive in relative terms.

Our Global Markets team has highlighted an easing in Financial Conditions (FCI) since earlyAugust that has been most pronounced in OECD countries, particularly the US and UK.Although the mechanics of easing may be unconventional in this case the impact shouldbe similar and include a weaker USD, reflationary pressure on equities, and lower averageglobal interest rates. Easing FCI should also help reduce the risk of another US recession,as our US Economists estimate $1 trillion of asset purchases could create a potential boostto real GDP growth of about percentage point, using historical rules of thumb.

The difference between the current case (QE2) and QE1 is that policy is more focused onlonger duration assets this time, which may mean a more direct impact on equities andforeign bonds in addition to domestic credit products. Even if the impact on equities issecond order, lower long-term interest rates should serve to increase the relativeattractiveness of equities versus credit products with the potential (albeit impossible toestimate) to motivate portfolio reallocation. Both support of long-dated asset prices and

asset allocation would argue for multiple expansion in US equities. Outside of the pointswe have highlighted, investors are also discussing the positive wealth effect from assetprice inflation, a weaker USD, and increased corporate investment.

Recent equity performance and our own analysis show that Fed security purchasesare positive for equity prices, all else equal. Our own 2011 S&P 500 earnings estimatealready reflects QE to some degree, as $1 trillion of asset purchases is an element of ourUS Economics 2011 real GDP forecast of 1.8%. Together that implies that QE2 might pushmultiples higher but would not have the real impact on the growth outlook or S&P 500earnings necessary to make equity markets attractive to incremental buyers.


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Exhibit 7: US Financial Conditions have eased furthersince July to a 5-year low

Exhibit 8: S&P earnings yield is at a large premium to 10-year Treasury bonds

Source: Goldman Sachs Global ECS Research Source: Factset, Compustat and Goldman Sachs Global ECS Research

Our rough estimate is that $1 trillion of QE2 could drive 8% to 10% of upside for USequities but that much of that move may have already occurred. Using the impact onfinancial conditions and asset prices of the first round of QE as a guide, our US Economicsteam estimates that an announcement of $1 trillion of QE2 could move the S&P 500 8%higher with additional upside to 10% in the ensuing month. They believe the market begananticipating QE2 in early August in response to FOMC announcements and media reportsat the time. See US Economics Daily: QE2: How Much Has Been Priced In? October 7, 2010 https://360.gs.com/gs/portal/home/fdh/?st=1&d=9793063

As a complement to that work we analyzed the impact on weekly equity returns since 2003from weekly changes in (1) AMG mutual fund flows (including ETFs); (2) aggregate US

MAP scores; and (3) securities held on the Feds balance sheet. This framework suggests a9.5% tailwind for the S&P 500 assuming $25 billion of securities purchases per week for 40weeks ($100 billion per month or $1 trillion of total purchases) all else equal. That timeframe is likely conservative as our economists believe larger purchases over a shorter timemay have more impact. While that conclusion is quite encouraging it comes with threeimportant caveats. First, there is a great deal of uncertainty around this framework and the3 factor model has an r-square of only 0.12. Second, the S&P 500 has outperformed thisframework by 750 bp since the start of August so much of the impact may already bepriced in, consistent with our Economists work. Third, QE2 will not occur in a vacuum andwe estimate the positive impact from $25 bn of security purchases would be offset by aMAP score of -9 or $1.6 bn in AMG mutual fund outflows (all numbers weekly).

Over time we believe QE2 will be positive for US equities through reduced economicuncertainty and price support (multiple expansion and lower interest rates). However,a meaningful amount is already reflected in recent S&P 500 performance and our take oninvestor expectations. Moderately below consensus reported economic data could alsooffset security purchases.

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Exhibit 9: Since first discussion of QE2, Gold and SPX appreciated while USD depreciatedas of October 13, 2010

Source: IDC via FactSet and Goldman Sachs Global ECS Research

Equities and QE2: The Micro SkepticMicro investors skepticism regarding QE rests on four points: (1) QE2 is confirmationof a weak US real GDP growth outlook with significant downside risks; (2) rates and

credit spreads are already low, muting the impact of more easing; (3) the monetarypolicy shift will have minimal near-term impact on 2011 S&P 500 earnings growth:and (4) stock market P/E multiples are already in line with previous periods when realinterest rates were in the 1%-2% range similar to today.

As detailed above, the QE2-driven low interest rate environment should attract buyers torisky assets (such as equities). Those interest rates if kept low enough for long enough will eventually create inflation, boost nominal GDP and increase sales (which are correlatedwith GDP). Earnings forecasts should then rise assuming there is no erosion in corporateprofit margins. The prospect that margins may also rise would represent a tailwind for EPSand could arguably lead to a P/E expansion resulting in higher share prices.

However, we believe it is important to separate the economic analysis of QE2 fromthe potential equity market impact. Our US economics research colleagues havepublished extensively on many aspects of how QE2 may work. We focus below onpotential equity market implications which are clouded by low corporate and consumerconfidence and already high margins that may limit the impact of QE.

Corporations have not taken advantage of already low rates due to low confidence.QE2 will effectively penalize individuals and companies for holding cash because yieldsacross the term structure will remain extraordinarily low for an extended period of time. Atsome point companies should begin to engage in capital spending. Even if the forecastreturn from a given project is low, it most likely will exceed the yield on cash, whichcurrently hovers just above zero and will stay unchanged for an extended period. That saidrates and spreads are low now and comments from corporate managements suggest theyare holding off on hiring and capital spending due to high macro uncertainty.

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Mergers motivated by low rates are unlikely to contribute to domestic economicgrowth. Low interest rates and a receptive corporate bond issuance market have led to anuptick in both friendly and unsolicited M&A activity. Mergers certainly represent one wayfor US companies to reduce the $1.0 trillion of cash on their balance sheets (excludingFinancials). But mergers are unlikely to contribute to domestic economic growth givenmost business combinations are justified or rationalized on the basis of anticipated cost

savings. Accretion or synergy in management consultant parlance typically involves job cuts and unfortunately works at cross purposes with policymakers goal of reducing thecurrent 9.6% unemployment rate in the US.

Further upside to corporate margins may be limited given near record levels for manyindustries. Managements are reluctant to slash margins and investors have come toexpect and reward steady improvements in operating efficiency. Given that GoldmanSachs Economics forecasts 1.8% GDP growth in 2011 vs. a consensus estimate of 2.5%, wecontinue to recommend our low vs. high operating leverage trade. Our intuition is that asconsensus GDP forecasts downshift closer to our expectation then sales growth forecastswill have to be reduced accordingly. Firms with low operating leverage should be lesssusceptible to negative EPS revisions relative to companies with high operating leverage.Our preferred implementation is via our Bloomberg baskets (GSTHOPLO vs. GSTHOPHI).

QE2 is unlikely to meaningfully boost company earnings above our current forecasts. Firms may be able to borrow at historically low interest rates, but excess capacity existsacross many industries so the prospect that cheap money abounds will not necessarilyspark a new round of capital spending. While equities may benefit from reduced downsiderisk (if recession probabilities are lowered by QE) our earnings estimates alreadyincorporate some degree of QE and a percentage point increase to US real GDP growthwill not significantly change our S&P 500 earnings outlook.

If QE2 wont meaningfully boost earnings (although it should over time as GDPgrowth improves) then the transmission mechanism to higher stock prices mustcome via another route. The bullish argument that QE2 will raise the price of risky assetsrests on the notion that lower interest rates will reduce the cost of equity and applying a

lower discount rate in a DDM will raise the present value of future earnings and dividendsand thereby boost the current fair value of stocks.

Exhibit 17 shows the sensitivity of 12-month forecast fair value levels of the S&P 500to a variety of cost of equity assumptions and long-term core inflation rates. Many ofthe other variables in our DDM will remain nearly unchanged over the next year includingthe real growth rate and the terminal EPS growth.

We agree with the theoretical argument above that a lower cost of equity raises thefair value of stocks. However, as a practical matter a lower cost of equity is simplyanother way of saying that stocks should trade at a higher P/E multiple.

The link between QE and P/E: Money FlowPositive money flow will be needed to expand S&P 500 P/E multiples above itscurrent level of 13.4x, slightly above with its 35-year average . At a minimum a firm bidmust exist from the marginal buyer such as hedge funds and retail investors. In our view,the lack of money flow into domestic equities represents the key obstacle to US stockstrading substantially above their long-term average following the 30% P/E multipleexpansion in 2009. Exhibit 10 shows the ownership of US equities since 1952.

Individual investors own more than 50% of US stocks. Direct share ownership totals33% and indirect ownership via mutual funds accounts for another 21%. In response to thedislocation in equity markets during the past two years individuals have consistentlyreduced their holdings of actively managed domestic equity mutual funds. Since the start


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of 2009, more than $1.0 tril lion has been withdrawn from money market mutual funds.None of the assets was re-directed to domestic equities. Instead, 60% was invested in bondmutual funds, with 6% allocated to international stocks. Additional proceeds may havebeen used to reduce debt or fund living expenses.

Looking ahead, money often follows performance. Therefore, a sustained uptrend instocks could lead to net inflows. In terms of QE2, if the Fed pushes interest rates loweracross the yield curve individual investors might shift their allocation again, this timemoving from bonds to stocks. Given the assets involved, such a move could have dramaticimpact on share prices. ETFs will likely continue to take market share.

We expect pension funds and government retirement funds are likely to at leastmaintain their roughly 17% ownership share of the domestic equity market. But givenhow significantly underfunded many pension plans are, a si tuation which is onlyexacerbated by QE2, these funds should arguably increase their equity exposure andreduce their bond allocation. In aggregate these organizations could have a dramaticimpact on the overall index level should CIOs choose to adjust long-term asset allocation.

The third ownership category worth highlighting is companies themselves wheretotal cash positions, cash/asset ratios, and free cash flow yields stand at or near all-time highs. Firms in the S&P 500 hold cash equivalent to roughly 12% of the equity cap ofthe market. Managements faced with the prospect of extremely low yields on their short tointermediate term cash, but reluctant to fund new capital spending projects, could decideto buyback shares. Although repurchase would have a positive impact on share prices, itwould not drive economic growth.

Exhibit 10: Ownership of US equity market: Individuals and pension funds own 71% of the equity marketas of June 30, 2010

Source: Federal Reserve, LionShare and Goldman Sachs Global ECS Research.

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Pension Funds 9%Government RetirementFunds 8%

International Investors 12%

Mutual Funds 21%

Ownership of US Corporate Equity Market

ETFs 3%

54%

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Economic risks serve as a headwind for the S&P 500 in early 2011

Our US Economics team expects GDP will grow at a 1%-2% rate through the middleof next year and the unemployment rate will rise to 10% (see Exhibits 12 and 13). Thereason is that short-cycle factors such as the inventory cycle and the impulse from fiscal

policy are likely to continue deteriorating through early 2011, keeping GDP growth verysluggish. (See The Risk of Recession: Concentrated over the Next 6-9 Months , US DailyComment, September 23, 2010).

The base case outlook is the US avoids slipping back into a recession. However, therecession scenario also has significant probability of perhaps 25%-30%. As noted earlier, itis still possible that all of the 2001-2003 and 2009 tax cuts will expire if Congress fails toagree on a bipartisan deal during the lame duck session. We estimate that full expirationwould result in a further hit to GDP growth in early 2011 of nearly 2 percentage points(annualized) relative to the baseline scenario that assumes extension of the lower- andmiddle-income tax cuts.

Exhibit 12: GS US Economics quarterly GDP forecasts Exhibit 13: Our US Economists forecast an average 2011

unemployment rate of 10%

Source: Bloomberg and Goldman Sachs Global ECS Research. Source: Bureau of Labor Statistics and Goldman Sachs Global ECS Research.

US MAP: macroeconomic data and equity returnsThe relationship between US-MAP scores and S&P 500 returns shows that reportedeconomic data is important to the equity market. MAP combines the relevance and thelevel of surprise vs. consensus forecasts in reported economic indicators to provide anestimate of the overall importance of a given data point. Relevance is based on the impacton the 2-year Treasury yield while surprise measures reported data against medianconsensus expectations. See US Economics Analyst , June 18, 2010 1 for more detail on theUS-MAP methodology.

An accumulation of macro data that is persistently above/below expectations is meaningfulfor the equity market. We find the monthly aggregate of US-MAP scores (a measure of thecumulative impact of economic data between ISM reports) has explained 26% of monthlyS&P 500 returns since 2008 and nearly 50% when 2 outlier months (Dec-08 and Jul-10) aredropped from the data. Removing those data points is arbitrary, but US ISM troughed inDec-08 while Jul-10 combined strong S&P 500 earnings with very weak macro data, partlyexplaining divergence in those cases. The relationship was weaker from 2001 to 2008 (r^2

1 Goldman Sachs Global ECS Research: US Economics Analyst , June 18, 2010.https://360.gs.com/gs/portal/?st=1&action=action.binary&d=9247611&r=34&fn=/document.pdf

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Q1A Q2A Q3E Q4E Q1E Q2E Q3E Q4E U S G D P G r o w

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Economics

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of 0.11) showing the markets macro bent (note: MAP scores before 18-Jun-10 are rawscores without US Economics judgmental adjustments).

US-MAP is tracking at -11 in October while the S&P 500 is up 2.5%. September MAP was+39, the strongest month for reported economic data relative to consensus expectationssince June 2009. Strong data last month also ended four months of sequentially weakerdata that significantly lowered investor expectations. Looking ahead we see the potentialfor US-MAP readings to again turn negative. Our US Economists expect the two MAPinputs with the highest relevance scores (US ISM and non-farm payrolls) to weaken intoyear-end. If realized that outlook would be negative for US equities and consistent with ourmore defensive sector weights.

Exhibit 14: US-MAP Index of macro surprises versus S&P 500as of October 15, 2010

Source: Goldman Sachs Global ECS Research.

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J a n - 1

0

M a r -

1 0

M a y - 1

0

J u

l - 1 0

S e p - 1

0

N o v - 1

0

M on

t h l y

S & P

5 0 0 r e

t ur n

( % )

M o n

t h l y t o t a l M A P

s c o r e

Oct2010(11)

US-MAP (LHS)

S&P 500 return (RHS)


14/23



Our dividend discount model anchors our 12-month price target

The DDM is our preferred method to gauge the long-term valuation of the S&P 500. Asluggish economic backdrop is not an environment conducive to ei ther rapid earningsgrowth or P/E multiple expansion. We expect neither development during the next year.

Instead, a second derivative improvement in economic data will be the most likely catalystfor investors to look past the interim economic slowdown anticipated during the next 6months.

Goldman Sachs Economics believe the rates of change of GDP and employment arelikely to improve as we move past early/mid-2011 and into 2012, provided theeconomy doesnt return to recession in the near term. Beyond early 2011, the impulseof short-cycle factors such as inventories and fiscal policy to GDP growth is no longer likelyto deteriorate (i.e. it will not get worse in a second-derivative sense, although it will likelyremain negative). Meanwhile, the slow-motion improvement in areas such as excesshousing supply and bank credit quality is likely to continue. This should add up to agradual acceleration in growth to a trend or slightly above-trend pace by late 2011 andgoing into 2012 (see US Economics Daily: More Q&A on the Outlook, October 4, 2010).

Our DDM implies a 12-month forward fair value for the S&P 500 of 1275, or 9% abovethe current index level. Key inputs in our DDM appear in Exhibit 15. We expect the cost ofequity, which incorporates our ERP assumption, to decline to 8.1% by September 2011.

The S&P 500 currently trades at a NTM P/E ratio of 13.4x using our top-down EPSestimates. Our model implies that the price improvement during the next 12 months willbe a function of declining cost of equity rather than P/E multiple expansion (see Exhibit 16).

Exhibit 15: DDM assumptionsas of October 14, 2010

Note: Terminal multiple calculated as 1 / (cost of equity long term inflation).


3 Month 6 Month 12 Month

AssumptionsAssumed long-term EPS growth rate

Real growth rate 2.5% 2.5% 2.5%Nominal growth rate 2.1 2.1 2.1

10 year US Treasury 2.5 2.5 3.0Equity risk premium 5.7 5.7 5.1Cost of Equity (risk free rate + ERP) 8.2% 8.2% 8.1%

Calculation of DCF valueTerminal year multiple 16.5 x 16.3 x 16.6 xPV of terminal year value 825 819 880PV of dividends years 1-20 375 381 395PV of terminal year value + PV of dividends 1200 1200 1275

S&P 500 DDM Fair Value 1200 1200 1275Current S&P 500 Price 1174Premium / (Discount) to Current 2% 2% 9%


15/23



Exhibit 16: S&P 500 Cost of Equity = ERP + 10 Year Treasury Yieldas of October 5, 2010

Note: We estimate the equity risk premium (ERP) using our DDM framework to model expected future cash flows. We solve for the cost of equity that implies themarket is at fair v alue and then deduct the10-year US Treasury.

Source: IDC via FactSet and Goldman Sachs Global ECS Research.

Sensitivity of DDM to cost of equity and inflationThe dividend discount model is most sensitive to the cost of equity and the rate oflong-term inflation. Exhibit 17 shows the range of forward 12-month fair values based onvarious assumptions of cost of equity and inflation. A 10 bp change in either input adjuststhe forward 12-month fair value by approximately 30 points.

Exhibit 17: 12-Month forward DDM Fair Value sensitivity to cost of equity and long-term inflation assumptions


0

2

4

6

8

10

12

14

16

18

D e c - 8

1

D e c - 8

6

D e c - 9

1

D e c - 9

6

D e c - 0

1

D e c - 0

6

D e c - 1

1

D e c - 1

6

Cost of Equity

Forecast

10 Year US Treasury

Yield

ERP

12-Month Forward Fair Value

12-Month Forward Cost of Equity1,275 7.6 % 7.7 % 7.8 % 7.9 % 8.0 % 8.1 % 8.2 % 8.3 % 8.4 % 8.5 % 8.6 %1.5 % 1264 1231 1199 1169 1139 1111 1084 1057 1032 1007 9841.6 1295 1260 1227 1196 1165 1136 1108 1080 1054 1029 10051.7 1326 1291 1257 1224 1192 1162 1132 1104 1077 1051 10261.8 1359 1322 1287 1253 1220 1188 1158 1129 1101 1074 1048

1.9 1394 1355 1318 1283 1249 1216 1185 1155 1126 1098 10712.0 1429 1389 1351 1314 1279 1245 1213 1181 1151 1122 10942.1 1466 1425 1385 1347 1310 1275 1241 1209 1178 1148 1119

2.2 1505 1461 1420 1381 1343 1306 1271 1237 1205 1174 11442.3 1545 1500 1457 1416 1376 1338 1302 1267 1234 1202 11712.4 1587 1540 1495 1452 1411 1372 1334 1298 1263 1230 11982.5 1630 1582 1535 1490 1448 1407 1368 1330 1294 1259 12262.6 1676 1625 1577 1530 1486 1443 1402 1363 1326 1290 12562.7 1724 1671 1620 1572 1525 1481 1439 1398 1359 1322 1286

L o n g - t e r m

c o r e

i n f l a t

i o n


16/23



Exhibit 18: We expect no P/E expansion during the next 12 monthsas of October 14, 2010

Source: Compustat, I/B/E/S and Goldman Sachs Global ECS Research.

Exhibit 19: Consensus NTM P/E over timeas of October 14, 2010

Source: Compustat, I/B/E/S and Goldman Sachs Global ECS Research.

8

9

10

11

12

13

14

15

16

17

M a r -

0 8

J u n -

0 8

S e p -

0 8

D e c -

0 8

M a r -

0 9

J u n -

0 9

S e p -

0 9

D e c -

0 9

M a r -

1 0

J u n -

1 0

S e p -

1 0

D e c -

1 0

M a r -

1 1

J u n -

1 1

S e p -

1 1

D e c -

1 1

P / E M u

l t i p l e

P/E (NTM)

Currenttop-down

P/E

11.5x

13.5x

TargetYear-end 201 0

P/E

SPXTrough

13.4x

13.4x

13.3x

Bottom-upConsensus

P/E

0

5

10

15

20

25

30

D e c - 7

6

D e c - 7

9

D e c - 8

2

D e c - 8

5

D e c - 8

8

D e c - 9

1

D e c - 9

4

D e c - 9

7

D e c - 0

0

D e c - 0

3

D e c - 0

6

D e c - 0

9

D e c - 1

2

D e c - 1

5

P / E M u

l t i p l e

P/E (NTM)

Bottom-upConsensus

P/ECurrent

Bottom-upConsensus

13.3x

Long-termaverage

13.0x


17/23



Appendix A: Triangulation of three valuation approaches

Our traditional valuation framework for the S&P 500 incorporates three differentanalyses. The dividend discount model (DDM) represents one element of our three-pronged approach to estimating fair value for the S&P 500. We also use a mean reversion

of P/E multiples and various versions of the Fed model.We place a greater emphasis on the results of our DDM compared with the othervaluation approaches. Our DDM implies a 2010 year-end fair value for the S&P 500 of1200, 2% above the current level of the S&P 500.

The Fed model (a macro or top-down approach) suggests the S&P 500 trades 20%below fair value. Todays unusually low interest rate environment explains why thismethod shows the market to be so undervalued. The P/E multiple mean reversion method(a micro or bottom-up approach) implies the undervaluation of the S&P 500 is almost 25%.

Exhibit 20: Triangulation of three approachesas of October 14, 2010

Note: Valuation based on pre-provision and write-down earnings estimates


The Fed model suggests the S&P 500 is 20% below fair value. The Fed Model approachat its core compares the S&P 500 earnings yield (inverse of P/E using NTM earnings) with

the 10-year Treasury yield. The rationale for the model is that investors ultimately choosewhether to invest in equities or bonds, and that the yield differential of the two assetsshould be roughly comparable over time. We calculate the S&P 500 upside or downside tofair value by assuming the yield spread reverts to the 10-year trailing average spread with aprice change by the S&P 500 that closes half the gap.

We base our Fed Model valuation on an average of three versions of the model: thetraditional model comparing S&P 500 earnings yield to 10-year Treasury yield, one whichsubstitutes 10-year BBB corporate bond yields, and a third that uses TIPs. The current yieldgap is extremely wide by historical standards. Mean reversion of the yield spreadrelationship suggests 20% upside to S&P 500 and an implied P/E of 15.9x.

Year-end 2010 S&P 500 Fair ValueUpside / (Downside)

Goldman Sachs From CurrentMethodology Top-down S&P 500 Level

US Portfolio Strategy DDM 1200 2 %

Fed model 1410 20 %US Treasury 10 Year Yield 1410 20BBB Corporate 10 Year Yield 1410 2010 Year TIPS Yield 1410 20

Reversion of P/E to 10-yr avg 1440 23 %

Avg Fair Value (using 3 approaches) 1350 15 %


18/23



Exhibit 21: 10-year Treasury yield near all-time lowas of October 14, 2010

Exhibit 22: Fed Model implies P/E of 15.9Xas of October 14, 2010

Source: First Call, Compustat and Goldman Sachs Global ECS Research. Source: First Call, Compustat and Goldman Sachs Global ECS Research.

Current P/E valuation is low relative to the average historical multiple in tameinflation environments. On a cyclically-adjusted basis, the S&P 500 trades at 17.1x trailing10-year average EPS, slightly above the 80-year average of 16.7x.

Exhibit 23: On a cyclically-adjusted basis, S&P 500 P/E valuation is near 80-year averageas of October 14, 2010

Source: Compustat, Robert Shiller, and Goldman Sachs Global ECS Research.

2 %

4 %

6 %

8 %

10 %

12 %

14 %

1 9 8 6

1 9 8 8

1 9 9 0

1 9 9 2

1 9 9 4

1 9 9 6

1 9 9 8

2 0 0 0

2 0 0 2

2 0 0 4

2 0 0 6

2 0 0 8

2 0 1 0

2 0 1 2

Y i e l d s

10-year Treasury yieldand S&P 500 earnings yield

2000

1987

US Treasury10-Year Yield

ConsensusBottom-up

Earnings Yield

(800) bp

(600) bp

(400) bp

(200) bp

0 bp

200 bp

400 bp

600 bp

1 9 8 6

1 9 8 8

1 9 9 0

1 9 9 2

1 9 9 4

1 9 9 6

1 9 9 8

2 0 0 0

2 0 0 2

2 0 0 4

2 0 0 6

2 0 0 8

2 0 1 0

2 0 1 2

Y i e l d S p r e a

d ( 1 0 y r y

i e l d -

S & P 5 0 0 E / P )

10-year Treasury yieldless S&P 500 earnings yield Rolling 10-year

average

0

5

10

15

20

25

30

35

40

45

D e c - 2

7

D e c - 3

0

D e c - 3

3

D e c - 3

6

D e c - 3

9

D e c - 4

2

D e c - 4

5

D e c - 4

8

D e c - 5

1

D e c - 5

4

D e c - 5

7

D e c - 6

0

D e c - 6

3

D e c - 6

6

D e c - 6

9

D e c - 7

2

D e c - 7

5

D e c - 7

8

D e c - 8

1

D e c - 8

4

D e c - 8

7

D e c - 9

0

D e c - 9

3

D e c - 9

6

D e c - 9

9

D e c - 0

2

D e c - 0

5

D e c - 0

8

D e c - 1

1

D e c - 1

4

C y c

l i c a l

l y - A

d j u s t e d

P / E

Cyclically AdjustedS&P 500 P/E Ratio

(10-year average trailing EPS)

16-Aug-826.2x

Current(14-Oct)

17.1x

19325.1x

80 year avg = 16.7x

9-Mar-099.9x


19/23



Exhibit 24: Average S&P 500 Forward P/E by Inflation Bandsas of October 13, 2010

Source: FactSet and Goldman Sachs Global ECS Research.

Exhibit 25: Average S&P 500 Forward P/E by Real 10-Yr Bandsas of October 13, 2010


14.7x

17.1x

15.6x14.3x

10.6x10.1x

8.0x6.8x 6.7x 6.5x

0x

5x

10x

15x

20x

1% &below

1% to2%

2% to3%

3% to4%

4% to5%

5% to6%

6% to7%

7% to8%

8% to9%

9% &above

A v e r a g e

N T M

P / E

Headline CPI Band

Average S&P 500 Forward P/Eby Inflation Bands, 1976-2010

11mo

53 105 2793 56 24 356 6

10.1x

13.6x

16.0x 16.0x

12.8x

10.8x

7.7x 7.5x 7.7x 7.3x

0x

5x

10x

15x

20x

1% &below

1% to2%

2% to3%

3% to4%

4% to5%

5% to6%

6% to7%

7% to8%

8% to9%

9% &above

A v e r a g e

N T M

P / E

US Ten Year Yield minus Headline CPI Band

Average S&P 500 Forward P/Eby Real 10 Yr Rate Bands, 1976-2010

63mo

66 58 1692 63 25 416 9


20/23



Exhibit 26: The Bottom LineOur key forecasts for the S&P 500 index, recommended sector positioning and top thematic trade ideas;Price targets as of October 15, 2010 and pricing as of October 14, 2010

(a) Sector weightings last rebalanced on 14-Sep-10. (b) US Portfolio Strategy baskets may be found on Bloomberg by typing . The Bloomberg page providesreal-time basket performance and current basket constituents. To obtain access to our baskets on Bloomberg, please contact your Goldman Sachs salesperson. Theability to trade these baskets will depend upon market conditions, including liquidity and borrow constraints at the time of trade.


S&P 500 Index Forecasts

S&P 500 Price Targets Current Level 3 Month 6 Month 12 Month

1174 1200 (+2%) 1200 (+2%) 1275 (+9%)S&P 500 EPS estimates 2008A 2009A 2010E 2011EGS Portfolio Strategy top-down $50 $57 $81 $89

Growth (% year/year) (40) 15 43 10

Recommended Sector Positioning

Recommended GS Overweight / S&P 500 Total Return GS AlphaS&P 500 Sector Positioning Underweight (a) Weight 2010 YTD

Information Technology 300 bp 19% 3% (10)bpConsumer Staples 200 11 10 (1)Telecom Services 100 3 12 (4)

Energy 0 11 4 (17)Financials 0 16 2 0

Industrials 0 11 18 3Materials 0 4 8 (11)Utilities 0 4 6 5

Consumer Discretionary (300) 10 17 (22)Health Care (300) 12 1 19

S&P 500 0 bp 100% 7% (37)bp

Thematic Trade Recommendations

InitiationOur best trade ideas: Portfolio Strategy thematic baskets (b) Date Return

BUY Low Operating Leverage (GSTHOPLO); SELL High Operating Leverage (GSTHOPHI)See US Equity Views: Adjusting S&P 500 earnings forecasts and price targets (9-Aug-10). 9-Aug-10 (3.9)%

BUY High Dividend Growth (GSTHDIVG); SELL S&P 500See US Equity Views: Adjusting S&P 500 earnings forecasts and price targets (9-Aug-10). 9-Aug-10 0.3 %

BUY High Sharpe Ratio Basket (GSTHSHRP); SELL S&P 500See 2010 Outlook: Cyclical start; defensive finish (7-Dec-09). 7-Dec-09 9.1 %

BUY BRICs Sales Basket (GSTHBRIC); SELL S&P 500See Portfolio Passport: Coming to America (5-Nov-08). 4-May-09 15.2 %

Overweight

Neutral

Underweight


21/23



Disclosures

The Equities Division of the firm has previously introduced the basket of securities discussed in this report. The Equity

Analyst may have been consulted as to the composition of the basket prior to its launch. However, the views expressedin this research and its timing were not shared with the Equities Division.

Note: The ability to trade this basket will depend upon market conditions, including liquidity and borrow constraints atthe time of trade.


22/23



Reg ACWe, David J. Kostin, Stuart Kaiser, CFA, Amanda Sneider, CFA and Yi Zhang, hereby certify that all of the views expressed in this report accuratelyreflect our personal views about the subject company or companies and its or their securities. We also certify that no part of our compensation was,is or will be, directly or indirectly, related to the specific recommendations or views expressed in this report.

Disclosures

Disclosures required by United States laws and regulationsSee company-specific regulatory disclosures above for any of the following disclosures required as to companies referred to in this report: manageror co-manager in a pending transaction; 1% or other ownership; compensation for certain services; types of client relationships; managed/co-managed public offerings in prior periods; directorships; for equity securities, market making and/or specialist role. Goldman Sachs usually makes amarket in fixed income securities of issuers discussed in this report and usually deals as a principal in these securities.

The following are additional required disclosures: Ownership and material conflicts of interest: Goldman Sachs policy prohibits its analysts,professionals reporting to analysts and members of their households from owning securities of any company in the analyst's area of coverage.Analyst compensation: Analysts are paid in part based on the profitability of Goldman Sachs, which includes investment banking revenues. Analystas officer or director: Goldman Sachs policy prohibits its analysts, persons reporting to analysts or members of their households from serving as anofficer, director, advisory board member or employee of any company in the analyst's area of coverage. Non-U.S. Analysts: Non-U.S. analysts may

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Additional disclosures required under the laws and regulations of jurisdictions other than the United StatesThe following disclosures are those required by the jurisdiction indicated, except to the extent already made above pursuant to United States lawsand regulations. Australia: This research, and any access to it, is intended only for "wholesale clients" within the meaning of the AustralianCorporations Act. Canada: Goldman Sachs & Co. has approved of, and agreed to take responsibility for, this research in Canada if and to the extent itrelates to equity securities of Canadian issuers. Analysts may conduct site visits but are prohibited from accepting payment or reimbursement by thecompany of travel expenses for such visits. Hong Kong: Further information on the securities of covered companies referred to in this research maybe obtained on request from Goldman Sachs (Asia) L.L.C. India: Further information on the subject company or companies referred to in thisresearch may be obtained from Goldman Sachs (India) Securities Private Limited; Japan: See below. Korea: Further information on the subjectcompany or companies referred to in this research may be obtained from Goldman Sachs (Asia) L.L.C., Seoul Branch. Russia: Research reportsdistributed in the Russian Federation are not advertising as defined in the Russian legislation, but are information and analysis not having productpromotion as their main purpose and do not provide appraisal within the meaning of the Russian legislation on appraisal activity. Singapore: Furtherinformation on the covered companies referred to in this research may be obtained from Goldman Sachs (Singapore) Pte. (Company Number:198602165W). Taiwan: This material is for reference only and must not be reprinted without permission. Investors should carefully consider their

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Ratings, coverage groups and views and related definitionsBuy (B), Neutral (N), Sell (S) - Analysts recommend stocks as Buys or Sells for inclusion on various regional Investment Lists. Being assigned a Buyor Sell on an Investment List is determined by a stock's return potential relative to its coverage group as described below. Any stock not assigned asa Buy or a Sell on an Investment List is deemed Neutral. Each regional Investment Review Committee manages various regional Investment Lists to aglobal guideline of 25%-35% of stocks as Buy and 10%-15% of stocks as Sell; however, the distribution of Buys and Sells in any particular coveragegroup may vary as determined by the regional Investment Review Committee. Regional Conviction Buy and Sell lists represent investmentrecommendations focused on either the size of the potential return or the likelihood of the realization of the return.Return potential represents the price differential between the current share price and the price target expected during the time horizon associatedwith the price target. Price targets are required for all covered stocks. The return potential, price target and associated time horizon are stated in eachreport adding or reiterating an Investment List membership.Coverage groups and views: A list of all stocks in each coverage group is available by primary analyst, stock and coverage group athttp://www.gs.com/research/hedge.html. The analyst assigns one of the following coverage views which represents the analyst's investment outlookon the coverage group relative to the group's historical fundamentals and/or valuation. Attractive (A). The investment outlook over the following 12months is favorable relative to the coverage group's historical fundamentals and/or valuation. Neutral (N). The investment outlook over the following12 months is neutral relative to the coverage group's historical fundamentals and/or valuation. Cautious (C). The investment outlook over thefollowing 12 months is unfavorable relative to the coverage group's historical fundamentals and/or valuation.


23/23


Not Rated (NR). The investment rating and target price have been removed pursuant to Goldman Sachs policy when Goldman Sachs is acting in anadvisory capacity in a merger or strategic transaction involving this company and in certain other circumstances. Rating Suspended (RS). GoldmanSachs Research has suspended the investment rating and price target for this stock, because there is not a sufficient fundamental basis fordetermining, or there are legal, regulatory or policy constraints around publishing, an investment rating or target. The previous investment rating andprice target, if any, are no longer in effect for this stock and should not be relied upon. Coverage Suspended (CS). Goldman Sachs has suspendedcoverage of this company. Not Covered (NC). Goldman Sachs does not cover this company. Not Available or Not Applicable (NA). The informationis not available for display or is not applicable. Not Meaningful (NM). The information is not meaningful and is therefore excluded.

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