Financial Pacific - What if a Grey or Black skies lie ahead (third party)

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Financial Pacific - What if a Grey or Black skies lie ahead (third party)

  1. 1.  Global Equity Research Americas UBS Investment Research Equity Strategy US Equity Strategy Investment Strategy 16 August 2011 www.ubs.com/investmentresearch Jonathan Golub, CFA Strategist jonathan.golub@ubs.com +1-212-713 8673 Chip Miller, CFA Strategist chip.miller@ubs.com +1-203-719 3720 Manish Bangard, CFA Strategist manish.bangard@ubs.com +1-212-713 3036 “What if” Grey or Black Skies Lie Ahead? Daniel Murphy Strategist  We answer the question of “What if” we have a recession daniel-d.murphy@ubs.com +1-212-713 3186 In this report, we detail the stock-by-stock projections for earnings and valuations under both Grey Skies and Black Skies recession scenarios. In summary, the Grey Vishal Patel Associate Strategist Skies scenario reduces earnings by roughly 13% versus our base case and the vishal-a.patel@ubs.com Black Skies scenario reduces earnings by roughly 27% versus our base case. +1-212-713 4027  We estimate that a 40% chance of a recession is currently discounted Thomas M. Doerflinger, Ph.D. Equity markets have sold off sharply, volatility has spiked, and Treasury yields Strategist tom.doerflinger@ubs.com have collapsed to levels not seen since the depths of the financial crisis. Whether +1-212-713 2540 attributable to the S&P downgrade, European sovereign debt issues or decelerating macroeconomic indicators, we believe markets are now pricing in an increased Natalie Garner, CFA probability of recession. Using the target prices from our base case and valuations Strategist from our two scenarios defined below, we believe the market is pricing in a natalie.garner@ubs.com +1-212-713 4915 roughly 40% chance of a recession, allocated between a 30% chance of a Grey Skies recession and a 10% chance of a Black Skies recession. Maury N. Harris Economist  Nevertheless, we continue to believe a recession is unlikely maury.harris@ubs.com Our “base case” scenario assumes US real GDP grows 1.8% in 2011 and 2.3% in +1-212-713 2472 2012. In addition to recent constructive signs in the employment market, additional David A. Bleustein rationale for our “no recession” base case include (1) satisfactory credit flows; (2) Director of US Equities Research lower oil price circuit breakers ‘kicking in’; (3) home prices tentatively stabilizing david.bleustein@ubs.com as rents rise; (4) recent improvements in job quality, (5) the investing public’s +1-212-713 2615 ownership of rallying bonds (as well as retreating stocks); and (6) the back-end Ana Recinos loaded nature of the Budget Control Act of 2011. Analyst ana.recinos@ubs.com +1-212-713 9147 This report has been prepared by UBS Securities LLC ANALYST CERTIFICATION AND REQUIRED DISCLOSURES BEGIN ON PAGE 166. UBS does and seeks to do business with companies covered in its research reports. As a result, investors should be aware 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 single factor in making their investment decision.
  2. 2. US Equity Strategy 16 August 201116 August 2011To our valued clients,Based on our discussions with you, one of the critical issues in your investmentprocess relates to the near-term economic outlook. The debate on the topic iscomplicated by a confluence of divergent factors, including regulatory and fiscalpolicy uncertainty, decelerating macroeconomic data points and the marketdecline itself on one side, but offset by numerous non-recessionary data points,the already depressed state of activity in key markets (auto/housing), solidcorporate balance sheets and a few key leading indicators of economic recovery.Although in this document we outline the rationale for our “base case” of norecession, the purpose of the document is to answer the question “What if” wehave either a normal (Grey Skies) or severe (Black Skies) recession.In this report, we have included our strategists’ analysis of S&P earnings andvaluations in the scenarios defined by our economists. We have also includedthe backbone of that analysis, which is the company-by-company projection ofearnings and valuations using the macroeconomic scenarios defined by oureconomists.The project led to projections for companies with over $9 trillion of marketcapitalization in the US alone. Over the last 8 days, we believe over 1,000 hourshave been invested in this analysis. We hope you find it helpful.With our thanks and regards,David BleusteinHead of U.S. Equities ResearchUBS Investment Research1285 Avenue of the AmericasNew York, NY 10019Phone: (212) 713-2615 E-mail: david.bleustein@ubs.com UBS 2
  3. 3. US Equity Strategy 16 August 2011Contents page Jonathan Golub, CFA StrategistExecutive Summary 5 jonathan.golub@ubs.com +1-212-713 8673 — We continue to expect growth in 2012 ................................................................... 6 Chip Miller, CFA — Is a moderate recession already priced in?............................................................ 7 Strategist — Consensus Estimates Would Fall Significantly in Either Recession Scenario ....... 9 chip.miller@ubs.com +1-203-719 3720The Current Recession Debate 12 Manish Bangard, CFA — Early Warnings ..................................................................................................... 12 Strategist — Signs Point to Weak Growth, Not Recession ....................................................... 13 manish.bangard@ubs.com — Tug-of-War ........................................................................................................... 16 +1-212-713 3036Scenario Analysis — Base Case, Grey & Black Skies 17 Daniel Murphy StrategistEarnings Drivers 20 daniel-d.murphy@ubs.com — Revenues Driven by Nominal GDP ...................................................................... 20 +1-212-713 3186 — Margins Driven by Capacity Utilization ................................................................. 21 Vishal Patel Associate StrategistValuations — The Long View 22 vishal-a.patel@ubs.com — Disco Regime: Inflation the Key Driver of Multiples ............................................. 22 +1-212-713 4027 — The Great Moderation: Interest Rates the Key Driver of Multiples....................... 22 Thomas M. Doerflinger, Ph.D. — The Millennium Regime: Baa Yields the Key Driver of Multiples ......................... 23 Strategist tom.doerflinger@ubs.comMarket Targets 24 +1-212-713 2540 — Analysts Underestimate Earnings Downside ....................................................... 24 Natalie Garner, CFA — Prices and Multiples Move Before EPS Estimates............................................... 25 Strategist natalie.garner@ubs.com — Market Targets in Base Case, Grey & Black Skies .............................................. 26 +1-212-713 4915Market Leadership 27 David A. Bleustein — Leadership Since February Slowdown ................................................................. 28 Director of US Equities ResearchStock Selection: By Scenario 30 david.bleustein@ubs.com +1-212-713 2615UBS Cyclical and Defensive Baskets 33 Ana Recinos — Historical Results.................................................................................................. 33 Analyst — Background .......................................................................................................... 34 ana.recinos@ubs.com +1-212-713 9147 — Construction Methodology.................................................................................... 35Appendix A: Additional Assumptions 36 — Global Economic Assumptions............................................................................. 36 — Commodity Price Assumptions............................................................................. 36 — Key End Market Demand Assumptions................................................................ 36Appendix B: UBS Return Drivers 37 — Computation ......................................................................................................... 37Appendix C: U.S. Style Indices 39Communications 41 — Cable & Satellite / Telecom Services ................................................................... 42 — Internet & Interactive Entertainment ..................................................................... 44 — Media & Entertainment ......................................................................................... 46Consumer 49 — Apparel, Footwear & Luxury ................................................................................. 50 — Beverages ............................................................................................................ 52 — Lodging, Cruise Lines and Leisure ....................................................................... 54 — Hardline Retail ...................................................................................................... 58 — Household & Personal Care and Tobacco ........................................................... 62 — Packaged Food .................................................................................................... 64 UBS 3
  4. 4. US Equity Strategy 16 August 2011 — Restaurants .......................................................................................................... 66 — Toys...................................................................................................................... 68Energy 71 — Electric Utilities & IPPs ......................................................................................... 72 — Independent Refiners ........................................................................................... 76 — Integrated & Regulated Natural Gas .................................................................... 78 — Integrated Oil / Oil & Gas E&P ............................................................................. 82 — Oil Services & Drilling ........................................................................................... 86Financials 89 — Brokers and Universal Banks ............................................................................... 90 — Consumer & Specialty Finance ............................................................................ 92 — Exchanges and E-Brokers.................................................................................... 94 — Homebuilders & Building Products ....................................................................... 96 — Insurance (Life)..................................................................................................... 98 — Insurance (Non Life) ........................................................................................... 100 — REITs.................................................................................................................. 102Healthcare 105 — Biotechnology ..................................................................................................... 106 — Healthcare Distribution ....................................................................................... 108 — Healthcare IT ...................................................................................................... 110 — Healthcare Providers/Hospitals .......................................................................... 112 — Large Cap Pharma, Specialty Pharma & Generics ............................................ 114 — Life Sciences & Diagnostic Tools ....................................................................... 118 — Managed Care.................................................................................................... 120 — Medical Supplies & Devices ............................................................................... 122Industrials 125 — Aerospace & Defense......................................................................................... 126 — Airfreight & Surface Transportation .................................................................... 128 — Airlines & OTAs .................................................................................................. 130 — Autos & Auto Parts ............................................................................................. 132 — Chemicals........................................................................................................... 134 — Coal and Metals & Mining................................................................................... 136 — Electrical Equipment & Multi-Industry................................................................. 138 — Engineering & Construction................................................................................ 140 — Machinery ........................................................................................................... 142 — Paper & Forest Products .................................................................................... 144 — Small/Mid Cap Industrials................................................................................... 146Technology 149 — Business, Education and Professional Services ................................................ 150 — Computer Services & IT Consulting ................................................................... 152 — Data Networking & Wireline Equipment ............................................................. 154 — IT Hardware........................................................................................................ 156 — SemiCap Equipment / Alternative Energy .......................................................... 158 — Semiconductors.................................................................................................. 160 — Software ............................................................................................................. 162 — Technology Supply Chain & Wireless Equipment .............................................. 164 UBS 4
  5. 5. US Equity Strategy 16 August 2011Executive SummaryOver the past few weeks, equity markets have sold off sharply, volatility has Markets are pricing in an increasedspiked, and Treasury yields have collapsed to levels not seen since the depths of probability of recessionthe financial crisis. Regardless of the root causes of the current pullback (e.g.,S&P downgrade, European sovereign debt issues, decelerating macroeconomicindicators, etc), we believe markets are now pricing in an increased probabilityof recession. Exhibit 1: S&P 500 Exhibit 2: 10-Year Treasury Yields 1400 4.0 1300 1200 3.5 1100 1000 3.0 900 800 2.5 700 2.0 Jan-09 Jul-09 Jan-10 Jul-10 Feb-11 Aug-11 Jan-09 Jul-09 Jan-10 Jul-10 Feb-11 Aug-11Source: S&P, FactSet and UBS Source: Federal Reserve, FactSet and UBSThis report contains scenario analyses against three economic outcomes: ourbase case scenario, our standard recession “Grey Sky” scenario and our deeprecession “Black Sky” scenario. For each scenario, our analysts have estimatedearnings and valuations for the stocks under coverage. Our strategists thencalculated both bottoms-up and top-down S&P earnings forecasts under eachscenario.What odds of a recession are already priced in?As we support later in the document, we believe a recession is unlikely… andmaintain the moderate growth “base case” scenario defined below. Nevertheless,given the recent market decline, we attempted to calculate what “odds” of arecession are already priced in. One complicating factor is the additionalquestion of the severity of any potential recession.With those caveats, using the target prices from our base case and valuationsfrom our two scenarios defined below, we believe the market is pricing in aroughly 40% chance of a recession, split between a 30% chance of a Grey Skiesrecession and a 10% chance of a Black Skies recession. Obviously, the samemarket level could be discounting a smaller chance of the deeper recession or alarger chance of a smaller recession, but our Economics team formed aconsensus around this analysis of what is being discounted by the market today.The algebra to get there was to solve for the percentages that made 1,200 thediscounted level today, or a 60% chance of an S&P 500 at 1,425 at year end(855), plus a 30% chance of an S&P 500 at 1,100 at year end (330), plus a 10%chance of an S&P 500 at 900 at year end (10), less the expected return betweennow and year end (75) = 1,200. Although this is not a UBS forecast or target UBS 5
  6. 6. US Equity Strategy 16 August 2011price, we use the 60/30/10 percentages throughout the document, notably in thestock selection section.We continue to expect growth in 2012One key historical driver of recessions — a severe credit shock — appearsunlikely. That said, downside risks have clearly increased, as many of theeconomic indicators we watch have decelerated, albeit not to the point ofindicating a contraction of economic activity. Exhibit 3: Non-Farm Payrolls Exhibit 4: ISM Manufacturing 400 60 200 55 0 50 -200 45 -400 40 -600 35 -800 90 92 94 96 98 00 02 04 06 08 10 90 92 94 96 98 00 02 04 06 08 10Source: Dept. of Labor, FactSet and UBS Source: ISM, FactSet and UBS Note: Shaded areas mark recessionsIn this report, we examine the likely behavior of U.S. equities, including thebroad market, sectors, and individual stocks, under the following three economic In this report, we examine potentialscenarios: outcomes for the market, sectors, and Base Case Scenario. This scenario assumes modest, but positive growth stocks under three scenarios over the remainder of 2011 and 2012. UBSs current estimates and forecasts are based on this set of assumptions. Independent of this recession debate, we believe we have entered a lower multiple environment, reflecting more modest secular growth in coming years. We use a 12.5x NTM forward P/E as our baseline, applied to consensus EPS, to construct our base case S&P 500 target. Our current S&P 500 price target is 1,425 (12.5 * $113.67), 21% upside from current levels, with S&P 500 EPS estimates of $99.35 in 2011 and $108 in 2012. Grey Skies Scenario. This scenario assumes a GDP decline in-line with the post-war recession average of 2% beginning in 3Q11 and lasting four quarters. In such a scenario, we believe the S&P 500 would fall by roughly 7% through year-end to 1,100 and 15% to a trough of 1,000 in early 2012. We would expect S&P 500 earnings of $74 in 2012. Black Skies Scenario. This scenario assumes a more severe recession in both depth and duration. Beginning in 3Q11 and lasting six quarters, GDP would decline 4.1%. In this case, we believe the S&P 500 would fall by 24% through year-end to 900 and 34% to a trough of 775 in late 2012. We would expect S&P 500 earnings of $60 in 2012.The purpose of this scenario exercise is to evaluate "what if". To make thisprocess most pertinent, we applied this to the economy in the current quarter. UBS 6
  7. 7. US Equity Strategy 16 August 2011Fortunately, recent economic data appears non-recessionary. If a recession wereto hit in the current quarter, it would be quite abrupt, causing a substantialdisruption to corporate profits. As such, our Grey Skies and Black Skies EPSforecasts for 2011 of $87 and $85 reflect such a sharp back-half decline. Bycontrast, consensus estimates would be slower to adjust. Most importantly, webelieve that this scenario analysis provides a constructive starting point uponwhich to evaluate recent market movements and the future path for risk assets.Is a moderate recession already priced in?A wide variety of factors contribute to the onset of recessions, the most commonof which are credit events, the bursting of bubbles and oil supply shocks. Thefollowing exhibit shows the pattern of GDP growth in the post-war period. Exhibit 5: Real GDP 16 Real GDP growth, 4-quarter % chg 13 10 7 4 1 -2 -5 48 53 58 63 68 73 78 83 88 93 98 03 08Source: BEA and UBS Note: Shaded areas mark recessionsThere have been 11 recessions since the end of WWII. In our opinion, only twoof these periods would be defined as Black Skies (1973-75 and 2007-09). Moderate recessions: The nine more moderate recessions lasted 10 months on average and caused GDP to contract by 1.9% in real terms. The market tends to reach a high roughly eight months before the beginning of a moderate recession, with stocks falling 20%, on average, from peak-to- trough. The decline typically ends about halfway, or five months, into the downturn. Importantly, prices usually rebound sharply and make new highs within 12 months of the start of the recession. UBS 7
  8. 8. US Equity Strategy 16 August 2011 Exhibit 6: Average Market Price Change Around Moderate Recessions 1.15 During a moderate recession, the Market 1.10 market typically hits new highs within Recession Trough 12 months of its onset 1.05 Beginning 1.00 0.95 0.90 Market 0.85 Peak 0.80 -8 -6 -4 -2 0 2 4 6 8 10 12 14 16 18Source: NBER, S&P, FactSet, and UBSNotes: The horizontal axis represents the number of months from the recession beginning. Market price indexed to1.0 at average market peak Severe recessions: The two severe recessions lasted 17 months on average and caused GDP to contract by 4.2% in real terms. Not surprisingly, the market decline around severe recessions tends to be much greater in both depth and duration. Just as with shallower economic downturns, the market generally tops out several months before the recession begins. However, the peak-to-trough decline is about 50%. On average, stock prices do not find a bottom until about a year after the recession begins. Notably, even two years after the onset of a downturn, the market is still more than 25% below the pre-recession peak. Exhibit 7: Average Market Price Change Around Severe Recessions 1.0 During a Black Skies recession, the Market market typically remains below peak 0.9 Trough levels 2 years following its onset 0.8 Market 0.7 Peak 0.6 Recession 0.5 Beginning 0.4 -9 -6 -3 0 3 6 9 12 15 18 21 24Source: NBER, S&P, FactSet, and UBSNotes: The horizontal axis represents the number of months from the recession beginning. Market price indexed to1.0 at average market peak UBS 8
  9. 9. US Equity Strategy 16 August 2011On average, in the post-War period, stocks have declined by 19.8% in moderaterecessions; 49.4% in severe downturns. Exhibit 8: Stock Performance in Post WWII Recessions S&P 500 Max. GDP Peak to Length Decline Trough Peak Trough (months) (%) (%) Nov-48 Oct-49 11 -1.6 -15.4 Jul-53 May-54 10 -2.6 -12.2 Aug-57 Apr-58 8 -3.7 -16.5 Apr-60 Feb-61 10 -1.6 -11.8 Dec-69 Nov-70 11 -0.6 -29.9 Nov-73 Mar-75 16 -3.2 -46.2 Jan-80 Jul-80 6 -2.2 -6.6 Jul-81 Nov-82 16 -2.9 -23.8 Black Jul-90 Mar-91 8 -1.4 -15.8 Skies Mar-01 Nov-01 8 -0.3 -46.3 Dec-07 Jun-09 18 -5.1 -52.6Average All 11 -2.3 -25.2Average Black Skies 17 -4.2 -49.4Average All Other 10 -1.9 -19.8Source: NBER, S&P, FactSet, and UBS Note: Peak-to-trough market decline based on month-end index pricesUsing the same scale, the stock market has pulled back roughly 13% from itspeak at the end of April, which supports a view that some component of amoderate recession is already priced in, although we believe that some of thedecline relates to discounting some chance of a more severe recession.Consensus Estimates Would Fall Significantlyin Either Recession ScenarioMuch like stocks, earnings generally fall dramatically in recessions, but alsosnap back quickly. On average, earnings fell by 20.1% in the past six recessions,which we believe is a fair estimate for a moderate recession scenario. EPS fell48.8% in the most recent period (2008/09), 35.6% excluding asset write-downs.Importantly, analysts’ forecasts tend to remain much too rosy in recessions andlag once the economy begins to recover. Revenues Driven by Nominal GDP. S&P 500 revenues are quite Revenues are roughly 3x more volatile economically sensitive, moving roughly 2.9% for every 1% shift in nominal than GDP GDP. Of the traditionally cyclical sectors, Energy and Materials are the most sensitive to changes in the economy. Margins Driven by Capacity Utilization. Operating leverage is a function of fixed costs, and is best explained by capacity utilization. On average, a 1% shift in revenues results in a 1.5% and 2.5% shift in operating and net income margins. UBS 9
  10. 10. US Equity Strategy 16 August 2011 Exhibit 9: Y/Y Nominal GDP Growth Exhibit 10: Capacity Utilization 20 90 16 85 12 80 8 75 4 70 0 65 -4 50 55 60 65 70 75 80 85 90 95 00 05 10 70 75 80 85 90 95 00 05 10Source: BEA, FactSet and UBS Note: Shaded areas mark recessions Source: Federal Reserve, FactSet and UBS Note: Shaded areas mark recessionsOur Bottoms-Up Estimates are Significantly Above theResults of Prior RecessionsThe backbone of our scenario analysis is the work of the single-stock analysts,who were asked to provide earnings estimates and valuations for 2012 under theGrey and Black Skies scenarios. The analysts were provided with a set ofmacroeconomic assumptions, the most significant of which was US and GlobalGDP. The following exhibit illustrates how real GDP in our base, Grey, andBlack Skies scenarios compares to the recent trend as well as the 2008-09 GreatRecession. Exhibit 11: Real GDP with UBS Scenarios 6 Estimates Real GDP growth, 4-quarter % chg 4 2 0 -2 -4 -6 Baseline Grey skies Black skies 06 07 08 09 10 11 12Source: BEA and UBS Note: Shaded areas mark recessions UBS 10
  11. 11. US Equity Strategy 16 August 2011While not a surprise, the bottoms-up aggregation of UBS analyst forecasts underthe two recessionary scenarios leads to a much rosier outlook than a top-downapproach. More specifically, UBS analysts project a fall in earnings of 4% and19% in 2012, versus the current base case estimates. Exhibit 12: UBS Change in Net Income Under 3 ScenariosTotal 2011-12 2011-12 2011-12Sector Base Case Grey Skies Black SkiesNet Income ($m) % Change % Change % ChangeEnergy -2% -23% -58%Materials 16% -38% -75%Industrials 18% -7% -27%Consumer Discretionary 15% 3% -13%Consumer Staples 8% 7% 3%Healthcare 4% 3% 1%Financials 25% 2% -19%Information Technology 9% -1% -10%Telecom Services 26% 5% 0%Utilities -2% -8% -12%Total 10% -4% -19%Source: S&P, Haver and UBSIn Exhibit 12, we detail the sector by sector net income projections for the 485stocks (with a combined market capitalization of over $9 trillion) for which theanalysts provided scenario-based forecasts. In order to present the percentages inan easy-to-compare format, the percentage change columns contain the growthrates (or rates of decline) in 2012 vs. our current 2011 forecasts. As expected,the segments that are most vulnerable to a Black Skies scenario are Energy,Materials, Industrials and Financials. The sectors that are most resilient includeConsumer Staples, Healthcare and Telecom Services.Of note, UBS has created two baskets; one designed to capture the market’s UBS has created baskets designed forupside should the economy strengthen, as in our base case, and the other to expansions and recessionsprovide protection on the downside should conditions deteriorate: the UBSCyclical (UBSECYC) and Defensive (UBSEDEF) Baskets. UBS 11
  12. 12. US Equity Strategy 16 August 2011The Current Recession DebateGiven historical stock declines around recessions, it’s no wonder that marketshave recently sold off sharply into rising fears of a double dip. While there are anumber of cautionary indicators pointing to a recession, we believe the overalldata is more consistent with modest growth.Early WarningsIn our May 6 report entitled Spring Break, we highlighted a number of potentialwarning signs including economic disappointments and defensive marketleadership.As illustrated below, the UBS U.S. Economic Surprise Index began todeteriorate in February. At the time, much of this weakness was attributed to asharp rise in oil prices and industrial weakness resulting from the Japanesenatural disasters. In other words, it was widely believed that the ‘soft patch’would be transitory. Exhibit 13: U.S. Economic Surprise Index 3 > 0 represents Positive Surprise Economic data began to surprise to the 2 downside in February 1 0 -1 -2 -3 < 0 represents Negative Surprise -4 06 07 08 09 10 11Source: Bloomberg and UBS Global Economics teamWhile the S&P 500 held up relatively well through May, the tone of the marketbegan to change in February as defensive stocks began outperforming their moreeconomically-sensitive peers. To that extent, the case could be made thatinvestor sentiment began to turn well before the market peak. Exhibit 14: S&P 500 vs. Cyclical Outperformance 1360 Feb 2011 95 While stocks held up well through May, Cycl. vs. ► investors began to position defensively 88 1185 Non-Cycl. in conjunction with weakening economic data 81 1010 74 835 ◄ S&P 500 67 660 60 Mar-09 Aug-09 Jan-10 Jun-10 Nov-10 Apr-11Source: S&P, Haver, FactSet and UBS Note: Performance indexed to 100 as of Dec. 31, 2004 UBS 12
  13. 13. US Equity Strategy 16 August 2011Signs Point to Weak Growth, Not RecessionAs discussed above, while the skies may be darkening over the capital markets,UBS Chief U.S. Economist Maury Harris places the probability of a recession atjust 20%. As further outlined in the “Scenario Analysis” section, we do notbelieve that the preconditions of a downturn are currently in place.A Severe Credit Disruption Appears UnlikelyWhile it is possible that concerns surrounding the European sovereign debtsituation and/or S&P’s recent downgrade of U.S. debt could lead to a creditevent, we believe this remains unlikely.As illustrated by the TED spread (the difference between three month Treasuriesand LIBOR), there are few signs to date of stress in the U.S. inter-bank markets.This is in contrast to the tremendous strain experienced during the financialcrisis. Deterioration here could be swift, however, and is important to monitor. Exhibit 15: TED Spread 4.5 Funding markets show few signs of 4.0 strain 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 00 02 04 06 08 10Source: Federal Reserve, BBA, FactSet and UBSLikewise, the corporate credit environment has not deteriorated, as it did duringthe prior recession. This is evidenced by Baa bond spreads, which appear wellcontained, although they have been rising. Exhibit 16: Baa Bond Spreads 6 Corporate spreads remain well contained 5 4 3 2 00 02 04 06 08 10Source: Moody’s, Federal Reserve, FactSet and UBS UBS 13
  14. 14. US Equity Strategy 16 August 2011Traditional Recession Signals Have Not EmergedWhile it is conceivable that concerns over long-term global imbalances could Data is pointing to weak economicreduce demand to a level that leads to a contraction, this scenario is inconsistent growth – NOT a recessionwith history.We are particularly focused on economic data in three key areas for signs ofstability or further deterioration: (1) business activity; (2) employment; and(3) credit expansion. Recent readings in these areas are consistent with asubdued growth environment, but not recession.Business Activity: Decelerating, but not RecessionaryAs the exhibit below highlights, the most recent ISM manufacturing andservices sector reports point to a continued modest expansion. According toUBS economists, these combined scores are consistent with an economygrowing 1.8%. Exhibit 17: ISM Manufacturing & Non-Manufacturing >50 is Expansionary 60 ◄ ISM Non-Mfg Recent ISM readings are consistent with GDP growth of 1.8% 55 53.7 50 50.9 45 ◄ ISM Mfg 40 35 <50 is Contractionary 98 00 02 04 06 08 10Source: ISM, FactSet and UBSWhile economic data is extremely helpful in ascertaining the direction of the We cannot overemphasize theeconomy, we cannot overemphasize the importance of boots on the ground — importance of analyst insights atanalysts speaking to scores of line managers in every industry and region. At economic turning pointsthis time, the anecdotal evidence is consistent with slow growth and is bestdescribed as mixed: Amitabh Passi, Technology Analyst — Companies across the technology supply chain saw decelerating growth exiting the June quarter, with many reporting book-to-bill ratios at or just below 1. While companies are incrementally more cautious based on the financial and economic gyrations it does not yet appear many are seeing any major impact to their businesses day to day and the business environment appears more akin to a general softening than a major drop-off. Andy Cash, Chemicals Analyst — US-based chemical companies have experienced very, very strong gross profit improvement in the current cycle on volume and price. However, the pricing story has buoyed the gross profit more recently, and with volume slip-sliding away gross profit will very likely fall. The pricing story will collapse without the support of volume growth. Interestingly, the decline in volume has been across the globe. UBS 14
  15. 15. US Equity Strategy 16 August 2011 Henry Kirn, Machinery Analyst — Our rental survey continues to indicate improving business conditions and rental rates, corroborated by recent conference calls held by URI and RRR on August 5th and 8th, respectively. Both companies noted rental rates, volumes and utilization levels improved sequentially in July.Employment: No signs of Deterioration in Unemployment ClaimsEconomies don’t move in pretty sine waves and recessions don’t approachquietly. For this reason, it is important to focus on signposts that move rapidlyaround periods of economic change. Job conditions are such a signpost.Weekly jobless claims tend to rise and fall precipitously around recessions andrecoveries. Importantly, it is the direction of change rather than the level ofemployment that is most critical in this analysis. To date, we have not seensigns of deterioration in this important area. Exhibit 18: Weekly Unemployment Claims (4-Week Average) 700 Jobless claims spike around 600 recessions 500 400 4- 300 week avg. 200 405k 70 75 80 85 90 95 00 05 10Source: Department of Labor, FactSet and UBSLoan Volumes: Pointing to Continued GrowthSimilarly, commercial and industrial loan activity also tends to fall dramaticallyduring recessions due to a combination of falling loan demand and tighter creditstandards, as banks become fearful of accelerating loan losses. As Maury Harrispoints out with great regularity, this is a source of improvement in the economicpicture. Exhibit 19: C&I Loan Volumes 40 C&I loan volumes fall dramatically 30 during recessions 20 10 0 -10 -20 -30 73 77 81 85 89 93 97 01 05 09Source: Federal Reserve, Haver and UBS Note: 3-month moving average UBS 15
  16. 16. US Equity Strategy 16 August 2011Tug-of-WarWhile economic data and analyst expectations are not signaling a recession,capital markets seem to have a differing opinion.Typically, analysts’ projections are a function of incoming economic data aswell as guidance from management. With few signs of actual deterioration inthe economy and generally constructive, albeit cautious comments fromcompany managements, analysts have continued to ratchet their 12-monthforward earnings estimates higher.Stock multiples, by contrast, typically act in anticipation of longer-termevents/patterns. The exhibit below highlights this tug-of-war, with stockvaluations rolling while analyst estimates remain rosy. Exhibit 20: S&P 500 PE vs. NTM Bottom-Up Estimates 110 $109 15.0 Multiples have gotten crushed, while earnings estimates have remained 100 13.5 steady 90 12.0 Fwd P/E ► ◄ Fwd EPS ▼ 10.9x 80 10.5 70 9.0 Sep-09 Jan-10 May-10 Sep-10 Jan-11 May-11Source: S&P, Thomson Financial, FactSet and UBS UBS 16
  17. 17. US Equity Strategy 16 August 2011Scenario Analysis — Base Case, Grey & BlackSkiesThis exercise begins with a series of assumptions developed by our U.S.Economics Team, and are summarized below. Please note that additionalassumptions including global GDP growth, key global indicators and end-market demand are provided in Appendix A of this note. Exhibit 21: U.S. Economic Scenario AssumptionsPercent change, except where noted Base Case Grey Black Annual change Annual change Annual change 2010A 2011E 2012E 2010A 2011E 2012E 2010A 2011E 2012EReal GDP (Chain) 3.0 1.8 2.3 3.0 0.9 -1.0 3.0 0.8 -2.5 Personal consumption expenditures 2.0 2.3 2.1 2.0 1.5 -0.4 2.0 1.4 -1.2 Business fixed investment 4.4 7.1 7.9 4.4 4.4 -3.8 4.4 2.9 -12.5 Government purchases 0.7 -2.3 -0.4 0.7 -2.3 -1.7 0.7 -2.5 -3.5 Private final demand 1.5 2.7 2.8 1.5 2.1 0.1 1.5 2.0 -1.0 Real domestic purchases 3.4 1.7 2.5 3.4 0.6 -1.7 3.4 0.3 -3.9 Nominal GDP 4.2 3.8 4.1 4.2 2.9 0.4 4.2 2.6 -2.3Key business indicators FRB industrial production index 5.3 4.2 4.5 5.3 2.4 -2.3 5.3 1.9 -5.3 Capacity utilization rate (%, level) 74.5 77.5 80.9 74.5 76.2 74.3 74.5 75.8 71.7 Civilian unemployment rate (%, level) 9.6 8.9 8.6 9.6 9.3 10.5 9.6 9.5 11.7Saving rate (%, level) 5.3 5.0 4.7 5.3 5.5 6.3 5.3 5.6 7.8Global real output 4.3 3.4 3.8 4.3 2.9 1.9 4.3 2.4 0.0Source: Department of Commerce, Federal Reserve Board, Bureau of Labor Statistics, Treasury Department, and UBS estimatesBase CaseDespite dramatic moves in the financial markets, we believe modest economicgrowth remains the most likely outcome. In our Base Case, economic growth ismodest but positive. Real GDP grows 1.8% this year and 2.3% in 2012,weighed down in part by a decline in government spending.As discussed earlier, the July payrolls report and other data points such asjobless claims and the ISM employment measure, point to continuingimprovement in the labor market, albeit with slower momentum than in 1Q.Meanwhile, average hourly earnings growth accelerated from 2.3% y/y in Julyfrom 2.0% the prior month and consumers continue to spend despite weakconsumer confidence gauges. Nominal retail sales rose 0.5% in July while Mayand June were revised up. Based on this retail sales data, we estimate realconsumer spending beginning 3Q up at about a 1¾% annual rate, a decentacceleration from the flattish readings for 2Q.Additional rationale for our “no recession” base case can be summarized asfollows, (1) credit flows remain satisfactory; (2) lower oil price circuit breakersare ‘kicking in’; (3) home prices are tentatively stabilizing as rents rise; (4) jobquality recently has been improving; (5) the investing public owns rallyingbonds as well as retreating stocks; and (6) the Budget Control Act of 2011 isback-end loaded. UBS 17
  18. 18. US Equity Strategy 16 August 2011Grey SkiesOur Grey Skies recession assumes that the GDP decline matches the post-warrecession average of 2%. The recession begins in 3Q11 and lasts for fourquarters. The unemployment rate rises to a quarterly peak of 10.7% in 2Q12.There are several differences to the “normal” post-war recession. First, federalfiscal policy cannot fill in to the degree it has in past dips. On the other hand,already-depressed residential investment is also unlikely to plunge to the samedegree. (Also, there are limited export impacts from the mainly homegrowndisaster.) In short, the recession is a consumption-led downturn, with associatedinventory correction and some weakness in capex.We see two main reasons why this scenario may play out: (1) low momentumUS recovery is more vulnerable to weakening European economy; and (2) fiscalausterity/policy uncertainties generate extreme caution.Main Differences with Our Base CaseRelative to our baseline forecast, real GDP growth is a bit less than a pointweaker in 2011 and a bit more than 3 points weaker in 2012. In 2011, weakerconsumer spending accounts for almost all of the deterioration, with slowerinventory accumulation also contributing. Employment effects limit incomegrowth; and weaker confidence and negative wealth effects push the saving rateup. Business and residential investment also decline, but with smaller impactson overall spending.In 2012, the drag from a weaker household sector continues as does theinventory correction. Together they account for about 80% of the downgrade tototal growth. The spillover into investment spending is also somewhat greaterthan in 2011.Black SkiesThe Black Skies recession repeats the severity of the most recent recession, withabout a 4% cumulative decline in real GDP. In comparison to the Grey Skiesscenario, the drop in GDP is sharper and lasts longer — with average quarterlydeclines of 2.75% at an annual rate, beginning in 3Q11 and continuing for sixquarters. Consumption weakness spills to a greater degree into capex, residentialspending, and inventory cuts, and there is also a bit more federal spendingweakness. In the Black Skies simulation, the unemployment rate reaches 12.5%at the end of 2012.Data points to watch for signs of deterioration towards either of these recessionscenarios include jobless claims, bank lending, and our all-economy ISM index.We see the following reasons why this scenario may play out: (1) Grey Skiesrecession reasons discussed above; (2) plus potential contagion effects from aEuropean banking crisis on US credit conditions. UBS 18
  19. 19. US Equity Strategy 16 August 2011Main Differences with Our Base CaseRelative to our baseline forecast, real GDP is 1% lower in 2011 and almost 5%weaker in 2012. In 2011, consumption accounts for 60% of the downgrade andinventories another 30% — with investment spending making up a bit more ofthe cut to GDP than in the grey skies simulation. That relative weakness ininvestment is a function of greater credit market strains than in our baseline orGrey Skies scenarios.The larger difference occurs in 2012. Consumption declines account for abouthalf of the overall downgrade and inventories for another quarter. However, aplunge in business fixed investment figures more importantly (almost half of theoverall downgrade to 2012). Government spending is also a more noticeabledrag as budgets are strained. Residential investment, although plunging, is asmall enough share of the economy that the overall GDP effects are not too great. UBS 19
  20. 20. US Equity Strategy 16 August 2011Earnings DriversCorporate earnings tend to follow a similar pattern as the economy. The tablebelow summarizes changes in S&P 500 EPS over the past 6 recessions.Earnings, on average, have declined by 20% during these instances, which webelieve is a fair representation of what to expect under the Grey Skies scenariorecession. For our Black Skies scenario, we assume a contraction of 35%,similar to that witnessed in the 2008-09 recession. Exhibit 22: S&P 500 EPS in Past Recessions S&P 500 EPS 4-Qtr 4-Qtr % Earnings have fallen by 20% on averageYear Peak Trough Peak Trough change during recessions1970 3Q69 4Q70 5.89 5.13 -12.91974-75 3Q74 3Q75 9.11 7.65 -16.01981-82 4Q81 1Q83 15.36 12.42 -19.11990-91 3Q90 4Q91 23.80 20.34 -14.5 EPS declined by 35% during the2000-01 3Q00 1Q02 56.71 44.19 -22.1 2008-09 recession2008-09 4Q07* 3Q09 93.41* 60.14* -35.6Average 5.3 qtrs -20.1Source: S&P, FactSet, First Call, UBSNote: 2008-09 EPS of $93.41 and $60.14 adds back $8.85 and $9.30, respectively, to account for extraordinarywrite-offs taken by the Financials sectorRevenues Driven by Nominal GDPAs expected, U.S. GDP and S&P 500 revenue growth are highly correlated overtime. However, S&P 500 revenue is significantly more volatile than the broadereconomy due to exposure to non-U.S. markets, a heavier weighting towardcyclical sectors, and other structural differences.For every 1% increase in nominal U.S. GDP, S&P 500 revenues rise 2.8x, witha correlation of roughly 81%. Exhibit 23: S&P 500 Revenues vs. Nominal GDP 18% YoY ◄ Revenues YoY 8% Revenues move roughly 3% for every 12% 1% shift in nominal GDP 6% 5% 0% 2% -6% -12% -1% -18% GDP ► -24% -4% 00 01 02 03 04 05 06 07 08 09 10 11Source: BEA, Compustat, S&P, and UBS Note: Universe excludes Financials UBS 20
  21. 21. US Equity Strategy 16 August 2011Based on this relationship, we can calculate sales growth under our threescenarios. More specifically, we can adjust our base case for a degradation inGDP growth. The following table provides projections based on theseassumptions. Exhibit 24: Revenue Growth Scenarios Base Case Grey Black 2011E 2012E 2011E 2012E 2011E 2012E 2012 revenues would decline byReal GDP (YoY) 1.8 2.3 0.9 -1.0 0.8 -2.5 roughly 13% in a Black Skies recessionNominal GDP (YoY) 3.8 4.1 2.9 0.4 2.6 -2.3S&P 500 Rev Growth 7.8 5.6 5.0 -5.4 4.2 -13.0Source: UBSMargins Driven by Capacity UtilizationGenerally speaking, changes in margins primarily result from fixed costs beingspread over higher or lower volumes. Margins are particularly variable in morecapital intensive industries with cyclical demand, such as Industrials, Autos,Semiconductors, Materials and Energy. These types of companies are muchmore prevalent in the S&P 500 than in the broader economy.Historically, the best proxy for this has been capacity utilization. Whilerevenues gyrate with GDP on a quarterly basis, margins and capacity utilizationmove in large sweeping cycles. Exhibit 25: S&P 500 Operating Margins vs. Capacity Utilization 15% 14.8% 82 14.6% Margins move as a function of capacity Capacity utilization Utilization ► 78 74.5 13% 74 70 11% ◄ S&P 500 (ex-Finl.) 66 Operating Margins 9.8% 9% 62 00 01 02 03 04 05 06 07 08 09 10 11Source: Federal Reserve Board, Compustat, S&P, and UBS Note: Note universe excludes FinancialsUnder our base case, we believe that margins can drift higher even though theyare near peak levels. Our analysis shows that while margins are near priorhighs, input costs should not be an impediment given low unit labor costs. Exhibit 26: Operating Margin Scenarios Base Case Grey Black 2011E 2012E 2011E 2012E 2011E 2012ENominal GDP (YoY) 3.8 4.1 2.9 0.4 2.6 -2.3Capacity Utilization 77.5 80.9 76.2 74.3 75.8 71.7S&P 500 EBIT Margin 15.9 16.2 14.6 13.0 14.5 11.6Source: UBS UBS 21
  22. 22. US Equity Strategy 16 August 2011Valuations — The Long ViewAccording to our work, stock multiples tend to become anchored on a singlevaluation variable for prolonged periods of time. To some, a single variableapproach to stock valuation may seem a bit simplistic. However, asdemonstrated below, there is an impressive fit between a single key valuationmetric and stock multiples for prolonged periods of time that we call InvestmentRegimes.Disco Regime: Inflation the Key Driver of MultiplesIn the 70’s, earnings yields moved in almost perfect lock-step with inflationexpectations, largely ignoring other factors. More specifically, we found a tightcorrelation between CPI (lagged by 3 months) plus 2% and S&P 500 earningsyields. Exhibit 27: CPI and S&P 500 Earnings Yield 16 Stock multiples were anchored to 14 inflation expectations in the 1970s Earnings Yield  12 Inflation  10 8 6 4 70 72 74 76 78 80Source: Dept of Labor, Standard and Poor’s, First Call, FactSet and UBSNote: Inflation is represented as CPI + 2%, lagged three months.The Great Moderation: Interest Rates the Key Driver of MultiplesWith inflation whipped and GDP relatively benign from 1980-1999, the ‘FedModel’ ruled the day, with equity valuations marching in almost perfect lock-step with the nominal level of interest rates. Exhibit 28: 10-Year Treasury Yield and S&P 500 Earnings Yield 16 ◄ Earnings Yield 14 After Paul Volcker squashed inflation, nominal yields drove stock multiples 12 10 8 6 10-year Yield ▲ 4 82 84 86 88 90 92 94 96 98Source: Federal Reserve, S&P, FactSet and UBS UBS 22
  23. 23. US Equity Strategy 16 August 2011The Great Moderation resulted in tremendous economic prosperity in generaland in asset values in particular. Ultimately, however, the combination ofoverly accommodative monetary policy, low inflation, and a stable economy,drove excessive risk taking by investors.The Millennium Regime: Baa Yields the Key Driver of MultiplesFollowing the implosion of the TMT bubble, the market began to use a full costof capital, including credit spreads, as the primary discounting mechanism forfuture stock earnings. Exhibit 29: Baa Bond Yield and S&P 500 Earnings Yield P/E anchored to Recessionary Slower Growth 10 Bond Yields Fears 9 8 Earnings Yield ► 7 6 ▲ Baa Yield 5 04 05 06 07 08 09 10 11Source: Moody’s, S&P, First Call, FactSet, and UBSThe relationship between corporate bond yields and stock multiples began to From Nov 09 to June 11, stockbreak down in November 2009 — six months following the markets post-crisis multiples implied weaker long termlows. growthOur work indicates that between November 2009 – June 2011, investors beganto discount slower growth. More specifically, our model suggests that with amultiple of 12.4 at the end of June, the market was discounting one-third slower More recently, multiples are signalinglong-term growth. recessionThe more recent fall in multiples, however, is most likely the result of investordisbelief in analyst forecasts given their recessionary concerns. UBS 23
  24. 24. US Equity Strategy 16 August 2011Market TargetsBelow, we discuss our methodology for developing market price targets in our Our price target is based on our P/EBase Case, Grey, and Black Skies scenarios. Our price targets are based upon forecast applied to expected consensus(1) our estimate of forward consensus earnings at a certain point in time, estimatesmultiplied by (2) a projected forward P/E multiple.Importantly, our process takes into account both how sell-side analysts and buy-side investors normally behave around recessions.Analysts Underestimate Earnings DownsideThe bars in the exhibit below compare each quarter’s actual S&P 500 operatingearnings to bottom-up consensus earnings estimates one year prior. Asillustrated, analysts tend to do a relatively good job of projecting companyresults in the middle innings of the economic cycle. However, they tend tosignificantly underestimate the magnitude of earnings declines that typicallyoccur during recessions. Exhibit 30: Percent Error in S&P 500 Next-Twelve-Months Consensus Expectations 100% > 0 is Overestimation Analysts remain too optimistic in 80% recessions 60% 40% 20% 0% -20% < 0 is Underestimation 01 02 03 04 05 06 07 08 09 10 11Source: Thomson Financial, FactSet and UBS Note: Black bars indicate quarters during a recessionAs such, our process for projecting consensus earnings estimates consists of twosteps. First, we project actual earnings using our revenue and marginframeworks (see pages 20-21). Second, we assume that analysts will continue tounderestimate the amount of earnings decline during a recession.More specifically, we ‘gross up’ our actual earnings forecasts for the amountthat we believe analysts will underestimate actual results. For both our Grey andBlack Skies scenarios, we assume that analysts will miss actual earnings by anamount similar to the 2001 recession.As illustrated below, even in the 2001 relatively moderate economic downturn,analysts’ forward estimates were considerably higher than reported actuals — attimes differing by more than 30%. UBS 24
  25. 25. US Equity Strategy 16 August 2011 Exhibit 31: S&P 500 Next-Twelve-Months Consensus EPS vs. Actuals Consensus 70 Analyst expectations can be more than Actual 63 63 30% too high in a recession 61 60 58 58 60 56 57 55 54 52 53 50 48 48 45 45 46 44 40 30 4Q00 1Q01 2Q01 3Q01 4Q01 1Q02 2Q02 3Q02 4Q02Source: S&P, Thomson Financial, FactSet and UBSWe have chosen not to apply a level of underestimation that typically occurs insevere recessions, such as the recent 2008-09 recession caused by the financialcrisis, as we do not expect a similar level of write-downs, even in our BlackSkies analysis.Prices and Multiples Move Before EPS EstimatesIn determining multiples to apply to projected consensus earnings, we considerthe difference in reaction time between investors and analysts to turns ineconomic data.While analyst estimates tend to lag behind underlying fundamentals aroundrecessions, stock prices and multiples tend to trade with leading indicators. Putdifferently, investors tend to sell stocks at the first signs of a significantdownturn, and load up when early signs of a bottom in economic activityemerge.By way of example, this dynamic was easily seen coming out of the 2008-09recession. As illustrated below, stocks began to rally in late-2008 on early signsof an economic recovery. While this trend was interrupted following Lehman’sbankruptcy, P/E’s continued to expand while consensus earnings estimatestrended down until mid-2009. Exhibit 32: S&P 500 P/E vs. NTM Bottom-Up Estimates ◄ Fwd EPS ▼ 100 Stock prices and multiples move well 14.5 before estimate changes 90 13.0 80 11.5 70 Fwd P/E ► 60 10.0 May-08 Sep-08 Jan-09 May-09 Sep-09Source: S&P, Thomson Financial, FactSet and UBS UBS 25
  26. 26. US Equity Strategy 16 August 2011In developing our market targets, we assume that a similar dynamic will occur infuture recessions. More specifically, we assume that, in a recession, P/Emultiples will bottom roughly one quarter ahead of a trough in trailing fourquarters earnings growth.Market Targets in Base Case, Grey & Black SkiesThe following bullets detail our price targets under each of the three scenarios.Our market targets are based upon (1) our estimate of forward consensusearnings at a certain point in time, multiplied by (2) a projected forward PEmultiple. Base Case. Our base case S&P 500 year-end 2011 price target of 1,425 Current target: 1,425 remains unchanged. This is based upon our projected P/E at year-end of 12.6x applied to 2012 consensus operating EPS of $113. (We assume that 2012 consensus remains unchanged from now until December 31.) Grey Skies. In our Grey Skies scenario, we project that the S&P 500 would Grey Skies year-end target: 1,100 end 2011 at 1,100, applying a forward P/E of 11.7x to projected 2012 consensus of $94. In this scenario, we project that the S&P 500 would trough in 1Q12 at 1,000 applying a trough P/E of 11.0x to forward consensus earnings of $91. Black Skies. In our Black Skies scenario, we project that the S&P 500 Black Skies year-end target: 900 would end 2011 at 900, applying a forward P/E of 11.3x to projected 2012 consensus of $79. In this scenario, we project that the S&P 500 would trough in 3Q12 at 775 applying a trough P/E of 10.5x to forward consensus earnings of $74. Exhibit 33: S&P 500 Price, Earnings and Valuation EstimatesS&P 500 Price Level Base Case Change Grey Change Black Change Current (at 8/12/2011) 1179 1179 1179 2011 Year-End Target Price 1425 20.9% 1100 -6.7% 900 -23.7% Market Trough Target Price 1000 -15.2% 775 -34.2% Market Trough Date 1Q12E 3Q12EUBS - Operating EPS Base Case Growth Grey Growth Black Growth 2010 Actual 85 37.3% 85 37.3% 85 37.3% 2011 Estimate 99 16.2% 87 1.6% 85 -0.2% NTM Estimate 106 72 65 2012 Estimate 108 8.7% 74 -14.8% 60 -29.8% Market Trough Fwd Est. 78 64Consensus - Operating EPS Base Case Premium Grey Premium Black Premium 2011 Estimate (at 8/12/2011) 99 99 99 NTM Estimate (at 8/12/2011) 108 108 108 2012 Estimate (at 12/31/2011) 113 4.6% 94 26.9% 79 32.7% Market Trough Fwd Est. (1Y Prior) 91 16.3% 74 16.3%Forward P/E on Consensus Current Yr End Current Yr End Current Yr End on Consensus 2011 EPS 11.9x 11.9x 11.9x on NTM Consensus EPS 10.9x 10.9x 10.9x on Consensus 2012 EPS 10.4x 12.6x 12.6x 11.7x 14.8x 11.3x Market Trough Fwd P/E 11.0x 10.5xSource: S&P, Thomson Financial, Bloomberg, FactSet and UBS UBS 26
  27. 27. US Equity Strategy 16 August 2011Market LeadershipWhile investors would love to build a portfolio of undervalued stocks, withstrong global franchises, employing little financial leverage, and experiencingstrong upward revisions, in reality these and other investment characteristics fallin and out of favor throughout the investment cycle.To this purpose, we regularly monitor a variety of factors including Size,Valuation, Growth, Earnings Revisions, Volatility, and more, to ascertain theirbehavior under different market conditions. We have dubbed these “UBSReturn Drivers.” We calculate these factors on a sector neutral basis. Please seeAppendix B for details.In the exhibit below, we break the investment cycles into three distinct phases,with a focus on which investment characteristics and sectors lead at eachparticular stage. Exhibit 34: UBS Market Leadership Framework I. Early Phase II. Middle Phase III. Late Phase Each investment characteristic behaves differently throughout the cycle Earnings Fundamentals Op Leverage Valuation Volatility Quality Cyclicals Non-CyclicalsSource: UBS Early Phase: In the initial phases of the investment cycle, investors reward the most volatile and economically-sensitive companies, and cyclical sectors outperform. Middle Phase: During the middle innings, earnings fundamentals and valuations become more important to investors. At the sector level, cyclicals and non-cyclicals tend to perform in-line with one another. Late Phase: The investment cycle usually ends with a recession or a significant economic slowdown. In such environments, investors rotate toward quality characteristics and less cyclical stocks. UBS 27
  28. 28. US Equity Strategy 16 August 2011The stark difference between defensive and cyclical leadership is highlighted inthe exhibit below which shows the relative performance of these investmentcharacteristics. Exhibit 35: Performance of UBS Return Drivers Feb08 - Feb09 20.2 Feb09 - Feb10 Defensive Leadership Cyclical Leadership Defensive characteristics led the market during the 2008 recession 9.9 7.8 4.5 2.8 Cyclical characteristics led during the recovery -7.7 -7.0 -9.4 -9.6 -10.4 ROE Fwd Earn Op Price Price Op Fwd Earn ROE PE Rev Levg Vol Vol Levg PE RevSource: S&P, Compustat, Thomson Financial, Worldscope, FactSet and UBSLeadership Since February SlowdownIn contrast to the cyclical leadership during the S&P 500s bounce in 2010 and2011, the tone of the market has turned much more recessionary since February.As the exhibits below highlight, Early Phase characteristics have rolled over andLate Phase characteristics are once again leading. This would indicate that themarket is already discounting continued economic weakness. Exhibit 36: Price Volatility and Operating Leverage Return Drivers 4% 3-Month Moving Avg ◄ Op Levg 2% 0% -2% ◄ Price Vol -4% Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11Source: S&P, Compustat, Thomson Financial, Worldscope, FactSet and UBS UBS 28
  29. 29. US Equity Strategy 16 August 2011 Exhibit 37: ROE Return Driver 2% 3-Month Moving Avg Current market leadership is consistent 1% with a recession 0% -1% -2% ROE ► -3% -4% Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11Source: S&P, Compustat, Thomson Financial, Worldscope, FactSet and UBSUnder our Base Case we would expect more speculative stocks to lead themarket higher. For those that are convinced — as we are — that this outcome isthe most likely case, we recommend tilting portfolios toward Early Phasecharacteristics such as Volatility and Operating Leverage.In the event of a downturn, Late Phase characteristics such as ROE andDividend Yield should do well. Our colleagues David Jessop and Berry Cox,heads of Global and U.S. Quantitative Research, also highlight low debt-to-enterprise value, high free cash flow yield, and high ROIC as additionaldefensive characteristics. Details of their work can be found in Appendix C. UBS 29

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