Market strategy

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Market strategy

  1. 1. July 9, 2012 Market Strategy Macro & Portfolio Strategy Market Commentary/StrategyStifel 3Q12 Macro: 1,600 S&P 500 in 2012 on 2H GDP Traction & Policy MovesWe see 2H12 U.S. GDP recovery lifting the S&P 500 to 1,600 in 2H12 (P/E ~16x). Late secular bearmarkets move quickly and discourage trend following. The U.S. rebalancing borne of crisis is 3-4years ahead of the eurozone and China, enforcing a U.S. playbook. We believe self-preservationinstincts should soon take hold for overseas political & monetary institutions under rising duress,leading to a eurozone bank liability guarantee (collapsing spreads, ending capital flight) that is a backdoor to fiscal control (i.e., control of sovereign issuance via bank asset oversight), Chinastimulus/acceleration of the 5-year plan (bridging fixed investment vs. consumption, social spending),coordinated central bank monetary ease to offset fiscal austerity (if real), and political calculus thatforces fiscal cliff negotiation into Nov/Dec-12. We like Tech/Growth in a P/E expansion market, butexpect Financials to lead the S&P in 2012, ringing the late cycle bell at the top. S&P 500 as of 07/06/12: $1,354.68In Our ViewU.S. Equity Outlook [See pages 2-14]Rapid S&P lift to 1,600 by year-end, Tech & Financials lead, inevitable policy moves.Fiscal & Monetary Policy [See pages 15-22]Fed/Treasury “create” S&P EPS (hurting EPS quality), but policy outlasts skeptics.EU & China Transition Risk [See pages 23-26]ECB crisis blanket guarantee with supervision; China fiscal stimulus “Hail Mary” pass in 2H12.Housing & Labor Outlook [See pages 27-31]Payrolls to improve 2H12 as productivity cyclically peaked, construction up in 2H12/2013.Paper vs. Hard Assets [See pages 32-41]Policy-driven bounce later in 2012, but commodity economic profit tailwind has ended.Long-term Equity Outlook [See pages 42-47]Choppy 7%-9% equity return (price + dividends) 2012-2022E, too late to be a super-bear.Barry B. Bannister, CFA bbbannister@stifel.com (443) 224-1317Stifel Nicolaus Equity Trading Desk US: (800) 424-8870 Canada: (866) 752-4446Stifel Nicolaus 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 thisreport. Investors should consider this report as only a single factor in making their investment decision.All relevant disclosures and certifications appear on pages 48 - 49 of this report.
  2. 2. Market StrategyMacro & Portfolio Strategy July 9, 2012 U.S. Equity Outlook In our view: • We see 2H12 confidence in reflation (avoidance of deflation) lifting the S&P 500 to 1,600 in 2H12 led by Financials as well as Tech “duration” growth equity(1) at the expense of bond equivalent equities (Utilities, Communications). • The U.S. wrote the playbook for addressing the eurozone crisis, and overcoming their resistance to the U.S. prescription of coordinated fiscal and monetary policy response has been the challenge. • Inflation lowers P/E ratios, and deflation dims EPS, but navigating the extremes of inflation and deflation, which we see in 2H12, as well as loose monetary policy as the offset to fiscal tightening, is the sweet spot for equity we see. • We realize S&P EPS supported by the Treasury and Federal Reserve are of lower quality, but investor confidence that policy will be sustained could lift stocks and lower the Equity Risk premium, which is near 40-year highs. • We believe the top will be evident when Financials (note lending is late cycle in de-leveraging) beat the worst performing sector (probably Utilities, a bond proxy) by the “normal” ~45% gap between the best and worst groups. • If we are wrong in 2H12 it may be due to the Fed being out-gunned by deflation – a liquidity trap, or recession. We see that as a mid-decade, but secular bear markets require that we view the future as a series of short-term trades. • Commodity stocks may bounce on European euro-crisis confidence (stronger euro, weaker dollar) and Chinese stimulus, late 2012 events we expect, but we think commodity-related economic profit has peaked, so we are wary. • There is precedent for weakness overseas, domestic GDP traction, capital flows to the U.S., a surging dollar, U.S. P/E expansion, Europe struggling with currency union and cheaper fuel - it was the equity-friendly “late 1990s.” (1) Duration is a bond concept that applies to equities, measuring the sensitivity of price to a change in interest rates (in the case of equity, inflation/deflation as it affects the earnings yield, which is the inverse P/E ratio). Duration “Growth” stocks are low dividend payout, high unit growing (minimal reliance on pricing power), low asset intensity, high /well-protected margin (network effects, patents/copyrights) companies with above-average return on generally un-levered equity. Page 2
  3. 3. Market StrategyMacro & Portfolio Strategy July 9, 2012 Recapping our views at the end of each quarter in 2012: Our 1Q12 Outlook click favored the U.S., and targeted S&P 500 1,400 with mid-year deflation concerns. Jan-3, 2012 S&P 500 1,277.06 Our 2Q12 Outlook click harbored mid-2012 growth concerns, and noted the S&P 500 had little upside. Apr-2, 2012 S&P 500 1,419.04 On May 29 click we raised our 2012 S&P 500 view to 1,600 and a spring-loaded market remains our view. May 29, 2012 S&P 500 1,332.42 Page 3
  4. 4. Market StrategyMacro & Portfolio Strategy July 9, 2012 Some confidence in reflation (i.e., avoidance of deflation) is our 2H12 view, and much like 1Q12 (left table) we see this as a catalyst for Financials as well as Tech “duration(1)” growth equity to rise while bond equivalent equities (Utilities, Communications) lag. Alternatively, deflation produces the opposite outcome, as occurred in 2Q12 (right table), but we see a reversal of that in 3Q12. "Risk On" Reflation Confidence "Risk Off" Deflation Fear 1Q12 Relative Total Return 2Q12 Relative Total Return Relative Relative Total Return Total Return Electronics (Semis, aero/def., computing, telco eq.)…………………………………………………………………….. 10.9% Communications…..…………………………………………………. 15.2% Banks & Financial Services………………………………………………….…………………………………………………. 10.4% Utilities………………..…………………………………………………. 8.6% Consumer Durables……………………………………………………. 7.8% Health Technology………………………………………………….…………………………………………………. 6.8% Technology Services (Software, internet)…………………………………………………………………….. 3.4% Retail Trade…………………………………………………………………….. 5.6% Consumer Services (Media, restaurants, lodging)…………………………………………………………………. 3.1% Consumer Non-Durables…………………………………………………………………. 5.6% Producer Manufacturing…………………………………………………………………….. 2.9% Transportation……………………………………………………………………………. 5.4% Process Industries (Chemical, ag, paper)………………………………………… Consumer Services (Media, restaurants, lodging)…………………………………………………………………. 2.9% 3.2% Health Services………………………..…………………………………………………. 2.6% Health Services………………………..…………………………………………………. -0.5% 3Q12 Retail Trade…………………………………………………………………….. 0.6% Process Industries (Chemical, ag, paper)………………………………………… -0.8% Distribution Services…………………………………………………………………….. -1.8% Distribution Services…………………………………………………………………….. Commercial Svcs (Finl. pub., personnel, advertising)…………………………………………………………………….. -2.4% Energy Minerals……………………..…………………………………………………. -0.9% -1.4% view Health Technology………………………………………………….………………………………………………….pub., personnel, advertising)…………………………………………………………………….. -3.0% Commercial Svcs (Finl. -2.5% Consumer Non-Durables…………………………………………………………………. -5.4% Producer Manufacturing…………………………………………………………………….. -2.9% Transportation……………………………………………………………………………. -5.6% Technology Services (Software, internet)…………………………………………………………………….. -3.3% Non-Energy Minerals…………………………………………………… -7.4% Industrial Services (Oil svc./equip., E&C, pipelines)……….. -5.0% Industrial Services (Oil svc./equip., E&C, pipelines)……………………………….. -7.6% Electronics (Semis, aero/def., computing, telco eq.)…………………………………………………………………….. -5.6% Communications…..…………………………………………………………. -9.1% Non-Energy Minerals…………………………………………………… -5.9% Energy Minerals……………………..…………………………………………………. Banks & Financial Services………………………………………………….…………………………………………………. -9.6% -7.0% Utilities………………..………………………………………………………….. -13.9% Consumer Durables……………………………………………………. -8.6% --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- KEY: CORE GROUPS TRADING GROUPS Core favored groups in "sweet spot" that avoids both the "Value" trade for alternating reflation/deflation sentiment deflation and inflation extremes, i.e. long duration equity Bond equivalents, representing "Deflation" and "Risk-Off" Source: Factset, Stifel annotations. Relative returns are measured against S&P 500, including dividends. (1) Duration is a bond concept that applies to equities, measuring the sensitivity of price to a change in interest rates (in the case of equity, inflation/deflation as it affects the earnings yield, which is the inverse P/E ratio). Duration “Growth” stocks are low dividend payout, high unit growing (minimal reliance on pricing power), low asset intensity, high /well-protected margin (network effects, patents/copyrights) companies with above-average return on generally un-levered equity. Page 4
  5. 5. Market StrategyMacro & Portfolio Strategy July 9, 2012 This is the 4th “Secular Bear Market” the past century (left chart), each of which de-capitalized equity as a percentage of GDP from elevated starting points (1907, 1929, 1968, 2000). Within secular bear markets there are rough “stages” of investor psychology (right chart), and we see a “Late Bull” momentum phase and rally to 1,600 (only slightly higher than the 2007 and 2000 peaks). Phases of a Secular Bear Market - The S&P 500 (1,362 as of 06/29/12) Late Bull Early Late Bear Early Nominal S&P 500 (S&P Composite before the existence of the Late Bull Bear Market Bull Mature Bull Bull Market Bull Mature Bull 10,000 S&P 500) - Chart is through June 2012 Momentum Defensive Oversold Multiple Momentum Defensive Oversold Stocks 200dma Stocks crosses Est. 1600 1500 1,000 1400 2000 to Present 1300 Nominal S&P 500 1200 100 1100 1968 to 1982 1000 900 10 800 1907 to 1921 1929 to 1949 700 1 600 06/01/98 12/01/98 06/01/99 12/01/99 06/01/00 12/01/00 06/01/01 12/01/01 06/01/02 12/01/02 06/01/03 12/01/03 06/01/04 12/01/04 06/01/05 12/01/05 06/01/06 12/01/06 06/01/07 12/01/07 06/01/08 12/01/08 06/01/09 12/01/09 06/01/10 12/01/10 06/01/11 12/01/11 06/01/12 1895 1900 1905 1910 1915 1920 1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Source: Stifel Nicolaus estimates, Standard & Poors, Factset prices. Page 5
  6. 6. Market StrategyMacro & Portfolio Strategy July 9, 2012 We believe slowing S&P 500 EPS is embedded in economic data (left chart), and the Equity Risk Premium falling from 5.2% to 3.5% achieves our 1,600 S&P 500 in 2012 price target (right chart). S&P 500 forward EPS consensus ~$109 (the A 2012E S&P 500 P/E ~16X (6.25% avg. of 2012-13E) already embeds a sharply Earnings Yield) and 10Y ~2.75% would slowing Durable Goods y/y percent change. narrow the Equity Risk Premium to 3.5%. S&P 500 Operating Earnings (Left Axis) vs. S&P 500 Earnings Yield minus 10-Yr. Risk Free U.S. Government Durable Goods New Orders (Right Axis), 16.0% Bond Yield... Y/Y % Changes, Jan-93 to Present 15.0% 14.0% 50% 40% 13.0% 12.0% Truncated 11.0% 40% at 50% 30% 10.0% earnings 9.0% growth 8.0% 30% 7.0% 20% X 6.0% 5.0% 20% 4.0% 10% 3.0% X 2.0% 10% 1.0% 0% 0.0% 0% 7.0% ...Equals the Equity Risk Premium -10% 6.0% -10% S&P 5.0% Consensus 4.0% Ests. -20% -20% $103.75 12E 3.0% $114.28 13E 2.0% -30% 1.0% -30% 0.0% S&P 500 Operating Earnings -40% -40% -1.0% Durable Goods: New Orders, y/y % 3 -2.0% -50% mo. avg. -50% -3.0% -4.0% Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 -5.0% Jan-62 Jan-64 Jan-66 Jan-68 Jan-70 Jan-72 Jan-74 Jan-76 Jan-78 Jan-80 Jan-82 Jan-84 Jan-86 Jan-88 Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12 Source: FactSet Prices, Moody’s Economy.com data, Stifel Nicolaus format Page 6
  7. 7. Market StrategyMacro & Portfolio Strategy July 9, 2012 Inflation lowers P/E ratios, and deflation dims EPS, but navigating the extremes of inflation and deflation, which we see in 2H12, may be a sweet spot for equity at ~2% CPI inflation. We see ~2% inflation and a P/E ~17x applied to 2012 quality-adjusted EPS view of ~$95, or 1,600 for the S&P. Note this is a P/E of only ~14.7x the (albeit falling) consensus ~$109 avg. EPS in 2012-13E. U.S. Consumer Price Inflation (Inverted, Right Median % of months S&P P/E ratio since Jan-1870 Axis) vs. S&P 500 P/E Ratio (Left Axis), 100 Years at that level in that range of An S&P 500 5-year average P/E of 17x is applicable (Deflation)/ of deflation/ (Deflation)/ 28X to ~2% annual inflation. -7.0% Inflation inflation Inflation 27X -6.0% 26X -5.0% 25X Post-war deflation is (10.0)% + 14.1x 3.5% 24X destructive to EPS, leading -4.0% (9.0)%-(9.9)% 14.0x 1.5% 23X to higher P/E ratios -3.0% 22X (8.0)%-(8.9)% 16.6x 1.1% -2.0% 21X -1.0% (7.0)%-(7.9)% 13.1x 1.3% 20X (6.0)%-(6.9)% 12.8x 1.6% 0.0% 19X (5.0)%-(5.9)% 13.8x 2.6% 18X 1.0% 17X 2.0% (4.0)%-(4.9)% 15.6x 2.2% 16X 3.0% (3.0)%-(3.9)% 14.7x 1.4% 15X 4.0% (2.0)%-(2.9)% 14.8x 2.9% 14X (1.0)%-(1.9)% 14.8x 3.6% 13X 5.0% 12X 6.0% (0.1)%-(0.9)% 12.5x 2.6% 11X 7.0% 0.0% 14.9x 3.6% 10X 8.0% 0.1%-0.9% 12.6x 3.3% 9X W.W. II Cold 9.0% 1.0%-1.9% 17.1x 13.0% Optimal P/E at 8X 7X War 10.0% 2.0%-2.9% 17.2x 13.0% inflation ~2% 6X 11.0% 3.0%-3.9% 15.9x 12.2% 5X 12.0% 4X 4.0%-4.9% 15.1x 6.5% Wartime inflation is destructive to P/E ratios 13.0% 3X 5.0%-5.9% 15.0x 4.3% (but not EPS), leading to lower P/E ratios. 14.0% 2X 6.0%-6.9% 11.3x 4.0% 1X W.W. I 15.0% 7.0%-7.9% 12.0x 2.7% 0X 16.0% 8.0%-8.9% 11.8x 1.7% 1911 1916 1921 1926 1931 1936 1941 1946 1951 1956 1961 1966 1971 1976 1981 1986 1991 1996 2001 2006 2011 9.0%-9.9% 9.2x 2.2% >10.0% 9.0x 9.1% P/E of the S&P 500, 5-Yr. Moving Avg. (Left) 100.0% U.S. CPI Inflation, Y/Y % Chng., 5-Yr. Moving Avg. (Right, INVERTED) Source: Robert J. Shiller data www.econ.yale.edu and Standard & Poor’s price and EPS data. U.S. Census and BLS inflation data. The chart above, left is the period 1911 to 2011 expressed as annual averages, rolling 5 year basis, and the table above, right is the period since January 1870 based on monthly data. Page 7
  8. 8. Market StrategyMacro & Portfolio Strategy July 9, 2012 We realize S&P 500 EPS supported by the Treasury (left chart) and Federal Reserve (right chart) are of lower quality, but investor confidence that policy will be sustained could lift stocks, in our view. Weak housing (a part of “Net Investment” below) has Fed commitment to a negative real Fed Funds (Fed been offset by deficits that “prop-up” GDP. Funds minus y/y inflation) has boosted margins(1). Reduced "Investment" spending (i.e., housing) Real Fed Funds Rate (FFR), Advanced 5 Qtrs (Red, led to large deficits to support GDP Right) vs. Corporate Profit Margins (Blue, Left) 14% 23% -4% 1985 - Current 22% 12% We think margins are -3% ~500bps elevated, but 21% 10% margins and S&P returns -2% are not well correlated. 20% 8% -1% INVERTED AXIS 19% 6% 0% 18% % of GDP 4% 17% 1% 2% 16% 2% 0% 15% 3% -2% 14% 4% 13% -4% 5% 12% -6% Corporate Profit Margins (Left) 6% 1Q1947 1Q1951 1Q1955 1Q1959 1Q1963 1Q1967 1Q1971 1Q1975 1Q1979 1Q1983 1Q1987 1Q1991 1Q1995 1Q1999 1Q2003 1Q2007 1Q2011 11% Real Fed Funds Rate (Inverted, Right) 10% 7% 1Q1985 1Q1987 1Q1989 1Q1991 1Q1993 1Q1995 1Q1997 1Q1999 1Q2001 1Q2003 1Q2005 1Q2007 1Q2009 1Q2011 1Q2013 Net Private Investment Net Govt Saving/(Deficits if >0%) Source: BEA, BLS, NIPA Flow of Funds, U.S. Fed. Corporate margin is pretax corporate profits (adj. for IVA & CCA) as % of gross value added by corporations. (1) A negative real FFR boosts export competitiveness, translation gains, margins (if U.S. firms don’t pass through currency gains) and shifting wealth from creditors to debtors. Page 8
  9. 9. Market StrategyMacro & Portfolio Strategy July 9, 2012 Our Financial stock rally call is really just hurdling low market expectations. Lagging bank stocks and the falling 10Y yield (left chart) have been the same trade – deflation worries. Since lending is “late cycle” in a private sector de-leveraging we believe Financials may bring up the rear for the S&P 500 (right chart). Longer term, we agree that banks face over-capacity, private sector de- leveraging (deflation), over-regulation, lower leveraged returns, derivatives exposure to overseas and tighter spreads due to Fed policy. But that is the long term, and we are just looking at a trade. US Major and Regional Banks Relative to S&P500, Total Return (Black, Left) vs. US Constant Maturity 10-Yr S&P 500 vs. S&P 500 Ex-Financials (Rebased), Treasury Yields (Red, Right), Jan-06 to present Jan-2007 to Present $2,000 100.0 5.40% $1,900 95.0 Banks Relative to $1,800 S&P500 (Left) 4.90% 90.0 U.S. 10-Yr. Treasury $1,700 Yield (Right) 85.0 4.40% $1,600 80.0 QE1 $1,500 QE2 3.90% 75.0 $1,400 $1,300 70.0 3.40% GDP traction $1,200 65.0 + Fed policy 2.90% $1,100 60.0 ~2.75% X $1,000 10Y? 55.0 2.40% $900 50.0 Nov. 25, 2008 Fed Aug. 26,2010 $800 1.90% announces asset Jackson Hole S&P 500 45.0 purchase plans, $700 Fed QE2 hint. doubles up Mar-09. S&P Ex-Financials (Rebased) 40.0 1.40% $600 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jul-06 Jul-07 Jul-08 Jul-09 Jul-10 Jul-11 Jul-12 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 May-07 May-08 May-09 May-10 May-11 May-12 Sep-07 Sep-08 Sep-09 Sep-10 Sep-11 Sep-12 Source: Bloomberg, Factset data, Stifel Nicolaus format. Page 9
  10. 10. Market StrategyMacro & Portfolio Strategy July 9, 2012 We think the S&P 500 “top” at ~1,600 will occur when Financials beat the worst performing sector (probably Utilities, a bond proxy) by the “standard” 40%-50% gap (left chart). S&P 500 profits have shifted from Financials to Technology since the secular bear market began in 2000, accelerated by the 2008-09 crisis (right chart). Our expectation is that Technology-as-growth will be re-rated upward concurrent with Financials bouncing in relief due to the avoidance (for now) of deflation. Annual gap: best minus worst S&P sector % of S&P 500 Income from Continuing prof it Operations by Sector Other than crisis years, the gap is usually ~40%-50% 100% Utilities 150% 140% 90% Telecom. Tech Services 130% 80% larger Materials 120% 110% 70% Info. Tech. 100% 60% 90% Industrials 80% 50% Health Care 70% Finance 60% 40% smaller Financials 50% 30% Energy 40% 30% 20% Consumer 20% Staples 10% 10% Consumer Discretionary 0% 0% 2011 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 1Q00 4Q00 3Q01 2Q02 1Q03 4Q03 3Q04 2Q05 1Q06 4Q06 3Q07 2Q08 1Q09 4Q09 3Q10 2Q11 1Q12 Source: Stifel Nicolaus chart, Factset prices. Dip in the right chart is due to Finance sector sustaining large operating losses in the aggregate 2008-09. Page 10

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