October 23 2009 pe: Portfolio Strategy The phases can be interpreted in relationship to the economy The phases are clearly linked to the economy. this allows for a clearer interpretation of the phases and helps in identifying when we are moving from one phase to the next. The output gap falls in the Despair and Hope phase as output falls behind potential. The trough occurs between the middle and the end of the Hope Phase. In the growth Phase the We measure investors' forward-looking return requirements in terms of the Real Required Return(RRR)defined as the equity Risk Premium plus the 10 year nominal bond yield minus five year historical average inflation. this measure generally increases in the Despair and growth phases and decreases in the Hope and optimism phases. We interpret these movements in investors' forward-looking return requirements across the phases as follows During the Despair phase, investors get increasingly concerned about future prospects, and therefore require an increasingly high future expected return for holding equities. this reaction happens against a backdrop of an increase in volatility an increase in the output gap and in four out of five cycles the start of a recession during this phase in the US. This leads to lower P/E multiples and a falling market. In the Hope phase, an end to the crisis starts to be visible and this visibility caps the potential downside risk Investors respond to the lower tail risk by accepting lower future expected returns. This drives up multiples and the market. While volatility is still high, it tends to fall towards the end of the Hope phase. In this phase investors essentially prepay for the expected recovery in earnings during the growth phase In the beginning of the growth phase, investors have been through a period with high volatility. This is likely to make investors perceive equities as more risky and therefore less attractive. Investors have also already been paid for expected future earnings growth during the Hope phase, but the growth has yet to materialize. The output gap typically peaks some time during the Hope phase, but remains very high at the beginning of the growth phase. the onset of the growth phase is therefore a reasonable point in time for investors to question long- run growth expectations. These initial negatives tend to make investors less willing to pay for the earnings growth they see in the early stages of the growth phase. this gives lower rates of return, which reinforces the negative picture of equities and makes investors less willing to pay for the improvements in fundamentals that they see on an ongoing basis. The result is that value in terms of expected future returns are rebuilt during the Growth phase as earnings growth outpaces returns, and volatility declines Another likely driver of the higher real return requirements in the equity market that are built up during this phase is the increase in the real yield which is seen in bond Eventually, in the Optimism phase, the built-up value becomes large enough to attract investors and to reverse the dynamic of poor returns keeping away investors despite strengthening fundamentals In the Optimism phase, returns outpace earnings and expected future returns consequently decline. Towards the end of the phase volatility picks up as the sustainability of the high returns are being tested by the market. In the next sections we develop these conclusions in more detail. First we show how investors pay for most of the earnings growth before it occurs in the hope phase and after it occurs in the Optimism phase. We then cover each cycle in detail, showing the cut-offs we have chosen for the phases, and the performance of earnings growth and multiple expansion for the two markets(Europe ex UK and the UK)that we consider. We also oldman Sachs Global Economics, Commodities and strategy Research
October 23, 2009 Europe: Portfolio Strategy Goldman Sachs Global Economics, Commodities and Strategy Research 5 The phases can be interpreted in relationship to the economy The phases are clearly linked to the economy. This allows for a clearer interpretation of the phases and helps in identifying when we are moving from one phase to the next. The output gap falls in the Despair and Hope phase as output falls behind potential. The trough occurs between the middle and the end of the Hope Phase. In the Growth Phase the output gap increases as actual output growth outpaces potential growth. We measure investors’ forward-looking return requirements in terms of the Real Required Return (RRR) defined as the Equity Risk Premium plus the 10 year nominal bond yield minus five year historical average inflation. This measure generally increases in the Despair and Growth phases and decreases in the Hope and Optimism phases. We interpret these movements in investors’ forward-looking return requirements across the phases as follows: • During the Despair phase, investors get increasingly concerned about future prospects, and therefore require an increasingly high future expected return for holding equities. This reaction happens against a backdrop of an increase in volatility, an increase in the output gap and in four out of five cycles the start of a recession during this phase in the US. This leads to lower P/E multiples and a falling market. • In the Hope phase, an end to the crisis starts to be visible and this visibility caps the potential downside risk. Investors respond to the lower tail risk by accepting lower future expected returns. This drives up multiples and the market. While volatility is still high, it tends to fall towards the end of the Hope phase. In this phase investors essentially prepay for the expected recovery in earnings during the Growth phase. • In the beginning of the Growth phase, investors have been through a period with high volatility. This is likely to make investors perceive equities as more risky and therefore less attractive. Investors have also already been paid for expected future earnings growth during the Hope phase, but the growth has yet to materialize. The output gap typically peaks some time during the Hope phase, but remains very high at the beginning of the Growth phase. The onset of the Growth phase is therefore a reasonable point in time for investors to question long-run growth expectations. These initial negatives tend to make investors less willing to pay for the earnings growth they see in the early stages of the Growth phase. This gives lower rates of return, which reinforces the negative picture of equities and makes investors less willing to pay for the improvements in fundamentals that they see on an ongoing basis. The result is that value in terms of expected future returns are rebuilt during the Growth phase as earnings growth outpaces returns, and volatility declines. Another likely driver of the higher real return requirements in the equity market that are built up during this phase is the increase in the real yield which is seen in bond markets. • Eventually, in the Optimism phase, the built-up value becomes large enough to attract investors and to reverse the dynamic of poor returns keeping away investors despite strengthening fundamentals. In the Optimism phase, returns outpace earnings and expected future returns consequently decline. Towards the end of the phase volatility picks up as the sustainability of the high returns are being tested by the market. In the next sections we develop these conclusions in more detail. First we show how investors pay for most of the earnings growth before it occurs in the Hope phase and after it occurs in the Optimism phase. We then cover each cycle in detail, showing the cut-offs we have chosen for the phases, and the performance of earnings growth and multiple expansion for the two markets (Europe ex UK and the UK) that we consider. We also
October 23 2009 Europe: Portfolio Strategy provide data on the Us for illustrative purposes only. this allows us to test the robustness ur conclusions by showing that they are not driven by a Europe-specific factor or the lower frequency of earnings reports in Europe. Finally, we provide a more in depth analysis of the economic backdrop for the phases and, in an appendix, show how key economic variables have moved for each cycle Most earnings growth is not paid for when it occurs In this section we aggregate the earnings growth and price return performance for each phase across the five cycles. there are three key conclusions: The highest annualized returns occur during the Hope phase, followed by the Optimism phase, the growth phase and finally the Despair phase. This has been true in every cycle in the US and holds in all regions on average Actual profit growth and returns are surprisingly unsynchronized. Almost the entire earnings growth for each region occurs during the growth phase, yet only 28%, 3%and% of the index real price return from the trough to the peak of the market accumulates during that phase, for Europe ex. UK, the UK and the Us respectively It is not surprising that the market rises in expectation of future earnings growth and that a part of the earnings growth in the growth phase is therefore paid for during Hope phase. But the degree to which this happens is surprising, leaving negative returns on average for the growth phase in the US market, where the quarterly reporting of earnings allows us to make the most precise cut-off between the historical Real interest rates recover in the growth phase in the Us In every cycle since 1973 the largest increase in the real interest rate occurred during the growth phase. In total across the five cycles, the real interest rate increased 10.2 percentage points during the Growth phase. In Europe the pattern has been much less clear. We believe this is partly due to the lower frequency of earnings data making the changes between phases less clear, and partly due to European equities pricing the Us The data are given in Exhibits 3-5. The aggregate section of each Exhibit shows the cumulative real price return, real earnings growth and P/E expansion these are calculated by looking at the compound growth in each of the metrics over the 5 times each phase has occurred between the market peak in 1973 and the market peak in 2007. As an example, Exhibit 3 shows that an investor, who invested in Europe ex UK from the beginning to the end of each Despair phase and earned a zero return in all other phases would have earned a compounded real return of -95%, and have owned the index during periods of time where the compound real earnings growth(on an LTM basis)was-56% The proportion of return line shows how much of the compound return from the trough the peak of the five cycles was earned in the Hope growth and Optimism phases respectively. Finally, the change in real interest rate line shows the sum over the five cycles, of the change in real interest rate from the beginning to the end of each phase. Some of these figures are then annualized in the lower section of the tables oldman Sachs Global Economics, Commodities and strategy Research
October 23, 2009 Europe: Portfolio Strategy Goldman Sachs Global Economics, Commodities and Strategy Research 6 provide data on the US for illustrative purposes only. This allows us to test the robustness of our conclusions by showing that they are not driven by a Europe-specific factor or the lower frequency of earnings reports in Europe. Finally, we provide a more in depth analysis of the economic backdrop for the phases and, in an appendix, show how key economic variables have moved for each cycle. Most earnings growth is not paid for when it occurs In this section we aggregate the earnings growth and price return performance for each phase across the five cycles. There are three key conclusions: • The highest annualized returns occur during the Hope phase, followed by the Optimism phase, the Growth phase and finally the Despair phase. This has been true in every cycle in the US and holds in all regions on average. • Actual profit growth and returns are surprisingly unsynchronized. Almost the entire earnings growth for each region occurs during the growth phase, yet only 28%, 3% and -1% of the index real price return from the trough to the peak of the market accumulates during that phase, for Europe ex. UK, the UK and the US respectively. It is not surprising that the market rises in expectation of future earnings growth and that a part of the earnings growth in the Growth phase is therefore paid for during the Hope phase. But the degree to which this happens is surprising, leaving negative returns on average for the Growth phase in the US market, where the quarterly reporting of earnings allows us to make the most precise cut-off between the historical phases. • Real interest rates recover in the Growth phase in the US. In every cycle since 1973 the largest increase in the real interest rate occurred during the Growth phase. In total across the five cycles, the real interest rate increased 10.2 percentage points during the Growth phase. In Europe the pattern has been much less clear. We believe this is partly due to the lower frequency of earnings data making the changes between phases less clear, and partly due to European equities pricing the US economic cycle to some extent. The data are given in Exhibits 3-5. The aggregate section of each Exhibit shows the cumulative real price return, real earnings growth and P/E expansion. These are calculated by looking at the compound growth in each of the metrics over the 5 times each phase has occurred between the market peak in 1973 and the market peak in 2007. As an example, Exhibit 3 shows that an investor, who invested in Europe ex UK from the beginning to the end of each Despair phase and earned a zero return in all other phases, would have earned a compounded real return of -95%, and have owned the index during periods of time where the compound real earnings growth (on an LTM basis) was -56%. The proportion of return line shows how much of the compound return from the trough to the peak of the five cycles was earned in the Hope, Growth and Optimism phases respectively. Finally, the change in real interest rate line shows the sum over the five cycles, of the change in real interest rate from the beginning to the end of each phase. Some of these figures are then annualized in the lower section of the tables
October 23 2009 pe: Portfolio Strategy Exhibit 3: Decomposition of Europe ex UK equity market performance over the cycle Despair Hope Growth Optimist Average length(months 14.3 emulative Real Price Return -95.3 453.0 316.0 55.8 2.8 14.6 P/E expansion 89.5 438.2 74.0 263.0 Proportion of Retum(% 42.2 28.4 Change in real interest rate 222 Real Price Return(%) 24.9 51.2 0.9 27.1 Real Earnings Growth 22.5 .3 Change in real interest rate(pp) 1.1 0.9 Source: Worldscope, Haver Analytics, Datastream, Goldman Sachs Global ECS Research Exhibit 4: Decomposition of UK equity market performance over the cycle Despair Hope Growth Optimism ge length(months) 17.1 emulative Real Price Return (% 96.2 40.4 7.1 P/E expansion -95.513273 82.2 381.8 Proportion of return (%) 37.9 Change in real interest rates(pp 352 3.0 28.0 Real Eamings Growth Change in real interest rates (pp) 2. 0.3 0.0 Source: Worldscope, Haver Analytics, Datastream, Goldman Sachs Global ECS Research. Exhibit 5: Decomposition of Us equity market performance over the cycl Despair Hope Growth Optimism ngth(months) Real Price Return 2.9 392.3 16.1 836.6 Real Eamings Growth 41.5 92.8 84.5 Proportion of return(%) 32.3 13 69.0 Change in real interest rates(pp) 2 10.2 Real Price Return(%) 32.9 50.9 1.2 eal Earnings Growth .2 hange in real interest rates(pp) -0.3 oldman Sachs Global Economics, Commodities and strategy Research
October 23, 2009 Europe: Portfolio Strategy Goldman Sachs Global Economics, Commodities and Strategy Research 7 Exhibit 3: Decomposition of Europe ex UK equity market performance over the cycle Despair Hope Growth Optimism Average length (months) 25.7 9.9 32.5 14.3 Cumulative Real Price Return (%) -95.3 453.0 304.8 316.0 Real Earnings Growth -55.8 2.8 1456.1 14.6 P/E expansion -89.5 438.2 -74.0 263.0 Proportion of Return (%) 42.2 28.4 29.4 Change in real interest rate (pp) -2.2 -4.5 -0.1 5.1 Annualized Real Price Return (%) -24.9 51.2 10.9 27.1 Real Earnings Growth -7.3 0.7 22.5 2.3 Change in real interest rate (pp) -0.2 -1.1 0.0 0.9 Source: Worldscope, Haver Analytics, Datastream, Goldman Sachs Global ECS Research. Exhibit 4: Decomposition of UK equity market performance over the cycle Despair Hope Growth Optimism Average length (months) 21.4 17.1 27.5 16.7 Cumulative Real Price Return (%) -96.2 716.7 40.4 461.3 Real Earnings Growth -17.1 -42.8 687.5 16.5 P/E expansion -95.5 1327.3 -82.2 381.8 Proportion of return (%) 58.8 3.3 37.9 Change in real interest rates (pp) 12.0 -15.7 3.4 0.1 Annualized Real Price Return (%) -30.8 34.3 3.0 28.0 Real Earnings Growth -2.1 -7.5 19.8 2.2 Change in real interest rates (pp) 1.3 -2.2 0.3 0.0 Source: Worldscope, Haver Analytics, Datastream, Goldman Sachs Global ECS Research. Exhibit 5: Decomposition of US equity market performance over the cycle Despair Hope Growth Optimism Average length (months) 15.9 9.3 34.1 24.1 Cumulative Real Price Return (%) -92.9 392.3 -16.1 836.6 Real Earnings Growth -1.4 -21.4 441.5 -17.5 P/E expansion -92.8 525.9 -84.5 1035.5 Proportion of return (%) 32.3 -1.3 69.0 Change in real interest rates (pp) -1.2 -5.0 10.2 -3.1 Annualized Real Price Return (%) -32.9 50.9 -1.2 24.9 Real Earnings Growth -0.2 -6.0 12.6 -1.9 Change in real interest rates (pp) -0.2 -1.3 0.7 -0.3 Source: Compustat, Haver Analytics, Datastream, Goldman Sachs Global ECS Research
October 23 2009 pe: Portfolio Strategy The 1970s cycle in charts: a tough cycle for equity markets The cycle in the 1970s was the worst of the five cycles we consider in Continental Europe, the UK and the Us from an equity market perspective. Multiple contraction over the cycle ranging from 42% in the UK to 52% in the US overpowered earnings growth ind led to negative price returns over the cycle for all three markets The poor market performance reflected the large supply-side shock from higher oil prices and the inflationary process initiated by this shock getting out of control Generally cycles where the initial setback is driven by structural problems tend to have longer growth phases than other cycles, as it takes longer for investors to regain the confidence that makes them willing to pay more for earnings and therefore move the market into the optimism phase. this is particularly pronounced in the US where the growth phase in the 1970s was the longest on record The end of the cycle includes the first part of the double dip recession in the early 1980s for the Us but not in Continental Europe and the UK. We have done this as the Us index recovered enough between the two dips to make up the lost ground from the first dip whereas this did not happen in Europe Exhibit 6: Division of the 1970s cycle into phases for Europe ex UK Europe ex UK Cumulative Change -Despair- Grow th. 100 80 Mar-73 Mar-74 Mar-78 US Recessions -Returns End date07/101974150419751507/197720101978 Length(in months) 15.2 39 12.9 Eamings Growth 48.9 P/E expansion Proportion of return ( Annualized 38.5 Earnings Growth Change in real interest rate (pp) 1.0 Analytics,Datastream,Goldman Sachs Global ECS. Goldman Sachs Global Economics, Commodities and strategy Research
October 23, 2009 Europe: Portfolio Strategy Goldman Sachs Global Economics, Commodities and Strategy Research 8 The 1970s cycle in charts: A tough cycle for equity markets The cycle in the 1970s was the worst of the five cycles we consider in Continental Europe, the UK and the US from an equity market perspective. Multiple contraction over the cycle ranging from 42% in the UK to 52% in the US overpowered earnings growth and led to negative price returns over the cycle for all three markets. The poor market performance reflected the large supply-side shock from higher oil prices and the inflationary process initiated by this shock getting out of control. Generally cycles where the initial setback is driven by structural problems tend to have longer growth phases than other cycles, as it takes longer for investors to regain the confidence that makes them willing to pay more for earnings and therefore move the market into the optimism phase. This is particularly pronounced in the US where the growth phase in the 1970s was the longest on record. The end of the cycle includes the first part of the double dip recession in the early 1980s for the US but not in Continental Europe and the UK. We have done this as the US index recovered enough between the two dips to make up the lost ground from the first dip, whereas this did not happen in Europe. Exhibit 6: Division of the 1970s cycle into phases for Europe ex UK Europe ex UK 20 40 60 80 100 120 140 160 180 200 Mar-73 Mar-74 Mar-75 Mar-76 Mar-77 Mar-78 US Recessions Returns Earnings PE Cumulative Change <---------Despair------> <--------------Grow th-------------> <Hope> <-----Optimism-----> Despair Hope Growth Optimism Start date 22/03/1973 07/10/1974 15/04/1975 15/07/1977 End date 07/10/1974 15/04/1975 15/07/1977 20/10/1978 Length (in months) 18.5 6.2 27.0 15.2 Real Return -52.8 39.8 12.9 13.0 Real Earnings Growth 19.6 1.2 48.9 -8.8 P/E expansion -60.5 38.1 -24.1 23.9 Proportion of return (%) 60.5 19.7 19.8 Annualized Real Return -38.5 90.4 5.6 10.1 Earnings Growth 12.3 2.4 19.3 -7.0 Change in real interest rate (pp) 0.7 -2.0 -2.3 1.0 Source: Worldscope, Haver Analytics, Datastream, Goldman Sachs Global ECS Research
October 23 2009 pe: Portfolio Strategy Exhibit 7: Division of the 1970s cycle into phases for the UK and US United Kingdom emulative Change espair----------> <---Hope----> <------------Grow th----------> <--Optimsm--> 120 80 Jan -73 an-76 Jan -77 Jan-78 Jan-79 Earnings Despair Growth Start date10/01/19731212/197430/01/197609031978 End date12/12/197430/01/1976o9/03/19780405/1979 Real Ret 122.8 25.7 P/E expansion 310.3 -31.1 Proportion of return (% .5 66.6 25.4 armings Growth Change in real interest rate(pp) 5.6 22.1 0.9 United States Cumulative change Grow theas ><Optimism Jan-74 Jan-75 Jan-76 Jan77 Jan-78 Jan-79 Jan-80 US Recessions etu 03/1019741507/197527/03198020/11/1980 Length(n m he Real Eamings Growth 15.6 9 48.8 Proportion of return ( %6 90.4 59.7 -36.6 60.3 7.1 56.9 7 -0.2 Source: Worldscope, Compustat, Haver Analytics, Datastream, Goldman Sachs Global ECS Research. oldman Sachs Global Economics, Commodities and strategy Research
October 23, 2009 Europe: Portfolio Strategy Goldman Sachs Global Economics, Commodities and Strategy Research 9 Exhibit 7: Division of the 1970s cycle into phases for the UK and US United Kingdom 0 20 40 60 80 100 120 140 160 180 Jan-73 Jan-74 Jan-75 Jan-76 Jan-77 Jan-78 Jan-79 US Recessions Returns Earnings PE Cumulative Change <----------Despair----------> <-------------Grow th-----------> <----Hope----> <--Optimism--> Despair Hope Growth Optimism Start date 10/01/1973 12/12/1974 30/01/1976 09/03/1978 End date 12/12/1974 30/01/1976 09/03/1978 04/05/1979 Length (in months) 23.0 13.6 25.3 13.8 Real Return -76.0 122.8 -13.4 29.9 Real Earnings Growth 66.1 -45.7 25.7 -9.0 P/E expansion -85.6 310.3 -31.1 42.7 Proportion of return (%) 88.2 -9.6 21.5 Annualized Real Return -52.5 102.6 -6.6 25.4 Earnings Growth 30.2 -41.6 11.4 -7.8 Change in real interest rate (pp) 2.0 -5.6 -2.1 0.9 United States 20 40 60 80 100 120 140 160 Jan-73 Jan-74 Jan-75 Jan-76 Jan-77 Jan-78 Jan-79 Jan-80 -100 -90 -80 -70 -60 -50 -40 -30 -20 -10 0 US Recessions Returns Earnings PE Cumulative Change <-----Despair-----> <------------------------Grow th---------------------> <Hope> <Optimism> Despair Hope Growth Optimism Start date 11/01/1973 03/10/1974 15/07/1975 27/03/1980 End date 03/10/1974 15/07/1975 27/03/1980 20/11/1980 Length (in months) 20.7 9.4 56.4 7.8 Real Return -54.5 44.5 -29.4 34.2 Real Earnings Growth 21.4 -15.6 37.9 -8.1 P/E expansion -62.5 71.3 -48.8 46.0 Proportion of return (%) 90.4 -59.7 69.3 Annualized Real Return -36.6 60.3 -7.1 56.9 Earnings Growth 11.9 -19.5 7.1 -12.1 Change in real interest rate (pp) 0.7 -0.2 2.5 -0.9 Source: Worldscope, Compustat, Haver Analytics, Datastream, Goldman Sachs Global ECS Research